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Intermediate Microeconomic Theory

Market Supply

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Market Supply

Similar to demand, market supply will simply be the summation of all the individual firm supply curves:

Qs(p) = q1s(p) + q2

s(p) +…+ qns(p)

Also similar to demand, a price change can change amount supplied on both the intensive and extensive margin. What is key to extensive margin?

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Market Supply

Given market supply curve, along with market demand curve, we can now define an equilibrium price.

Equilibrium price: the price that equates supply and demand in a given market

(p* such that Qd(p*) = Qs(p) ).

Qs(p)

Qd(p)

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Price and Costs in Equilibrium

Note: all profit maximizing firms that are supplying output to a given market must be operating at p* = MC(qs(p*)).

So while each firm may have quite different cost functions, all must have the same cost of producing their last unit of output.

Therefore, in perfect competition, the price consumers pay for a good equals the cost (including opportunity costs) firms must incur to bring the marginal good to the market.

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Economic Profits

When does it make sense to enter a given industry?

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Economic Profits

Example: Should Lisa enter the tea business? To do so, she needs gallon sized tea kettle ($20). For each cup of tea she supplies, she needs 1 tea bag ($0.49/bag) However, in making tea she gets tired, meaning the amount of tea she can make

in a month is given by the production function q = 10L0.5 (L is hrs of her time). When she isn’t making iced tea, she can work at Moe’s bar for $5hr. (paid at the

end of each month) Any money she doesn’t put into the business, she loans to Barney at a monthly

interest rate of 2%. Lisa gets her tea via mail order, which she has to pay for on the first of each

month. Suppose the going price for tea in Springfield is $3/cup.

What are Lisa’s monthly economic profits from this business? What does this say about whether she should enter?

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Economic Profits

How would her economic profit change if she could lend to Barney at an interest rate of 0.53/month?

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Market Supply in the Long-run

How will things change over the longer-run? Think of the market demand/market supply graph. What is aggregate

profit in graph?

What if there are a bunch more individuals like Lisa out there (specifically, Lisa with the lower return on her savings)?

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Market Supply in the Long-run

So how will Industry Supply curve change over the long-run? Why?

So what is long-run shape?

Where will it lie?

What does this mean about (economic) profits in a competitive market in the long-run?

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Profits in the Long-run

So in short-run there are positive economic profits (or “rents”), but if there is “free-entry” the industry operates at zero (economic) profits in the long-run.

However, it is still rational for suppliers to continue using resources to produce and supply goods to the market they are in (accounting profits are strictly positive)

Zero “economic” profits simply means that there are no excess returns to be had by allocating further resources and inputs into that market. In the end, this is what venture capital and

entrepreneurism is all about---finding a market niches that allow for (possibly “short-term”) excess returns (i.e. economic profits).

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Profits in the Long-run

How does selection from “Free: The Future of the Radical Price” relate to this discussion?

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Costs and Benefits of Competition

Our theory of the firm reveals the costs and benefits of competition. Benefits?

Costs?

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Economic Rent

So economic profits in the short-run are part of our theory (essentially come from innovation and cost saving choices)

But how do we explain firms in mature industries making seeming economic rents (i.e. Exxon Mobil, Haliburton)?

Assumption of free-entry in the long-run fails because some factor is fixed or limited. There are a fixed number of functioning oil wells. Provision of services to military awarded by government contract

only Any constraint that leads to a fixed number of suppliers.

Why are such barriers to entry so valuable?

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Rent setting

The implicit “value” of the fixed factor is what we call “economic rent”. How is one of these assets that earns economic rent valued?

Consider a contract to supply troop meals in Afghanistan. Contract will pay $1 million and requires meals 21 meals/day for 300K

troops for 40 weeks. Cost function is c(q) = q/300

What will a company pay up to in order to win this contract?

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Rent Seeking

So we can see why millions are spent each year lobbying by firms or individuals in an attempt to somehow constrain entry into an industry. Positive economic profits can be made if free-entry is limited. So, it

might make sense for firms to pay lots of money to lobby for entry barriers.

Often called “rent seeking”.

Examples: Limits on medical school slots hair cutting licenses zoning restrictions Agricultural subsidies Military contracts