In order to maximize profits, firms must ensure that any given output level is produced at least cost and then select the price-output combination that results in total revenue exceeding total cost by the greatest amount possible. With this in mind, this second module of the Power of Markets course addresses how firms can most effectively convert inputs into final output and then covers determining the best price-output combination for a firm and how this varies depending on whether the firm is operating in a perfectly competitive or imperfectly competitive market setting.
The Long-run Industry Supply Curve
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En provenance du cours de University of Rochester
The Power of Markets II: Market Structure and Firm Behavior
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À partir de la leçon
Week 7 - Profit Maximization in Perfectly Competitive Markets
How Firms Maximize Profits in Perfectly Competitive Markets.
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Mark ZupanProfessor of Economics and Public Policy
Simon School of Business
Welcome back.
In the last session, we looked at how long
run competitive equilibrium gets established
in a perfectly competitive industry.
Now, we're going to turn to dealing with a subtlety, an important
one at that, as an overall competitive industry expands or shrinks.
What happens if input prices change along the way?
So far, we've assumed
that input prices don't change along the way, and we've
dealt with what is known as a Constant cost competitive industry.
That input prices, no matter how small the industry is or
how large, stay the same at different at different levels of operation.
The more common case is an industry that's Increasing
cost, that certain inputs get bit up in price as
an industry seeks to expand.
take the case of land in a place like Hong Kong or in
a place like Los Angeles where
there's certain limits imposed by mountainous terrain.
As the industry expands for producing real estate, the input particularly
land, gets more and more expensive and that has to be reflected in the cost of
doing business in the LA Basin or in the Hong Kong area.
There are other spots, let's say in the Midwest of
the United States, where there are no similar geographic constraints imposed
by mountains, that we won't see that increase in real estate
costs, should a city, expand, that have to be dealt with.
And then there's also potential, although very rare, where
certain input costs may decrease as an industry expands.
Now let's take a closer look at what this means,
so far we've looked at a Constant Cost Industry, and let's run
through what that means say initially and panel B shows what's going
on In the market for MBA education overall, the United States, for example,
produces 120,000 MBAs each year through over 500 accredited different schools.
And say the initial demand
is D, and the initial short-run supply curve,
the summation of the existing business schools is SS
and we look at the individual business school,
in particular the NYU Stern School of Business,
the price this firm faces for the tuition it can charge is at a level of P.
In long-run competitive equilibrium, assuming that's where
we start, the price where it intersects
with the firm's short-run marginal cost curve
NYU's business school isn't making any money.
It's operating
at Q1, small Q1, charging P in tuition, and just covering
long-run average cost. What happens if the industry expands?
There's an increase in demand for MBA education so the overall demand curve
shifts to D'. Initially, if there's no entry, that D',
we look at panel B, the short run effect on price is a rise in tuition to P'.
We look at where that new D prime curve hits
the short-run supply curve, SS, higher price of P prime.
And what that provides is an incentive for each business school
like NYU to expand output from Q1 to Q2 in panel a.
And each representative business school makes
money, average revenue prime is above long-run average cost.
Is that a long run equilibrium?
No.
Why?
Because profits are greater than zero and that
positive signal will track more entry into this business.
More marginal cost curves mean the short run supply curve
shifts over to SS prime and that shift will keep occurring
so long as there's positive profit signal.
And in a case where input costs don't change, where the long-run average
cost doesn't change as the industry expands, as does the, nor does the
short-run marginal cost curve, price will end up being driven down to its
original level, entry will keep occurring until it wipes out the profit signal.
So we started with the change in demand short
run going from point A to point B in the overall industry panel, panel
B, a representative firm changed output to point E in panel A.
But long-run, the long-run equilibrium that gets established after entry occurs
brings us back down to point C where the SS prime curve hits the D prime curve.
What the long-run
supply curve does is it connects all points of long-run equilibrium and
the points in panel B where the industry is no longer in equilibrium.
One of the points is point A, another point is point C, note
why point B isn't on the long run supply curve, that's because there's still
positive profits and there's still that signal to handle the business that
prevails at point b.
If input cost stay the same as an industry expands, the long-run supply curve
is flat, as we see in panel B, when we connect points A and C.
And what that flatness indicates is that, the average cost of production in
the long run hasn't changed, as this industry's expanded from Q1 to Q3.
Maybe the case, but it doesn't need to be and
let's turn now to another possibility. We're going to take
the same MBA education market and that same initial shift
from D to D prime, let's see what happens
in both the short-run and the long-run Initially, NYU's business school,
still producing small Q1, where the SMC curve hits
the price curve.
With the increase in price, as demand increases for MBA education, price goes to
P' just like before, this firm this particular
business school expands output in the short-run to Q2 and makes money because
average revenue prime is above average long-run average cost.
But in an increasing cost business what will happen differently
along the way as entry occurs, certain inputs get bid up in price and what we've
seen in the business education process, in the marketplace in business education.
Faculty have been one particular input that's been bid up in price, and
nowadays for example, a Rookie Finance professor
can cost a business school 200,000 dollars,
a more senior finance professor can cost $350,000.
Salaries as the industry's expanded over the last
40 years have been going up but at quicker
than inflation rate, if inputs costs go up,
like Finance professors, what'll happen to the cost curves?
The cost curves themselves, the long-run average cost
curve will rise to reflect those higher input
costs for any individual firm producing output in this business,
so will the short-run marginal cost curve as I've seen prime.
And note here we've been focused on just
the cost towards the matter driving home this point.
Long-Run average cost of production and the short-run marginal cost
to determine what particular output level the firm would produce
at an in any short-run setting,
entry by itself will serve to lower price, just like we saw before.
As the SS curve starts shifting to the right driving down price,
that lower and lower price will work to extinguish the profit signal, will
shave some profits off the top and yet in an increasing cost
industry as costs rise, they also serve to eliminate profits from the bottom.
There's less opportunity,
there's less of a wedge between the prevailing price and
the height of costs. Where do we end up in an increasing cost
case? Price will fall to the point where
profits are wiped out, at the new higher long-run average
cost curve so, we'll end up at the bottom of an LAC prime curve,
higher input costs for any representative firm.
Each firm will still be producing at a price now P double prime, where P
double prime equals the SMC prime, the higher marginal cost of production but
no profits, and so instead of price falling to its initial
level, it doesn't fall as much, why? Because costs, have been rising along
the way and squeezing out profits from the bottom.
In an increasing costs case, the long run supply curve will be upward sloping,
it's height will get larger, higher, as the industry expands.
We still made that same initial move from point A to point B in the
short run but now we've ended up at point C, at a higher level of unit
cost than prevailed before as this industry expanded.
And connecting the long-run equilibrium points A and
C, we end up with that long-run supply curve.
Now, to emphasize the, that MBA education is an
increasing cost business just to share with you some facts.
So USC's Marshall school, a representative school that
I used to be a part of, in 1970,
believe it or not, actually charged $1950 a
year nowadays, the school charges $55,000 a year for MBA
tuition, in real terms, that's the equivalent of about $10,000.
So prices have gone up as the MBA education market has expanded
and a key reason those prices have gone up, haven't returned to
their initial real levels is because input costs, like
faculty costs have been driven up along the way.
Now, let me just cover, is it possible for
a cost to actually go down as an industry expands?
There's certain costs like GMAT tests potentially or how business
schools take applications that may become cheaper to do as the industry gets
larger but it, it's, still rare to think of the situation where an overall industry
is able to access a certain technology of lower input cost as the industry expands.
It is true that we observe certain industries
with price declining over time, but more then
likely it's not due to being a Decreasing Cost case as an industry, more than likely
it's due to technology improving over time.
Let's look at figure 9.12 where we look at the price and
equilibrium quantities over time of pocket calculators in the seventies, where the
long run supply curve met demand was at a pretty high unit
price calculators at that time, were going for 300 dollars a unit.
Over time sales have expanded but the cost have
come down significantly and isn't because necessarily the
long-run supply curve's downward sloping, it's much more likely
that it's been due to the long-run supply
curve rightward shifting over time as technology has improved.
So along long-run supply curve we assume
technology remains the same, when technology changes, the long-run
supply curve shifts. We'll now turn in the next session to
emphasizing a few other key points, about the long-run supply curve.
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