Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Econ 401 Price Theory
Chapter 23: Aggregate Supply Instructor: Hiroki Watanabe
Summer 2009
1 / 40
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
Rent
Σ
2 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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.
3 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Inverse Demand Functions
Marginal Willingness to Pay ($)
500 Civilians Navy Crews Aggregate Demand
400
300
200
100
0 0
100
200 300 400 Hotel Rooms (x)
500
600 4 / 40
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
Rent
Σ
5 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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.
6 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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.
7 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Short-Run Aggregate Supply
8 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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.
9 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Short-Run Profit
10 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Short-Run Profit
11 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply Figure:
Rent
Σ
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.
12 / 40
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
Rent
Σ
13 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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?
14 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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).
15 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Determining the Number of Firms
16 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Determining the Number of Firms
17 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply Figure:
Rent
Σ
Determining the Number of Firms
18 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Determining the Number of Firms
19 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply Figure:
Rent
Σ
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).
20 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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.
22 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Example
Long−Run Market 16 Aggregate Demand min ATC
$
12
8
4
0 0
Intro
100
200
300 400 500 Cheesecake (Y)
Short-Run Aggregate Supply
600
700
800
Long-Run Aggregate Supply
23 / 40
Rent
Σ
Long-Run Supply Curve
Figure:
24 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Long-Run Supply Curve
Figure:
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
25 / 40
Rent
Σ
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).
26 / 40
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
Rent
Σ
27 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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?
28 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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.
29 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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.
30 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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.
31 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Market Equilibrium in the Presence of Fixed Resources
32 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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.
33 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Rent
What if it costs some to produce fixed input? Unlike the license, lithium cannot be processed and shipped without cost.
34 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Rent
$
$
S
S
D
D
Lithium/Beyoncé
me
O
O
35 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Rent
Note rent depends on demand as well as firm’s technology.
36 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
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?
37 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Long-Run Implications for Taxation
38 / 40
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
Rent
Σ
39 / 40
Intro
Short-Run Aggregate Supply
Long-Run Aggregate Supply
Rent
Σ
Short-run aggregate supply and sunk cost. Long-run aggregate supply and break even point. Rent.
40 / 40