MBA201a: Entry, Exit & Equilibrium
MBA201a: Entry, Exit & Equilibrium. Professor WolframMBA201a - Fall 2009 Page 1 Basic definitions & principles (I) In the short run (SR), –for an individual.
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MBA201a: Entry, Exit & Equilibrium
Professor Wolfram MBA201a - Fall 2009 Page 2
Basic definitions & principles (I)
• In the short run (SR),
– for an individual firm, many costs are sunk, and
– for an entire industry, the number of firms is fixed.
• In the long run (LR),
– everything is variable: production process within a firm and
the number of firms.
Professor Wolfram MBA201a - Fall 2009 Page 3
Basic definitions & principles (II)
Profit maximization implies the following decision rules:
– In the short run:
• Produce at the quantity level where MR=MC*, so long as your revenues cover your variable costs.
• Otherwise, exit.
– In the long run:
• Enter markets or expand capacity as long as your incremental revenues will cover your incremental total costs.
• Stay in the market as long as you continue to cover your total costs.
• Exit if you can no longer cover your total costs.
* Remember that MR=P for a price-taking firm (aka a firm in a perfectly competitive industry).
Professor Wolfram MBA201a - Fall 2009 Page 4
LR vs. SR example: Recall the t-shirt factory
To produce T-shirts:
• Lease one machine at $20 / week.
• Machine requires one worker.
• The machine, operated by the worker, produces one T-shirt per hour.
• Worker is paid $1/hour on weekdays (up to 40 hours), $2/hour on Saturdays (up to 8 hours), $3 on Sundays (up to 8 hours).
Professor Wolfram MBA201a - Fall 2009 Page 5
T-shirt factory cost curves
Cost ($)
ATC
10
3
1
20 30 40 50
1.5
2
MC
48 T-shirts
Professor Wolfram MBA201a - Fall 2009 Page 6
T-shirt factory cost curves
Cost ($)
ATC
10
3
1
20 30 40 50
1.5
2
MC
48 T-shirts
AVC
Professor Wolfram MBA201a - Fall 2009 Page 7
Short versus long run
It’s Monday morning. The weekly machine lease has been paid. p=$1.3. Should the factory shut down?
It’s Friday afternoon. Should it pay for next week’s lease?
Professor Wolfram MBA201a - Fall 2009 Page 8
SR pricing & LR profitability
Cost
AC
qcap
p1
p2
MC/AVC
D1
Professor Wolfram MBA201a - Fall 2009 Page 9
SR pricing & LR profitability
Cost
AC
qcap
p1
p2
In industries with low MC/high fixed costs, market pressures may produce prices that are highly volatile.
MC/AVC
Professor Wolfram MBA201a - Fall 2009 Page 10
Entry/expansion & exit
ATC
Cost
MCmarket price
Say you:• observe the market price,• know your costs would look something like the curves on the graph.
Would you want to get into this industry?
Q
Professor Wolfram MBA201a - Fall 2009 Page 11
Entry/expansion & exit
Cost
ATC
MC
market price
Say you:• observe the market price,• know your costs would look something like the curves on the graph.
Would you want to get into this industry?
Q
Professor Wolfram MBA201a - Fall 2009 Page 12
Entry/expansion & exit
Cost ($)
ATC
MC
market price
Say you:• observe the market price,• know your costs would look something like the curves on the graph.
Would you want to get into this industry?
Would you want to stay in the industry if you were already in it?
Q
Professor Wolfram MBA201a - Fall 2009 Page 13
Constructing the industry supply curve
Recall that the industry supply curve is the sum ofindividual firm’s supply curves:
180
100
10 100 30 10 100 130
P P P
Q Q Q
Firm A Firm B Industry
Professor Wolfram MBA201a - Fall 2009 Page 14
Entry and the industry supply curve
Imagine that a firm identical to Firm A enters the industry.
180
100
10 100 30 10 20 100 130 200
P P P
Q Q Q
2xFirm A Firm B Industry
Supply Curve with Firm A & Firm B
Supply Curve with 2 Firm A’s & Firm B
Professor Wolfram MBA201a - Fall 2009 Page 15
Entry and the market equilibrium price
Entry shifts the supply curve to the right.
As a result, the market equilibrium price goes down.
P
Q
Pbefore entry
Pafter entry
Professor Wolfram MBA201a - Fall 2009 Page 16
When does entry stop?
P
Q
P1
P2
Cost
MC
ATC
Q
Professor Wolfram MBA201a - Fall 2009 Page 17
Which firms stay and which firms exit?
If several firms have access to the same technology as Firm A, what will happen to Firm B?
180
100
10 100 30 10 20 100 130 200
P P P
Q Q Q
2xFirm A Firm B Industry
D
Professor Wolfram MBA201a - Fall 2009 Page 18
How much do the remaining firms produce?
140
100
10 80 10 10 160
P P P
Q Q Q
2xFirm A 3rd Firm A Industry
D
Supply Curve with 2 Firm A’s
Supply Curve with 3 Firm A’s
Professor Wolfram MBA201a - Fall 2009 Page 19
The third firm A’s entry decision
140
100
10 80
P
Q
Profits at P = 140
Professor Wolfram MBA201a - Fall 2009 Page 20
The third firm A’s entry decision
120
100
10 55
P
Q
Profits at P = 120
Professor Wolfram MBA201a - Fall 2009 Page 21
Long run competitive equilibrium
100
10 160 170
Industry
P
Q
D
Supply Curve with 3 Firm A’s
= Long run competitive equilibrium supply curve; 17 firms, each producing 10 units each at price = 100.
Professor Wolfram MBA201a - Fall 2009 Page 22
Long run competitive equilibrium
In a long-run competitive equilibrium:
– All of the existing firms are maximizing their short-run profits.
– None of the existing firms want to either exit or expand
output.
– No new firms want to enter.
– All existing firms earn zero economic profits.
– The market price equals the minimum of the long-run
average cost curve (P=min(LRAC)).
– All consumers who want to buy the product at this price are
able to.
Professor Wolfram MBA201a - Fall 2009 Page 23
Can an industry with a monopoly be in a LR equilibrium?
Cost
MC
ATC
D
Professor Wolfram MBA201a - Fall 2009 Page 24
Takeaways
– Firms have more control over their costs in the long run.
– A firm should stay in business in the short run as long as it is
making some contribution towards its fixed costs (i.e. P>AVC).
– The following dynamics contribute to the long-run competitive
equilibrium:
• Firms entering markets where there are opportunities to make
profits.
• Firms exiting markets where they can no longer cover their total
costs, even if they’re making profit maximizing price/output
decisions.
– In a long-run competitive equilibrium: p=min(LRAC), all firms earn
zero economic profits.
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