1 00:00:00,040 --> 00:00:02,460 The following content is provided under a Creative 2 00:00:02,460 --> 00:00:03,870 Commons license. 3 00:00:03,870 --> 00:00:06,910 Your support will help MIT OpenCourseWare continue to 4 00:00:06,910 --> 00:00:10,560 offer high quality educational resources for free. 5 00:00:10,560 --> 00:00:13,460 To make a donation or view additional materials from 6 00:00:13,460 --> 00:00:16,180 hundreds of MIT courses, visit mitopencourseware@ocw.mit.edu. 7 00:00:23,850 --> 00:00:24,260 PROFESSOR: All right. 8 00:00:24,260 --> 00:00:28,320 So today we're going to continue our discussion of the 9 00:00:28,320 --> 00:00:30,990 perfectly competitive market outcome. 10 00:00:30,990 --> 00:00:33,080 And remember, once again, where we're coming from here. 11 00:00:33,080 --> 00:00:35,140 We're trying to figure out how firms 12 00:00:35,140 --> 00:00:36,740 decide how much to produce. 13 00:00:36,740 --> 00:00:41,410 We talked about the firm's production decision in costs. 14 00:00:41,410 --> 00:00:43,220 Then we said how the firm decides how much to produce is 15 00:00:43,220 --> 00:00:45,060 going to get dictated by the market. 16 00:00:45,060 --> 00:00:46,640 We're going to talk about different market structures. 17 00:00:46,640 --> 00:00:49,640 We'll start with our benchmark of perfect competition and 18 00:00:49,640 --> 00:00:51,410 then move on to some more interesting and realistic 19 00:00:51,410 --> 00:00:52,970 cases next. 20 00:00:52,970 --> 00:00:55,270 Now, I just want to finish up where we were last time. 21 00:00:55,270 --> 00:00:57,110 Remember last time we were dealing with a firm that had a 22 00:00:57,110 --> 00:01:04,440 cost function of the form 10 plus 0.5q squared. 23 00:01:04,440 --> 00:01:07,800 And if you remember, the key condition we derived last time 24 00:01:07,800 --> 00:01:10,900 for profit maximization with a perfectly competitive firm is 25 00:01:10,900 --> 00:01:15,680 that price equals marginal cost. If you differentiate 26 00:01:15,680 --> 00:01:21,300 this with respect to q, you get that that means that p 27 00:01:21,300 --> 00:01:25,150 equals q is the profit maximizing 28 00:01:25,150 --> 00:01:26,850 condition for this firm. 29 00:01:26,850 --> 00:01:29,400 It sets the price equal to quantity it's going to sell. 30 00:01:29,400 --> 00:01:31,480 That's the profit maximizing condition with this particular 31 00:01:31,480 --> 00:01:33,940 functional form of the cost function. 32 00:01:33,940 --> 00:01:36,770 Now, before we left last time, I said, this was not enough. 33 00:01:36,770 --> 00:01:38,960 There's one other thing you have to consider which is the 34 00:01:38,960 --> 00:01:40,350 firm's shutdown decision. 35 00:01:45,740 --> 00:01:49,620 In the short run, a firm might not shut down even if it's 36 00:01:49,620 --> 00:01:51,460 losing money. 37 00:01:51,460 --> 00:01:54,360 And the reason is because the firm has already paid its 38 00:01:54,360 --> 00:01:55,790 fixed costs. 39 00:01:55,790 --> 00:01:58,280 It's already paid 10. 40 00:01:58,280 --> 00:02:03,550 So even if it's losing money, it might still not shut down. 41 00:02:03,550 --> 00:02:06,750 So, for example, imagine that the price, as I said last 42 00:02:06,750 --> 00:02:09,862 time, imagine the price fell from 6 to 3. 43 00:02:09,862 --> 00:02:12,130 The price equals 3. 44 00:02:12,130 --> 00:02:14,700 If the price equals 3, the firm will choose to produce 3 45 00:02:14,700 --> 00:02:16,710 units, because it will still follow the 46 00:02:16,710 --> 00:02:18,830 profit maximizing condition. 47 00:02:18,830 --> 00:02:21,360 It will still choose to produce three units. 48 00:02:21,360 --> 00:02:25,660 If it produces 3 units, its profits are its 49 00:02:25,660 --> 00:02:28,446 revenues which is 9-- 50 00:02:28,446 --> 00:02:30,710 3 units at a price of 3-- 51 00:02:30,710 --> 00:02:34,340 minus its cost which is 14.5. 52 00:02:34,340 --> 00:02:37,060 So that equals negative 5.5. 53 00:02:37,060 --> 00:02:39,680 So its profits are negative. 54 00:02:39,680 --> 00:02:42,250 So now I say, well, if profits are negative, maybe I should 55 00:02:42,250 --> 00:02:44,460 shut down and stop doing business. 56 00:02:44,460 --> 00:02:48,670 Well, what are its profits if it shuts down? 57 00:02:48,670 --> 00:02:49,460 Negative 10. 58 00:02:49,460 --> 00:02:54,160 If it shuts down, its profits are 0 minus 10 59 00:02:54,160 --> 00:02:55,580 equals negative 10. 60 00:02:55,580 --> 00:02:58,060 So it actually makes more money by staying in business 61 00:02:58,060 --> 00:03:02,290 than shutting down, because it has these fixed costs. 62 00:03:02,290 --> 00:03:05,500 So because it's going to pay the 10 anyway, as long as it's 63 00:03:05,500 --> 00:03:08,040 going to lose less than 10, it might as 64 00:03:08,040 --> 00:03:10,230 well stay in business. 65 00:03:10,230 --> 00:03:16,000 More generally, what we say is a firm will stay in business 66 00:03:16,000 --> 00:03:19,750 in the short run as long as its price covers 67 00:03:19,750 --> 00:03:21,900 its variable costs. 68 00:03:21,900 --> 00:03:27,820 So a firm will stay in business so long as the price 69 00:03:27,820 --> 00:03:31,760 is greater or equal to its variable costs. 70 00:03:31,760 --> 00:03:33,010 Then it will stay in business. 71 00:03:42,480 --> 00:03:44,500 If we go further-- 72 00:03:44,500 --> 00:03:45,980 let me just derive it for a second-- as long as they cover 73 00:03:45,980 --> 00:03:48,720 its fixed costs, that means a firm will stay in business as 74 00:03:48,720 --> 00:03:52,330 long as its revenues are greater than 75 00:03:52,330 --> 00:03:53,910 its variable costs. 76 00:03:53,910 --> 00:03:55,800 As long as its revenues are greater than or equal to its 77 00:03:55,800 --> 00:03:57,320 variable costs, it will stay in business. 78 00:04:00,010 --> 00:04:02,246 And that means that it will stay in business at long as 79 00:04:02,246 --> 00:04:04,540 its price is greater than or equal-- this should be a 80 00:04:04,540 --> 00:04:06,470 little q, sorry, this is just a firm-- 81 00:04:06,470 --> 00:04:07,820 as long as its price is greater than or equal to 82 00:04:07,820 --> 00:04:12,970 variable costs over quantity, or as long as price is greater 83 00:04:12,970 --> 00:04:16,310 than or equal to average variable cost. 84 00:04:16,310 --> 00:04:18,380 As long as its price is greater than or equal to its 85 00:04:18,380 --> 00:04:23,100 average variable cost, it will stay in business. 86 00:04:23,100 --> 00:04:26,440 As long as its revenues cover its variable costs, it will 87 00:04:26,440 --> 00:04:27,030 say in business. 88 00:04:27,030 --> 00:04:29,466 And that's saying the same as long as its price is great 89 00:04:29,466 --> 00:04:31,045 than or equal to average variable cost, it 90 00:04:31,045 --> 00:04:32,295 will stay in business. 91 00:04:34,930 --> 00:04:39,790 Now, what are the average variable costs for our firm? 92 00:04:39,790 --> 00:04:42,880 Well, the variable costs for our firm 93 00:04:42,880 --> 00:04:47,410 are 0.5 times q squared. 94 00:04:47,410 --> 00:04:50,980 The variable costs for our firm are 0.5 times q squared. 95 00:04:57,350 --> 00:05:00,510 We know that in equilibrium, if it's profit maximizing, it 96 00:05:00,510 --> 00:05:02,950 will produce where q equals p. 97 00:05:02,950 --> 00:05:05,040 So we can replace the q with the p. 98 00:05:05,040 --> 00:05:08,320 The variable costs are 0.5 times p squared, because we 99 00:05:08,320 --> 00:05:11,000 know we'll produce where q equals p. 100 00:05:11,000 --> 00:05:17,510 So its average variable costs are 0.5 times p. 101 00:05:17,510 --> 00:05:22,010 Its average variable costs are 0.5 times p. 102 00:05:22,010 --> 00:05:24,490 Well, by definition, p is always greater 103 00:05:24,490 --> 00:05:26,470 than 0.5 times p. 104 00:05:26,470 --> 00:05:30,440 So our firm will never go out of business in the short run. 105 00:05:30,440 --> 00:05:33,500 In the short run, our firm will never go out of business, 106 00:05:33,500 --> 00:05:37,900 because at the profit maximizing price, at p equals 107 00:05:37,900 --> 00:05:42,460 q, it will always be producing a point where the price is 108 00:05:42,460 --> 00:05:45,066 greater than its average variable cost. So it will 109 00:05:45,066 --> 00:05:47,880 never shut down. 110 00:05:47,880 --> 00:05:50,580 So, more generally, when we think about a short run supply 111 00:05:50,580 --> 00:05:52,550 decision, a short run supply decision for a 112 00:05:52,550 --> 00:05:55,130 firm, there's two steps. 113 00:05:55,130 --> 00:05:59,260 The first step is set price equal to marginal cost to 114 00:05:59,260 --> 00:06:02,310 figure out what the firm is going to produce. 115 00:06:02,310 --> 00:06:07,670 So step one is set price equal to marginal cost. And that 116 00:06:07,670 --> 00:06:10,200 will give you the firm's q*. 117 00:06:10,200 --> 00:06:13,550 That will give you what the firm is going to produce. 118 00:06:13,550 --> 00:06:19,885 The second step is check that price is greater than or equal 119 00:06:19,885 --> 00:06:21,210 to average variable costs. 120 00:06:21,210 --> 00:06:23,760 Because you may solve for an optimal quantity that turns 121 00:06:23,760 --> 00:06:25,110 out to be a money loser for the firm. 122 00:06:25,110 --> 00:06:26,840 So they'd rather shut down. 123 00:06:26,840 --> 00:06:28,180 So it's a two-step process. 124 00:06:28,180 --> 00:06:30,024 You've got to first solve for the optimal quantity that the 125 00:06:30,024 --> 00:06:32,100 firm is going to produce. 126 00:06:32,100 --> 00:06:33,500 But then you've got to make sure that the firm actually 127 00:06:33,500 --> 00:06:37,190 makes money on that quantity, or it won't produce at all. 128 00:06:37,190 --> 00:06:39,920 And that's how we do the profit maximization decision 129 00:06:39,920 --> 00:06:42,890 in the short run for the firm. 130 00:06:42,890 --> 00:06:45,520 You've got to produce at the efficient point and make sure 131 00:06:45,520 --> 00:06:48,760 the firm actually makes some money. 132 00:06:48,760 --> 00:06:52,530 All right, questions about that? 133 00:06:52,530 --> 00:06:57,600 Now, armed with these rules, we can now, finally, derive 134 00:06:57,600 --> 00:06:59,280 the supply curve. 135 00:06:59,280 --> 00:07:03,360 Remember we derived the demand curve a number of lectures ago 136 00:07:03,360 --> 00:07:08,540 by getting the tangency at different price ratios with 137 00:07:08,540 --> 00:07:09,690 the indifference curves. 138 00:07:09,690 --> 00:07:12,860 Well, to derive the firm's supply function, what we now 139 00:07:12,860 --> 00:07:16,420 need to do is say, OK, at different prices, how much 140 00:07:16,420 --> 00:07:17,760 will the firm produce? 141 00:07:17,760 --> 00:07:21,000 Well, we can now get that if we go to Figure 11-1. 142 00:07:21,000 --> 00:07:24,640 We can now see the supply curve for this firm. 143 00:07:24,640 --> 00:07:28,060 What we see is that at a price of 3, it will produce 3 units. 144 00:07:28,060 --> 00:07:31,310 At a price of 4, it will produce 4 units, et cetera. 145 00:07:31,310 --> 00:07:35,860 The supply curve is the marginal cost curve. 146 00:07:35,860 --> 00:07:37,920 So now we know where supply curves come from. 147 00:07:37,920 --> 00:07:42,800 Supply curves are marginal cost curves above the point 148 00:07:42,800 --> 00:07:45,590 where price equals average variable cost. So the 149 00:07:45,590 --> 00:07:51,540 definition of a firm's supply curve is the marginal cost 150 00:07:51,540 --> 00:07:58,290 curve above p is greater than or equal to average variable 151 00:07:58,290 --> 00:08:01,920 cost. That is the firm's short run supply curve. 152 00:08:01,920 --> 00:08:04,800 Now, in our case, p is always greater than average variable 153 00:08:04,800 --> 00:08:07,940 cost. So the second condition is irrelevant. 154 00:08:07,940 --> 00:08:09,750 The firm's supply curve is just literally that marginal 155 00:08:09,750 --> 00:08:10,570 cost curve. 156 00:08:10,570 --> 00:08:13,170 With different functions, which you may someday see in a 157 00:08:13,170 --> 00:08:16,680 problem set or an exam, that won't be true. 158 00:08:16,680 --> 00:08:18,800 So, in that case, you'll need to check 159 00:08:18,800 --> 00:08:21,380 that shutdown condition. 160 00:08:21,380 --> 00:08:25,880 But the supply curve is the marginal cost curve above that 161 00:08:25,880 --> 00:08:28,010 0 profit point. 162 00:08:28,010 --> 00:08:30,390 And that's where supply curves come from. 163 00:08:30,390 --> 00:08:32,740 So where supply curves comes from is the same kind of 164 00:08:32,740 --> 00:08:34,679 maximization we did with consumers. 165 00:08:34,679 --> 00:08:39,200 But instead of their parents giving them their income, the 166 00:08:39,200 --> 00:08:41,460 market conditions firms face are dictated by the 167 00:08:41,460 --> 00:08:44,440 competitive nature of the market. 168 00:08:44,440 --> 00:08:47,710 And that's the firm's supply curve. 169 00:08:47,710 --> 00:08:52,560 Now, this is the firm's supply curve. 170 00:08:52,560 --> 00:08:54,590 Now, of course, what we talked about in the first lecture was 171 00:08:54,590 --> 00:08:57,770 not firm supply curves but market supply curves. 172 00:08:57,770 --> 00:08:59,480 So now let's take the next step and say, well, where do 173 00:08:59,480 --> 00:09:00,850 market supply curves come from? 174 00:09:00,850 --> 00:09:03,780 We now know where firm supply curves come from. 175 00:09:03,780 --> 00:09:06,600 The marginal cost stork brings them. 176 00:09:06,600 --> 00:09:09,640 Now, where do market supply curves come from? 177 00:09:09,640 --> 00:09:15,010 Well, to do that, we need to now imagine that there's not 178 00:09:15,010 --> 00:09:19,230 one firm in the market but many firms in the market. 179 00:09:19,230 --> 00:09:25,080 And we need to recognize that the market demand may not be 180 00:09:25,080 --> 00:09:26,090 perfectly elastic. 181 00:09:26,090 --> 00:09:30,700 But, as we talked about last time, the firm's own demand 182 00:09:30,700 --> 00:09:32,140 will be close to perfectly elastic. 183 00:09:32,140 --> 00:09:33,835 Or, in this case, a perfect competition will 184 00:09:33,835 --> 00:09:36,830 be perfectly elastic. 185 00:09:36,830 --> 00:09:44,590 So, basically, the way to get market demand is to say, look, 186 00:09:44,590 --> 00:09:46,330 we're going to take each firm. 187 00:09:46,330 --> 00:09:48,195 It's going to take a market price as given. 188 00:09:51,420 --> 00:09:52,490 I'm sorry, we get market supply. 189 00:09:52,490 --> 00:09:53,180 I'm sorry. 190 00:09:53,180 --> 00:09:56,030 Each firm is going to take a market price as given. 191 00:09:56,030 --> 00:09:58,110 Based on that market price, it's going to decide how much 192 00:09:58,110 --> 00:09:59,690 to produce. 193 00:09:59,690 --> 00:10:01,850 We're going to add up that production. 194 00:10:01,850 --> 00:10:05,360 That will make a market supply curve. 195 00:10:05,360 --> 00:10:07,570 And that market supply curve will then interact with market 196 00:10:07,570 --> 00:10:09,750 demand to give you a price. 197 00:10:09,750 --> 00:10:12,830 If that price is the same one the firms were using, then the 198 00:10:12,830 --> 00:10:15,000 whole thing is in equilibrium. 199 00:10:15,000 --> 00:10:19,320 Let me explain that in less steps just to make it clear. 200 00:10:19,320 --> 00:10:23,190 Let's talk about the steps involved in getting to short 201 00:10:23,190 --> 00:10:27,952 run equilibrium in the market, the steps involved in getting 202 00:10:27,952 --> 00:10:31,400 to short run market equilibrium. 203 00:10:31,400 --> 00:10:36,000 The first step is each firm chooses an amount of capital. 204 00:10:36,000 --> 00:10:38,490 So the first step of the short run is you're going to enter 205 00:10:38,490 --> 00:10:39,450 this market. 206 00:10:39,450 --> 00:10:41,370 And to enter this market, you're going to have an amount 207 00:10:41,370 --> 00:10:43,860 of capital you're going to pick. 208 00:10:43,860 --> 00:10:49,410 So each firm is going to have some cost function which 209 00:10:49,410 --> 00:10:52,500 involves picking some amount of capital or fixed costs. 210 00:10:57,040 --> 00:10:59,070 It's going to say, I want to build a building this big. 211 00:11:03,350 --> 00:11:05,670 Having built that building, we're going to get the firm's 212 00:11:05,670 --> 00:11:12,050 supply curve which is p equals MC. 213 00:11:14,650 --> 00:11:15,260 That's step one. 214 00:11:15,260 --> 00:11:18,600 That's a step we've derived. 215 00:11:18,600 --> 00:11:23,690 The second step is we're going to add up the firm's supply 216 00:11:23,690 --> 00:11:30,140 curves to get a market supply curve. 217 00:11:33,040 --> 00:11:35,610 We're going to add up the firm's supply curve to get a 218 00:11:35,610 --> 00:11:37,570 market supply curve. 219 00:11:37,570 --> 00:11:41,640 So, for example, suppose that there's five 220 00:11:41,640 --> 00:11:42,890 firms in the market. 221 00:11:47,180 --> 00:11:50,750 Suppose that there's five firms in the market. 222 00:11:53,530 --> 00:11:56,740 Those five firms are going to produce. 223 00:11:56,740 --> 00:12:01,120 Now to see that, let's go to Figure 11-2. 224 00:12:01,120 --> 00:12:02,740 This is the second step. 225 00:12:02,740 --> 00:12:06,180 It's how we get to that short run market supply curve. 226 00:12:06,180 --> 00:12:09,600 Each firm has a marginal cost curve. 227 00:12:09,600 --> 00:12:13,320 Here we're using our same cost function we've used. 228 00:12:13,320 --> 00:12:15,340 That same cost function up there where price equals 229 00:12:15,340 --> 00:12:18,980 marginal cost, where p equals q, is the supply curve. 230 00:12:18,980 --> 00:12:20,900 So each firm has that supply curve you see 231 00:12:20,900 --> 00:12:22,570 in the first panel. 232 00:12:22,570 --> 00:12:27,220 Then what you see is as you add more firms, the second 233 00:12:27,220 --> 00:12:28,720 panel gives you the market supply curve. 234 00:12:28,720 --> 00:12:31,280 So if there's only one firm in the market, the market supply 235 00:12:31,280 --> 00:12:33,940 curve would be S1. 236 00:12:33,940 --> 00:12:36,600 Now, if there were two firms in the market, the market 237 00:12:36,600 --> 00:12:37,460 supply curve is S2. 238 00:12:37,460 --> 00:12:40,770 That is, at a price of 2, you're now producing 4 units 239 00:12:40,770 --> 00:12:42,020 in the market. 240 00:12:42,020 --> 00:12:45,180 If there's three firms, the curve is S3, four 241 00:12:45,180 --> 00:12:46,980 firms, S4, and so on. 242 00:12:46,980 --> 00:12:51,850 As you add more firms, that market supply curve shifts out 243 00:12:51,850 --> 00:12:55,070 and becomes flatter. 244 00:12:55,070 --> 00:12:56,730 Remember firms are identical here. 245 00:12:56,730 --> 00:12:58,380 We're adding identical firms. That was an assumption of 246 00:12:58,380 --> 00:12:59,300 perfect competition. 247 00:12:59,300 --> 00:13:01,340 We're adding more and more identical firms 248 00:13:01,340 --> 00:13:02,430 producing the same good. 249 00:13:02,430 --> 00:13:06,120 You can see that market supply curve is shifting out and 250 00:13:06,120 --> 00:13:08,170 becoming flatter. 251 00:13:08,170 --> 00:13:13,500 That is the supply of goods is becoming more elastic as there 252 00:13:13,500 --> 00:13:17,960 are more firms. The more firms in the market the more elastic 253 00:13:17,960 --> 00:13:18,530 the supply. 254 00:13:18,530 --> 00:13:20,820 And that comes to what we talked about last time when I 255 00:13:20,820 --> 00:13:22,070 derived residual demand. 256 00:13:25,106 --> 00:13:27,120 It's sort of the flip side of that. 257 00:13:27,120 --> 00:13:29,850 Basically, the more firms you have with a given supply curve 258 00:13:29,850 --> 00:13:32,610 in the market, the more elastic it's going to become. 259 00:13:32,610 --> 00:13:33,640 Why is that? 260 00:13:33,640 --> 00:13:35,115 Well, just think about it. 261 00:13:35,115 --> 00:13:37,150 Think about what elasticity of supply is. 262 00:13:37,150 --> 00:13:40,000 It's saying, if I increase the price by $1, how much more 263 00:13:40,000 --> 00:13:42,110 production do I call forth? 264 00:13:42,110 --> 00:13:44,920 Well, the more identical firms I have, every time I increase 265 00:13:44,920 --> 00:13:47,970 the price by $1, I call forth production from all these 266 00:13:47,970 --> 00:13:50,840 firms. So the more firms I have, the more production I 267 00:13:50,840 --> 00:13:52,010 call forth. 268 00:13:52,010 --> 00:13:54,700 So for every increment in price, the more firms in the 269 00:13:54,700 --> 00:13:56,840 market, the more production I call forth. 270 00:13:56,840 --> 00:14:00,380 Therefore, the more elastic is the supply. 271 00:14:00,380 --> 00:14:03,330 So as there are more firms, that market supply curve 272 00:14:03,330 --> 00:14:05,670 becomes more and more elastic. 273 00:14:05,670 --> 00:14:06,970 And that's the market supply curve. 274 00:14:06,970 --> 00:14:10,150 That's the second step. 275 00:14:10,150 --> 00:14:23,880 The third step is we intersect market supply with market 276 00:14:23,880 --> 00:14:29,450 demand to get the equilibrium price. 277 00:14:32,880 --> 00:14:36,900 So, in other words, we say, look, there's some market 278 00:14:36,900 --> 00:14:38,900 supply, which we've derived. 279 00:14:38,900 --> 00:14:41,160 Now let's imagine there's some market demand. 280 00:14:41,160 --> 00:14:43,240 And that will give us the equilibrium price. 281 00:14:43,240 --> 00:14:51,510 So, for example, in our case, market supply is what? 282 00:14:54,850 --> 00:14:56,230 Let's say, for example, there's five 283 00:14:56,230 --> 00:14:56,850 firms in the market. 284 00:14:56,850 --> 00:14:59,120 Just to make an example, let's say five firms have entered. 285 00:14:59,120 --> 00:15:00,970 There's five firms in the market. 286 00:15:00,970 --> 00:15:06,710 Well, the total market supply Q is 5 of the little q, 287 00:15:06,710 --> 00:15:10,290 because there's five identical firms in the market. 288 00:15:10,290 --> 00:15:12,240 Five identical firms are in the market. 289 00:15:12,240 --> 00:15:15,160 Well, we know, from the marginal cost condition, 290 00:15:15,160 --> 00:15:18,450 that's the same as saying Q equals 5 times p. 291 00:15:18,450 --> 00:15:22,200 So our market supply curve, which is actually S5 on Figure 292 00:15:22,200 --> 00:15:24,940 11-2, is Q equals 5p. 293 00:15:24,940 --> 00:15:25,400 You can see that. 294 00:15:25,400 --> 00:15:27,860 Because when the price is 2, Q equals 10. 295 00:15:27,860 --> 00:15:34,180 When the price is 5, Q equals 25. 296 00:15:34,180 --> 00:15:37,980 So you can see that S super 5 is the market supply curve. 297 00:15:37,980 --> 00:15:39,230 Big Q equals 5p. 298 00:15:42,800 --> 00:15:44,260 Let's just make this up. 299 00:15:44,260 --> 00:15:46,290 So this is the quantity supplied. 300 00:15:46,290 --> 00:15:51,280 Let's say the demand function is that the quantity demanded 301 00:15:51,280 --> 00:15:54,930 is 30 minus p. 302 00:15:54,930 --> 00:15:56,470 I just made this up. 303 00:15:56,470 --> 00:15:57,370 I'm making all this up. 304 00:15:57,370 --> 00:15:59,550 But this is just an example demand curve. 305 00:15:59,550 --> 00:16:03,430 We have a downward sloping demand curve with a slope of 306 00:16:03,430 --> 00:16:05,080 negative 1. 307 00:16:05,080 --> 00:16:08,020 The quantity demanded is 30 minus p. 308 00:16:08,020 --> 00:16:12,450 So to get equilibrium, we set these equal. 309 00:16:12,450 --> 00:16:20,610 And we get that 30 minus p equals 5p or p equals 5. 310 00:16:23,330 --> 00:16:28,830 30 minus p equals 5p or p equals 5, that's the 311 00:16:28,830 --> 00:16:30,460 equilibrium price. 312 00:16:30,460 --> 00:16:34,470 Given the market supply curve, given the demand curve, I've 313 00:16:34,470 --> 00:16:36,695 derived the equilibrium price of 5. 314 00:16:39,480 --> 00:16:43,170 Now, at a price of 5, what's the quantity demanded? 315 00:16:43,170 --> 00:16:46,840 At a price of 5, quantity demanded equals 25. 316 00:16:46,840 --> 00:16:50,340 So, at a price of 5, the market wants 25 of these 317 00:16:50,340 --> 00:16:51,980 things, whatever the heck it's producing. 318 00:16:51,980 --> 00:16:55,960 At a price of 5, the market wants 25 of them. 319 00:16:55,960 --> 00:16:58,520 That's the quantity demanded. 320 00:16:58,520 --> 00:17:05,270 Then the final step in solving for equilibrium is that each 321 00:17:05,270 --> 00:17:07,595 firm then decides how much to produce. 322 00:17:21,930 --> 00:17:24,150 Well, what is each firm going to decide to produce? 323 00:17:24,150 --> 00:17:26,630 How much is each firm going to decide to produce? 324 00:17:26,630 --> 00:17:28,590 Somebody raise their hand and tell me. 325 00:17:28,590 --> 00:17:29,213 Yeah. 326 00:17:29,213 --> 00:17:29,980 AUDIENCE: p. 327 00:17:29,980 --> 00:17:30,740 PROFESSOR: p which is? 328 00:17:30,740 --> 00:17:31,150 AUDIENCE: 5 329 00:17:31,150 --> 00:17:31,415 PROFESSOR: 5. 330 00:17:31,415 --> 00:17:33,710 So each firm is going to produce 5. 331 00:17:33,710 --> 00:17:35,260 How many firms are there? 332 00:17:35,260 --> 00:17:35,750 AUDIENCE: 5. 333 00:17:35,750 --> 00:17:36,820 PROFESSOR: How much gets produced? 334 00:17:36,820 --> 00:17:37,215 AUDIENCE: 25. 335 00:17:37,215 --> 00:17:38,890 PROFESSOR: Which is exactly what people want. 336 00:17:38,890 --> 00:17:41,020 We're done. 337 00:17:41,020 --> 00:17:43,840 That's the magic of the market. 338 00:17:43,840 --> 00:17:45,950 Through these four steps, we've gotten equilibrium which 339 00:17:45,950 --> 00:17:47,860 is defined as the quantity supplied equals the quantity 340 00:17:47,860 --> 00:17:50,870 demanded, just by following these steps. 341 00:17:50,870 --> 00:17:54,900 The firms didn't come at it saying, hey, let's figure this 342 00:17:54,900 --> 00:17:57,290 out beforehand. 343 00:17:57,290 --> 00:17:59,310 Let's all get together and coordinate and figure out how 344 00:17:59,310 --> 00:17:59,980 much we're going to produce at what price. 345 00:17:59,980 --> 00:18:01,760 They didn't do that at all. 346 00:18:01,760 --> 00:18:04,550 The firms just entered the market. 347 00:18:04,550 --> 00:18:07,010 They said, this is my supply curve. 348 00:18:07,010 --> 00:18:08,330 We added it up. 349 00:18:08,330 --> 00:18:10,120 We interact it with demand. 350 00:18:10,120 --> 00:18:12,240 We find an equilibrium price. 351 00:18:12,240 --> 00:18:14,630 At that equilibrium price, the quantity demanded equals the 352 00:18:14,630 --> 00:18:15,730 quantity supplied. 353 00:18:15,730 --> 00:18:16,980 We're done. 354 00:18:19,410 --> 00:18:23,290 We've now finally gotten to where we started this course. 355 00:18:23,290 --> 00:18:25,650 We started this course with a supply and demand graph. 356 00:18:25,650 --> 00:18:27,250 I told you how to derive demand. 357 00:18:27,250 --> 00:18:29,360 You took a test on that already. 358 00:18:29,360 --> 00:18:31,350 Now I've just told you where supply comes from. 359 00:18:31,350 --> 00:18:32,760 Now we interact, and we're done. 360 00:18:32,760 --> 00:18:35,860 And this tells us now, given this price, how much each firm 361 00:18:35,860 --> 00:18:37,110 is going to produce. 362 00:18:39,680 --> 00:18:43,960 So, basically, what do you need to find equilibrium? 363 00:18:43,960 --> 00:18:47,160 What do you need to find the short run equilibrium? 364 00:18:47,160 --> 00:18:49,780 To find the short run equilibrium, you need a demand 365 00:18:49,780 --> 00:18:56,790 function, a cost function, and a number of firms. You have to 366 00:18:56,790 --> 00:18:58,840 be given a number firms, because there's no entry and 367 00:18:58,840 --> 00:19:00,380 exit in the short run, remember. 368 00:19:00,380 --> 00:19:03,220 So, basically, the firms are magically put on the earth in 369 00:19:03,220 --> 00:19:04,400 the short run. 370 00:19:04,400 --> 00:19:07,230 So if you're asked about the short run equilibrium, you 371 00:19:07,230 --> 00:19:08,420 have to be given the number of firms. You 372 00:19:08,420 --> 00:19:10,120 can't derive that yet. 373 00:19:10,120 --> 00:19:11,270 That comes in the long run. 374 00:19:11,270 --> 00:19:14,100 But given a number of firms, given a cost function, and 375 00:19:14,100 --> 00:19:17,310 given the demand function, you can find the short run 376 00:19:17,310 --> 00:19:19,360 equilibrium. 377 00:19:19,360 --> 00:19:20,610 Questions about that? 378 00:19:23,400 --> 00:19:26,460 Now, with that in place, now let's get to where it gets 379 00:19:26,460 --> 00:19:27,440 really interesting. 380 00:19:27,440 --> 00:19:29,640 Let's talk now about the long run. 381 00:19:29,640 --> 00:19:31,830 Now what makes the long run interesting is you no longer 382 00:19:31,830 --> 00:19:35,750 have to be given the number of firms. Now, in the long run, 383 00:19:35,750 --> 00:19:37,800 we're going to actually figure out how many 384 00:19:37,800 --> 00:19:39,510 firms are in the market. 385 00:19:39,510 --> 00:19:41,765 So at the end of the day, in the long run, all we'll need 386 00:19:41,765 --> 00:19:44,170 is two things, a demand function and a cost function. 387 00:19:44,170 --> 00:19:46,640 And then we'll be done. 388 00:19:46,640 --> 00:19:49,310 Now, here's the key thing for the long run. 389 00:19:49,310 --> 00:19:51,630 The key point in the long run is that in the long run, no 390 00:19:51,630 --> 00:19:53,290 one can lose money. 391 00:19:53,290 --> 00:19:54,170 So we don't have to worry about the 392 00:19:54,170 --> 00:19:56,030 shutdown condition anymore. 393 00:19:56,030 --> 00:19:57,330 The shutdown condition goes away. 394 00:19:57,330 --> 00:20:00,200 In the long run, nothing is fixed. 395 00:20:00,200 --> 00:20:02,400 So in the long run, no one loses money. 396 00:20:02,400 --> 00:20:04,560 There's no reason to be in the market if you're losing money 397 00:20:04,560 --> 00:20:06,840 in the long run. 398 00:20:06,840 --> 00:20:09,520 So, in long run, the first thing is now we only have one 399 00:20:09,520 --> 00:20:12,890 condition to worry about, which is price equals marginal 400 00:20:12,890 --> 00:20:17,930 cost. Price equals marginal cost is what we 401 00:20:17,930 --> 00:20:19,180 need to worry about. 402 00:20:25,870 --> 00:20:28,680 And you're only going to be in a situation, in the long run, 403 00:20:28,680 --> 00:20:30,570 where you're only going to be making either 404 00:20:30,570 --> 00:20:31,810 0 or positive profits. 405 00:20:31,810 --> 00:20:35,170 If you're making negative profits, you'll be gone. 406 00:20:35,170 --> 00:20:39,180 Now, the key difference in the long run, is now we can't take 407 00:20:39,180 --> 00:20:40,810 the number of firms as given. 408 00:20:40,810 --> 00:20:43,450 Now we need to derive the number of firms. And the way 409 00:20:43,450 --> 00:20:47,920 we do that is by thinking about entry and exit. 410 00:20:47,920 --> 00:20:50,060 Now, what's going to determine entry and exit? 411 00:20:50,060 --> 00:20:51,970 Well, it's quite simple. 412 00:20:51,970 --> 00:20:56,160 If in the market, as it stands today with some number of 413 00:20:56,160 --> 00:21:01,190 firms, there's profit to be made, new firms will enter. 414 00:21:01,190 --> 00:21:03,500 If in the market, as it stands today with some number of 415 00:21:03,500 --> 00:21:07,000 firms, there's losses being made, some firms will leave. 416 00:21:07,000 --> 00:21:09,490 Remember, no one stays in making losses anymore. 417 00:21:09,490 --> 00:21:14,890 And that continues until you reach a situation where all 418 00:21:14,890 --> 00:21:16,860 firms make zero profit. 419 00:21:16,860 --> 00:21:20,470 And here's the key lesson. 420 00:21:20,470 --> 00:21:27,040 In a perfectly competitive long run equilibrium, all 421 00:21:27,040 --> 00:21:30,960 firms make zero profit. 422 00:21:34,700 --> 00:21:37,860 It's the fundamental lesson about perfect competition. 423 00:21:37,860 --> 00:21:39,340 Obviously, there's no place that works 424 00:21:39,340 --> 00:21:40,110 like this in the world. 425 00:21:40,110 --> 00:21:41,650 This is an extreme. 426 00:21:41,650 --> 00:21:43,420 But, nonetheless, you should understand this extreme. 427 00:21:43,420 --> 00:21:45,090 In a perfectly competitive long run equilibrium, all 428 00:21:45,090 --> 00:21:46,220 firms make zero profit. 429 00:21:46,220 --> 00:21:47,140 Why? 430 00:21:47,140 --> 00:21:49,810 Because if there's any profit to be made, a new firm will 431 00:21:49,810 --> 00:21:51,770 enter and take it away. 432 00:21:51,770 --> 00:21:53,805 And if there's any unprofitable industry, a firm 433 00:21:53,805 --> 00:21:56,780 will exit until the profits go back to zero. 434 00:21:56,780 --> 00:22:02,130 So profits will always be zero in the long run equilibrium. 435 00:22:02,130 --> 00:22:06,910 Now, to understand how this works, let's think about a 436 00:22:06,910 --> 00:22:07,730 realistic example. 437 00:22:07,730 --> 00:22:11,300 Let's think about the PC market circa 1990 when all you 438 00:22:11,300 --> 00:22:13,196 youngins were being born. 439 00:22:13,196 --> 00:22:16,870 It's circa about 1990, the PC market, cast 440 00:22:16,870 --> 00:22:18,180 your mind way back. 441 00:22:18,180 --> 00:22:20,710 It's a history lesson for you guys. 442 00:22:20,710 --> 00:22:27,220 In 1990, not that many folks had PCs. 443 00:22:27,220 --> 00:22:31,190 There was still a vibrant use of mainframe computers. 444 00:22:31,190 --> 00:22:34,490 And, basically, you had big firms like IBM who were 445 00:22:34,490 --> 00:22:36,590 producing these mainframe computers, which is what I did 446 00:22:36,590 --> 00:22:37,310 my computing on. 447 00:22:37,310 --> 00:22:40,390 A lot of people did their computing on it in 1990. 448 00:22:40,390 --> 00:22:42,130 And there was starting to be a market, however, 449 00:22:42,130 --> 00:22:43,530 for personal computers. 450 00:22:43,530 --> 00:22:46,330 The chip strength had gotten large enough that it was 451 00:22:46,330 --> 00:22:48,636 actually viable to have desktop computing that was 452 00:22:48,636 --> 00:22:49,930 powerful enough. 453 00:22:49,930 --> 00:22:52,320 Firms like Dell were starting out-- not starting out, 454 00:22:52,320 --> 00:22:54,320 necessarily-- but were starting to make money making 455 00:22:54,320 --> 00:22:57,670 desktop computers, making PCs. 456 00:23:03,470 --> 00:23:06,050 Let's actually think about how that market might look. 457 00:23:06,050 --> 00:23:11,020 So let's actually talk about, in Figure 11-3, this is the 458 00:23:11,020 --> 00:23:15,960 market for PCs circa 1990. 459 00:23:15,960 --> 00:23:19,190 In 1990, if you were making PCs, that was a great 460 00:23:19,190 --> 00:23:20,650 business to be in. 461 00:23:20,650 --> 00:23:23,240 Because people wanted them, there weren't that many firms 462 00:23:23,240 --> 00:23:25,840 making them, and you were making a killing. 463 00:23:25,840 --> 00:23:30,630 So if you were Dell in 1990, that was a great place to be. 464 00:23:30,630 --> 00:23:35,800 So let's say Dell in 1990 was facing a demand curve D and 465 00:23:35,800 --> 00:23:37,510 the supply curve SR1. 466 00:23:41,580 --> 00:23:44,000 The supply curve was pretty steep because there weren't 467 00:23:44,000 --> 00:23:46,880 many firms making PCs. 468 00:23:46,880 --> 00:23:49,760 So the market price was P1. 469 00:23:52,570 --> 00:23:54,400 So on the right, you have the market. 470 00:23:54,400 --> 00:23:55,820 We should label this actually. 471 00:23:55,820 --> 00:23:57,090 On the right, you have the market. 472 00:23:57,090 --> 00:24:00,350 On the left, you have Dell. 473 00:24:00,350 --> 00:24:02,310 On the right, you have the market. 474 00:24:02,310 --> 00:24:06,480 In the market, in initial equilibrium, there's a price 475 00:24:06,480 --> 00:24:10,090 of P1 with big Q1 being sold. 476 00:24:10,090 --> 00:24:13,420 So Q1 PCs are being sold at a high price of P1. 477 00:24:13,420 --> 00:24:15,770 It's the novel technology. 478 00:24:15,770 --> 00:24:18,500 People want it, but not many firms are doing it. 479 00:24:18,500 --> 00:24:19,700 What happens with Dell? 480 00:24:19,700 --> 00:24:21,790 Now let's go to the left-hand side diagram. 481 00:24:21,790 --> 00:24:25,440 Well, Dell is producing where that price equals their 482 00:24:25,440 --> 00:24:28,480 marginal cost. That price equals their marginal 483 00:24:28,480 --> 00:24:30,790 cost at little q1. 484 00:24:30,790 --> 00:24:34,900 So Dell's producing little q1. 485 00:24:34,900 --> 00:24:40,840 But its average costs at that point are all the way down. 486 00:24:40,840 --> 00:24:41,720 It's not really labeled. 487 00:24:41,720 --> 00:24:45,670 But you can see it's where that vertical line for Q1 488 00:24:45,670 --> 00:24:49,080 intersects average total cost. That's where their costs are. 489 00:24:49,080 --> 00:24:53,350 So, in each unit, they're making the height between 490 00:24:53,350 --> 00:24:55,570 marginal cost and average total cost at that Q1. 491 00:24:55,570 --> 00:24:57,200 They're making that vertical bar. 492 00:24:57,200 --> 00:25:00,670 So they make that entire rectangle of profit. 493 00:25:00,670 --> 00:25:04,250 So Dell makes a big profit, because not many firms are in 494 00:25:04,250 --> 00:25:05,070 this business. 495 00:25:05,070 --> 00:25:07,590 And yet demand for PCs are high. 496 00:25:07,590 --> 00:25:11,760 And that's where things are circa 1990. 497 00:25:11,760 --> 00:25:12,840 So what happens? 498 00:25:12,840 --> 00:25:14,180 Well, Gateway arrives. 499 00:25:14,180 --> 00:25:15,650 Does Gateway still exist? 500 00:25:15,650 --> 00:25:16,460 Do people still buy Gateway? 501 00:25:16,460 --> 00:25:17,560 Gateway is gone, right? 502 00:25:17,560 --> 00:25:19,160 So, while Gateway was big, they were 503 00:25:19,160 --> 00:25:21,700 sort of a big upstart. 504 00:25:21,700 --> 00:25:24,070 They had the boxes with cow colors on them and stuff. 505 00:25:24,070 --> 00:25:27,590 You guys didn't even know Gateway? 506 00:25:27,590 --> 00:25:28,490 Well, they were big. 507 00:25:28,490 --> 00:25:32,520 They were the first cheap knockoff computer makers that 508 00:25:32,520 --> 00:25:34,790 competed with the big folks. 509 00:25:34,790 --> 00:25:38,710 And they came and said look, we can do this. 510 00:25:38,710 --> 00:25:39,910 OK, we can produce. 511 00:25:39,910 --> 00:25:40,880 This is a profitable business. 512 00:25:40,880 --> 00:25:41,750 We can make PCs. 513 00:25:41,750 --> 00:25:42,970 It's not that expensive. 514 00:25:42,970 --> 00:25:45,360 It's largely a variable cost business. 515 00:25:45,360 --> 00:25:47,100 You just have to build your plant first. 516 00:25:47,100 --> 00:25:49,200 So they built their plant, and then they come in. 517 00:25:49,200 --> 00:25:51,900 Well, what happens when a new firm comes in? 518 00:25:51,900 --> 00:25:54,720 The market supply curve flattens. 519 00:25:54,720 --> 00:25:57,340 Because now, at any price, you're producing more. 520 00:25:57,340 --> 00:26:03,016 So the market supply curve flattens to the point SR2. 521 00:26:03,016 --> 00:26:04,720 In fact, maybe it's not just Gateway. 522 00:26:04,720 --> 00:26:07,510 Maybe you get a bunch of entrants until you get the 523 00:26:07,510 --> 00:26:08,790 market supply curve SR2. 524 00:26:08,790 --> 00:26:15,390 Well, SR2 intersects demand at a new higher market 525 00:26:15,390 --> 00:26:16,640 quantity big Q2. 526 00:26:20,840 --> 00:26:24,400 Well, that higher market quantity going to the left, 527 00:26:24,400 --> 00:26:27,300 there's now no longer profits to be made. 528 00:26:27,300 --> 00:26:30,220 Because at that market quantity, Dell is going to 529 00:26:30,220 --> 00:26:32,330 produce little q2. 530 00:26:32,330 --> 00:26:36,090 Little q2 is exactly at the minimum of the average total 531 00:26:36,090 --> 00:26:38,510 cost curve. 532 00:26:38,510 --> 00:26:40,990 It's where the marginal cost curve intersects the average 533 00:26:40,990 --> 00:26:42,730 total cost curve, the minimum of that 534 00:26:42,730 --> 00:26:43,890 average total cost curve. 535 00:26:43,890 --> 00:26:45,520 So Dell no longer makes profits. 536 00:26:48,080 --> 00:26:50,900 Dell shrinks its production. 537 00:26:50,900 --> 00:26:51,730 The price has fallen. 538 00:26:51,730 --> 00:26:52,610 It doesn't lower its price. 539 00:26:52,610 --> 00:26:53,660 Dell doesn't set the price. 540 00:26:53,660 --> 00:26:55,320 Remember, this a price taker in a 541 00:26:55,320 --> 00:26:56,370 perfectly competitive market. 542 00:26:56,370 --> 00:26:59,160 The price is given by that diagram on the right. 543 00:26:59,160 --> 00:27:00,870 Dell gets a price of P2. 544 00:27:00,870 --> 00:27:03,700 It says look, at P2, I have to produce along my 545 00:27:03,700 --> 00:27:04,540 marginal cost curve. 546 00:27:04,540 --> 00:27:05,370 I have no choice. 547 00:27:05,370 --> 00:27:08,600 That's what's profit maximizing. 548 00:27:08,600 --> 00:27:10,660 I can't choose a point not on that marginal cost curve. 549 00:27:10,660 --> 00:27:12,370 That will not be profit maximizing. 550 00:27:12,370 --> 00:27:14,790 Well, where does that price intersect that 551 00:27:14,790 --> 00:27:15,930 marginal cost curve? 552 00:27:15,930 --> 00:27:17,390 At little q2. 553 00:27:17,390 --> 00:27:18,510 So I'm producing at little q2. 554 00:27:18,510 --> 00:27:21,240 And at little q2, I make no profit. 555 00:27:21,240 --> 00:27:23,730 So the entry of Gateway and other firms into the PC 556 00:27:23,730 --> 00:27:29,720 business has removed the profit from the PC business. 557 00:27:29,720 --> 00:27:31,700 Now note what's interesting here. 558 00:27:31,700 --> 00:27:34,940 Market quantity has gone up. 559 00:27:34,940 --> 00:27:37,540 Big Q2 is bigger than big Q1. 560 00:27:37,540 --> 00:27:39,910 But Dell's quantity has gone down. 561 00:27:39,910 --> 00:27:42,310 Little q2 is smaller than little q1. 562 00:27:42,310 --> 00:27:44,730 That's because more firms are in the market producing. 563 00:27:44,730 --> 00:27:47,600 So as more firms come in, total market quantity goes up. 564 00:27:47,600 --> 00:27:50,110 But any given firm is going to produce less. 565 00:27:50,110 --> 00:27:54,290 And that will continue until profits go to zero. 566 00:27:54,290 --> 00:27:58,150 That is how firm entry wipes out profits. 567 00:27:58,150 --> 00:28:02,970 That is how firm entry wipes out profits, by driving firms 568 00:28:02,970 --> 00:28:08,000 to the point where price equals average cost. 569 00:28:08,000 --> 00:28:11,900 So, in the long run, firms make zero profit because, 570 00:28:11,900 --> 00:28:20,720 first of all, entry drives price down to average cost. 571 00:28:20,720 --> 00:28:23,730 Entry drives price down to average cost. And when price 572 00:28:23,730 --> 00:28:27,290 equals average cost, profits are zero. 573 00:28:27,290 --> 00:28:28,790 Profits are zero when price equals average cost. Because 574 00:28:28,790 --> 00:28:35,670 profits are pq minus C. So if you divide by qp profits are p 575 00:28:35,670 --> 00:28:37,040 minus average costs. 576 00:28:37,040 --> 00:28:40,360 So if price equals average cost, profits are zero. 577 00:28:40,360 --> 00:28:42,230 So entry drives profits to zero. 578 00:28:42,230 --> 00:28:45,760 It drives price to equal average cost. Since price 579 00:28:45,760 --> 00:28:48,720 equals marginal cost, it's the point where marginal cost 580 00:28:48,720 --> 00:28:54,410 equals average cost. That's the technological outcome in a 581 00:28:54,410 --> 00:28:57,000 perfectly competitive long run equilibrium. 582 00:28:57,000 --> 00:28:59,610 You'll end up producing where marginal cost equals average 583 00:28:59,610 --> 00:29:02,750 cost. That's what will end up happening naturally through 584 00:29:02,750 --> 00:29:04,000 the forces of entry. 585 00:29:08,380 --> 00:29:12,220 Likewise, you see this through the force of exit. 586 00:29:12,220 --> 00:29:13,990 Now let's go to Figure 11-4. 587 00:29:13,990 --> 00:29:15,240 And now let's look at IBM. 588 00:29:22,400 --> 00:29:24,430 I guess we're calling this the broader computer market now. 589 00:29:24,430 --> 00:29:25,430 It's not just a PC market. 590 00:29:25,430 --> 00:29:26,680 It's the broader computer market. 591 00:29:30,140 --> 00:29:35,670 So IBM, they're producing these mainframes. 592 00:29:41,670 --> 00:29:42,640 This is the mainframe market. 593 00:29:42,640 --> 00:29:43,220 This isn't the PC market. 594 00:29:43,220 --> 00:29:44,470 This is the mainframe market. 595 00:29:44,470 --> 00:29:47,300 In the mainframe market, now people don't want mainframes 596 00:29:47,300 --> 00:29:49,090 much anymore. 597 00:29:49,090 --> 00:29:50,640 But there were a lot of firms producing. 598 00:29:50,640 --> 00:29:52,420 There was IBM and tons of other firms producing these 599 00:29:52,420 --> 00:29:52,820 mainframes. 600 00:29:52,820 --> 00:29:53,890 Because that's what everybody wanted. 601 00:29:53,890 --> 00:29:57,820 So the original supply curve was very flat at SR1. 602 00:29:57,820 --> 00:29:59,540 So, initially, in the mainframe market, we're in 603 00:29:59,540 --> 00:30:07,840 equilibrium with quantity Q1-- big Q1-- and a price P1. 604 00:30:07,840 --> 00:30:09,380 And what's happening there? 605 00:30:09,380 --> 00:30:11,740 Where does that price intersect marginal cost? 606 00:30:11,740 --> 00:30:16,070 It intersects marginal cost for IBM at little q1 which is 607 00:30:16,070 --> 00:30:21,586 below average total cost. So IBM is losing money. 608 00:30:21,586 --> 00:30:24,950 In the initial short run equilibrium, IBM is producing 609 00:30:24,950 --> 00:30:28,120 at little q1, and it's losing money. 610 00:30:28,120 --> 00:30:29,580 Now, why is it still in business? 611 00:30:29,580 --> 00:30:30,730 Because it's the short run. 612 00:30:30,730 --> 00:30:33,340 And as long as those losses are less than its fixed cost, 613 00:30:33,340 --> 00:30:35,410 it's staying in business. 614 00:30:35,410 --> 00:30:38,010 So, in the short run, you can lose money. 615 00:30:38,010 --> 00:30:39,300 So IBM is losing money. 616 00:30:39,300 --> 00:30:41,050 Because it's built this big plant. 617 00:30:41,050 --> 00:30:42,700 It's cranking out these mainframes. 618 00:30:42,700 --> 00:30:43,750 People don't want them anymore. 619 00:30:43,750 --> 00:30:48,580 The price has fallen so low that they can still make 620 00:30:48,580 --> 00:30:51,990 enough money than it costs to produce the next mainframe. 621 00:30:51,990 --> 00:30:55,480 Price is still greater than marginal costs, but price is 622 00:30:55,480 --> 00:30:58,540 below average costs. 623 00:30:58,540 --> 00:30:59,070 I'm sorry. 624 00:30:59,070 --> 00:31:00,555 Prices are greater than average variable cost. But 625 00:31:00,555 --> 00:31:02,880 it's lower the total average cost. They're losing money. 626 00:31:02,880 --> 00:31:03,770 So what happens? 627 00:31:03,770 --> 00:31:06,370 They leave. 628 00:31:06,370 --> 00:31:07,790 There was a company called [? Deck ?] 629 00:31:07,790 --> 00:31:10,590 that went out of business. 630 00:31:10,590 --> 00:31:14,760 And what happened was that then raised the supply curve. 631 00:31:14,760 --> 00:31:17,800 It steepened the supply curve in the mainframe market. 632 00:31:21,520 --> 00:31:23,230 It steepened the supply curve, because now you have fewer 633 00:31:23,230 --> 00:31:25,200 firms producing mainframes. 634 00:31:25,200 --> 00:31:26,390 That supply curve gets steeper. 635 00:31:26,390 --> 00:31:28,420 That raises the price. 636 00:31:28,420 --> 00:31:32,040 And, indeed, exit will continue until you raise the 637 00:31:32,040 --> 00:31:35,620 price to the point where marginal cost equals average 638 00:31:35,620 --> 00:31:38,270 total cost. 639 00:31:38,270 --> 00:31:41,500 And what you'll see is the market will shrink from 640 00:31:41,500 --> 00:31:43,150 big Q1 to big Q2. 641 00:31:43,150 --> 00:31:46,000 The remaining market participants will increase 642 00:31:46,000 --> 00:31:49,310 from little q1 to little q2. 643 00:31:49,310 --> 00:31:54,110 And profits go to 0 with price going to the minimum average 644 00:31:54,110 --> 00:31:58,830 cost. So through both entry and exit, we get this 645 00:31:58,830 --> 00:32:04,690 condition that's illustrated in Figure 11-5. 646 00:32:04,690 --> 00:32:11,220 In 11-5, we see that in the long run, firms always supply 647 00:32:11,220 --> 00:32:15,500 not on a single curve but at a single point. 648 00:32:15,500 --> 00:32:19,220 In the long run, with a perfectly competitive market, 649 00:32:19,220 --> 00:32:22,290 for a given firm, there is no longer even meaningfully a 650 00:32:22,290 --> 00:32:23,900 supply curve to a firm. 651 00:32:23,900 --> 00:32:26,810 There's just literally a supply point. 652 00:32:26,810 --> 00:32:30,390 Every firm produces at exactly the point where marginal costs 653 00:32:30,390 --> 00:32:32,600 equal average costs. 654 00:32:32,600 --> 00:32:35,860 So in some sense, once again, for a given firm-- 655 00:32:35,860 --> 00:32:39,010 this is not the market-- but for a given firm, there's not 656 00:32:39,010 --> 00:32:41,440 even meaningfully a supply curve anymore. 657 00:32:41,440 --> 00:32:44,430 For a given firm, in the long run, they literally choose one 658 00:32:44,430 --> 00:32:48,220 production point which is technologically given. 659 00:32:48,220 --> 00:32:49,330 So this is interesting. 660 00:32:49,330 --> 00:32:52,900 For a given firm, the market doesn't matter. 661 00:32:52,900 --> 00:32:54,550 For a given firm in a perfectly competitive market, 662 00:32:54,550 --> 00:32:57,350 we don't need to know anything about demand. 663 00:32:57,350 --> 00:33:00,520 All we need to know is the firm's production function. 664 00:33:00,520 --> 00:33:01,210 That's all we need to know. 665 00:33:01,210 --> 00:33:03,735 We don't even need to know anything about costs. 666 00:33:03,735 --> 00:33:07,960 Well, we need to know cost. We need to 667 00:33:07,960 --> 00:33:09,040 know their cost function. 668 00:33:09,040 --> 00:33:11,380 All we need to know is their cost function. 669 00:33:11,380 --> 00:33:14,270 And then all we need to do is derive where marginal costs 670 00:33:14,270 --> 00:33:17,140 equals average costs, and we're done. 671 00:33:17,140 --> 00:33:18,650 This is the power of the perfectly competitive 672 00:33:18,650 --> 00:33:19,150 equilibrium. 673 00:33:19,150 --> 00:33:21,120 This is why economists love it so much. 674 00:33:21,120 --> 00:33:23,830 Because we don't need to go through all this. 675 00:33:23,830 --> 00:33:24,910 This is all short run stuff. 676 00:33:24,910 --> 00:33:26,010 In the long run, it's easy. 677 00:33:26,010 --> 00:33:27,661 You just say, give me a cost function, I'll tell you what 678 00:33:27,661 --> 00:33:29,160 the firm will produce. 679 00:33:29,160 --> 00:33:31,270 And I'll tell you what the price is. 680 00:33:31,270 --> 00:33:33,200 The firm will produce where marginal cost equals average 681 00:33:33,200 --> 00:33:35,400 cost. And the price will be where marginal cost equals 682 00:33:35,400 --> 00:33:36,460 average costs. 683 00:33:36,460 --> 00:33:39,300 I can tell you the p and the q in equilibrium just if you 684 00:33:39,300 --> 00:33:40,880 give me a cost function. 685 00:33:40,880 --> 00:33:43,950 And that's the beauty of the long run perfectly competitive 686 00:33:43,950 --> 00:33:44,310 equilibrium. 687 00:33:44,310 --> 00:33:46,290 That's why it's so attractive to economists for modeling 688 00:33:46,290 --> 00:33:47,590 purposes and other things. 689 00:33:47,590 --> 00:33:50,150 It's incredibly easy to work with. 690 00:33:50,150 --> 00:33:55,090 Because all you need is a cost function, and you're done. 691 00:33:55,090 --> 00:33:59,430 The key lesson is what is true at the point where marginal 692 00:33:59,430 --> 00:34:01,950 costs equals average costs? 693 00:34:01,950 --> 00:34:03,910 Well, look at our graph. 694 00:34:03,910 --> 00:34:08,090 That is the point of cost minimization. 695 00:34:08,090 --> 00:34:11,730 Note that that is the very minimum point of the long run 696 00:34:11,730 --> 00:34:13,250 average cost curve. 697 00:34:13,250 --> 00:34:17,940 So where marginal cost equals average cost is the point of 698 00:34:17,940 --> 00:34:19,190 cost minimization. 699 00:34:21,719 --> 00:34:23,320 So we're saying further-- 700 00:34:23,320 --> 00:34:24,780 this is even more powerful-- 701 00:34:24,780 --> 00:34:27,120 we're saying that in the long run of perfectly competitive 702 00:34:27,120 --> 00:34:29,440 equilibrium firms will, by definition, 703 00:34:29,440 --> 00:34:31,050 minimize their costs. 704 00:34:31,050 --> 00:34:34,830 They will produce as efficiently as possible not 705 00:34:34,830 --> 00:34:36,900 because God told them to, but through the 706 00:34:36,900 --> 00:34:39,300 power of the market. 707 00:34:39,300 --> 00:34:41,940 Because what happens if you start a firm and you aren't 708 00:34:41,940 --> 00:34:43,900 cost minimizing? 709 00:34:43,900 --> 00:34:45,010 What happens? 710 00:34:45,010 --> 00:34:48,114 What happens is, in the short run, you might make money even 711 00:34:48,114 --> 00:34:49,880 if you aren't cost minimizing. 712 00:34:49,880 --> 00:34:52,750 But, in long run, you'll get driven out of business. 713 00:34:52,750 --> 00:34:55,300 Because if there's someone else who can produce more 714 00:34:55,300 --> 00:34:59,150 cheaply than you, they'll be able to charge a lower price 715 00:34:59,150 --> 00:35:00,480 and drive you out of business. 716 00:35:00,480 --> 00:35:03,020 Your price will end up above the long run equilibrium price 717 00:35:03,020 --> 00:35:04,940 if you're not cost minimizing. 718 00:35:04,940 --> 00:35:08,090 So any firm that is not cost minimizing will get driven out 719 00:35:08,090 --> 00:35:09,520 of business. 720 00:35:09,520 --> 00:35:13,540 And the equilibrium will be a market where all firms are 721 00:35:13,540 --> 00:35:16,570 producing at the cost minimizing level. 722 00:35:16,570 --> 00:35:21,830 And that's why we get the high tech Figure 11-6, which is 723 00:35:21,830 --> 00:35:24,580 that the long run market supply curve 724 00:35:24,580 --> 00:35:25,830 is perfectly elastic. 725 00:35:30,200 --> 00:35:31,910 Now this comes all the way back to what I talked about at 726 00:35:31,910 --> 00:35:33,700 the beginning of the last lecture. 727 00:35:33,700 --> 00:35:35,960 Remember I said, what determines perfect 728 00:35:35,960 --> 00:35:36,620 competition? 729 00:35:36,620 --> 00:35:41,300 Two things, the demand curve to the firm was perfectly 730 00:35:41,300 --> 00:35:46,120 elastic, and the supply curve to the market 731 00:35:46,120 --> 00:35:49,350 is perfectly elastic. 732 00:35:49,350 --> 00:35:51,670 And we talked last time about why the demand curve to the 733 00:35:51,670 --> 00:35:52,660 firm is perfectly elastic. 734 00:35:52,660 --> 00:35:54,900 Because with lots of firms, any given firm has a perfectly 735 00:35:54,900 --> 00:35:56,160 elastic demand. 736 00:35:56,160 --> 00:35:58,940 Now we've just derived why the market supply curve is 737 00:35:58,940 --> 00:36:01,090 perfectly elastic. 738 00:36:01,090 --> 00:36:05,650 It's perfectly elastic at the cost minimizing point. 739 00:36:05,650 --> 00:36:08,790 If the price ever rises above that cost minimizing point, 740 00:36:08,790 --> 00:36:11,350 what happens? 741 00:36:11,350 --> 00:36:15,910 What happens if the price should suddenly rise above it? 742 00:36:15,910 --> 00:36:17,402 What happens? 743 00:36:17,402 --> 00:36:21,720 Firms enter and drive the price back down. 744 00:36:21,720 --> 00:36:24,670 If the price ever drops below that cost minimizing point, 745 00:36:24,670 --> 00:36:27,610 firms exit, and the price goes back up. 746 00:36:27,610 --> 00:36:30,760 So through the power of firm entry and exit, in the long 747 00:36:30,760 --> 00:36:35,400 run, you end up with a horizontal or perfectly 748 00:36:35,400 --> 00:36:37,560 elastic supply curve. 749 00:36:37,560 --> 00:36:38,810 And that's perfect competition. 750 00:36:41,600 --> 00:36:43,037 Questions about that? 751 00:36:43,037 --> 00:36:44,031 Yeah? 752 00:36:44,031 --> 00:36:49,001 AUDIENCE: You said that if it's not profit maximizing, 753 00:36:49,001 --> 00:36:51,983 then it cannot [INAUDIBLE PHRASE]. 754 00:36:51,983 --> 00:36:54,970 But [INAUDIBLE PHRASE]. 755 00:36:54,970 --> 00:36:55,530 PROFESSOR: Yes, they are. 756 00:36:55,530 --> 00:36:56,570 So that's a great point. 757 00:36:56,570 --> 00:36:59,280 So what will happen is it's not that a firm will charge a 758 00:36:59,280 --> 00:37:00,110 lower price. 759 00:37:00,110 --> 00:37:01,140 I shouldn't have said it that way. 760 00:37:01,140 --> 00:37:03,150 It's that another firm will enter. 761 00:37:03,150 --> 00:37:05,140 And, by definition, the price will then fall, because the 762 00:37:05,140 --> 00:37:08,170 supply curve will flatten, and the price will then fall. 763 00:37:08,170 --> 00:37:10,490 So if you're in there producing inefficiently and I 764 00:37:10,490 --> 00:37:12,690 say, hey, your firm sucks. 765 00:37:12,690 --> 00:37:15,050 I can come in and produce much more efficiently than you. 766 00:37:15,050 --> 00:37:17,740 I'll hop in, that will flatten the supply curve. 767 00:37:17,740 --> 00:37:18,800 The price will fall. 768 00:37:18,800 --> 00:37:22,300 At that price, if I'm not cost minimizing, 769 00:37:22,300 --> 00:37:23,310 I'll be losing money. 770 00:37:23,310 --> 00:37:26,070 So I'll leave. 771 00:37:26,070 --> 00:37:27,770 That's a good clarifying question. 772 00:37:27,770 --> 00:37:31,080 So if we have a market with a bunch of guys in it, and one 773 00:37:31,080 --> 00:37:34,100 of them is not cost minimizing, well, that means 774 00:37:34,100 --> 00:37:36,390 someone else can come in. 775 00:37:36,390 --> 00:37:39,640 They'll, in the short run, expand the market. 776 00:37:39,640 --> 00:37:43,040 That will flatten the supply curve, drive the price down. 777 00:37:43,040 --> 00:37:45,490 At that lower price, the non-cost maximizing firm says, 778 00:37:45,490 --> 00:37:46,060 I'm losing money. 779 00:37:46,060 --> 00:37:47,410 So I leave. 780 00:37:47,410 --> 00:37:49,610 The price goes back up, and it goes up and down and up and 781 00:37:49,610 --> 00:37:51,250 down until it settles at this point 782 00:37:51,250 --> 00:37:54,640 where costs are minimized. 783 00:37:54,640 --> 00:37:57,945 So perfect competition leads to a perfectly elastic supply 784 00:37:57,945 --> 00:37:59,195 and cost minimization. 785 00:38:01,460 --> 00:38:04,300 So that is our extreme. 786 00:38:04,300 --> 00:38:08,950 That is the theoretical point of no return. 787 00:38:08,950 --> 00:38:11,710 Of course, in reality, we never get there. 788 00:38:11,710 --> 00:38:14,270 In reality, there's no such thing as a purely perfectly 789 00:38:14,270 --> 00:38:17,410 competitive equilibrium. 790 00:38:17,410 --> 00:38:18,300 Why not? 791 00:38:18,300 --> 00:38:23,950 Well, in the long run, supply is actually upward sloping. 792 00:38:23,950 --> 00:38:27,270 In the long run, market supply will be upward sloping. 793 00:38:27,270 --> 00:38:30,640 And that's going to be for at least three reasons. 794 00:38:30,640 --> 00:38:33,810 So why is long run supply upward sloping in reality? 795 00:38:45,100 --> 00:38:47,350 Well, in reality, if would be for at least three reasons. 796 00:38:47,350 --> 00:38:51,180 The first reason is that entry and exit are not free. 797 00:38:51,180 --> 00:38:58,410 There could be barriers to entry or exit. 798 00:38:58,410 --> 00:39:01,650 Even in the long run, there could be barriers 799 00:39:01,650 --> 00:39:04,220 to entry and exit. 800 00:39:04,220 --> 00:39:07,110 There could be features of the market which make it hard to 801 00:39:07,110 --> 00:39:09,590 leave or hard to join. 802 00:39:09,590 --> 00:39:12,870 A classic example is something that we introduced a couple 803 00:39:12,870 --> 00:39:17,500 lectures ago, the notion of sunk costs, costs which even 804 00:39:17,500 --> 00:39:19,750 in the long run might be fixed. 805 00:39:26,850 --> 00:39:30,380 If they're large sunk costs, if one firm's incurred them, 806 00:39:30,380 --> 00:39:32,480 another firm is going to say, look, it's not worth it 807 00:39:32,480 --> 00:39:33,730 for me to get in. 808 00:39:36,990 --> 00:39:40,470 If you have to build such a massive plant to produce your 809 00:39:40,470 --> 00:39:43,160 good, then it takes an unbelievable amount of 810 00:39:43,160 --> 00:39:45,560 capital, it's a huge investment, and once you're 811 00:39:45,560 --> 00:39:48,670 in, it's going to be really hard to drive you out, because 812 00:39:48,670 --> 00:39:50,590 you made that big investment, other firms 813 00:39:50,590 --> 00:39:52,670 might say, forget it. 814 00:39:52,670 --> 00:39:55,080 Dell made this huge investment in this huge plant. 815 00:39:55,080 --> 00:39:56,730 They're never going to leave having built that plant. 816 00:39:56,730 --> 00:39:59,180 That's virtually a sunk cost. So I'm not even going to 817 00:39:59,180 --> 00:40:00,590 bother entering. 818 00:40:00,590 --> 00:40:02,580 So Dell can exist making some profit, maybe 819 00:40:02,580 --> 00:40:03,570 not too much profit. 820 00:40:03,570 --> 00:40:05,470 If they make too much profit, then another firm 821 00:40:05,470 --> 00:40:07,230 will build a plant. 822 00:40:07,230 --> 00:40:09,040 Well, as long as they're not making too much profit, they 823 00:40:09,040 --> 00:40:09,950 can make some profit. 824 00:40:09,950 --> 00:40:11,590 Because another firm says, you know what, I 825 00:40:11,590 --> 00:40:12,500 can't fight that battle. 826 00:40:12,500 --> 00:40:14,640 I can't build a plant that big. 827 00:40:14,640 --> 00:40:17,300 Or there could be other things like that. 828 00:40:23,170 --> 00:40:24,660 That's sort of a natural barrier to entry. 829 00:40:24,660 --> 00:40:26,580 There are some artificial barriers to entry we see. 830 00:40:26,580 --> 00:40:31,120 For example, take med school. 831 00:40:31,120 --> 00:40:34,330 The number of slots to be doctors is limited by the 832 00:40:34,330 --> 00:40:35,740 physician profession. 833 00:40:35,740 --> 00:40:38,230 So even if docs make lots of money, which they do-- 834 00:40:38,230 --> 00:40:39,730 especially specialists-- 835 00:40:39,730 --> 00:40:42,120 you can't just compete and have new doctors enter. 836 00:40:42,120 --> 00:40:44,070 Because the number of slots are actually limited. 837 00:40:44,070 --> 00:40:46,760 You have to be licensed by an organization which is run by 838 00:40:46,760 --> 00:40:48,660 the people making all the money. 839 00:40:48,660 --> 00:40:51,320 So if you're a doc, and you're in, this is 840 00:40:51,320 --> 00:40:52,180 a pretty good deal. 841 00:40:52,180 --> 00:40:53,390 You say, hey, let's have a system where new 842 00:40:53,390 --> 00:40:54,950 docs can't be licensed. 843 00:40:54,950 --> 00:40:56,240 They'll have to come to me, and I can 844 00:40:56,240 --> 00:40:57,560 charge whatever I want. 845 00:40:57,560 --> 00:40:58,490 That's a barrier to entry. 846 00:40:58,490 --> 00:41:00,400 We call that occupational licensing. 847 00:41:00,400 --> 00:41:01,460 We see that in lots of professions. 848 00:41:01,460 --> 00:41:04,390 Plumbing, taxi drivers, we see it everywhere. 849 00:41:04,390 --> 00:41:07,420 It's occupational licensing. 850 00:41:07,420 --> 00:41:09,180 A second example, of course, is patents. 851 00:41:09,180 --> 00:41:11,660 And we'll talk about patents more in a few lectures. 852 00:41:11,660 --> 00:41:15,160 If I invented a new drug, and it's patented, nobody can sell 853 00:41:15,160 --> 00:41:17,770 that same chemical compound for 17 years. 854 00:41:17,770 --> 00:41:20,620 That's a barrier to entry. 855 00:41:20,620 --> 00:41:22,890 There could be more informal barriers to entry. 856 00:41:22,890 --> 00:41:26,150 Let's say you're around Port Authority setting up these 857 00:41:26,150 --> 00:41:27,680 little shlocky stands, the ones we said were perfect 858 00:41:27,680 --> 00:41:29,720 competition. 859 00:41:29,720 --> 00:41:31,650 You've got yours, and the guy comes in next to you, you just 860 00:41:31,650 --> 00:41:33,710 beat the crap out out of him. 861 00:41:33,710 --> 00:41:35,190 That's an informal barrier to entry. 862 00:41:35,190 --> 00:41:38,120 You say, you come in, and you're going to get beaten up. 863 00:41:38,120 --> 00:41:40,320 The guy says, well look, if it's a big profit, it's worth 864 00:41:40,320 --> 00:41:41,390 getting beaten up. 865 00:41:41,390 --> 00:41:42,970 Or I'll hire protection if it's a big profit. 866 00:41:42,970 --> 00:41:44,160 But it's not that big of a profit, I'm not going to 867 00:41:44,160 --> 00:41:45,670 bother getting beaten up over it. 868 00:41:45,670 --> 00:41:46,690 So I'll let you make your profit. 869 00:41:46,690 --> 00:41:48,110 I won't come in. 870 00:41:48,110 --> 00:41:50,780 So barriers to entry exist all over the place. 871 00:41:50,780 --> 00:41:53,250 And they're a big reason why we don't get a perfectly 872 00:41:53,250 --> 00:41:56,620 elastic supply curve in most markets because of things like 873 00:41:56,620 --> 00:41:59,540 patents or thuggery. 874 00:41:59,540 --> 00:42:02,820 So that's one example of why you don't get it. 875 00:42:02,820 --> 00:42:04,880 Another example of why you might not get a perfectly 876 00:42:04,880 --> 00:42:11,960 elastic supply curve is that firms might differ. 877 00:42:11,960 --> 00:42:15,150 In particular, we have assumed critically, through the last 878 00:42:15,150 --> 00:42:18,870 lecture and this lecture, that firms are identical. 879 00:42:18,870 --> 00:42:19,970 We have assumed that firms are identical. 880 00:42:19,970 --> 00:42:22,560 But, in fact, of course, firms aren't. 881 00:42:22,560 --> 00:42:25,770 And one firm's cost minimizing production level might be 882 00:42:25,770 --> 00:42:27,040 different than another firm's cost 883 00:42:27,040 --> 00:42:28,810 minimizing production level. 884 00:42:28,810 --> 00:42:30,900 Not all firms will have exactly the same cost 885 00:42:30,900 --> 00:42:32,590 minimizing production level. 886 00:42:32,590 --> 00:42:36,430 In particular, some firms may have a lower minimum average 887 00:42:36,430 --> 00:42:39,480 cost than others for a while. 888 00:42:39,480 --> 00:42:41,740 So it may be that as long as I'm producing less than x 889 00:42:41,740 --> 00:42:47,080 units, I have a lower minimum average cost than you do. 890 00:42:47,080 --> 00:42:49,710 But once I produce more than x units, my minimum average cost 891 00:42:49,710 --> 00:42:51,900 rises to above yours. 892 00:42:51,900 --> 00:42:56,780 Well, in that case, I might be able to make money for a while 893 00:42:56,780 --> 00:42:57,410 staying in. 894 00:42:57,410 --> 00:42:59,480 But then once I produce too much, I'm going to have to 895 00:42:59,480 --> 00:43:00,900 raise the price. 896 00:43:00,900 --> 00:43:04,550 So to see this, there's a great example in Perloff which 897 00:43:04,550 --> 00:43:07,170 you see in Figure 11-7, where he talks about the 898 00:43:07,170 --> 00:43:10,940 international long run market supply curve for cotton. 899 00:43:10,940 --> 00:43:16,540 And he says, look, in Pakistan, you can produce 900 00:43:16,540 --> 00:43:18,350 cotton incredibly cheaply. 901 00:43:18,350 --> 00:43:20,500 This is a dated example, but in Pakistan, you can produce 902 00:43:20,500 --> 00:43:22,080 cotton incredibly cheaply. 903 00:43:22,080 --> 00:43:26,960 You can produce it at $0.71 per kilogram. 904 00:43:26,960 --> 00:43:32,190 So if the world demand for cotton is less than $2 billion 905 00:43:32,190 --> 00:43:34,990 kilograms per year, or less than $1.8 billion kilograms 906 00:43:34,990 --> 00:43:39,400 per year, then Pakistan would provide it all, and the price 907 00:43:39,400 --> 00:43:42,290 would be $0.71. 908 00:43:42,290 --> 00:43:43,900 But let's say the demand is more than that. 909 00:43:43,900 --> 00:43:46,290 Well, Pakistan just runs out of cotton. 910 00:43:46,290 --> 00:43:46,880 They can't do that. 911 00:43:46,880 --> 00:43:48,450 Well, then you have to go to the next cheapest country. 912 00:43:48,450 --> 00:43:50,110 Well, the next cheapest country is Argentina. 913 00:43:50,110 --> 00:43:53,100 It costs a lot more to produce cotton there. 914 00:43:53,100 --> 00:43:55,240 And then comes Australia, Brazil, Nicaragua, Turkey, 915 00:43:55,240 --> 00:43:56,060 then finally the US. 916 00:43:56,060 --> 00:43:59,380 And then Iran is the most expensive. 917 00:43:59,380 --> 00:44:02,460 So this is, effectively, an upward sloping supply curve. 918 00:44:02,460 --> 00:44:05,340 It's stepwise, but it's an upward sloping supply in the 919 00:44:05,340 --> 00:44:10,980 sense that as you want more quantity, the price goes up. 920 00:44:10,980 --> 00:44:14,750 So if the market wants $5 billion kilograms of cotton a 921 00:44:14,750 --> 00:44:19,000 year, then that means that the marginal producer is the US 922 00:44:19,000 --> 00:44:22,940 even though they're much less efficient than Pakistan. 923 00:44:22,940 --> 00:44:25,370 Because Pakistan hit a constraint. 924 00:44:25,370 --> 00:44:28,340 You have to go to that next less efficient producer. 925 00:44:28,340 --> 00:44:32,190 So that's taking an upward sloping supply curve. 926 00:44:32,190 --> 00:44:35,340 Basically you're getting an upward sloping supply curve, 927 00:44:35,340 --> 00:44:37,380 because you have constraints on how much any 928 00:44:37,380 --> 00:44:39,380 given firm can produce. 929 00:44:39,380 --> 00:44:42,570 Those constraints can make you move onto less efficient firms 930 00:44:42,570 --> 00:44:44,360 as you go on. 931 00:44:44,360 --> 00:44:46,440 And so in a market, you'll end up, in reality, with a 932 00:44:46,440 --> 00:44:48,670 distribution of firms ranging from most 933 00:44:48,670 --> 00:44:50,970 efficient to least efficient. 934 00:44:50,970 --> 00:44:52,740 The most efficient would produce as much as it can at 935 00:44:52,740 --> 00:44:53,760 that efficiency level. 936 00:44:53,760 --> 00:44:55,660 But then some less efficient ones will get in the game as 937 00:44:55,660 --> 00:44:57,690 well just depending on where demand is. 938 00:44:57,690 --> 00:44:59,540 So you can see if you put in demand curves at different 939 00:44:59,540 --> 00:45:02,070 points in the supply curve, you get different prices. 940 00:45:02,070 --> 00:45:04,970 That's an upward sloping supply curve. 941 00:45:04,970 --> 00:45:07,810 That's a second reason. 942 00:45:07,810 --> 00:45:09,350 And then a third reason-- 943 00:45:09,350 --> 00:45:11,680 these aren't a comprehensive list, but types of reasons why 944 00:45:11,680 --> 00:45:13,870 supply curves will slope up in reality-- 945 00:45:13,870 --> 00:45:19,610 is that input prices might rise as the market expands. 946 00:45:19,610 --> 00:45:21,400 We've assumed fixed input prices. 947 00:45:21,400 --> 00:45:25,300 I gave you an r and w, and I assume they were fixed. 948 00:45:25,300 --> 00:45:27,640 But, in fact, that might not be true. 949 00:45:27,640 --> 00:45:32,470 It might be that, in reality, as you want to produce more, 950 00:45:32,470 --> 00:45:34,690 you need to buy more of the input. 951 00:45:34,690 --> 00:45:36,650 Well, if you need to buy more of the input, and the input 952 00:45:36,650 --> 00:45:39,320 has an upward sloping supply curve, then you'll have to pay 953 00:45:39,320 --> 00:45:41,030 more to get more of that input. 954 00:45:41,030 --> 00:45:44,260 So to see that, let's run through an example. 955 00:45:44,260 --> 00:45:47,550 Let's imagine that you want to produce something in the long 956 00:45:47,550 --> 00:45:50,690 run, and you need more labor to produce it. 957 00:45:50,690 --> 00:45:52,570 So as you produce more of it, you need more labor. 958 00:45:55,860 --> 00:45:57,860 So now let's go to Figure 11-8. 959 00:45:57,860 --> 00:46:01,050 You're initially, in your firm, demanding L1 units of 960 00:46:01,050 --> 00:46:03,990 labor at a the wage of W1. 961 00:46:03,990 --> 00:46:07,570 And let's say that at that point, at that wage, you're 962 00:46:07,570 --> 00:46:09,160 cost minimizing. 963 00:46:09,160 --> 00:46:12,320 That's the cost minimizing point, and you've got this 964 00:46:12,320 --> 00:46:15,210 flat supply curve. 965 00:46:15,210 --> 00:46:15,900 You're at that point. 966 00:46:15,900 --> 00:46:17,800 Now let's say you want to produce more. 967 00:46:17,800 --> 00:46:19,615 Well, to produce more, you've got to go to the market and 968 00:46:19,615 --> 00:46:20,830 hire more labor. 969 00:46:20,830 --> 00:46:24,940 If the supply curve for labor is upward sloping, if labor is 970 00:46:24,940 --> 00:46:27,550 not a perfectly competitive market and, therefore, is an 971 00:46:27,550 --> 00:46:29,330 upward sloping supply, they'll say, fine. 972 00:46:29,330 --> 00:46:30,520 If you want more workers, you've got to pay more. 973 00:46:30,520 --> 00:46:32,410 You've got to pay W2. 974 00:46:32,410 --> 00:46:34,590 You've got to pay more for your workers. 975 00:46:34,590 --> 00:46:35,920 Well, think about what that does. 976 00:46:35,920 --> 00:46:38,030 Now, go to Figure 11-9. 977 00:46:38,030 --> 00:46:45,730 What that means is that as I produce more units, I have to 978 00:46:45,730 --> 00:46:48,300 pay more for the labor. 979 00:46:48,300 --> 00:46:50,460 Now let's start on the left-hand side figure. 980 00:46:50,460 --> 00:46:56,000 That says that if I'm producing little q1 as a firm, 981 00:46:56,000 --> 00:46:58,230 my marginal cost is MC super 1, and my average 982 00:46:58,230 --> 00:46:59,990 cost is AC super 1. 983 00:46:59,990 --> 00:47:02,370 So I'm at P1. 984 00:47:02,370 --> 00:47:08,230 Now if I want to produce more, if I want to produce q2, my 985 00:47:08,230 --> 00:47:10,560 average cost is going to be higher, and my marginal cost 986 00:47:10,560 --> 00:47:11,690 is going to be higher, because I have to pay a 987 00:47:11,690 --> 00:47:13,790 higher wage to workers. 988 00:47:13,790 --> 00:47:15,650 So that's going to shift me up to have to 989 00:47:15,650 --> 00:47:18,770 charge a higher price. 990 00:47:18,770 --> 00:47:20,720 Now, I'm still cost minimizing. 991 00:47:20,720 --> 00:47:23,420 Given the wage the market gives me, I'm still cost 992 00:47:23,420 --> 00:47:23,620 minimizing. 993 00:47:23,620 --> 00:47:25,520 There's nothing non-cost minimizing about this. 994 00:47:25,520 --> 00:47:27,180 I'm still cost minimizing. 995 00:47:27,180 --> 00:47:29,730 But to cost minimize, I have to charge more. 996 00:47:29,730 --> 00:47:32,600 Because the market's charging me a higher price. 997 00:47:32,600 --> 00:47:36,890 If you go back to solving our initial production decision, 998 00:47:36,890 --> 00:47:39,360 you'll see that because this is a higher wage, that's going 999 00:47:39,360 --> 00:47:42,060 to shift my cost function up. 1000 00:47:42,060 --> 00:47:44,070 A high wage is going to make my costs higher. 1001 00:47:44,070 --> 00:47:47,450 That's going to make my cost minimizing price be higher. 1002 00:47:47,450 --> 00:47:49,030 So I'm going to shift. 1003 00:47:49,030 --> 00:47:50,520 I'm going to need to charge a higher price. 1004 00:47:50,520 --> 00:47:53,050 That, itself, will also yield an upward 1005 00:47:53,050 --> 00:47:55,530 sloping supply curve. 1006 00:47:55,530 --> 00:47:59,820 So an upward sloping supply curve comes from the fact that 1007 00:47:59,820 --> 00:48:02,510 as I produce more, I've got to pay higher 1008 00:48:02,510 --> 00:48:03,870 prices for my inputs. 1009 00:48:03,870 --> 00:48:05,910 That means I've got to charge higher prices for my outputs. 1010 00:48:08,560 --> 00:48:12,310 So these are three examples of reasons why, in reality, we 1011 00:48:12,310 --> 00:48:15,550 don't see a perfectly flat long run supply curve. 1012 00:48:15,550 --> 00:48:19,490 So once again, to review, because this is the end of 1013 00:48:19,490 --> 00:48:23,660 this particular topic, to review where we are, the way 1014 00:48:23,660 --> 00:48:25,940 it works is firms are given a cost function. 1015 00:48:25,940 --> 00:48:28,810 Well, they choose a technology. 1016 00:48:28,810 --> 00:48:30,390 That gives them a cost function. 1017 00:48:30,390 --> 00:48:31,800 They enter the market. 1018 00:48:31,800 --> 00:48:35,250 In the short run, they're stuck with that technology. 1019 00:48:35,250 --> 00:48:37,860 So they decide to produce where price equals marginal 1020 00:48:37,860 --> 00:48:39,830 cost as long as they're not losing more money than they've 1021 00:48:39,830 --> 00:48:41,600 paid in fixed costs. 1022 00:48:41,600 --> 00:48:45,440 In the long run, firms come in and out until the point where 1023 00:48:45,440 --> 00:48:48,530 every firm is producing efficiently. 1024 00:48:48,530 --> 00:48:51,110 As long as entry is free, as long as there are not barriers 1025 00:48:51,110 --> 00:48:54,910 to entry, every firm is producing efficiently. 1026 00:48:57,640 --> 00:48:59,410 Then every firm is producing at a single point, which is 1027 00:48:59,410 --> 00:49:02,700 where marginal cost equals average cost. That yields a 1028 00:49:02,700 --> 00:49:07,080 flat long run supply curve at the technological minimum. 1029 00:49:07,080 --> 00:49:10,540 In reality, supply curves slope up because there might 1030 00:49:10,540 --> 00:49:13,470 be barriers to entry which leads to non-cost 1031 00:49:13,470 --> 00:49:14,720 minimization. 1032 00:49:20,540 --> 00:49:22,040 So this leads to non-cost minimization. 1033 00:49:24,630 --> 00:49:26,700 And then there's two reasons, even if you're cost 1034 00:49:26,700 --> 00:49:31,480 minimizing, you still could have capacity constraints, 1035 00:49:31,480 --> 00:49:38,480 which is like our cotton example, or you could have 1036 00:49:38,480 --> 00:49:40,210 upward sloping input supply. 1037 00:49:47,810 --> 00:49:51,540 So that's why, in reality, we draw the upward sloping supply 1038 00:49:51,540 --> 00:49:53,720 curves that we started with at the beginning of this course 1039 00:49:53,720 --> 00:49:56,550 even with a perfectly competitive market. 1040 00:49:56,550 --> 00:49:58,140 So let's stop there. 1041 00:49:58,140 --> 00:50:00,520 That's a lot of stuff to digest. We're going to come 1042 00:50:00,520 --> 00:50:03,100 back next time and talk about why all this is crap, and 1043 00:50:03,100 --> 00:50:05,240 firms don't really cost minimize or maximize profits 1044 00:50:05,240 --> 00:50:06,490 or any of that.