ajaz_eco_204_2012_2013_chapter_15_Competition

Price taking firms price taking consumers market

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Unformatted text preview: d. _________________________________________________________________________________________________ We know how to compute the competitive market equilibrium (notice that, due to capacity constraints, the supply curve looks different from ECO 100): 21 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. Market Supply Curve Sum of individual firms’ supply curves. Sum of individual agents’ demand curves. Price taking firms Price taking consumers Market Demand Curve Industry Capacity This graph shows linear demand and supply curves. Of course, as we have seen, these curves can be non-linear. Now, if all consumers can be modeled as a single “representative consumer” with a quasi-linear utility function where equilibrium quantity of good traded in this competitive market and all other goods, and if we set all other goods as the base good (i.e. ) and if then we know that: Market Supply Curve Price taking firms Price taking consumers Market Demand Curve Industry Capacity 22 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 fact allows us to measure the impact on consumer welfare due to changes in price (review consumer theory where we used consumer surplus to measure changes in utility due to changes in price). Notice also that the equilibrium quantity is less than capacity; as such, whenever there are small shifts in demand, we will observe changes in price and quantity: Price taking firms Price taking consumers Industry Capacity However, when the equilibrium quantity equals capacity then with small shifts in demand, we will observe changes in price only: Price taking firms Price taking consumers Industry Capacity 23 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 model shows us that when market output is near or at capacity, small fluctuations in demand will result in price movements (volatility) where the degree of volatility depends on the shape of the supply curve in that region – let’s examine this point in the context of the HBS case The Aluminum Industry in 19945. 6. “Irrational Firms” So far we’ve assumed “rational” competitive firms, i.e. firms which shut down if This is because rational firms’ objective is profit maximization and in the event that , rational firms will minimize losses by shutting down. To see this, express profits as: Now suppose : (⏟ If the firm continues operating, i.e. ) then its losses are the sum of two negative terms: (⏟ On the other, if the firm shuts down, i.e. )⏟ then its loss comprises of a single negative term: (⏟ )⏟ By shutting down, a rational firm avoids all avoidable costs (i.e. ) and its losses are less than if it continued to operate. This is why profit maximizing/loss minimizing rational firms shut down when (of course, in reality firms don’t shut down as soon as price dips below ; rather, rational firms shut down when the price is, or expected to be, consistently below ). On the other hand, irrational firms’ objective is something besides profit maximization and won’t shut down when : irrational firms’ output is always “in the market”. For example, many state owned aluminum smelters operate to reduce unemployment and/or to serve national security/strategic interests. As such, state owned primary aluminum smelters tend to be irrational producers and once operational, produce aluminum irrespective of the price and even if What does an irrational firm’s supply curve look like? Take a look at the following table, reproduced from the HBS Case The Aluminum Industry in 1994 (AL = Aluminum): 5 Note to self: whether the supply curve is steep or flat depends on the of the least efficient producers vis a vis the rest. If these are substantially different from the rest then we’d expect extreme volatility whereas if they are close to rest there will be little volatility. This has obvious implications for trading. Look into this further and make a new model where o ne firm is much less efficient than others. Empirically, variance and kurtosis of matters in commodities trading – look into this as a mini-case. 24 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. Average Primary Aluminum Smelter (1993) All cost figures $/metric ton Italicized items are variable cost components and/or inputs Capacity (‘000s tpy) 133.02 Electricity usage (kWh/t) 15,800 Electricity price ($/kWh) $0.02 Alumina usage (t/t Al) 1.94 Alumina price ($/t Alumina) $190 Other raw materials $125 Plant power and fuel $10 Consumables $70 Maintenance $50 Labor $150 Freight $45 General and Administrative $75 Summing up variable cost components tells us that the average smelter’s ton (make sure you...
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This document was uploaded on 01/19/2014.

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