pcecon.com Class Notes

A Simple Seller Environment...

A seller who has no control over product price, and charges a price set by the market is called a...
price taker
Another name for an industry of price takers is a "
purely competitive" market.

The Price Taker Market

Each seller in a price taker market:

Each individual seller in a price taker market has a horizontal demand curve (at the level of market price) for its individually produced output. This is true even though the market demand is downward sloping.

Short Run Supply for Price Takers
Individual Price Takers
Which cost is the supply for the individual seller in a price taker market, in the short run?
marginal cost
The portion of the marginal cost curve that is above the minimum AVC is the short run supply curve of an individual price taker.

Market Supply for Price Takers

The short run market supply for the entire industry of price takers is found by adding up the output that each producer will produce at each price. To see this, suppose there are only two producers (not the case in a price taker market, but easy to show). Also suppose that they have about the same cost curves (especially marginal cost):

Each seller increases its output based on its MC curve when price goes up. With two sellers sellers, the output increase when the price goes up is twice as great as with one seller. With 100 sellers, it would be 100 times as great.

Since we are adding up the quantities of the individual firms, the
short run supply curve of a price taker industry or market in is the horizontal sum (we add horizontally, get it?) of the marginal cost curves of the individual producers.

Notice that this means that the market or industry supply for price takers will be flatter than the marginal cost curve for an individual seller, but still upward sloping.

The paradox of price taker supply is that each seller is acting as if it has no control (individually) over the market price. However, when all of the sellers' actions are added up, the sellers together determine (through their decisions) the market supply. Thus, while no one firm "sets" the price, together they all contribute to determining that price, by creating the market supply. It's sort of like voting; no one voter's vote counts that much, but together they determine the election.

Long Run Cost and Supply for Price Takers

Long Run Cost
In the long run, costs are all variable. This means that even capital can be altered. Output can be changed by changing both capital and labor.
We say that changing the amount of capital that a producer uses is changing its
By changing scale in the long run, a firm can pick which short run average total cost curve it wants to have.
If we drew all of the short run average total cost curves that a producer could select between, and then draw another curve containing all of these, the new curve is called the long run average total cost curve:

The long run average total cost curve slopes down (indicating lower average costs) if the scale is increased from a very small scale to a little larger scale. These declining average costs as scale is increased are called "economies of scale" or "increasing returns to scale."
As output and scale are increased, a point is reached at which greater scale no longer decreases average costs. This begins the range of output for which we say there are
"constant returns to scale;" average costs neither rise nor fall as scale is increased.
Eventually, larger scale will lead to average costs getting larger. This is referred to as
"diseconomies of scale," or "decreasing returns to scale."
In the long run, if a seller is a price taker, it will probably choose to pick one of the (short run) average total cost curves that will put it in the range of constant returns, since these cost curves involve the lowest average total cost, and thus the greatest chance of earning a profit in the short run, no matter what the price is.

In the long run, every seller will be doing this.

Long Run Supply for Price Takers

The main thing determining supply in the long run in a price taker market is the ability of other sellers to enter the market. They will do this if there is a potential for economic profit in the market, since that means they would earn more than their opportunity cost (more than the benefit of pursuing other opportunities). Assuming that these potential entrants in the market could, if they entered the market, have costs similar to those sellers already in the market, they will assume that they could earn an economic profit if, and only if, they observe profit being earned by the already existing sellers.
If the existing firms have similar cost curves, and are all taking advantage of constant returns, the picture looks like this (each dot is a firm's LR output choice):

If the long run price were to be above the minimum LRATC, firms in the market will be making a profit (remember, if P > ATC, there is profit). This would attract new firms to enter the market. The output of these new entrants would lower the price, thus removing the economic profit. The result will be a long run equilibrium, in which the price must be equal to the minimum long run average total cost. The producers in the market will thus make zero economic profit in the long run (there still may be temporary short run profit for brief periods, however).

The supply curve in the long run will reflect the fact that price is equal to the minimum long run average total cost. The market will supply as much or as little of the good as buyers want, as long as this price is paid. Producing more of the good may raise the price in the short run (remember, the short run supply curve is upward sloping), but in the long run, more firms will simply enter the market to create the needed supply.

If more firms can enter the market without affecting cost, then the long run supply will be horizontal, and we say it is a
constant cost industry.
However, the costs may rise for all firms when lots of firms are trying to enter the market.

This is called an
increasing cost industry, and implies that the long run supply will be upward sloping (since a greater quantity requires a greater number of suppliers, and thus a higher cost for all of them).
An example might be the market for a crop that requires a particular kind of land. As more sellers enter the market, the price for that kind of land will be bid up, raising the producers' LRATC curves.

The opposite can occur, with more sellers actually having a lower long run average total cost curve than a few do. This might occur if there are economies of scale in producing some input that all the sellers need (not the product the sellers are producing, but some input they use). Such an industry is called a decreasing cost industry, and would result in a downward sloping long run supply.
An example of this might be the production of purified water, which requires special filters. If only a few sellers try to sell purified water, the filters may be rare and hard to get, so the sellers of the purified water will have high costs. As more sellers of purified water enter the market, they will increase the number of filters purchased and produced. Economies of scale in producing the filters may bring down the price of the filters, and thus the costs of producing purified water.
The long run supply of purified water might thus be downward sloping.

Copyright 2006 by Ray Bromley. For economics information, and other information about Ray Bromley, visit www.raybromley.com. Permission to copy for educational use is granted, provided this notice is retained. All other rights reserved.
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