A study published by the Canadian Health Association (CHA) shows that consumptio
ID: 1185498 • Letter: A
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A study published by the Canadian Health Association (CHA) shows that consumption of red meats (such as beef) can substantially reduce the probability of a heart attack. This study has encouraged more consumption of beef in Canada at any given price. (a)Suppose that the expansion of the beef industry has no impact on the cost of production for an individual firm. How would the long-run supply curve look like in this case. Make sure to verbally explain your graph(s)? (b) Now, suppose that expansion of the beef industry bids up the prices for major production inputs. What would be the long-run effects of the CHAExplanation / Answer
PRICE TAKERS - Firms that must take/accept the market price, no control over setting price. Markets where: 1. Homogeneous, identical products: coffee, sugar, steel, oil, gold, beef, milk, corn, wheat, soybeans, eggs, etc. 2. Many small firms whose output is small relative to the market: e.g. wheat farms. 3. Sellers/producers can sell all output at the market price, but cannot sell at a price above market price. No pricing decision. 4. No barriers to entering the market/industry. Easy to get into the business, easy to get out. PRICE SEARCHERS (next chapter, CH 23) - 1. Downward sloping demand curve. 2. Products are not identical. 3. Firms may or may not be small relative to the market. 4. Firm faces a pricing decision, know that if it raises (lowers) prices, it will sell less (more). Examples: Nike, GM, Coke, Disney, Mars, etc. Most firms are price searchers. Why study price-takers? 1. Many industries are price-taker markets: agriculture, energy and utilities, commodities, currency, credit markets, etc. 2. Price taker markets are also known as "perfectly competitive markets" or markets with "pure or perfect competition" and they help us understand competition in the economy, e.g. competitive markets and competitive behavior. Price-searcher markets can be just as competitive as price-taker markets, they are not necessarily "less pure" than price-taker markets. Perfectly competitive markets: large numbers of small firms producing an identical, homogeneous product. "No brand names/no advertising" e.g. wheat farms. No barriers to entry or exit: easy to get in, easy to get out. Barriers to entry: obstacles to entering and competing in a market/industry. Occupational licensure for example (lawyers, doctors, accountants, barbers, plumbers, etc.). See Exhibit 1. Market prices are determined by market forces in the overall, world market for corn, soybeans, wheat, beef, etc. (Panel b) The individual firm/farm then faces a horizontal demand curve (panel a). If the price of wheat is $5/bu., the wheat farmer can sell his/her entire crop at $5/bu., but would find no buyers at $5.01/bu. There would be no reason to accept $4.99/bu., so the farmer is a "price taker" at $5/bu., and his/her output decision cannot influence the market price because their output is so small relative to the overall market. OUTPUT IN THE SR Firm's output decision is based on comparing Benefits (additional or marginal revenue, MR) vs. Costs of additional or marginal units of output (MC). MR = ? Total Revenue / ? Output = ?TR/ ?Q (where ? = change) Due to the Law of Diminishing Marginal Returns, MC will eventually rise, and so will ATC. In the SR, profit-maximizing Price-Taker will expand output as long as MR > MC, and will stop when MR=MC. Beyond that level of output, MC > MR and firm would lose money on those units. RULE: PRODUCE ADDITIONAL UNITS UNTIL MR = MC, TO MAX PROFITS (OR MIN LOSSES). See Exhibit 2. Demand (d) = P = MR. If market price is $5/bu., that's the firm's Price, and also is the firm's MR, since each additional bushel generates $5 in revenue. Firm would continue producing to Output level "q" to maximize profits. TR($) = (P x q) = 0PBq = Rectangle area for Total Revenue. Remember that: ATC = TC / q, therefore TC = ATC x q (or TC = C x q). (TC = Average cost (C) per unit ($) x the number of units (q)). TC = C x q = OCAq = Rectangle area for Total Cost. TR ($) - TC($) = Profits ($) = Rectangle area CPBA Entrepreneur probably doesn't actually make decisions based on considering MR and MC curves, ATC curves, etc., but follows this process intuitively. To Max Profits, you want to sell output where the Price > Costs of Production, you don't want to sell units where the Cost > Price. Without formal understanding of economics, the entrepreneur follows economic principles - "organized common sense." Music example. PROFIT MAX - EXAMPLE, see Exhibit 3. At 1-10 units of output, and when Q >= 20, profits are negative, in both cases P 15, MC > MR of $5, and profits fall. See graphs page 490, Exhibit 4. LOSSES and GOING OUT OF BUSINESS Firm should always produce where MR = MC, to either MAX profits or MIN loss. Profits/loss involves comparing ATC v P. What if firm is producing where MR = MC, but P AVC or TR > VC), then it makes sense to operate in SR, since it can make some money (profits) to cover FC (fixed costs). If P ATC, Supply increases from S1 to S2. New long-run equilibrium is established. Market Supply curve in LR (Slr) is now upward sloping, reflecting increasing costs of production in the industry. 3. Decreasing cost industry. Industry where input costs decline as output expands. Not as common as increasing cost industries. Could happen if expanded production lowers component prices, e.g. electronic industry. Market Supply curve would slope downward. SUPPLY ELASTICITY and TIME See Exhibit 11. Suppose market P rises from P1 to P2. Firms in the industry will expand output from Q1 to Q2 initially. Over time, firms will gradually adjust to higher price, by expanding output gradually to Q3, Q4, Q5. Why not expand right away? Might be too costly, "cost penalty" for immediate increases in output. Might take time to find new sources of inputs/raw material, best sources of capital (credit card vs. bank loan), new employees (vs. overtime), etc. Supply curve is more elastic over time, as firms can adjust to higher levels of output. PROFITS and LOSSES The role of economic profits is clearly illustrated in the Price-Taker model. 1. Free entry (or low barriers to entry) serves consumers, protects them from producers, and ensures low or competitive prices. Example: taxi cabs in D.C. versus NYC. 2. Profits and losses communicate signals to producers from consumers, about how well they are doing at pleasing consumers, creating value for consumers. Profits are rewards to successful producers for creating value, losses are penalties to firms that are unsuccessful at pleasing consumers. Profit/loss system is a very effective disciplining system, rewarding success, efficiency, value, service in the market and penalizing inefficiency, poor service, low value in the market. Successful firms are rewarded with profits, and they attract resources to expand. Unsuccessful firms face the discipline of the market, they are forced to operate more efficiently, serve customers more effectively, create more consumer value, or they will be forced out of business. 3. Market system of Economic Profits and Losses produces a continual reallocation of scarce resources, away from unsuccessful, inefficient firms, towards successful, efficient firms. Success = pleasing consumers. "Consumer sovereignty." " Incentives matter." Important role of the entrepreneur. Example: Videotape rental market. Market with low barriers to entry. In 1982, market was just developing, there were only 5000 stores in US, prices were $5/day. Profits were very high in the videotape rental market, attracting entry, increasing supply to 25,000 stores in 1990. Prices came down to $1-2/day, due to intense competition. Producers responded to the consumer preferences, profits attracted resources to an expanding industry. Consumers were served by the producers. Profits in the LR were restored to normal level. Some firms left the industry, because it was so highly competitive. PRICE TAKERS, COMPETITION AND PROSPERITY 1. Price-taker firms have no control over price, they have to take the market price. However, they can control their costs, so there is a strong incentive to reduce costs of production, and invest in cost-saving technology, to operate more efficiently. Eggs - physical product has not changed over time, but costs of production have been reduced by 80% over time, due to intense competition. 2. Firms face the competitive pressure of the market - forces them to be serve consumers, operate at maximum efficiency - or they go out of business. Invisible hand - Adam Smith. See quote page 502. Main point: "Competition breeds competence."Related Questions
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