econ 5 and 6

5.0 PRODUCT MARKET SUPPLY

5.1 PRODUCT SUPPLY

5.1.1 Why the Product Supply Line Slopes Up: Setting the Scene

Alfred Marshall wrote the book on microeconomic theory. His Principles of Economics

published in 1890 laid out the framework that we now use for modern micro market

analysis. One of Marshall’s many major insights lay in his analysis of the supply side in

the product market.

Marshall’s early predecessors in modern economic analysis, following the work of

David Ricardo who published his Principles of Political Economy in 1817, believed that the

product market supply line was perfectly elastic, a horizontal line. Ricardo argued that

cost of production determined the price suppliers put on their product, and that in most

market cases the cost of producing any item is constant. A perfectly horizontal supply

line reflects this view. No matter where the demand is, the price is determined by the

level of production costs as reflected in the level of the supply line.

In the 1870s three economists (William Stanley Jevons, Carl Menger, and Leon

Walras) argued, independently of one another, that Ricardo had it all wrong. They

viewed level of supply as fixed by the quantity available in the market. That implies a

vertical supply line at the given level of quantity supplied. In this case the market price is

determined by the level of demand. In effect they reversed the logic from Ricardo’s

“supply determines price” and made the case that “demand determines price.”

5.1.2 Why the Product Supply Line Slopes Up: Marshall’s Analysis

In 1890 Marshall offered a more complete analysis that included both Ricardo and

the Jevons/Menger/Walras cases as special cases of a larger set of possible market

conditions.

Marshall defined Ricardo’s case as the long run condition and agreed that in the long

run the supply line would be horizontal.

Marshall defined the Jevons/Menger/Walras case as the market period condition and

agreed that in the market period the supply line would be vertical.

Having defined the long run and the market period, Marshall went on to argue that

the most reasonable frame for analyzing market activity is in an intermediate case

between these two extremes – a case he called the short run. For reasons we will see

shortly, in the short run the cost of each successive unit produced rises, and if that is the

case the supply line slopes up.

Thus, in Marshall’s analysis it is not supply, as Ricardo argued, or demand, as

Jevons/Menger/Walras argued, that determines price, it is the interaction of supply

conditions and demand conditions that determines price. Marshall wrote in his Principles:

We might as reasonably dispute whether it is the upper or the under blade of

a pair of scissors that cuts a piece of paper, as whether value is governed by

utility [(demand)] or cost of production [(supply)]. It is true that when one

blade is held still, and the cutting is effected by moving the other, we may

say with careless brevity that the cutting is done by the second; but the

statement is not strictly accurate …

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Modern economics has adopted Marshall’s more complete analysis and his

representation of the short run upward sloping supply line as the most important case

for market analysis. So let’s see why the short run makes the supply line slope up.

5.1.3 Why the Product Supply Line Slopes Up: From Marginal Product to Marginal Cost

We learned in Chapter 2 that, holding all other factors constant, as you increase one

input the output from successive units of that input may increase initially but eventually

the marginal product of that input will decline. This is our assumption of eventually

diminishing marginal productivity represented graphically in Figure 5.1.1.

This has important implications for what it costs to produce successive unit of

output, or what we will refer to as the marginal cost of production.

To see why consider the following: Suppose the one variable input is labor, so we are

talking about successive units of labor applied to production. Assume that the labor is

being paid at a constant rate – say $20/hour. (Remember, under our nice assumptions the

market sets the price and the firm has no power over that price.) As the marginal product

of that labor rises then falls while the worker is being paid a constant rate per hour, what

is going to happen to the cost per successive unit of output? In other words, if the

marginal product of labor looks like Figure 5.1.1, what will the output marginal cost

curve look like?

Output

Units of Input

Figure 5.1.1 - Marginal Productivity

5.1.4 Why the Product Supply Line Slopes Up: Deriving the Marginal Cost Curve

To answer this question let’s walk through a simple case. Suppose the labor is

producing candy bars. Successive units of labor produce more candy bars at first, but

eventually they produce less. Table 5.1.1 is a marginal product (MP) table showing candy

bar output for each successive unit of labor input.

Table 5.1.1 - Marginal Product in

Candy Bars

Unit

Labor

MP for Labor

in Candy Bars

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1st 25

2nd 100

3rd 200

4th 180

5th 160

6th 140

7th 120

8th 110

9th 100

10th 90

These numbers are consistent with the shape of the marginal product line (MP) in

Figure 5.1.1 – MP rises, then falls. Now, let’s assume that labor is paid $20/hour. With

the MP schedule and the wage we can calculate the marginal cost of successive units of

candy bars. This is shown in Table 5.1.2.

Table 5.1.2 - From Marginal Product and Marginal Cost

Labor at

$20/hour

MP of Labor

in Candy

Bars

MC/unit of

candy

in cents

(rounded off)

1st 25 .80

2nd 100 .20

3rd 200 .10

4th 180 .11

5th 160 .13

6th 140 .14

7th 120 .17

8th 110 .18

9th 100 .20

10th 90 .22

Based on this we see that when we pay constant input price and the marginal

product of that input rises and then falls, it follows that the marginal cost of the output

will fall and then rise. Graphically, given our assumptions, a generic marginal cost curve

(labeled MC) looks like Figure 5.1.2.

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Units of Output

Figure 5.1.2 - Marginal Cost

We can understand the relationship between the marginal product and marginal cost

curves as follows: If you pay workers $20/hour and they are producing more and more

output per hour, then the cost for successive units of that output is going to go down.

When they are most productive, where the MP is highest, the cost per unit, the MC, is

lowest. Beyond that point they begin to get less productive at the margin, and thus

output is going to be more and more expensive to produce. So we see that the MC curve

in Figure 5.1.2 is derived from our assumption of eventually diminishing marginal

productivity.

5.1.5 Why the Product Supply Line Slopes Up: From MC to the Supply Line

This marginal cost (MC) line is important because for an individual firm the upward

sloping segment of the MC curve is the firm’s supply line. Think about it from the firm’s

point of view: It is easy for a firm to expand production when marginal costs are falling;

the real question a firm faces is “How far do we want to expand production as MC

rises?”

Let’s follow the firm’s thinking on this: In our perfectly competitive market (our

current assumption) the firm is faced with a market price it can’t control. It just has to

take that as the price it will receive. In effect, that price is a signal from the market that

says: “We’ll pay you this much for each unit.” Given that price signal, the firm has to

answer the question: How many do we want to supply?”

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FIRM MARKET

MC,

Supply Line

Figure 5.1.3 - Price Signal and a Firm's Response

As shown in Figure 5.1.3, the firm will look at that market price, it will look at its

marginal cost curve, and it will say, “At that price we can cover the marginal cost of

successive units up to the point at which that price (po) equals marginal cost (MC). If you

want more you have to pay more, because the marginal cost of units beyond that is

higher than the price you offer.” If the market price rises, the firm looks at its MC curve

and in effect says, “OK, that’ll cover a higher MC, so we’re willing to supply this much

more.”

The firm determines its quantity supplied by identifying at what quantity the price

equals the marginal cost. The upward sloping section of the MC curve tracks the quantity

the firm will supply as the market price rises or falls, so this section of the MC curve is

the firm’s supply line.

5.1.6 Supply, MC, and Normal Returns

It is very important to note that when a firm considers the costs it incurs, those costs

include all that the firm has to pay other people and the return that the owner of the firm

has to pay herself.

Consider the gift shop that my sister owned for many years. She had to pay a lot for

the rent on her space in the mall … she had to pay for the electricity, the phone, the water

… the gift paper and mailing paper and bags … the salaries for all the employees … the

insurance … the gifts on the shelves … and on and on and on. There were a lot of costs to

running her business. All these costs are included in her marginal cost curve. … And

when she finished writing checks to all of those other people that she had to pay to be in

business, she wasn’t finished with the basic cost of running a business. She also had to be

able to pay herself. We have a term in economics that describes what she had to pay

herself to make it worth staying in business. It is called a normal return

You could work for someone else rather than run your own business. A normal

return is just enough to beat that opportunity cost – using your resources (e.g., your time,

your financial capital) in someone else’s business instead of your own. To stay in

business you have to make enough to cover all that you pay others and you have to pay

yourself at least a normal return. If you cannot cover all that, then you are better off

working for someone else. When all the bills are paid, there has got to be enough left to

make it worth staying in business – you’ve got to make at least a normal return.

For everyone cash matters a lot – but there is more to it than cash. There is also the

personal satisfaction of running one’s own business. There is the sense of independence

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in working for yourself. There is the pride in ownership of a firm others point to with

respect. However you “compensate” yourself for being in business, you must make at

least a normal return to make it worth staying in business.

Since the normal return is an essential part of a firm’s costs, the marginal cost curve

of every firm has this normal return built right into it. When a firm is just covering the

costs embodied in the marginal cost curve there is just enough revenue to stay in

business.

5.1.7 Cost Structure and Individual Firm’s Supply Shift Variables

The marginal cost curve shows how the cost of a unit of output changes for each

successive unit produced. It is one way to represent an individual firm’s cost structure.

This cost structure is based on

• the prices of inputs into production

• level of technology, and

• the environment of production

These variables determine the level of costs that underlie the cost structure. If one of

these changes, it changes the level of the cost structure and thus the level of the MC

curve. Higher cost structure shifts MC up (for any given quantity, it costs more to make

each successive unit) and lower cost structure shifts MC down (for any given quantity, it

costs less to make each successive unit). Since the MC curve of a firm is its supply line,

these are the shift variables for the firm’s supply line. Using the same functional form

tool we used with demand, we can write the functional form of the supply relationship

as:

S= S1 (p1 I pI, Tech., Env.)

Where

• pI stands for the prices of inputs,

• Tech. stands for the level of technology, and

• Env. stands for the environment of production

5.1.8 Cost Structure and Individual Firm’s Supply Shift Variables – Case of Input Prices

(pI)

If the price of an input, pI, goes up (e.g., the price of gasoline rises for a trucking

company), then, ceteris paribus, the whole cost structure of the firm goes up. With higher

input prices it costs more to produce any given quantity. On the graph in Figure 5.1.4 a

rise in an input price, pI, causes the supply line to shift up because for any given quantity,

it costs more at the margin to make it.

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Figure 5.1.4 - A Shift Up in Supply

Note: In what follows I’ll refer to shift ‘up’ or ‘down’ in supply when these three shift

variables change because on the supply side I think in terms of cost structure going up or

down and in turn causing supply, S, to go up or down.

Suppose for example that the cost of fabric went up for a firm producing clothes.

That would look like the case in Figure 5.1.4. If this happened, ceteris paribus, would the

firm hope that the demand for its clothes was elastic or inelastic? Inelastic, because in that

case it would be able to pass on the higher costs without losing much in the way of sales

or revenue.

Suppose the cost of oil went down for a gasoline company. In that case the supply

line shifts down. If this happened, ceteris paribus, would this firm hope that the demand

for its gasoline was elastic or inelastic? The firm would hope that demand would be

elastic, because the company would love to expand sales quickly as the price fell.

5.1.9 Cost Structure and Individual Firm’s Supply Shift Variables – Case of Technology

Suppose a new, improved technology is developed that lowers the cost of

production. Obviously there is a cost to implementing this technology, but once it is in

place the improved technology will lower production cost structure and thus shift the

supply line down.

5.1.10 Cost Structure and Individual Firm’s Supply Shift Variables –

Case of Environment of Production

The classic case of environment of production can be found in agriculture. Suppose

the weather was miserable for apples and the orchards produce a terrible crop. The

output per unit of cost is way down on account of the bad environmental conditions.

This means a rise in the cost of production per unit of output and thus a shift up for the

supply line. Ceteris paribus, is this good for the orchard owners? This cannot be answered

until we know the demand conditions, because it depends on the elasticity of demand. If

demand is elastic the rise in price will not be enough to offset the more significant decline

in quantity demanded, so the total revenue of the orchards will fall. If demand is inelastic

the rise in price will more than offset the decline in quantity demanded, so the total

revenue of the orchards will rise. But keep in mind that weather does not affect all

producers the same. One grower’s disaster can be a boon for another whose crop now

faces less competition.

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5.1.11 From Individual to Market Supply

The sum of all individual firms' supplies for a given good or service is the market

supply for that good or service. In other words, at any given price, the market quantity

supplied is the sum of the individual firms' quantities supplied at that price.

Consider Figure 5.1.5. At the top we see three pictures that represent three different

firms’ supply lines for candy bars. At any given price, the market quantity supplied is the

sum of the three firms' quantities supplied at that price. The picture at the bottom shows

the market supply if these are the only three firms in the market.

In this example at a $1 price for candy bars we find that firm #1 has a quantity

supplied of 1 bar, firm #2 has a quantity supplied of 1 bar, and firm #3 has a quantity

supplied of 1 bar. Summing these up, we see that the market quantity supplied at a $1

price is 1+1+1 or 3 candy bars. At a $5 price, firms 1, 2, and 3 have as quantities supplied

4, 4, and 4 respectively. Therefore the market quantity supplied for candy bars at a $5

price is 12 bars. By repeating this summing of the individual firms’ quantities supplied

over all prices we derive the market supply line.

Since the market supply line is simply the sum of the individual firms' supplies,

changes in firms’ supplies due to changes in input prices, technology, or environment of

production can cause a shift in the market supply. Whether the market supply moves

depends on the net effect of all the individual changes.

p S

1 3 5

2 6

1 3 5

2 6

1 3 5

2 6

1 3 7

2 8

0 15

6 9 10 11 12 13 14

Figure 5.1.5 - From Individual to Market Supply

5.1.12 Entry & Exit, and Shifts in Market Supply

At the level of the market there is one more shift variable in addition to the variables

that can affect the cost structures of individual firms: The entry of firms into or exit of

firms out of the market will shift market supply. Ceteris paribus, the entry of new firms

shifts the market supply line to the right since there will be more quantity supplied in the

995.0 Product Market Supply

market at any given price. Conversely, ceteris paribus, the exit of existing firms from the

market shifts the market supply line to the left since there will be less quantity supplied

in the market at any given price.

5.1.13 The Firm in the Market –

Firms as Price Takers Under the Perfect Competition of Our Nice Assumptions

We have seen that under our nice assumptions that ensure perfect competition, the

market sets the price and each individual and each firm simply responds to that price.

Firms and individuals are price takers – that’s the market price, take it or leave it..

Graphically, the relationship among individuals, firms, and the market under perfect

competition can be represented as shown in Figure 5.1.6.

FIRM

MARKET

INDIVIDUAL

Figure 5.1.6 - Individuals and Firms as Price Takers

The market, pictured in the middle, determines the price. Given that the vertical

price axes have the same scale we can trace that price over from the market to the graph

representing the generic firm and the generic individual.

The firm can sell as much as it likes at that going market price, so from the

perspective of the firm the demand line it faces is perfectly elastic at the level of the price

set in the market. What quantity will the firm choose to supply?

Consider … The price line from the market is the firm’s demand line. The MC curve

is the firm’s supply line. The firm can cover the cost of each successive unit it produces

up to the point where the price equals marginal cost, or where its supply and demand

lines intersect. The quantity at this point, which we identify by going down from there to

the horizontal axis, is the quantity the generic firm will choose to supply. This is

represented in Figure 5.1.7.

100

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FIRM MARKET

MC, S

Figure 5.1.7 - The Firm and the Market

Now suppose there is entry of new firms into the market. If this shift in supply

occurred in the market, what would happen to the quantity the generic firm would

supply?

FIRM MARKET

MC, S

Figure 5.1.8 - The Firm in a Changing Market - As New Firms Enter

In Figure 5.1.8 you can see that, ceteris paribus, as the market supply expands, the

market price falls. As this happens, the intersection between the price and the MC lines in

the firm graph slides down to the left. When the market price stops falling the firm will

be at a new position with a lower quantity supplied.

Just as with the demanders, the suppliers in the product market are constantly

responding to the price signal. Under our nice assumptions that ensure perfect

competition, all this individual behavior leads to an incredibly efficient outcome. Let’s

see how.

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6.0 REPRESENTING THE POWER

OF THE INVISIBLE HAND

6.1 THE MAGIC OF MARKETS – PRODUCT MARKET EFFICIENCY UNDER

OUR NICE ASSUMPTIONS

6.1.1 Introduction

In the last 30 years many nations of the world have opened up their economies and

joined the global market system. They have done so because there is a conviction among

many that markets can do magic, that the invisible hand of markets can guide nations to

realize greater wealth by making their systems of production more efficient.

This conviction does have a theoretical basis. With one more tool we will have all the

equipment necessary to demonstrate the potential magic of markets. We will see that the

perfect competition that exists under our nice assumptions forces firms in product

markets to choose the most efficient (lowest cost) technique of production. Furthermore,

we will see that perfect competition encourages constructive creativity by firms because

it rewards those that are dynamic developers of ever greater efficiency.

The one additional tool we need for this analysis is the concept of average cost.

6.1.2 Marginal and Average -- Introduction

Marginal cost is one way to represent a firm’s cost structure; average cost (AC) is

another. Let’s be clear about the distinction. Marginal cost identifies how much each

specific unit costs as it is produced; it represents the unique cost of each successive unit.

The average cost is measured by dividing total cost of production by total number

produced, thus it spreads out the costs evenly among the units produced as if they all

cost the same to produce.

Look at Table 6.1.1. It shows how marginal cost, MC, and average cost, AC, are

changing as successive units are produced.

Table 6.1.1 Marginal and Average Cost

Unit of

Output

MC AC

(rounded)

Calculating

AC:

Total Cost for

that # (Sum of

MCs)/

# of units

1st 100 100 100/1

2nd 90 95 190/2

3rd 80 90 270/3

4th 70 85 340/4

5th 80 84 420/5

6th 90 85 510/6

7th 100 87 610/7

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8th 110 90 720/8

9th 120 93 840/9

10th 130 97 970/10

The marginal cost of the first unit is 100. To calculate the average cost we divide the

total costs for all the production by the number of units produced. In the case of the first

unit the total cost is just the 100 that the first unit cost and the total number of units is just

1, so the Average Cost is 100/1 or 100. For the first unit the margin always equals the

average.

The marginal cost of the second unit is 90. That is how much it cost to produce that

particular unit. The total cost after two units is the sum of the marginal costs of the first

two units produced, so it is 100 + 90, or 190. Dividing this total cost by the number of

units, 2, gives the average cost after two units, 95.

And so it goes down the table. The marginal cost represents the actual cost of a

specific additional unit. The average cost represents a measure of how much units cost if

we spread the total costs out evenly for the given number produced.

6.1.3 Marginal and Average – The Relationship Between Them

The margin moves faster than the average. For example in Table 6.1.1, the margin

goes 100, 90, 80, 70 while the average goes 100, 95, 90, 85. This lag of the average behind

the margin is due to the way the average is calculated. In this falling margin case the

average calculation does not drop as fast because it includes the effects of the higher

margins from before.

Now think about how changes at the margin affect the average. Suppose you play in

the Women’s Professional Soccer League and over the last five seasons you have

averaged 8 goals a season. Then this season you score 12 goals. How is that change in

your productivity at the margin, your goals this particular season, going to affect your

career average goals scored per season?

It is going to raise your career average. If you scored fewer than 8 goals this season

your career average would go down.

More personally, consider your GPA. Suppose your GPA this semester, your

“marginal GPA”, ends up higher than your overall average GPA has been up until this

semester. What is this marginal semester’s performance going to do to your overall

average? It is going to raise it. On the other hand if your current semester’s GPA ends up

below your overall average, it’ll pull your overall average down.

The margin always pulls the average in its direction. Whenever the margin is above

the average it pulls the average up. Conversely, if the margin is below the average it

pulls the average down. Even when the margin is rising, if it is below the average it will

pull the average down. Look at the data in Table 6.1.1. As the margin goes from 70 to 80,

the average goes from 85 to 84. Even though the margin went up, the average fell. This is

so because while the margin is rising at that point, it is still below the average so it pulls

the average down. Once the margin goes above the average, the average starts to rise

because then the margin is pulling the average up. In our example as the margin goes

from 90 to 100 to 110, the average goes from 85 to 87 to 90.

6.1.4 Marginal and Average Cost Curves – Their Relationship

Now let’s look back at the MC line for our generic firm. It starts down and then

swoops up. If we add an AC line to this cost structure picture what would it look like?

AC would start right with the MC line at the first unit (not shown on the graph). Average

cost would follow the marginal cost down, but because AC does not fall as fast as MC,

the MC would be below the AC. Even when the MC turns up the AC would continue to

go down as long as the MC is below it.

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As marginal cost rises it would eventually reach and cut above the average cost. At

the point at which the MC cuts above the AC it starts to pull the AC up. So what can we

say about that point along the AC line at which the MC cuts from below to above the

AC?

Units of Output

Figure 6.1.1- Marginal Cost cuts Average Cost at the Minimum Point along AC curve

As shown in Figure 6.1.1, the marginal cost curve, MC, intersects going from below

to above the average cost curve, AC, at the bottom or minimum point along the AC

curve. It does so because the margin always pulls the average in its direction. When the

marginal cost is below average cost, AC falls. Where the marginal cost moves above the

average cost the AC begins to rise. So the marginal cost cuts the average cost at that point

where AC stops going down and starts going up – i.e., the MC cuts the AC at the

minimum average cost point. This bears repeating because the relationship between the

marginal and average costs is a very important tool for our analysis that demonstrates

the efficiency of perfect competition.

6.1.5 Total Revenue, Total Cost, and the Case of Profit

Now that we have these two ways of representing the cost structure of an individual

firm (MC and AC) in place we can represent the condition of a generic firm in the

product market. In particular, we can identify whether the firm is making a profit,

suffering a loss, or breaking even. We will call it a profit when the total revenue of the

firm is greater than the total costs, a loss (or a negative profit) when total costs are higher

than total revenue, and breaking even when total costs equal total revenue.

The total revenue of a firm, TR, is the amount of money it takes in from the sale of its

product. Total revenue is measured by price times quantity:

TR = p x Q

For example, if a firm sells 5 cars at $20,000/car, its total revenue is $100,000.

The total cost of a firm, TC, is the amount of money the firm spends in the process of

producing. Total cost is measured by average cost times quantity:

TC = AC x Q

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For example, if a firm produces 5 cars at an average cost of $17,000, its total cost is

$85,000.

We will use a Greek letter pie, , to stand for profit.

 = TR – TC

In the case of this firm producing the 5 cars, total revenue minus total cost is

$100,000 - $85,000 so this firm is making a profit of $15,000. Let’s see how we represent

this kind of situation with our graphs.

6.1.6 Representing Profit on Our Graph

In Figure 6.1.2 we have our generic firm on the left and the market picture on the

right. Given the current conditions in the market, the market price is p1. At that market

price (which under our nice assumptions is the firm’s demand line, D1) and given the

firm’s MC curve (which is the firm’s supply line, S), the firm will produce Q1. To measure

the AC at Q1, we go up from Q1 to the AC line and over to the vertical axis.

FIRM MARKET

MC, S

PROFIT

AC1

Figure 6.1.2 - The Firm and the Market - Identifying Profit

On our graph p is measured vertically so we can think of it as a height, and Q is

measured horizontally so we can think of it as a width. Height multiplied by width is the

area of a rectangle, so in the framework of our generic firm’s graph we can represent the

total revenue, TR = p1 x Q1, by the area of the rectangle on which price, p1, is the height,

and quantity, Q1, is the width.

Given that at Q1 the AC is AC1, we can represent the total cost, TC = AC1 x Q1, by the

area of a rectangle on which AC1 is the height and Q1 is the width.

Look at the total revenue and the total cost rectangles we have just identified. The

total revenue rectangle is bigger. Since total revenue is greater than total cost, the firm is

making a profit. How big is the profit? The area of the rectangle (p1-AC1) x Q, identified

by hash-marks, measures the firm’s profit:  = TR – TC

6.1.7 The Market’s Response to Profits

Like many of our terms, profit may be defined differently in other contexts. As

always, the important thing for our purposes is that we share a common understanding

of what it means here. In our model, a positive profit is realized when total revenue is

1058.0 General Competitive Equilibrium

greater than total cost. As such, it is “gravy”. All firms want a profit, but no firm needs a

profit. Why?

Remember, our definition of costs includes a normal return for the owner of the firm.

So as long as a firm is covering its costs, it is bringing in enough revenue to make staying

in business worthwhile. It is covering its opportunity cost. Anything above a normal

return is gravy: Very nice, but not necessary. So in our model profit is gravy … or sugar –

very desirable … very sweet, but not necessary to stay in business.

It is also a very important signal in the market system.

Profits signal that a particular market is a very nice place to be. Under our nice

assumptions everyone has equal access to information and equal access to the markets,

so as competitors learn about this sweet market that offers a profit they join the market.

As each new competitor enters the market the market supply shifts out and the price

falls. As long as profits exist, more competitors enter the market to get a piece of the

action. As the market price falls with each new entrant, the profits of the firms in the

market get squeezed. Ultimately competition will force the price down to the point at

which only the costs are covered. The profit is gone. New entries stop.

Figure 6.1.3 represents this dynamic. At the initial market supply, S1, the market

price, p1, generates a profit (as in Figure 6.1.2 above) for every firm in the market. (Note:

All the firms have the same cost structure because under our nice assumptions everyone

knows and uses the best available production process.) As firms enter the market Supply

(S) shifts out and market price (p) falls. Firms continue to enter until supply reaches S2

and price has fallen to p2. At that price, each firm in the market will produce Q2 at

average cost AC2. But now for every firm p=AC so TR=TC. Firms are covering all of their

costs, including their normal returns – so they can stay in business as long as they like,

but there is no longer any profit.

FIRM MARKET

Fall in

Market

Price

Shift in S

AC1

AC2, p2

D2 p2

Figure 6.1.3 - Competition, Market Entry, and the Squeezing of Profits

6.1.8 Profit, Market Signaling, and the Invisible Hand

Profit is a powerful yet ephemeral signal. By signaling that a market is a sweet place

to be it attracts resources in pursuit of it, and yet it extinguishes itself in the process.

Under perfectly competitive conditions firms seek profit, but they end up earning only a

normal return.

In the case of a market in which firms are suffering losses, the firms aren’t making

enough to cover a normal return so losses cause some of the owners to exit the market.

1068.0 General Competitive Equilibrium

This shifts market supply up and raises the market price. Exit will continue until the

losses are gone.

The net effect of these resource flows into or out of markets is that under perfect

competition normal returns are the norm. Adam Smith described this dynamic of

perfectly competitive markets and how it eliminates advantages (profits) or

disadvantages (losses) very nicely more than 200 years ago in The Wealth of Nations:

The whole of the advantages and disadvantages of the different

employments of labour and stock must, in the same neighbourhood, be

either perfectly equal or continually tending to equality [(i.e., ultimately

everyone will just make the same return: a normal return)]. If in the same

neighbourhood, there was any employment evidently either more or less

advantageous than the rest [(i.e. making a profit or a loss respectively)], so

many people would crowd into it in the one case [entry], and so many would

desert it in the other [exit], that its advantages would soon return to the level

of other employments [a normal return]. This at least would be the case in a

society where things were left to follow their natural course, where there was

perfect liberty, and where every man was perfectly free both to chuse what

occupation he thought proper, and to change it as often as he thought

proper. Every man's interest would prompt him to seek the advantageous,

and to shun the disadvantageous employment.

and Smith also writes in The Wealth of Nations that

by directing that industry in such a manner as its produce may be of the

greatest value, he intends only his own gain, and he is in this, as in many

other cases, led by an invisible hand to promote an end which was no part of

his intention. … By pursuing his own interest he frequently promotes that of

the society … (emphasis added)

This is almost certainly the most famous passage in the most famous book ever

written about economics. It highlights that in pursuit of our self-interest we will, under

our nice assumptions, promote the wealth of the nation. To see how this self-interested

behavior serves society, let’s look again at our firm/market picture: Figure 6.1.3.

6.1.9 Efficiency and the Invisible Hand

We have demonstrated that profit attracts competitors. These new entrants expand

market supply. This lowers the price. As the price falls, the profits of the individual firms

in the market get squeezed. But so long as profits exist new competitors continue to enter

in pursuit of some of this “gravy” or “sugar”. This dynamic only ends when the

expansion of market supply lowers the market price to a level that squeezes all profits

out of the market. In that case, p = AC. Graphically that happens when the price

intersects the MC curve just where the MC cuts the AC curve.

This is a very special point along the average cost curve. It is the lowest point on the

average cost curve.

What can we say about the efficiency of production at this point? … Because it is the

minimum average cost point, it is the most efficient way to produce this product. That is

hugely significant. Look at what the market dynamic has done when our nice

assumptions hold and competition is perfect. Nobody is in charge. Everyone is pursuing

her own self-interest. In pursuit of profits all firms are driven to produce at a level that

realizes the minimum average cost. That is the absolutely most efficient level of

production. This is a central part of the story of the magic of markets. Under our nice

assumptions, the dynamic of a perfectly competitive market forces every firm to charge

1078.0 General Competitive Equilibrium

the lowest price consistent with making a living - a normal return, and to produce in the

most efficient way.

6.2 MARKETS, PERFECT COMPETITION, CREATIVITY, AND MATERIAL

PROGRESS

6.2.1 Introduction

We have seen that under our nice assumptions that ensure perfect competition, all

firms in a market will be driven toward the most efficient level of production with the

most efficient available technique – or they will be driven out of business. But there is

more to the efficiency story. There is another dynamic that over the long run is even

more significant: Market systems encourage creativity and inventiveness because they

reward it.

6.2.2 The Incentive for and the Dynamics of Entrepreneurial Thinking

To see where the incentive for creativity comes from in markets let’s reflect on our

picture of the generic firm and the market. Recall that under perfect competition the firm

is forced to produce at the bottom of its average cost curve with no profit, no loss, just a

normal return … so it is just breaking even. If they want to survive, its competitors are

forced to use the same technique as well, so their pictures are identical and they are also

making only a normal return.

All these firms can survive like this forever. A normal return is enough to make this

business worthwhile since it beats the best available alternative – the opportunity cost –

of being in this business.

But if you are one who thinks creatively/divergently, who sees new possibilities, and

who is willing to take the risk of trying new things – if you are an entrepreneur and you

are in this market – you can do better!

How can you get ahead of the market? How do you get a profit out of this market

again?

You can do it by lowering your cost structure.

How do you do that? You have to come up with an innovation that makes you more

efficient than your competitors. An obvious source of such an innovation is improved

technology. If you can come up with innovations that lower your cost structure, then

while everyone else is breaking even, you are making a profit until they figure out what

you have done.

As you innovate and make a profit, the firms using the old technique (with the old

cost structure) are breaking even at the market price. Since under our nice assumptions

all players have equal access to information and equal access to the market, the other

firms will see that you’ve innovated and are making a profit, they will figure out how

you lowered cost structure, and they will imitate your innovation in order to share in the

profit. But inevitably these profits will attract new competitors driving the price down

and all participants back to the lowest average cost of production with no profit. Thus

your innovation has led to a more efficiency and a lower price. In pursuit of personal

profit, your creativity has served the market system.

As price falls in this dynamic, if any of the participating higher-cost firms do not

adjust to the more efficient production they will eventually be too inefficient to survive.

Competition from more efficient firms drives down the price and drives the slow footed

out of business. Under our nice assumptions market systems reward speed and agility. If

you can’t keep up, you can’t survive.

1088.0 General Competitive Equilibrium

6.2.3 Creating a New Market Niche: Inventing the Better Mousetrap

Another way to beat the market is to identify or create a new market niche. Before

mousetraps people had cats to catch mice. Cats still catch mice, but mousetraps obviously

have some major advantages in the eyes of many in the market because a lot of them are

sold. If you had been the first person to market one you had the market to yourself – a

big advantage that produces a big profit. When others see this sweet spot in the market

they’d enter by imitating your product. If you want to stay ahead, you have to build a

better mousetrap to continue to beat the market. This is classic: Build a better mousetrap

and the world will beat a path to your door.

6.2.4 The Market Dynamic

When you bring your better mousetrap to the market, what are your competitors

going to do? They are going to imitate you again. As competitors enter the market to

share in the profit, the market price will fall and your profit will begin to disappear …

again. So what is your incentive as they catch up with you? What do you always want to

be doing? You want to come up with yet a better idea ... to innovate.

This is really the beauty of markets. Not only do they drive people to do what is

currently most efficient, they encourage creativity and inventiveness by rewarding it.

Indeed, the competition demands that one be creative and inventive if one wants to stay

ahead. So people are constantly thinking of new products, better versions of old

products, or ever more efficient ways of producing products. Under our nice

assumptions, markets are incredibly powerful engines for material progress, and this

benefits all of us with cheaper, better, more diverse products.

6.2.3 The Magic of Markets

With words and graphs we have painted a picture in your mind’s eye of one of the

most powerful ideas in modern history; a picture first fully painted in Adam Smith’s

Inquiry into the Nature and Causes of the Wealth of Nations in 1776.

Smith understood that the magic of markets lies in their potential for efficiency,

creativity, and inventiveness. It is this magic that underlies the fascination with markets

and the movement of so many countries (e.g., China and Russia) toward market based

economic systems.

Under our nice assumptions, perfect competition in markets makes every firm move

to the most efficient available technology and to produce at the most efficient level. Even

more amazing, markets bring out the creativity, the entrepreneurial imagination of

people to always do it better. If you join this competition, even as you are striving to do it

better, you are being chased by the people who are trying to keep up and get ahead of

you. You are pressed by this competition to do even better yet, to be even more

imaginative in responding to the market. In this case the nation gets the most from its

resources and thus achieves the greatest wealth for the nation. This is the power of Adam

Smith’s invisible hand.

But as Smith understood very well, while the invisible hand can bring efficiency

under the nice assumptions, it does not necessarily assure a just distribution of the

product among the individuals in society. Remember, markets are amoral. They just

coordinate individuals’ choices given:

• the distribution of the social endowment among individuals,

• individuals’ preferences, and

• the state of technology.

1098.0 General Competitive Equilibrium

Now we want to see how the distribution is determined in the best market case, that

is, under our nice assumptions. For that we turn to the factor markets.