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54 Chapter Highlights
Chapter 23
Firm Supply
After all that material on technology and optimization problems, it is fun to
get back to the behavior of “real” economic units. I devote a fair amount of
time to laying out the idea of a purely competitive market. It is important to
distinguish between the definition of a competitive market and the rationale for
that definition. The definition is that it is a market where firms take the market
price as being given, independent of the actions of any particular firm. The usual
rationale for this assumption is that each firm is a negligible part of the market.
However, it is also important to emphasize that even markets with a middling
number of firms may act in a reasonably competitive fashion. For example, if
each firm believes that the other firms will keep their prices fixed no matter what
price it charges, we have a model where each firm faces a demand curve for its
product that is essentially flat. This idea—the distinction between the market
demand curve and the demand curve facing a firm—is an important one to get
across. Economists often talk about a quantity-setting firm or a price-setting
firm, but these ideas are really rather unnatural. Real firms set both variables.
But a firm in a highly competitive market has no real choice about what price
to set—it has to meet the price at which everyone else is selling if it wants to
make any sales at all. For a competitive firm, the only real choice variable is
how much it wants to sell at the going market price.
Firm Supply
A. Firms face two sorts of constraints
1. technological constraints — summarize in cost function
B. Pure competition
1. formally — takes market price as given, outside of any particular firm’s
control
2. example: many small price takers
3. demand curve facing a competitive firm — Figure 21.1.
Chapter 23 55
C. Supply decision of competitive firm
1. maxypy −c(y)
2. first-order condition: p=c(y)
D. So supply curve is the upward-sloping part of MC curve that lies above the
AV C curve
E. Inverse supply curve
F. Example: c(y)=y2+1
1. p=2ygives the (inverse) supply curve
G. Producer’s surplus
1. producer’s surplus is defined to be py −cv(y)
2. since cv(y) = area under marginal cost curve
H. Long-run supply — use long-run MC. In long run, price must be greater
than AC
I. Special case — constant average cost (CRS): flat supply curve
1. see Figure 21.10.
56 Chapter Highlights
Chapter 24
Industry Supply
The treatment of industry supply in the case of free entry given in this chapter
is more satisfactory than that one usually sees. I simply draw the supply curves
for different numbers of firms and look for the lowest intersection that allows
for nonnegative profits. After drawing a few examples of this sort, students are
quite ready to believe that the equilibrium price can never get very far above
minimum average cost. This naturally leads to the standard approximation of
taking the supply curve of a competitive industry as being flat at price equals
minimum average cost.
The idea that long-run profits are zero in Sections 22.4 and 22.5 is a very
important one, and often misunderstood. Be sure to emphasize the exact sense
in which it is true.
The other big idea in this chapter is the idea of economic rent. I like to
express the relationship between the two ideas this way:
Long-run profits in competitive industries are always zero. If there are
no barriers to entry, then entry competes profits away to zero. If there
are specific factors that prevent entry, then competition to acquire those
factors forces profits to zero. In a sense, it is always the attempt to enter
an industry that forces profits to zero: new firms either enter an industry
by adding firms to the industry or by buying out existing firms. The first
form of entry increases supply and decreases prices; the second form of
entry doesn’t affect supply, but simply pushes up the factor prices and
costs. But either way, profits get driven to zero.
I like the discussion of economic rent and the politics of rent quite a bit. One
great example of rent seeking is to discuss the social costs of theft. It’s not the
transfer of property that represents a social loss; it’s all the expense that one
has to go to to prevent theft that represents the social loss. The true social cost
of theft is not the lost TVs, but the cost of the locks on the doors! If students
appreciate the insight in this sentence, they are well on their way to becoming
real economists. (If they don’t appreciate the insight, they’ll just think you’re
nuts.)
Finally, the treatment of energy policy in Section 24.10 is a lot of fun. The
students really begin to appreciate why marginal cost is important after they see
this example.
Chapter 24 57
Industry Supply
A. Short-run industry supply
1. sum of the MC curves
2. equilibrium in short run
B. Long-run industry supply
1. change to long-run technology
2. entry and exit by firms
C. Long-run supply curve
1. exact — see Figure 22.4.
D. Taxation in long and short runs
1. see Figure 22.6.
E. Meaning of zero profits
1. pure economic profit means anyone can get it
F. Economic rent
1. what if some factors are scarce in the long run?
2. fixed from viewpoint of industry, variable from viewpoint of firm
3. in this case, industry can only support a certain number of firms
4. whatever factor is preventing entry earns rents
5. see Figure 22.7.
6. discount flow of rents to get asset value
7. politics of rent
a) rents are a pure surplus payment
1) tobacco subsidies
2) farm policy in general
e) rent seeking
