Page 155 - DECO405_MANAGERIAL_ECONOMICS

Managerial Economics

Notes 9.2.4 Efficiency of a Firm

Since the price in the market is unique, this implies that all firms in the industry have the same
minimum long run average cost. This, however, does not mean that all firms are of the same size
or have the same efficiency, despite the fact that their LAC is the same in equilibrium. The more
efficient firms employ more productive factors of production and/or able managers. These
more efficient factors must be remunerated of their higher productivity, otherwise they will be
bid off by the raw entrants in the industry. Or, as the price rises in the market the more efficient
firms earn a rent which they must pay to their superior resources. Thus rents of more efficient
factors become costs for the individual firm, and hence the LAC of the more efficient firm shifts
upwards as the market price rises, even if the factor prices for the industry as a whole remain
constant as the industry expands. In this situation, the LAC of the old, more efficient firms must
be redrawn so as to be tangent at the higher market price. The LMC of the old firms is not
affected by the rents occurring to its more productive factors. It will be shifted only if the prices
of factors for the industry in general increase. Thus, the more efficient firms will be in equilibrium,
producing that output at which the redrawn LAC is at its minimum (at which point the LAC is
cut by the initial LMC given that factor prices remain constant). Under these conditions, with the
superior, more productive resources properly costed at their opportunity cost, all firms have the
same unit cost in their long run equilibrium. In Figure 9.9, at the initial price P the second firm
o
was not in the industry as it could not cover its costs at that price. At the new price P , firm B
1
enters the industry, making just normal profits. The established firm A earns rents which are
imputed costs, so that its LAC shifts upward and it reaches a new long run equilibrium producing
a higher level of output (Q ).
2
Figure 9.9

9.3 Supply and Demand Together

The following three conditions exhibit how adjustment is likely to take place in the firm and in
the market under different situations.

Market Response to an Increase in Demand

Faced with an increase in demand which it sees as an increase in price and hence profits, a
competitive firm will respond by increasing output (from A to B) in order to maximise profit
(Figure 9.10). As all firms increase output and as new firms enter, price will fall until all profit is
competed away. Thus the long run supply curve will be perfectly elastic as is S in (a). The final
LR
equilibrium will be at the original price but a higher output. The original firms return to their
original output (A) but since there are more firms in the market the market output increases
to (C).

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