Principles of Microeconomics – Mr. Lilly

Topic 8 Skills

1. Know the meaning of the term “industry” and the difference between an industry and a market. (See page 219.)

(219) Industry = a group of firms producing a similar product.

2. Know that three reasons for the rise and fall of industries are (a) the invention of new products and services that replace or are superior to old ones, (b) the invention of cost-saving technologies in some industries that push the cost of production down dramatically, and (c) changes in consumer tastes and preferences.

3. Know that in a competitive industry, the demand curve faced by the individual firm is a horizontal line at the market price, and be able to explain why. Know that the market demand curve in a competitive market, however, is generally assumed to be downward sloping.

4. Know that when firms enter an industry, market supply increases. Know that this will cause the equilibrium price in the market to fall and therefore the horizontal demand curve faced by the individual firm will move to a lower price. Know that when firms exit an industry, the opposite happens.

5. Know that a. if zero economic profits are being earned in an industry, no firms will enter or exit the industry, b. if positive economic profits are being earned in an industry, new firms will enter the industry, and c. if negative economic profits are being earned in an industry, firms will exit the industry.

6. Know that the entry and exit of firms into and out of industries is a key feature of the economic analysis of market equilibrium in the long run, but is never included in the analysis of market equilibrium in the short run. Know the meaning of the expression “free entry and exit.” Know that if we assume there is free entry and exit in an industry, we have really made three assumptions: a. That firms have perfect information about the profit opportunities in this industry. This means that, even if a large investment is required to get started in the industry, it will not deter new entrants because they know with certainty whether or not they will be able to make a profit in the industry, and they will be able to persuade lenders of this fact. b. That there are no government barriers to entry, such as special licenses or permits that must be obtained before one can participate in the industry, and finally c. That there are no legal or ownership barriers such as patents, trademarks, special knowledge, or scarce factors of production possessed by firms already present in the industry.

7. Know the meaning of the expression “long-run equilibrium.” Know that when an industry is in long-run equilibrium, firms will neither enter nor exit the industry, price will be equal to the average total cost of the typical firm, and economic profits in the industry will be zero.

(220) long-run competitive equilibrium model = a model of firms in an industry in which free entry and exit produce an equilibrium such that price equals the minimum of average total cost

(222) long-run equilibrium = a situation in which entry into and exit from an industry are complete and economic profits are zero, with price P equal to average total cost (ATC)

8. Know that if market demand increases in a competitive industry, in the short-run both the equilibrium price and quantity in the market will increase. Each firm will produce a larger quantity than before, but the industry supply curve will not yet have shifted. In the long run, however, new firms will enter the industry in response to the positive profits being earned by the existing firms, causing the industry supply curve to shift to the right. This will cause the equilibrium quantity to increase still further but cause the price to come back down, as described in skill 4. (See Figure 9.4 in the text.) Know that in the long run, equilibrium quantity will increase in response to an increase in market demand, while equilibrium price returns to minimum average total cost and economic profits in the industry return to zero. This shows that markets automatically reallocate resources toward products consumers have decided they value more highly than before.

Ok.

9. Know that if market demand decreases in a competitive industry, a process opposite to that described in skill 8 will occur. Specifically: in the short-run both the equilibrium price and quantity in the market will decrease. Each firm will produce a smaller quantity than before, and will earn negative economic profits. In the long run, firms will exit the industry, shifting the short-run industry supply curve to the left. This will cause the equilibrium quantity to decrease still further but cause the equilibrium price to come back up. (See Figure 9.5 in the text.) Know that in the long run, equilibrium quantity will decrease in response to an decrease in market demand, while equilibrium price returns to minimum average total cost and economic profits in the industry return to zero. This shows that markets automatically reallocate resources away from products consumers have decided they value less highly than before.

10. Know that the Zinfandel grape industry data presented in the text is consistent with and therefore supports the predictions of short run and long run market adjustments described in skill 8 very well.

11. Know the meaning of the expressions economic profits, accounting profits, explicit costs?, implicit costs?, and normal profits. Know that economic profit plus normal profits equal accounting profit. Given the best wage the owner could get elsewhere and/or the amount of money he has tied up in the business and the interest rate in the economy, be able to calculate the implicit costs incurred by the owner. Know that implicit costs are also called “opportunity costs.” Given total revenue and total costs for a business (or their components price, quantity, and average total cost, from which you should be able to calculate total revenue and total costs,) be able to calculate that business’s accounting profit. Given a business’s accounting profit and implicit or opportunity costs, be able to calculate the business’s economic profit.

(224) accounting profits = total revenue minus total costs, where total costs exclude the implicit opportunity costs; this is the definition of profits usually reported by firms

(224) economic profits = total revenue minus total costs, where total costs include opportunity costs, whether implicit or explicit.

(225) normal profits = the amount of accounting profits when economic profits are equal to zero.

(Slide 13) Economic profits: Total revenue minus total costs, where total costs include both explicit and implicit costs.

Accounting profits: Total revenue minus total costs, where total costs include explicit costs only.

(Slide 14)

Explicit costs: Anything the firm actually pays for: rent, raw materials, salaries of workers, etc.

Implicit costs: The best wage the owner could get elsewhere and the highest interest rate he could earn if he took all the money he has tied up in this business and invested it elsewhere.

(Slide 15) Normal profits: The amount of accounting profit earned when economic profit is zero.

•Note that normal profits must therefore be equal to the implicit costs incurred by the owner.

Economic profit + Normal Profit = accounting profit

Wage, interest rate -> implicit cost?

Total revenue, total cost ->accounting profit?

Accounting profit, implicit or opportunity cost -> economic profit?

Implicit costs alsoed called “opportunity costs”

12. Know that firms in competitive markets have an incentive both to: a. be the first to discover ways of reducing the cost of production, and b. imitate or adopt the cost-saving innovations of other firms in their industry as soon as possible. (See Figure 9.6.) Specifically, the incentive for firms to innovate is that they will earn positive economic profits in the short run, and the incentive for firms to imitate or adopt is that unless they do, they will experience negative economic profits and end up leaving the industry. Know however that in the long-run, consumers will reap all the benefits of cost-saving innovations because the price will return to the minimum technologically feasible average total cost and economic profits will return to zero.

13. Know the meaning of the expressions “long-run industry supply curve,” “external diseconomies of scale,” and “external economies of scale.” Know that when there are external diseconomies of scale, the long-run industry supply curve will be upward-sloping, and then there are external economies of scale, the long-run industry supply curve will be downward-sloping. Know that problems with managing a large firm cause internal diseconomies of scale, not external diseconomies of scale. Know that if industry expansion causes the equilibrium price of one or more inputs needed in the production of the good to increase, that would be an example of external diseconomies of scale.

(233) Long-run industry supply curve = a curve traced out by the intersections of demand curves shifting to the right and the corresponding short-run supply curves

(233) external diseconomies of scale = a situation in which growth in an industry causes average total cost for the individual firm to rise because of some factor external to the firm; it corresponds to an upward-sloping long-run industry supply curve

(234) external economies of scale = a situation in which growth in an industry causes average total cost of the individual firm to fall because of some factor external to the firm; it corresponds to a downward-sloping long-run industry supply curve.

(Slide 34) Long-run industry supply curve: A curve traced out by the intersections of demand curves shifting to the right and the corresponding short-run supply curves.

(Slide 35) External diseconomies of scale: A situation in which growth in an industry causes average total cost for the individual firm to rise because of some factor external to the firm; it corresponds to an upward-sloping long-run industry supply curve.

(Slide 36) External economies of scale: A situation in which growth in an industry causes average total cost for the individual firm to fall because of some factor external to the firm; it corresponds to an downward-sloping long-run industry supply curve.