In this class, we will derive equilibrium outcomes across a variety of market structures. We will begin by understanding equilibrium under a market structure called Perfect Competition, a benchmark construction. Economists have tools to measure the efficiency of market outcomes. We next consider the polar extreme of a competitive market: a monopoly market. We will determine the monopoly equilibrium price and quantity and efficiency properties. Much economic activity takes place in markets with just a handful of very large producers. To understand equilibrium in these oligopoly markets requires more careful attention to strategic interdependence. To capture this interdependence, we consider collusive arrangements among a small number of rivals as well as the use of simple game theoretic techniques to model equilibrium. Market Failure describes situations where markets fail to find the efficient outcome. Information asymmetries are one fertile form of market failure. Another form of market failure occurs when externalities are present. We will examine one key externality, pollution, and construct a policy prescription to mitigate the negative efficiency impacts of this externality. Upon successful completion of this course, you will be able to: • Explain how different market structures result in different resource allocations. • Model the impact of external shocks to a particular market structure and demonstrate the new equilibrium price and quantity after the impact of this external shock has played out. • Evaluate the efficiency of an equilibrium. Different market structures produce different levels of efficiency. • Explain when and why the government might intervene with regulatory authority or antitrust litigation to lessen inefficiencies in some markets. • Describe how information problems can cause inefficient outcomes. • Understand externalities and consider optimal government response to these market failures. This course is part of the iMBA offered by the University of Illinois, a flexible, fully-accredited online MBA at an incredibly competitive price. For more information, please see the Resource page in this course and onlinemba.illinois.edu.
1-1.4. Firm Supply Curve in a Perfectly Competitive Industry
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From the course by University of Illinois at Urbana-Champaign
Firm Level Economics: Markets and Allocations
178 ratings
University of Illinois at Urbana-Champaign
Firm Level Economics: Markets and Allocations
178 ratings
Course 2 of 7 in the Specialization Managerial Economics and Business Analysis
From the lesson
Module 1: Perfect Competition
This module introduces the concept of a perfectly competitive market. It is a benchmark construction, but it accurately models many markets in our economy. We will understand equilibrium outcomes in both the short run and the long run. We will understand how to analyze shocks to these equilibria.
Meet the Instructors
Larry DeBrockDean Emeritus and Professor of Finance and Professor of Economics
University of Illinois, Urbana-Champaign College of Business Department of Business Administration
[SOUND]. Our goal, as you know, is to figure out equilibrium in this market. A perfectly competitive market. The conditions of perfect competition have let us to understand the perfectly competitive firms to treat price as given. Now, what we want to do is think about supply. That's what we're trying to construct here. We built demand a long time ago. We're trying to think about a supply curve in this industry. And here's what we're going to do. We're going to build a supply curve for a particular firm first. And then we'll aggregate up, because we got lots of these firms, right? So our goal is to derive a supply function for a single firm that's in a competitive market. And for us, just to be clear, we're calling it a perfectly competitive Industry. Once we know that, we can aggregate up. Now, again, we'll start with some notation. We're going to let lower case qi be defined as the individual output of firm i. And we're going to let capital Q be defined as market output of all firms. And what that means is that I know market output then is just going to be equal to the summation for i = 1 to n, where there are n players in this industry of the individual outputs of each of these firms. Where do these outputs come from? Well that's what we're doing, we're to build a supply curve to show the optimal response of an individual player. And once I figure out the response function for an individual player, then I'm going to sum across these response functions. And I'll have a market supply curve.
All right. So let's recall that for profit maximization, we wanted to set marginal revenue equal to marginal cost. That is, the individual firm which search for the output level, firm has no control over price, price is given.
Search for the output level where the marginal revenue of the last unit produced is just equal to the marginal cost of the last unit produced. Graphically, we put dollars and sense or price on the vertical axis. On the horizontal axis, we'll put lower case Q, representing the individual firm, and we know the marginal cost curve for that firm. Looks something like this. Now remember the marginal cost was actually U shaped when we built the cost curves. But we were able to determine earlier that for any parametrically given price the firm doesn't really care about the downward solving part of the marginal cost curve. The action happens where the marginal cost curve is solving up. So this curve really does have this part here, but I'm just not really showing it going forward. So we'll go forward and just take these off here, just to get the clutter factor a little bit reduced. Marginal cost remember was the slope of the total cost function. The derivative of cost, the change in cost for the change in output. And we once said that equal to marginal revenue for a firm and competitive market, we know that firm faces a price from the market. Some price P0 and that is in fact the marginal revenue for the firm. How do we know that well? We establish that they are price takers. For every given unit of production they get exactly price.
Think about, you can say, well how does that work? Well I guarantee take the largest corn farmer in Illinois, the largest corn farmer in Illinois and have her double her production. If the largest corn farmer doubled her production over the impact on the price of Chicago World of Trade, nothing. It would be like a little bug landing on the lake. The ripple effect would be small. Now, [LAUGH] if Honda were to double its production of Accords, there would be some impact on market prices. But that's a different game. That's what we're going to talk about later. When there's a small number of producers, their output decisions can actually have big impact. Here, we're talking about a special case where firms are relatively so small that their output decision doesn't impact price. And so, for this particular farmer, if corn is $3.40 a bushel, for every extra bushel of corn that is walking across the horizontal axis, the output for this particular farmer as she produced more and more corn, every extra unit will get exactly what the market price was. So that's why we have that horizontal line at, we'll call it marginal revenue, the change in revenue. And of course this means for profit maximization, that the firm will want to set marginal revenue equals marginal cost.
And we'll call this q star sub 0, associated with the price of P0. Now we don't know much about profits in this situation, but I'm sorry I'm a little bit sloppy here. I'll put this on here just to make sure that we remember we're in the short run.
We can't change our plan and equipment except in big lumpy time periods. >> We can certainly change our production level in the short run. In the short run, the firm can't really change its plan and equipment. It's stuck in this industry.
This is the profit optimized output. You would ask the question well, what if they're losing a lot of money? We have already worked through something called a shutdown condition which would tell us that even though you're losing money, sometimes it's important for you to continue to keep operating. Because if you're earning enough money from your operating cash, to payback some of that fixed cost. And the rule for that for us, if you recall, was the price just had to be above average variable cost. Let we remind you if price is greater than or equal to average variable cost then you do not shut down. Only when the price falls below average variable cost would you say I'm locking down my doors and I'm waiting until a broker calls and tells me I found a buyer for your corn acreage or your craft plant on the edge of town. Whatever the industry is that you're dealing with.
So in this situation, I now got a point that tells me for this particular price, exactly how much the firm would like to produce. Okay, let's go a long long time back. Module 1, course 1.
We introduce supply by saying a supply curve tells us how much producers are willing to supply, how much they're willing to put in the market for different possible prices. Well, that's the whole supply curve here. And what that means is that the exercise I want to start to tap. Let's try different prices. Let's try different prices. Send those prices as signals out, and see how when the price changes, the individual producer changes his or her optimal output. We'll say all right, let's try a different price. We'll call this price P1, and it'll have MR1. And the result would be the firm would go to a marginal revenue equals marginal cost back at that point. It always go to marginal revenue equals marginal cost. That always maximizes profit. And again, this price is greater than average variable cost. So even though the firm may be losing money, in the short run, this is the best thing to do. Keep slugging it out. And they may, in fact, depending on where I drew the average cost curve, we could still be making money here, positive economic profits. We don't know. How about trying a different price?
Now you can see that what's happening here as I vary price, the signal from the market comes in parametric to the producer. Because the producer is by constraints of this particular market the [INAUDIBLE] competitive market. The producer is a price taker. That's a horizontal margin revenue curve. So for every possible price you might call out here That line goes across. And you can see what happens, for different possible prices, what we're ending up doing is this whole locus of points along that upward-sloping marginal cost curve at or above the average variable cost curve
is in fact the short-run supply curve for an individual firm. The short-run supply for an individual firm in a competitive market is that portion of MC at or above AVC. That portion of the marginal cost curve at or above the average variable cost curve tells the firm exactly when it should stop producing. If price goes up, you could see they're going to produce a little more. They're going to produce a little more because they're getting a higher price but of course because of the law of diminishing marginal product that we've established before when we did cost. If they're going to produce more, it's going to get increasingly more expensive, so at some point they're going to stop. Just think about this point q2. At the point q2, the firm doesn't want to go any farther out because if the firm were to produce one more unit of this product, the extra revenue of that unit would be less than the extra cost of producing that. That's not good. Money in your cash register is going down. Also, you don't want to stop short of that because the extra revenue if you were here, is greater than the extra cost, go ahead and. Only when you focus in right in on that point, have you maximized the residuals to your firm and that's what you want to do.
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