ajaz_eco_204_2012_2013_chapter_15_Competition

Lets illustrate this through the hbs case the

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Unformatted text preview: privately owned smelters can be treated as being rational. Since the output of CIS and state owned smelters is always “in the market”, we can move the combined CIS and state cumulative to the left and move the supply curves of the privately owned smelters to the right to give: 31 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. $/mt Supply Industry Capacity 20.885m mt Next, we would have to pick one of these models to forecast AL prices into the future. We discussed how to do this in lectures – please review your lecture slides, class notes, and HWs. 8. Competitive Industries: Boom and Bust Cycles Many competitive industries, especially commodities, are characterized by “boom-bust” cycles. During a boom cycle, prices rise, incumbent firms earn positive profits, new firms enter the industry, expanding total capacity. Recent examples include boom in gold production spurred by high gold prices which have led existing gold mines to increase production and new mines to begin production (see: article 1, article 2). Boom cycles are inevitably followed by bust cycles during which prices fall, incumbent firms incur losses, spurring some firms to exit the industry, which (in the short run) results in excess capacity (see for example: Lobster industry, auto industry). Why do competitive industries regularly experience boom-bust cycles? Why do boom-bust cycles occur regularly? Here’s a simple model. Consider a competitive industry where all firms have decreasing returns which means each firm’s cost function is strictly convex and have “U-shaped” curves (review short run CMP chapter). For convenience, suppose that this industry is the long run (i.e. ) so that firms are earning zero (economic) profits: 32 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. $ A FIRM $ MARKET Since all firms are identical: . Now suppose there is a positive market demand shock (which leads to a higher price and output . Immediately following the demand shock, existing firms increase production from to : $ A FIRM $ MARKET Notice that in the short run, it is the existing firms which supply the higher demand: i.e. . With existing firms earn positive profits and if there are no barriers to entry new firms will enter the industry. Let’s assume the new firms have the same technology as existing firms. As new firms enter, market supply and equilibrium output increases, pushing down prices: 33 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. $ An Incumbent FIRM $ MARKET Notice that even though incumbent firms have reduced production from to that total market output has increased from !! What’s happening is that as new firms enter the market, price falls, leading incumbent firms to reduce their output. However, despite the fact incumbent firms are producing less, total output goes up because of the additional output produced by new entrants. There is a valuable lesson here: suppose you’re an analyst at an investment bank or an equity research company (check out the #1 company Creditsights). Suppose you always survey incumbent companies to form price and output forecasts. When prices begin to fall, your survey of incumbent firms would show that production is falling when in fact total production is rising! Your mistake lies in surveying the same set of firms each and every time. In fact, you should be conducting randomized surveys. Now, so long as firms in the industry are earning positive profits, new firms will continue to enter, resulting in lower prices and higher output. This process continues so long as and ceases when $ An Incumbent FIRM $ MARKET 34 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. Here, we’re assuming that while a higher output requires more inputs, that the price of inputs always remains constant, and that there is no learning by doing. This means that new firms will have the same cost function as the incumbent firms and that the cost functions stay the same. Total market output is which implies that the total industry capacity has increased, a characteristic of booms cycles. The discussion above has been for the upswing and downswing of the boom cycle: the graphs below illustrated what happened to price and profits. Price Entrants begin entering Time + Demand Shock Profits 0 Time What happens next? That depends on whether the (positive) demand shock was permanent or temporary. Let’s suppose the positive demand shock was temporary: perhaps demand went up when the economy was booming (as that wise chap Newton once remarked “What goes up must come down”) so that demand will fall when the economy goes into the inevitable recession. The negative demand shock lowers p...
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This document was uploaded on 01/19/2014.

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