How much the whole industry chooses to supply at each different price is called the Industry Supply Curve (or just the Supply Curve)
The Industry Supply curve is just the sum of the amounts (Q) each firm wants to supply at each price. Each point along the supply curve, the supply price represents the marginal cost of some firm producing one more. Which firm will produce that one more unit? The one with the lower MC for producing the next unit.
Class 10
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Putting together industry-market supply and demand
The supply curve of an industry represents the marginal cost of the industry supplying one more unit And we have shown this from company optimizing. The demand curve for the product/service is the result of consumers optimizing. The INDUSTRY supply/demand model is an equilibrium model: Where the two curves intersect, no company or consumer has any incentive to change their behavior.
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Class 10
If price starts above equilibrium, companies will cut price in order to sell more since P>MC. They keep doing this until P=MC. If price starts below equilibrium, companies will raise price since people will buy at a higher price…. They keep doing this until P=MC.
Supply (MC)
a P above equilibrium Equilibrium P
a P below equilibrium
Q at these non- Equilibrium equil. Prices Q
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Class 10
In competitive markets, prices are set by the market…. The price moves until Qsupply = Qdemand
Example: ?? Question: What is causing the price changes? Hints: Look for evidence of either: A shift in the MC (at each price) A shift in demand (at each price) Firms moving in or out of the industry. Note: Answers developed in class. No overheads.
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Class 10
In competitive markets, some things happen quickly (in the short run) but others take longer.
In the short run, some things are fixed, including the capacity of companies and the number of companies. In the long run, nothing is fixed. Companies can change their capacity, and they can move into or leave the industry.
So when we said that logically, if there are lots of identical or potentially identical companies, no company can make economic profit.
Class 10
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Short run - Long run in perfect competition
In the short run, competitive firms will make economic profits when demand increases However, that is not a long run equilibrium. In the long run, if other firms can enter and replicate exactly what existing firms do, new firms will be attracted by the profit opportunities. In a supply/demand graph [see your class notes] As firms enter, price is pushed down to the minimum average cost. Question: What does this imply about the long run supply curve in perfect competition?
Class 10
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Short run - Long run in perfect competition
Question: Logically, what does this imply about the long run supply curve in perfect competition if other
firms can enter and replicate exactly what existing firms do?
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Answer: In the long run supply curve is perfectly flat (elastic). Question: What does this imply about long run v. short run profits in perfect competition? In the short run, the company might be lucky – e.g. demand shifts right or their costs decrease – [or unlucky – e.g. demand falls or costs increase.] So in the short run, even competitive companies can make profits (or losses). Note, a lucky firm in the 10 short run has “something Class special” .. Capacity!
Short run - Long run in perfect competition
In the short run, competitive firms will make economic profits when demand increases However, that is not a long run equilibrium. In the long run, if other firms can enter and replicate exactly what existing firms do, new firms will be attracted by the profit opportunities. In a supply/demand graph [see your class notes] As firms enter, price is pushed down to the minimum average cost. Question: What does this imply about the long run supply curve in perfect competition?
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Class 10
Short run - Long run in perfect competition
Question: What does this imply about the long run supply curve in perfect competition if other firms
can enter and replicate exactly what existing firms do
In the long run supply curve is perfectly flat (elastic) Question: Is it possible that any firms make profits even when price is set by new entrants setting entering until P=MC? When? When some firm has “something special” so that
other firms CANNOT replicate exactly what that firm does
Class 10
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DDOOOOO
Examples of supply and demand… Probably not example of CRS with absolute capacity. CA electricity? Or should we do first something on identification?
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Class 10
Without something special….
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If companies in an industry have positive economic profits, more entrepreneurs will enter the market who can replicate what existing firms have done.. As new companies enter, they’ll take away some of the customers …. so existing companies will sell less and price lower to keep their customers. Eventually, economic profits drop to zero… meaning firms make the minimum ROR to keep them in business. This is called perfect competition or pure competition and Class 10 will model it starting we today.
What kinds of things give companies monopoly power?
Sometimes, the whole industry shares this “special something”. Sometimes, only one company has this “special something.” Sometimes this “special something” is about the product…. The company offers a product that new entrants cannot. Sometimes this “special something” is about the costs…. The company has lower costs than new entrants.
Class 10
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When can a company offer a product that new entrants cannot?
They might have a legal patent, copyright. They might control a key input. (Copper) They might control a key location. (Downtown) They might have a “secret formula”. (Coke) They might have brand recognition…
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Class 10
Will brand recognition confer long term economic profits?
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Often, brand recognition/loyalty only leads to economic profits for a limited period…. until other companies enter and develop their own brand recognition…. and this keeps happening until no one is making an economic profit. This is what occurs in economic model of an industry structure called monopolistic competition. American Eagle? Sometimes things change, like technology… AOL
Class 10
When a company has lower costs than new entrants….
To maintain lower costs, the company must have something special. (Walmart; Nuclear power) One important question: Why don’t companies with lower costs just under-price everyone and take over the market?
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Class 10
Sometimes, companies have such significant economies of scale compared to demand so that only a few companies can achieve minimum efficient scale
When there are only a few companies in an industry, we call it an oligopoly. We will develop some oligopoly models later. One important question we’ll address: Can oligopolies sustain economic profits (or will they be competed away)?
Class 10
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Strategic barriers to entry
Companies can try and create “something special” that becomes a barrier to entry …. We’ll discuss this under oligopoly.
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Class 10
Measuring market power
Market power tends to imply: 1. High concentration ratios 2. Low elasticities of demand 3. Economic profits (above the normal ROR)
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Class 10
Concentration ratios: Measuring market concentration
The concentration ratio (CR) is the percentage of market share by the largest companies: CR1: % market share by (1) largest company CR4: % market share by 4 largest companies CR8: % market share by 8 largest companies CR20: % market share by 20 largest companies
…. You need to look up or calculate the concentration ratio for your industry project.
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Class 10
Typically, the larger the concentration ratio, the more the market power of each firm.
There can be a very high concentration ratio, and yet no market power IF…. there are no barriers to entry In that case, if you raise the price to make profits, others will enter. This is called a “contestable market.”
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Class 10
Concentration ratios are correlated with market power, as this continuum suggests.
Monopoly Effective CR1=100% Monopoly CR1>90% Tight Oligopoly CR4>60%
Monopolistic Loose Competition Oligopoly CR4<40% 60%>CR4>40%
Perfectly Competitive CR20 small
However, this is a correlation only and there are many exceptions… such as contestable markets (Think of outliers on a regression). Do not use this alone to categorize your long run market structure in your industry project.
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Class 10
Defining Price Elasticity :
Price elasticity is how QD responds to price changes: elasticity E = % Q % P
Think of it as the percentage that Q changes when P increases by one percent … Some algebra that’s useful to calculate elasticities: % Q Q / Q Q P % P P / P P Q
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= (1/demand curve slope) P/Q Class 10
When a company offers a product that new entrants cannot replicate…
Here we graph the demand curve for a specific company’s specific product. When a company offers a product that new entrants cannot replicate… their demand is less elastic i.e. it is inelastic.. So they can set higher prices – Pricewill want to! and inelastic elastic
Price
Quantity
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Class 10
Quantity
Calculating elasticity in a linear demand curve
Some algebra that’s useful to calculate elasticities: % Q Q / Q Q P % P P / P P Q
= (1/demand curve slope) P/Q
Example Q = 600 – 150 P
Elasticity = Calculate! Since the slope is constant, a given amount of price change leads to a constant amount of change in the quantity demanded. Class 10 But NOT a constant percent….
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Elasticities and optimal pricing rules
Can a price-setter maximize profits without knowing the whole demand or cost functions, but knowing: the (price) elasticity (of demand) and the marginal cost?
YES!!!
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Class 10
Elasticity and optimal pricing
From the pricing rule MR = MC And the definition of elasticity written as dQ P dP Q I can derive the following equation: P= MC___ 1 + 1/E where E is the company’s demand elasticity. E is negative!!!
Note that since E is negative, as long as | E | > 1, the denominator 1 + 1/E is positive.
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Class 10
Elasticity and optimal pricing
So we have 3 versions of the same optimal pricing rule: Choose Q so that: 1. MR = MC 2. dπ = 0 dQ 3) P= MC___ 1 + 1/E where E is the company’s negative demand elasticity. e.g. if E = -2, MC = 8 P= 8 = 16 1 – 1/2 if E = -3, MC = 8 P= MC = 12 1 - 1/3 Class 10 Set lower prices when E is high. Why?????
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Markup pricing
Does it make sense to set a constant markup over cost? (Base your answer on MR = MC)
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Class 10
Does it make sense to set a constant markup over cost?
The markup is the percent over “cost of a unit” that the price is set. If we define the “cost of a unit” as MC, then: Markup ≡ P - 1 [example MC=2 P=3 markup=3/2 – 1 = ½ or 50%] MC since P = MC therefore P = 1 1 + 1/ E MC 1 + 1/ E [where E is the company’s negative demand elasticity.]
This says: the markup should reflect the elasticity E. The higher the | E |, the lower the price. Class 10 29 Only set a constant markup for products with similar
If a company does not have anything special so anyone else can make the same product at the same cost and sell it to the same customers…
They would have NOTHING special…. Equilibrium will be when companies make exactly zero economic profits. What will the demand elasticity for the product of a company in this industry? Zero. In other words, they cannot affect the price. For them, they can sell as much at the market/industry price … But nothing at a higher price.
Class 10
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Perfect Competition
Perfectly competitive industries are those where all companies are price takers:
They can’t (materially) affect the market price. They can’t raise their price and sell ANY, because there is nothing special about their product compared to those sold by other companies. No firm has a competitive advantage.
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Class 10