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Introduction to Microeconomics Long-run profit. Dropping the Assumption of the short-run The short-run is defined by whether you can vary any factor of.

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Presentation on theme: "Introduction to Microeconomics Long-run profit. Dropping the Assumption of the short-run The short-run is defined by whether you can vary any factor of."— Presentation transcript:

1 Introduction to Microeconomics Long-run profit

2 Dropping the Assumption of the short-run The short-run is defined by whether you can vary any factor of production This typically means piece-work labour (I can hire and fire with complete freedom) In most cases contracts/regulations impede the freedom of the firm – Labour law requires two weeks notice – Professional sports contracts often have “no cut” clauses What is the short-run for the following – Hot dog stand? – Flower shop? – Law firm? – Car assembly plant?

3 Accounting profit = Total Revenue – explicit costs (payments a firm makes to its factors of production and other suppliers) Economic profit = Total Revenue - explicit costs - implicit costs (opportunity costs of the resources supplied by the firm’s owners) Normal profit = accounting profits - economic profit – The opportunity cost of resources supplied by the firm’s owners. Three Types of Profit © 2012 McGraw-Hill Ryerson Limited Ch6-3 LO1: Difference Between Accounting and Economic Profit

4 FIGURE 6.1: The Difference Between Accounting Profit and Economic Profit Total revenue Explicit costs Accounting Profit Explicit costs Normal profit = opportunity cost of resources supplied by owners of firm Economic profit (a)(b)(c) © 2012 McGraw-Hill Ryerson Limited Ch6-4 LO1: Difference Between Accounting and Economic Profit

5 Firm, the Market, and a Shift in the Short-Run Supply: Responses of a Wheat Farm and the Wheat Market 0.08*12,000 = E1E1 E2E2 E3E3 ATC S MC S SRSSRS′ D′ D ATCs represents the lowest cost per unit of wheat that can be achieved for any given quantity of wheat. MCs is a short-run marginal cost curve. ATCs represents the lowest cost per unit of wheat that can be achieved for any given quantity of wheat. MCs is a short-run marginal cost curve. There are 1000 farmers in the market, SRS is the short-run supply curve for the market, E1 is the SR and LR equilibrium Assume the demand rises to D’, price increase to $2.20 E2 is the short-run equilibrium, where farmers product 12 million bu/year and make an economic profit. Assume the demand rises to D’, price increase to $2.20 E2 is the short-run equilibrium, where farmers product 12 million bu/year and make an economic profit. Bernard increase his production to bu at the cost of $2.12/bu. Total economic profit = ($2.20- $2.12)(12000) = 960/year. Bernard increase his production to bu at the cost of $2.12/bu. Total economic profit = ($2.20- $2.12)(12000) = 960/year. In the long run, Farmers will enter the industry until the price of wheat falls low enough to reduce economic profit to zero. E3 is the long-run equilibrium. In the long run, Farmers will enter the industry until the price of wheat falls low enough to reduce economic profit to zero. E3 is the long-run equilibrium. © 2012 McGraw-Hill Ryerson Limited Ch6-5 LO2: Economic profit and economic loss and entry or exit

6 Long-Run Average Cost ATC 2 ATC 1 ATC 3 ATC 4 ATC 5 LRAC © 2012 McGraw-Hill Ryerson Limited Ch6-6 LO3: Difference between Long Run and Short Run

7 Long-Run Average Cost (LRAC). – In the long run, firms can change their capital stock and thereby choose their size of operation. – Each size of firm has its own Average Total Cost curve. – LRAC is the minimum average cost for a given level of output. Long-Run Competitive Equilibrium. – Price is at the minimum of LRAC. If price is higher, firms producing at minimum LRAC can make an economic profit and will enter industry. – All firms operate at the size that minimizes LRAC. Long-Run Average Cost and Perfectly Competitive Markets © 2012 McGraw-Hill Ryerson Limited Ch6-7 LO3 & LO4: Difference between Long Run and Short Run, Long run operation at minimum point of LRAC

8 Long-Run Supply (LRS) in a Perfectly Competitive Market—Case I: Constant Opportunity Cost of Inputs LRAC SRS SRS′ LRS D D′ Q1Q1Q2Q2Q3Q3 ATC s © 2012 McGraw-Hill Ryerson Limited Ch6-8 LO4: Long run operation at minimum point of LRAC Panel (a) shows the firm’s long-run average cost curve, while panel (b) shows that long-run market supply is horizontal and pertains to a constant cost industry.

9 Case I: Cost of Additional Inputs is Constant. – Any increase in price will cause economic profits. – New firms will enter until the price is driven back to the level where it started. – Long-Run Supply (LRS) is therefore perfectly elastic. Case II: Cost of Additional Inputs Rises. – Increase in Price causes economic profits for existing firms. – New firms enter, driving down product price. but also bidding up the price of inputs. and thereby increasing industry costs. – Product price falls, but not to where it started. – Long-Run Supply (LRS) is upward sloping. Long-Run Market Supply – 2 cases © 2012 McGraw-Hill Ryerson Limited Ch6-9 LO4: Long run operation at minimum point of LRAC

10 FIGURE 6.5: Long-Run Supply (LRS) in a Perfectly Competitive Market—Case II: Cost of Inputs Rises as Short-Run Supply Increases LRAC2 LRAC1 SRS SRS′ LRS D D′ As the number of farms increases in response to an increase in the demand for wheat, long-run average cost increases from LRAC1 to LRAC2. After long-run adjustments are complete, market price is higher, so long-run market supply has a positive slope and pertains to an increasing cost industry. © 2012 McGraw-Hill Ryerson Limited Ch6-10 LO4: Long run operation at minimum point of LRAC Why?

11 It is possible that minimum LRAC can be achieved over a wide range of output. – If so, then different firm sizes can coexist in long-run equilibrium. We can divide the LRAC curve into 3 regions – Economies of scale: LRAC falling. – Constant returns to scale: LRAC constant. – Diseconomies of scale: LRAC rising. Firm Size and the Shape of the Long- Run Average Cost Curve © 2012 McGraw-Hill Ryerson Limited Ch6-11 LO5: Economies of scale, constant returns to scale, and diseconomies of scale

12 FIGURE 6.6: Long-Run Average Cost and Returns to Scale I: Economies of scale II: Constant returns to scale III: Diseconomies of scale LRAC Minimum long-run average cost Minimum efficient quantity © 2012 McGraw-Hill Ryerson Limited Ch6-12 LO5: Economies of scale, constant returns to scale, and diseconomies of scale

13 Barrier to entry: – Anything that prevents new suppliers from entering a market. Legal (e.g., copyright laws). Natural (e.g., product compatibility). – Barriers to entry allow price to be higher than the opportunity costs of production. Freedom to leave a market is just as important as freedom to enter. Without reasonably free entry and exit, the competitive market will not force prices down to minimum long-run-average cost. Free Entry and Exit © 2012 McGraw-Hill Ryerson Limited Ch6-13 LO6: Difference between economic profit and economic rent

14 That part of the payment for a factor of production that exceeds the owner’s reservation price. – Reservation price: The price below which the owner would not supply the factor. Unlike economic profit, which is driven toward zero by competition, economic rent may persist for extended periods. Economic rent accrues to inputs that cannot be replicated easily. Economic Rent © 2012 McGraw-Hill Ryerson Limited Ch6-14 LO6: Difference between economic profit and economic rent

15 Firms that develop and introduce cost-saving innovations: – Reap economic profits in the short run. Supply curves shift rightward as new firms enter. Product prices fall. Firms that do not use the new technology will suffer economic losses. Competition implies that the cost savings of new technology are passed along to consumers. Cost-Saving Innovations © 2012 McGraw-Hill Ryerson Limited Ch6-15

16 Forty merchant marine companies carry oil from the Middle East to the east coast of Canada. The cost per trip, is $ A navigator on one ship finds a new route, which results in fuel savings of $20 000/trip. At the beginning, the firm with the more efficient route will earn an economic profit of $20 000/trip. As others begin to adopt the new route, their individual supply curves shift downward. The market supply curve also shift downward, which will result in a lower market price for shipping and a decline in economic profit. When all firms have adopted the new route, the long-run supply curve for the industry will have shifted downward by $20 000/trip, and each earns a normal profit. Example 6.7: How do cost-saving innovations affect economic profit? © 2012 McGraw-Hill Ryerson Limited Ch6-16

17 The Impact of Improvement in Technology on Long-Run Supply Technological improvement causes long-run supply to shift to the right. If demand remains constant in this graph, which represents the market for wheat, the price of wheat will be lower in 2005 than it was in Technological improvement causes long-run supply to shift to the right. If demand remains constant in this graph, which represents the market for wheat, the price of wheat will be lower in 2005 than it was in © 2012 McGraw-Hill Ryerson Limited Ch6-17

18 Capital Intensive Industries

19 Source: Microeconomics by Parkin and Bade

20

21 “Capitalism [...] is by nature a form or method of economic change and not only never is but never can be stationary. [...] The opening up of new markets, foreign or domestic, and the organizational development from the craft shop and factory to such concerns as U.S. Steel illustrate the same process of industrial mutation [...] that incessantly revolutionizes the economic structure from within, incessantly destroying the old one, incessantly creating a new one. This process of Creative Destruction is the essential fact about capitalism. It is what capitalism consists in and what every capitalist concern has got to live in.” Joseph Schumpeter 1883 – 1950

22 Schumpeter starts with the circular flow The basic circular flow of income model consists of seven assumptions: The economy consists of two sectors: households and firms. Households spend all of their income (Y) on goods and services or consumption (C). There is no saving (S). All output (O) produced by firms is purchased by households through their expenditure (E). There is no financial or government sector. It is a closed economy with no exports or imports. accessed Oct 15, 2012

23 The entrepreneur is the hero for Schumpeter Profit motive creates the incentive to disrupt production/consumption cycles – Steve Jobs – Bill Gates – Anita Roddick – Ray Kroc

24 Can Apple Still Work Magic? (right click to open link) Pay attention to the chart that appears at about 3:40 Who is likely to be more innovative? – Apple – Samsung – Blackberry What does the failure of Apple Maps mean?


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