Chapter 14

THE PARTÌAL EQUÌLÌBRÌUM
COMPETÌTÌVE MODEL
Copyright ©2002 by South-Western, a division of Thomson Learning. All rights reserved.
MICROECONOMIC THEORY
BASÌC PRÌNCÌPLES AND EXTENSÌONS
EÌGHTH EDÌTÌON
WALTER NICHOLSON
Timing of the SuppIy Response
W Ìn the analysis of competitive pricing, the
time period under consideration is
important
÷ very short run
W no supply response (quantity supplied is fixed)
÷ short run
W existing firms can alter their quantity supplied, but
no new firms can enter the industry
÷ long run
W new firms may enter an industry
!ricing in the Very Short Run
W Ìn the very short run (or market period),
there is no supply response to changing
market conditions
÷ price acts only as a device to ration demand
W price will adjust to clear the market
÷ the supply curve is a vertical line
!ricing in the Very Short Run
Quantity
!rice
S
D
D'
Q*
P
1
P
2
When quantity is fixed in the
very short run, price will rise
from P
1
to P
2
when the demand
rises from D to D'
Short-Run !rice Determination
W The number of firms in an industry is
fixed
W These firms are able to adjust the
quantity they are producing
÷ they can do this by altering the levels of the
variable inputs they employ
!erfect Competition
W A perfectly competitive industry is one
that obeys the following assumptions:
÷ there are a large number of firms, each
producing the same homogeneous product
÷ each firm attempts to maximize profit
÷ each firm is a price taker
W its actions have no effect on the market price
÷ information is perfect
÷ transactions are costless
Short-Run Market SuppIy
W The quantity of output supplied to the
entire market in the short run is the sum
of the quantities supplied by each firm
÷ the amount supplied by each firm depends
on price
W The short-run market supply curve will
be upward-sloping because each firm's
short-run supply curve has a positive
slope
Short-Run Market SuppIy Curve

P
P P
s
A
s
B

A
*

B
*
P*
To derive the market supply curve, we sum the
quantities supplied at every price
Firm 's
supply curve
Firm 's
supply curve
Market supply
curve
*
S

A
* +
B
* = *
Short-Run Market SuppIy
Function
W The short-run market supply function
shows total quantity supplied by each
firm to a market

3

8
; P q ; P Q

) , , ( ) , , (
W Firms are assumed to face the same
market price and the same prices for
inputs
Short-Run SuppIy EIasticity
W The short-run supply elasticity describes
the responsiveness of quantity supplied
to changes in market price
$
$
P $
Q
P
P
Q
P
Q
e c
N
N

in change %
supplied in change %
,
W Because price and quantity supplied are
positively related, e
$,P
> 0
A Short-Run SuppIy Function
W Suppose that there are 100 identical
firms each with the following short-run
supply curve
q

= 50P ( = 1,2,.,100)
W This means that the market supply
function is given by

c

8
P P q Q , ) (
A Short-Run SuppIy Function
W Ìn this case, computation of the
elasticity of supply shows that it is unit
elastic

c c
N
N

P
P
Q
P
Q
P
P
Q
e
$ $
$
P $
,
,
,
EquiIibrium !rice
Determination
W An equilibrium price is one at which
quantity demanded is equal to quantity
supplied
÷ neither suppliers nor demanders have an
incentive to alter their economic decisions
W An equilibrium price (P*) solves the
equation:
) , *, ( ) , ' *, ( ; P Q I P P Q
$ D

EquiIibrium !rice
Determination
W The equilibrium price depends on many
exogenous factors
÷ changes in any of these factors will likely
result in a new equilibrium price
EquiIibrium !rice
Determination
Quantity
!rice
S
D
Q
1
P
1
The interaction between
market demand and market
supply determines the
equilibrium price
EquiIibrium !rice
Determination
Quantity
!rice
S
D
Q
1
P
1
Q
2
P
2
Equilibrium price and
equilibrium quantity will
both rise
Ìf many buyers experience
an increase in their demands,
the market demand curve
will shift to the right
D'
EquiIibrium !rice
Determination
Quantity
!rice
SMC
q
1
P
1
q
2
P
2
This is the short-run
supply response to an
increase in market price
Ìf the market rises, firms will
increase their level of output
SATC
Shifts in SuppIy and
Demand Curves
W Demand curves shift because
÷ incomes change
÷ prices of substitutes or complements change
÷ preferences change
W Supply curves shift because
÷ input prices change
÷ technology changes
÷ number of producers change
Shifts in SuppIy and
Demand Curves
W When either a supply curve or a
demand curve shift, equilibrium price
and quantity will change
W The relative magnitudes of these
changes depends on the shapes of the
supply and demand curves
Shifts in SuppIy
Quantity Quantity
!rice !rice
S
S'
S
S'
D
D
P
P
Q
P'
Q'
P'
Q Q'
EIastic Demand IneIastic Demand
SmaII increase in price,
Iarge drop in quantity
Large increase in price,
smaII drop in quantity
Shifts in Demand
Quantity Quantity
!rice !rice
S
S
D D
P
P
Q
P'
Q'
P'
Q Q'
EIastic SuppIy IneIastic SuppIy
SmaII increase in price,
Iarge rise in quantity
Large increase in price,
smaII rise in quantity
D'
D'
Changing Short-Run EquiIibria
W Suppose that the market demand for
hamburgers is
Q
D
= 10,000 ÷ 5,000P
and the short-run market supply is
Q
$
5,000P
W Setting these equal, we find
P* = $1
Q* = 5,000
Changing Short-Run EquiIibria
W Suppose that the wage of hamburger
workers rises so that the short-run
market supply becomes
Q
$
,000P
W Solving for the new equilibrium, we find
P* = $1.11
Q* = ,
W Equilibrium price rises and quantity falls
Changing Short-Run EquiIibria
W Suppose instead that the demand for
hamburgers rises to
Q
D
12,000 - 5,000P
W Solving for the new equilibrium, we find
P* = $1.20
Q* = 6,000
W Equilibrium price and quantity both rise
MathematicaI ModeI of
SuppIy and Demand
W Suppose that the demand function is
represented by
Q
D
= D(P,-)
÷ - is a parameter that shifts the demand curve
W NDN- = D
-
can have any sign
÷ NDNP = D
P
< 0
MathematicaI ModeI of
SuppIy and Demand
W The supply relationship can be shown as
Q
$
= $(P,.)
÷ . is a parameter that shifts the supply curve
W N$N. = $
.
can have any sign
÷ N$NP = $
P
> 0
W Equilibrium requires that Q
D
= Q
$
MathematicaI ModeI of
SuppIy and Demand
W To analyze the comparative statics of
this model, we need to use the total
differentials of the supply and demand
functions:
/Q
D
= D
P
/P + D
-
/-
/Q
$
= $
P
/P + $
.
/.
W Maintenance of equilibrium requires that
/Q
D
= /Q
$
MathematicaI ModeI of
SuppIy and Demand
W Suppose that the demand parameter (-)
changed while . remains constant
W The equilibrium condition requires that
D
P
/P + D
-
/- = $
P
/P
P P
D $
D P

- N
N
-
W Because $
P
- D
P
> 0, NPN- will have the
same sign as D
-
MathematicaI ModeI of
SuppIy and Demand
W We can convert our analysis to elasticities
P D $
D
P
P
e
P P
P
-
c

-
c
- N
N

-
- ,
P Q P $
Q
P P
P
e e
e
Q
P
D $
Q
D
e
, ,
,
,
) (

c
-

-
-
-
Long-Run AnaIysis
W Ìn the long run, a firm may adapt all of its
inputs to fit market conditions
÷ profit-maximization for a price-taking firm
implies that P is equal to long-run MC
W Firms can also enter and exit an industry
in the long run
÷ perfect competition assumes that there are
no special costs of entering or exiting an
industry
Long-Run AnaIysis
W New firms will be lured into any market
for which economic profits are greater
than zero
÷ entry of firms will cause the short-run market
supply curve to shift outward
÷ market price and profits will fall
÷ the process will continue until economic
profits are zero
Long-Run AnaIysis
W Existing firms will leave any industry for
which economic profits are negative
÷ exit of firms will cause the short-run market
supply curve to shift inward
÷ market price will rise and losses will fall
÷ the process will continue until economic
profits are zero
Long-Run Competitive
EquiIibrium
W A perfectly competitive industry is in
long-run equilibrium if there are no
incentives for profit-maximizing firms to
enter or to leave the industry
÷ this will occur when the number of firms is
such that PMCC and each firm
operates at minimum C
Long-Run Competitive
EquiIibrium
W We will assume that all firms in an
industry have identical cost curves
÷ no firm controls any special resources or
technology
W The equilibrium long-run position
requires that each firm earn zero
economic profit
Long-Run EquiIibrium:
Constant-Cost Case
W Assume that the entry of new firms in an
industry has no effect on the cost of
inputs
÷ no matter how many firms enter or leave
an industry, a firm's cost curves will remain
unchanged
W This is referred to as a constant-cost
industry
Long-Run EquiIibrium:
Constant-Cost Case
A TypicaI Firm TotaI Market
q
1
Quantity
Quantity
SMC
MC
AC
S
D
P
1
Q
1
This is a long-run equilibrium for this industry
PMCC
Long-Run EquiIibrium:
Constant-Cost Case
A TypicaI Firm TotaI Market
q
1
Quantity
Quantity
SMC
MC
AC
S
D
P
1
Q
1
Suppose that market demand rises to D'
D'
P
2
Market price rises to P
2
Q
2
Long-Run EquiIibrium:
Constant-Cost Case
A TypicaI Firm TotaI Market
q
1
Quantity
Quantity
SMC
MC
AC
S
D
P
1
Q
1
Ìn the short run, each firm increases output to q
2
D'
P
2
Economic profit > 0
Q
2
q
2
Long-Run EquiIibrium:
Constant-Cost Case
A TypicaI Firm TotaI Market
q
1
Quantity
Quantity
SMC
MC
AC
S
D
P
1
Q
1
Ìn the long run, new firms will enter the industry
D'
Economic profit will return to 0
Q

S'
Long-Run EquiIibrium:
Constant-Cost Case
A TypicaI Firm TotaI Market
q
1
Quantity
Quantity
SMC
MC
AC
S
D
P
1
Q
1
The long-run supply curve will be a horizontal line
(infinitely elastic) at P
1
D'
Q

S'
LS
InfiniteIy EIastic Long-Run
SuppIy
W Suppose that the total cost curve for a
typical firm in the bicycle industry is
%C = q
3
÷ 20q
2
+ 100q + 8,000
W Demand for bicycles is given by
Q
D
= 2,500 ÷ 3P
InfiniteIy EIastic Long-Run
SuppIy
W To find the long-run equilibrium for this
market, we must find the low point on the
firm's average cost curve
÷ where CMC
Cq
2
÷ 20q + 100 + 8,000q
MC3q
2
÷ 0q + 100
÷ this occurs where q = 20
W Ìf q = 20, CMC$500
÷ this will be the long-run equilibrium price
Shape of the Long-Run
SuppIy Curve
W The zero-profit condition is the factor that
determines the shape of the long-run cost
curve
÷ if average costs are constant as firms enter,
long-run supply will be horizontal
÷ if average costs rise as firms enter, long-run
supply will have an upward slope
÷ if average costs fall as firms enter, long-run
supply will be negatively sloped
Long-Run EquiIibrium:
Increasing-Cost Case
W The entry of new firms may cause the
average costs of all firms to rise
÷ prices of scarce inputs may rise
÷ new firms may impose "external¨ costs on
existing firms
÷ new firms may increase the demand for
tax-financed services
Long-Run EquiIibrium:
Increasing-Cost Case
A TypicaI Firm (before entry) TotaI Market
q
1
Quantity
Quantity
SMC
MC
AC
S
D
P
1
Q
1
Suppose that we are in long-run equilibrium in this industry
PMCC
Long-Run EquiIibrium:
Increasing-Cost Case
A TypicaI Firm (before entry) TotaI Market
q
1
Quantity
Quantity
SMC
MC
AC
S
D
P
1
Q
1
Suppose that market demand rises to D'
D'
P
2
Market price rises to P
2
and firms increase output to q
2
Q
2
q
2
Long-Run EquiIibrium:
Increasing-Cost Case
A TypicaI Firm (after entry) TotaI Market
q

Quantity
Quantity
SMC'
MC'
AC'
S
D
P
1
Q
1
Positive profits attract new firms and supply shifts out
D'
P

Entry of firms causes costs for each firm to rise
Q

S'
Long-Run EquiIibrium:
Increasing-Cost Case
A TypicaI Firm (after entry) TotaI Market
q

Quantity
Quantity
SMC'
MC'
AC'
S
D
P
1
Q
1
The long-run supply curve will be upward-sloping
D'
P

Q

S'
LS
Long-Run EquiIibrium:
Decreasing-Cost Case
W The entry of new firms may cause the
average costs of all firms to fall
÷ new firms may attract a larger pool of
trained labor
÷ entry of new firms may provide a "critical
mass¨ of industrialization
W permits the development of more efficient
transportation and communications networks
Long-Run EquiIibrium:
Decreasing-Cost Case
A TypicaI Firm (before entry) TotaI Market
q
1
Quantity
Quantity
SMC
MC
AC
S
D
P
1
Q
1
Suppose that we are in long-run equilibrium in this industry
PMCC
Long-Run EquiIibrium:
Decreasing-Cost Case
A TypicaI Firm (before entry) TotaI Market
q
1
Quantity
Quantity
SMC
MC
AC
S
D
P
1
Q
1
Suppose that market demand rises to D'
D'
P
2
Market price rises to P
2
and firms increase output to q
2
Q
2
q
2
Long-Run EquiIibrium:
Decreasing-Cost Case
A TypicaI Firm (before entry) TotaI Market
q
1
Quantity
Quantity
SMC'
MC'
AC'
S
D
P
1
Q
1
Positive profits attract new firms and supply shifts out
D'
P

Entry of firms causes costs for each firm to fall
Q

q

S'
Long-Run EquiIibrium:
Decreasing-Cost Case
A TypicaI Firm (before entry) TotaI Market
q
1
Quantity
Quantity
SMC'
MC'
AC'
S
D
P
1
Q
1
The long-run industry supply curve will be downward-sloping
D'
P

Q

q

S'
LS
CIassification of Long-Run
SuppIy Curves
W Constant Cost
÷ entry does not affect input costs
÷ the long-run supply curve is horizontal at
the long-run equilibrium price
W Ìncreasing Cost
÷ entry increases inputs costs
÷ the long-run supply curve is positively
sloped
CIassification of Long-Run
SuppIy Curves
W Decreasing Cost
÷ Entry reduces input costs
÷ the long-run supply curve is negatively
sloped
Long-Run EIasticity of SuppIy
W The long-run elasticity of supply (e
L$,P
)
records the proportionate change in long-
run industry output to a proportionate
change in price
L$
L$
P L$
Q
P
P
Q
P
Q
e c
N
N

in change %
in change %
,
W e
L$,P
can be positive or negative
÷ the sign depends on whether the industry
exhibits increasing or decreasing costs
Comparative Statics AnaIysis
of Long-Run EquiIibrium
W Comparative statics analysis of long-run
equilibria can be conducted using
estimates of long-run elasticities
W Remember that, in the long run, the
number of firms in the industry will vary
from one long-run equilibrium to another
Comparative Statics AnaIysis
of Long-Run EquiIibrium
W Assume that we are examining a
constant-cost industry
W Suppose that the initial long-run
equilibrium industry output is Q
0
and the
typical firm's output is q* (where C is
minimized)
W The equilibrium number of firms in the
industry (3
0
) is Q
0
q*
Comparative Statics AnaIysis
of Long-Run EquiIibrium
W A shift in demand that changes the
equilibrium industry output to Q
1
will (in
the long run) change the equilibrium
number of firms to 3
1
= Q
1
q*
W The change in the number of firms is
* q
Q Q
3 3

÷ completely determined by the extent of the
demand shift and the optimal output level for
the typical firm
Comparative Statics AnaIysis
of Long-Run EquiIibrium
W The effect of a change in input prices is
more complicated
÷ need to know how much minimum average
cost is affected
÷ need to know how an increase in long-run
equilibrium price will affect quantity
demanded
Comparative Statics AnaIysis
of Long-Run EquiIibrium
W The optimal level of output for each firm
may also be affected
W Therefore, the change in the number of
firms becomes
* *

q
Q
q
Q
3 3
Rising Input Costs and
Industry Structure
W Suppose that the total cost curve for a
typical firm in the bicycle industry is
%C = q
3
÷ 20q
2
+ 100q + 8,000
and then rises to
%C = q
3
÷ 20q
2
+ 100q + 11,616
W The optimal scale of each firm rises
from 20 to 22 (where MCC)
Rising Input Costs and
Industry Structure
W At q = 22, MCC$672 so the long-
run equilibrium price will be $672
W Ìf demand can be represented by
Q
D
= 2,500 ÷ 3P
then Q
D
= 8
W This means that the industry will have
22 firms (8 22)
!roducer SurpIus in the
Long Run
W Short-run producer surplus represents
the return to a firm's owners in excess
of what would be earned if output was
zero
÷ the sum of short-run profits and fixed costs
!roducer SurpIus in the
Long Run
W Ìn the long-run, all profits are zero and
there are no fixed costs
÷ owners are indifferent about whether they
are in a particular market
W could earn identical returns on their investments
elsewhere
W Suppliers of inputs may not be indifferent
about the level of production in an
industry
!roducer SurpIus in the
Long Run
W Ìn the constant-cost case, input prices
are assumed to be independent of the
level of production
÷ inputs can earn the same amount in
alternative occupations
W Ìn the increasing-cost case, entry will bid
up some input prices
÷ suppliers of these inputs will be better off
!roducer SurpIus in the
Long Run
W Long-run producer surplus represents
the additional returns to the inputs in an
industry in excess of what these inputs
would earn if industry output was zero
÷ the area above the long-run supply curve
and below the market price
W would be zero in the case of constant costs
Ricardian Rent
W Long-run producer surplus can be most
easily illustrated with a situation first
described by economist David Ricardo
÷ Assume that there are many parcels of land
on which a particular crop may be grown
W range from very fertile land (low costs of
production) to very poor, dry land (high costs of
production)
Ricardian Rent
W At low prices only the best land is used
W Higher prices lead to an increase in
output through the use of higher-cost
land
÷ the long-run supply curve is upward-sloping
because of the increased costs of using less
fertile land
Ricardian Rent
Low-Cost Firm TotaI Market
q*
Quantity
Quantity
MC
AC
S
D
P*
Q*
The owners of low-cost firms will earn positive profits
Ricardian Rent
MarginaI Firm TotaI Market
q*
Quantity
Quantity
MC
AC
S
D
P*
Q*
The owners of the marginal firm will earn zero profit
Ricardian Rent
W Firms with higher costs (than the
marginal firm) will stay out of the market
÷ would incur losses at a price of P*
W Profits earned by intramarginal firms
can persist in the long run
÷ they reflect a return to a unique resource
W The sum of these long-run profits
constitutes long-run producer surplus
Ricardian Rent
For each firm, P C represents
profit per unit of output
TotaI Market
Quantity
S
D
P*
Q*
Each point on the supply curve represents minimum
average cost for some firm
Total long-run profits can be
computed by summing over all
units of output
Ricardian Rent
W The long-run profits for the low-cost firms
will often be reflected in the prices of the
unique resources owned by those firms
÷ the more fertile the land is, the higher its
price
W Thus, profits are said to be capitalized
inputs' prices
÷ reflect the present value of all future profits
Ricardian Rent
W Ìt is the scarcity of low-cost inputs that
creates the possibility of Ricardian rent
W Ìn industries with upward-sloping long-
run supply curves, increases in output
not only raise firms' costs but also
generate rents for inputs
Important !oints to Note:
W Ìn the short run, equilibrium prices are
established by the intersection of what
demanders are willing to pay (as reflected
by the demand curve) and what firms are
willing to produce (as reflected by the
short-run supply curve)
÷ these prices are treated as fixed in both
demanders' and suppliers' decision-making
processes
Important !oints to Note:
W A shift in either demand or supply will
cause the equilibrium price to change
÷ the extent of such a change will depend on
the slopes of the various curves
W Firms may earn positive profits in the
short run
W Because fixed costs must always be paid,
firms will choose a positive output as long
as revenues exceed variable costs
Important !oints to Note:
W Ìn the long run, the number of firms is
variable in response to profit opportunities
÷ the assumption of free entry and exit implies
that firms in a competitive industry will earn
zero economic profits in the long run (PC)
÷ because firms also seek maximum profits,
the equality PCMC implies that firms
will operate at the low points of their long-run
average cost curves
Important !oints to Note:
W The shape of the long-run supply curve
depends on how entry and exit affect
firms' input costs
÷ in the constant-cost case, input prices do not
change and the long-run supply curve is
horizontal
÷ if entry raises input costs, the long-run supply
curve will have a positive slope
Important !oints to Note:
W Changes in long-run market equilibrium
will also change the number of firms
÷ precise predictions about the extent of these
changes is made difficult by the possibility
that the minimum average cost level of
output may be affected by changes in input
costs or by technical progress
Important !oints to Note:
W Ìf changes in the long-run equilibrium in a
market lead to a change in the prices of
inputs to that market, the welfare of the
suppliers of these inputs will be affected
÷ such changes can be measured by changes
in the value of long-run producer surplus

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