Chapter 23: Aggregate Supply

Intro Short-Run Aggregate Supply Long-Run Aggregate Supply Rent Σ Econ 401 Price Theory Chapter 23: Aggregate Supply Instructor: Hiroki Watanabe...
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Intro

Short-Run Aggregate Supply

Long-Run Aggregate Supply

Rent

Σ

Econ 401 Price Theory

Chapter 23: Aggregate Supply Instructor: Hiroki Watanabe

Summer 2009

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Intro

Short-Run Aggregate Supply

Long-Run Aggregate Supply

1

Introduction

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Short-Run Aggregate Supply Short-Run Aggregate Supply Short-Run Profit

3

Long-Run Aggregate Supply Determining the Number of Firms Example Long-Run Supply Curve

4

Fixed factors & Economic Rent Fixed Factors Market Equilibrium in the Presence of Fixed Resources Rent Long-Run Implications for Taxation

5

Summary

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Σ

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Corresponds to Ch 15A Aggregate Demand. Aggregate supply is lightly more complicated than aggregate demand. Kayak’s decision is twofold: 1 2

Whether engage in the market or not. How many cheesecakes to produce.

Time frame matters.

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Inverse Demand Functions

Marginal Willingness to Pay ($)

500 Civilians Navy Crews Aggregate Demand

400

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100

0 0

100

200 300 400 Hotel Rooms (x)

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1

Introduction

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Short-Run Aggregate Supply Short-Run Aggregate Supply Short-Run Profit

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Long-Run Aggregate Supply Determining the Number of Firms Example Long-Run Supply Curve

4

Fixed factors & Economic Rent Fixed Factors Market Equilibrium in the Presence of Fixed Resources Rent Long-Run Implications for Taxation

5

Summary

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Short-Run Aggregate Supply

How are the supply decisions of the many individual firms in a competitive industry to be combined to discover the market supply curve for the entire industry? Since every firm in the industry is a price-taker, total quantity supplied at a given price is the sum of quantities supplied at that price by the individual firms.

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Short-Run Aggregate Supply

In a short-run the number of firms in the industry is, temporarily, fixed. Let n be the number of firms; i = 1, 2, · · · , n. Si (p) is firm i’s supply function. The industry’s short-run supply function is S(p) = S1 (p) + S2 (p) + · · · + Sn (p). Caveat: Don’t add marginal costs. Kayak’s provides first slice at $3. Coffee Cartel provides first slice at $2. First slice is NOT sold at $3+$2 = $5.

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Short-Run Aggregate Supply

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Short-Run Profit

In the short term, neither entry nor exit can occur ˆ even when Sπ(y) < 0 (as long as Sπ(y) > 0). Consequently, in a short-run equilibrium, some firms may earn positive economic profits, others may suffer economic losses, and still others may earn zero economic profit.

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Short-Run Profit

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Short-Run Profit

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Long-Run Aggregate Supply Figure:

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Short-Run Profit

Q: Why does firm 2 stay in business when π(y) < 0? A: Because pE > AVC(y) or equivalently TR(y) > VC(y). They have already paid for the kitchen and ¯ K is sunk. FC = wK x Fixed cost is out of their equation. In the long run, firm 2 should close their business.

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Intro

Short-Run Aggregate Supply

Long-Run Aggregate Supply

1

Introduction

2

Short-Run Aggregate Supply Short-Run Aggregate Supply Short-Run Profit

3

Long-Run Aggregate Supply Determining the Number of Firms Example Long-Run Supply Curve

4

Fixed factors & Economic Rent Fixed Factors Market Equilibrium in the Presence of Fixed Resources Rent Long-Run Implications for Taxation

5

Summary

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Determining the Number of Firms

In the long-run every firm now in the industry is free to exit and firms now outside the industry are free to enter. The industry’s long-run supply function must account for entry and exit as well as for the supply choices of firms that choose to be in the industry. How is this done?

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Determining the Number of Firms

Positive economic profit induces entry. Economic profit is positive when the market price pE is higher than a firm’s minimum avg. cost; pE > min AC(y). Entry increases industry supply, causing pE to fall. When does entry cease? Let us start with 2 firms with aggregate supply curve S2 (p).

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Determining the Number of Firms

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Determining the Number of Firms

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Long-Run Aggregate Supply Figure:

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Determining the Number of Firms

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Determining the Number of Firms

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Long-Run Aggregate Supply Figure:

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Determining the Number of Firms

So the fourth firm would not enter. The long-run number of firms in the industry is the largest number for which the market price is at least as large as min AC(y). By the way, where does AC(y) take its smallest value? (C.f. Ch 21 Cost Curves).

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Example

Example: # of Firms in the Long Run Suppose a typical cheesecake-producing firm has MC(y) = 2y ATC(y) =

y2 + 16 y

and aggregate demand is given by AD(y) =

1 2

−y 50

+ 16.

What is the smallest average total cost and yBE ? What is the number of firms operating in the market? 21 / 40

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Example

1

yBE satisfies MC(yBE ) = ATC(yBE ). ⇒ yBE = 4 and ATC(yBE ) = 8.

2

Quantity demanded at p = 8 is Y E = 400.

3

A typical firm produces yBE = 4.

4

Y E / yBE = 100. There are 100 firms.

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Example

Long−Run Market 16 Aggregate Demand min ATC

$

12

8

4

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300 400 500 Cheesecake (Y)

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Long-Run Aggregate Supply

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Long-Run Supply Curve

Figure:

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Long-Run Supply Curve

Figure:

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Long-Run Supply Curve

In the long-run market equilibrium, the market price is determined solely by the long-run minimum average production cost. Long-run market price is pE = min ATC(y).

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Intro

Short-Run Aggregate Supply

Long-Run Aggregate Supply

1

Introduction

2

Short-Run Aggregate Supply Short-Run Aggregate Supply Short-Run Profit

3

Long-Run Aggregate Supply Determining the Number of Firms Example Long-Run Supply Curve

4

Fixed factors & Economic Rent Fixed Factors Market Equilibrium in the Presence of Fixed Resources Rent Long-Run Implications for Taxation

5

Summary

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Σ

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Fixed Factors

Is entry really free in the long run? Limited Resources: Lithium Listen to marketplace.publicradio.org/display/ web/2009/05/11/pm_bolivia_lithium/. Does every factor become "variable" in the long run?

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Fixed Factors

What if there is a barriers to entry or exit? The taxi-cab industry has a barrier to entry even though there are lots of cabs competing with each other. Liquor licensing is a barrier to entry into a competitive industry.

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Fixed Factors

An input (e.g. an operating license) that is fixed in the long-run causes a long-run fixed cost, FC. I.e., the firm owes FC even in the long-run environment (call this super long-run environment). In the super long-run environment, there is a fixed factor regardless of the time frame.

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Market Equilibrium in the Presence of Fixed Resources

Think of a firm that needs an operating license — the license is a fixed input that is rented but not owned by the firm. If the firm makes a positive economic profit then another firm can offer the license owner a higher price for it. Economic profits are competed away, to zero. So in the long-run equilibrium, each firm makes a zero economic profit and each firm’s fixed cost is its payment for its operating license.

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Market Equilibrium in the Presence of Fixed Resources

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Rent

Economic Rent Economic rent is the payment for an input that is in excess of the minimum payment required to have that input supplied. Inputs that are associated with economic rent are usually limited in its quantity supplied (even in the long-run). Each license essentially costs zero to supply, so the long-run economic rent paid to the license owner is the firm’s (super) long-run fixed cost.

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What if it costs some to produce fixed input? Unlike the license, lithium cannot be processed and shipped without cost.

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Rent

$

$

S

S

D

D

Lithium/Beyoncé

me

O

O

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Rent

Note rent depends on demand as well as firm’s technology.

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Long-Run Implications for Taxation

In a short-run equilibrium, the burden of a sales or an excise tax is typically shared by both buyers and sellers, tax incidence of the tax depending upon the own-price elasticities of demand and supply. Q: Is this true in a long-run market equilibrium?

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Long-Run Implications for Taxation

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Intro

Short-Run Aggregate Supply

Long-Run Aggregate Supply

1

Introduction

2

Short-Run Aggregate Supply Short-Run Aggregate Supply Short-Run Profit

3

Long-Run Aggregate Supply Determining the Number of Firms Example Long-Run Supply Curve

4

Fixed factors & Economic Rent Fixed Factors Market Equilibrium in the Presence of Fixed Resources Rent Long-Run Implications for Taxation

5

Summary

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Σ

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Short-run aggregate supply and sunk cost. Long-run aggregate supply and break even point. Rent.

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