Economics 50: Intermediate Microeconomics

Summer 2010
Stanford University
Michael Bailey
Lecture 7: Firm Supply
Overview
In a perfectly competitive market, the upward sloping portion of the rms marginal cost curve (that
is above AV C(y) in the short run, and above AC(y) in the long run) is its supply curve
The producers surplus is the area above the supply curve and below the price
The per-unit prot is p
y
AC(y)
Producers surplus is equal to prot plus xed costs
The rm will shut down in the long run if p
y
< AC(y); and will shut down in the short run if
p
y
< AV C(y)
A market is in long run equilibrium when prots are 0 and is characterized by p
y
= MC(y) = minAC(y)
A monopolist sets a price that is a markup above marginal cost, and produces less than the competitive
equilibrium
A monopsonist sets a wage that is below the marginal revenue product, and hires less labor than the
competitive equilibrium
Firm Supply in a Perfectly Competitive Market
If the rm is a price taker, then it will supply y

(w; p
y
) to the market where y

(w; p
y
) = f(x

i
(w; p
y
)): Given
the cost function, the supply function solves y = arg max p
y
y C(y): Notice that the rst order condition of
this problem is:
p
y

@C(y)
@y
= 0
=) p
y
= MC(y)
Thus the marginal cost is the inverse supply curve. In a perfectly competitive market, the market price is
the marginal revenue to the rm, since it takes the market price as given, and thus the prot-maximizing rm
1
equates the price with marginal cost. The second order condition of this problem puts another restriction
on the supply curve:

@
2
C(y)
@y
2
< 0
=)
@
2
C(y)
@y
2
=
@MC(y)
@y
> 0
The output where p = MC(y) is a maximum only if MC(y) is upward sloping, else the rm could produce
another unit and marginal cost would be falling. So the inverse supply curve is the upward sloping region of
the marginal cost curve.
Figure 1: The rm wants to maximize the dierence between revenue and cost
2
Figure 2: The maximum prot is where p = MC(y) and MC(y) is upward sloping
Figure 3: The upward-sloping portion of the marginal cost curve is the inverse supply curve
3
Graphical Analysis
We can rewrite prots as:
= p
y
y C(y)
= p
y
y y
C(y)
y
= p
y
y yAC(y)
= y(p
y
AC(y)
. .
per unit
)
Thus the prot per unit is equal to p
y
AC(y); the revenue per unit minus the cost per unit.
Revenue is the rectangle p
y
y
Prots are the rectangle y(p
y
AC(y))
Figure 4: = y(p
y
AC(y) which is the rectangle shown
4
Figure 5: When the price is less than AC(y); the rm incurs a loss equal to y(p
y
AC(y)
Variable costs are the area under MC(y)
_
MC(y) =
@V C(y)
@y
_
Producers surplus is the area above the supply curve (MC(y)) and below the price
PS =
_
p
0
y

(p)dp
PS =
_
p2
p1
y

(p)dp
Total Cost is the rectangle yAC(y) = C(y)
Therefore, producers surplus is equal to prots plus total costs minus variable costs:
PS = +C(y) V C(y)
= +FC
5
Figure 6: Revenue = 1 +2 +3 +4; = 1 +2; C(y) = y AC(y) = 3 +4; Variable Costs = 2 +4 (area under
MC(y)); PS = 1 + 3; FC = C(y) V C(y) = 3 2; =)PS = +FC
Shut Down Decision
The rm would prefer to shut down and make 0 output if the prot from doing so were greater than the
prot from producing. The rm will shut down if:
C(0) > max p
y
y C(y)
In the long run, C(0) = 0 so we can write this condition as:
0 > p
y
y C(y)
=)
C(y)
y
= AC(y) > p
y
So in the long run, if the price is less than the average cost, the rm will shut down and produce no
output.
6
Figure 7: The long-run supply curve is the upward-sloping portion of the marginal cost curve that is above
AC(y): If p < AC(y); the rm will shut down in the long run
In the short run, C(0) = FC; so the shut-down condition is:
FC > p
y
y FC V C(y)
=)
V C(y)
y
= AV C(y) > p
y
In the short run, the rm will shut down if the price is less than the average variable cost. Why are the
conditions dierent? In the long run, the rm can avoid all xed costs and make a prot of 0; so the rm
must make at least 0 prots in the long run. In the short-run, the rm will pay its xed costs no matter
what, so it could be that rm is making negative prot, but as long as the prot is greater than its xed
costs, it is still more protable to produce than to shut down. Notice that if the price is greater than the
average variable cost, then each unit will make positive prot for the rm, so it is better to produce, even if
those prots are not enough to cover xed costs, it is more protable than shutting down.
7
Figure 8: The short-run supply curve is the upward-sloping portion of the marginal cost curve that is above
AV C(y): If p < AV C(y); the rm will shut down in the short run
Long-run Market Equilibrium
In a perfectly competitive market, rms are free to costlessly enter or leave the market (no barriers to entry).
If all rms are identical, then if rms are making positive prot, then rms will enter the market which will
increase supply and lower the price. If rms are making negative prot, then rms will leave the market,
reducing supply and raising the price. The market is in equilibrium when no rms want to enter or exit the
industry and is characterized by 0 prot, or p = AC(y). Therefore, the market is long-run equilibrium when:
p = MC(y) = minAC(y)
Since MC(y) = AC(y) at the minimum of AC(y); we can just write:
p = MC(y) = AC(y)
Remember that this means that economic prot is 0; the rm could still be earning a large accounting
prot, but if we implicitly paid all factors according to their opportunity cost, it would just equal our prot.
8
Figure 9: Initially, rms in this industry make positive prots. In the long run, rms enter the industry
increasing supply. Firms will continue to enter until p = minAC(y)
Figure 10: Initially, rms in this industry make negative prots. In the long run, rms exit the industry
decreasing supply. Firms will continue to exit until p = minAC(y)
9
Example 1 The short-run cost function of the rm is C(F; w; K; y) = F +
wy
3
3K
; if all rms are identical,
what will be the long-run quantity and price in the market when w = 16; F = 32; and K = 9?
At the long-run equilibrium, p = MC = AC:
p =
wy
2
K
=
F
y
+
wy
2
3K
=)
wy
3
K
= F +
wy
2
3K
=)
2
3
wy
3
K
= F
=) y
3
=
3
2
FK
w
=) y =
_
3
2
FK
w
_
1
3
= 3
So for a rm in this industry to make 0 prots, each must be producing 3 units of output, and the price
must be:
p =
wy
2
K
=
3w
K
= 16
If there are N rms in the industry, then the market quantity will be Q
S
= 3N:
Example 2 The supply function of the 10 identical rms in the industry is y

(p) =
4
9
p
2
: Each rm has a
cost function C(y) = 500 +y
3
2
=)MC(y) =
3
2
p
y and AC(y) =
500
y
+
p
y: The market demand is given by
Q
D
= 9000
50
9
p
2
: What is the short-run equilibrium? How many rms will exist in this industry in the
long run?
= p
y
y 500 y
3
2
Q
S
=

y

(p) = 10
4
9
p
2
=
40
9
p
2
Q
D
= 9000
50
9
p
2
10
A short-run equilibrium is where Q
D
= Q
S
:
40
9
p
2
= 9000
50
9
p
2
=) p = 30
Q = 4000
y

= 400
= $3500
Because there is positive prot, in the long run rms enter the industry. Suppose that there are N rms
in the industry. Then the market supply curve will be given by:
Q
S
=

y

(p) = N
4
9
p
2
=
4N
9
p
2
At the equilibrium, we must have supply equal to demand:
Q
S
=
4N
9
p
2
= 9000
50
9
p
2
=) p =
90
p
10
p
50 + 4N
Q =
36000N
50 + 4N
y =
36000
50 + 4N
We could solve for where the prot equals 0; but it is easier to nd the output that minimizes the average
cost:
AC(y) =
500
y
+
p
y
=) 500y
2
+
1
2
y

1
2
= 0
=) y
3
2
= 1000
=) y = 100
=)
36000
50 + 4N
= 100
=) 36000 = 5000 + 400N
=) N =
31000
400
= 77:5
In the long run, there are 77 rms in the industry, so 67 rms must have entered the industry.
11
Monopoly
We now begin to relax some of the market constraints and consider a case where the rm is not a price
taker. A monopoly is a market with only one seller, and as the sole seller has the power to set the price in
the market. However, the monopolist is constrained by the inverse demand curve, p(y); so if it sets a price
of p(y); it will be able to sell at most y units of output. We can write the prots of the monopolist as:
max = p(y)y C(y)
The rst-order condition of this problem is:
@p(y)
@y
y +p(y)
. .
Marginal Revenue
=
@C(y)
@y
. .
Marginal Cost
As expected, the monopolist equates marginal revenue with marginal cost. The dierence between the
monopolist and the perfectly competitive rm is the marginal revenue term. In a perfectly competitive
market, the rm can sell all of its units of output at the market price, p
y
; and thus has MR(y) = p
y
: The
monopolist also has a p(y) term in its marginal revenue, if it increases output by one unit, revenue will
increase by the price, p(y): However, the monopolist also has a
@p(y)
@y
y term in its marginal revenue, this is
because it is constrained by the demand curve. If the rm increases its output by one unit, it must lower
the price on all of its output so the market clears, so the marginal revenue also changes by the change in
price times quantity, or
@p(y)
@y
y:
We can predict from the marginal revenue term that the monopolist will produce less than the perfectly
competitive rm. For the marginal unit of output, the rm has to lower the price on all of its units of outputs
for the market to clear. Due to this "negative" term dragging marginal revenue down, marginal revenue will
equal cost at a much lower output then the rm that has MR = p:
12
It is instructional to rewrite the rms optimal condition in terms of elasticities:
@p(y)
@y
y +p(y) = MC(y)
=)
@p(y)
@y
y
p(y)
p(y) +p(y) = MC(y)
=)
p(y)
"
y;p
+p(y) = MC(y)
=) p(y)
_
1
"
y;p
+ 1
_
= MC(y)
=) p(y)
_
"
y;p
+ 1
"
y;p
_
= MC(y)
=) p(y) =
_
"
y;p
"
y;p
+ 1
_
MC(y)
Thus the price the monopolist sets is a "markup" above marginal cost, and is referred to as "markup
pricing". Notice that the monopolist will never operate on the inelastic portion of the demand curve. If
1 < "
y;p
< 0; then
_
"y;p
"y;p+1
_
is negative, and the optimal price would be negative, so the optimality condition
cannot hold. This is an intuitive result, on the inelastic portion of the demand curve, the monopolist could
decrease output and increase revenue (as we discussed in detail in the rst part of the course). The rm
would move to a lower cost because less output means it uses fewer inputs. More revenue and less cost
means prots would be higher. We cant use this logic to rule out the rm operating on the elastic portion
of the demand curve. On the elastic portion, the rm could decrease its price and increase revenue, but it
would have to produce more output, so costs would icnrease and the change in prots is indeterminate. The
maximum prot is attained when MR = MC:
Example 3 Linear Demand p(y) = a bP
Revenue = p(y)y = ay by
2
and Marginal Revenue = a2by: So marginal revenue is demand with twice
the slope. Notice that the inelastic portion of the demand curve corresponds to a negative marginal revenue.
13
Figure 11: The monopolist produces where MR(y) = MC(y)
Figure 12: The monopolist produces less than the competitive output (where p = MC(y)); capturing some
of the consumers surplus as an increased producers surplus, but creating deadweight loss (DWL)
14
Example 4 Constant Elasticity Demand Function p(y) = ay
b
Because the elasticity is constant along the curve, we can plot the curve
_
"y;p
"y;p+1
_
MC(y) which is a
constant times marginal cost, or a marginal cost shifter. The monopolist will produce where this curve
intersects demand.
0.0 0.2 0.4 0.6 0.8 1.0 1.2 1.4 1.6 1.8 2.0 2.2 2.4 2.6 2.8 3.0
0
1
2
3
y
p
Figure 13: Constant Elasticity Demand Function plotted with MC(y) and MC(y)
"
"+1
: The monopolist
produces where p(y) = MC(y)
"
"+1
Monopsony
A monopsony is a market with only one buyer, in contrast to a monopoly with only one seller. The monop-
sonist cannot take the prices of the good it is buying as constant because it is constrained by the supply
curve. For example, consider a rm that is the only buyer of labor services. The rm is constrained by the
labor supply curve and must oer a higher wage to attract more labor. We can write the supply function
in the labor market as w(L) which tells us how much labor, L; will be supplied at a given wage w(L): The
objective function of the rm that only uses labor to produce an output is:
max p
y
f(L) w(L)L
As always, the rm sets marginal revenue equal to marginal cost:
p
y
@f(L)
@L
. .
MRP
L
=
@w(L)
@L
L +w(L)
. .
Marginal Cost of Labor
15
The marginal revenue term (marginal revenue product) is the same for the monopsonist, MRP
L
=
p
y
MP
L
; the marginal cost term is dierent. In the perfectly competitive case, this term is equal to w since
the rm can hire all the labor at wants at a constant wage. The monopsonist is constrained by the supply
curve however, and if it wants to higher more labor, it must oer a higher wage, thus the marginal cost has
a w(L) term indicating it must pay a wage of w to the marginal worker, but it also has a
@w(L)
@L
L term,
indicating it must also oer this higher wage to all its labor.
From this equation we can already see that the monopsonist will hire less labor than in the competitive
equilibrium. When deciding to hire the marginal worker, the rm must not only see if the MRP
L
is greater
than the wage, but also if the MRP
L
is greater than the wage plus the eect of raising the wages for all
other workers. This additional productivity requirement on the marginal worker induces the rm to set a
lower wage and higher fewer units of labor. Rewriting the optimal condition in terms of elasticities:
MRP
L
=
@w(L)
@L
L +w(L)
=
@w(L)
@L
L
w(L)
w(L) +w(L)
= w(L)
_
1
"
L;w
+ 1
_
= w(L)
_
"
L;w
+ 1
"
L;w
_
=) MRP
L
_
"
L;w
"
L;w+1
_
= w(L)
Because the elasticity of supply is positive, this means the rm will set a wage that is less than the
MRP
L
; as expected.
Example 5 Linear Supply w(L) = a +bL =)C(L) = aL +bL
2
; MC(y) = a + 2bL:
Notice that the marginal cost curve is the supply curve with twice the slope.
16
Figure 14: The monopsonist sets a wage where MC(y) = MRP
L
Figure 15: The monopsonist sets a wage that is less than the competitive one, hiring too little labor than
is ecient. The monopsonist captures some of the producers surplus (the surplus that would have gone
to labor suppliers) thus increasing consumers (i.e. the monopsonists) surplus, but creates deadweight loss
(DWL)
17