ajaz_eco_204_2012_2013_chapter_15_Competition

For convenience suppose that this industry is the

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Unformatted text preview: rices and market output: $ An Incumbent FIRM $ MARKET 35 ECO 204 Chapter 15: Competitive Firms and Markets (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. Observe that all firms (the incumbent firms before, and the new entrants after, the positive demand shock) reduce theor output – now there’ll be excess capacity, a hallmark of bust cycles. Moreover, since all firms lose money and if there are no barriers to exit7 some firms (which ones we can’t say) will exit the industry, shifting supply curve left and driving prices up. This process stops when : $ $ An Incumbent FIRM MARKET Observe that even though all remaining firms are producing more output, the industry as a whole is producing less. The output of exiting firms exceeds the increased output of remaining firms so that the total output is falling. The industry has “returned” to where it started from (just as in macroeconomics, GDP returns to trend levels): Prices Entrants begin entering Firms begin exiting + Demand Shock - Demand Shock Time Profits 0 Time __________________________________________________________________________________________________ 7 In many countries there are barriers to exit. For example, France and India, have restrictions on layoffs. . 36 ECO 204 Chapter 15: Competitive Firms and Markets (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. Example: Consider a constant cost perfectly competitive industry8. Suppose each firm has the cost function: Suppose the industry is in the long run and the industry demand is: What is the equilibrium price and how many firms will there be in the market? In the long run, all firms earn zero profits and will produce where: Let us calculate : To find the minimum solve the FOC: Substitute in: Thus: . With a long run price of $20 total market demand will be: With each firm producing 30 this implies there are Now suppose a positive demand shock shifts the initial demand curve firms in the market. up by $10. 8 Constant cost means that there are no limits on the amounts of the inputs so that as Inputs used No change in input prices, and that there is no learning by doing so that as (state of technology and management) stays constant. As such, the cost function doesn’t change when output changes. 37 ECO 204 Chapter 15: Competitive Firms and Markets (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. What is the new market price and each firm’s output in the short run immediately following the shock? The new demand curve is $10 higher than the initial demand curve. To get the equation of the new demand curve, write the initial demand curve as: ( ) If the demand curve shifts up by $10 then the new demand curve is: This can be re-arranged to get: The new equilibrium price can be found by setting market demand We know but don’t know : this can be found by recalling that: What is each firm’s supply? The supply curve is found by equating: Thus: Back to: 38 ECO 204 Chapter 15: Competitive Firms and Markets (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. Following the demand shock (before any new firms enter) each existing firm’s output can be found from its supply curve: Before the demand shock, each existing firm produced 30 units; following the demand shock, each firm produces 6 additional units. In contrast to the discussion of boom-bust cycles above, let’s suppose that before new firms enter the industry, an innovation lowers all firms (existing and new) average cost by $5. In response to the positive demand shock, how many new firms will enter the industry? Recall that firms will enter so long as all incumbent firms are earning positive profits. Entry ceases when: The trick here is that due to the innovation, we’ll have a new The innovation lowers To find the by $5 and the new . Previously, was: is: solve the FOC: Set: At this price, the market output can be found from the new demand curve: 39 ECO 204 Chapter 15: Competitive Firms and Markets (this version 2012-2013) University of Toronto, Department of Economics (STG). ECO 204, S. Ajaz Hussain. Do not distribute. This implies there will be firms, i.e. 10 firms entered the industry. 40 ECO 204 Chapter 15: Competitive Firms and Markets (this version 2012-2013)...
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