Session 16 & 17

Short run supply for firm and industry: The portion of the marginal curve above average variable cost,
below AVC the firm is not willing to supply and quantity is zero. The short run supply curve for an
industry can be obtained by horizontally summing the supply curves of all the firms in the industry. Short
run supply for the industry is always upward sloping.
Profit maximization in the long run: In the short run one input is fixed however in the long run, all inputs
are variable and the manager can decide the scale of operation as economic conditions warrant the
same.
The long run can also be viewed as a planning stage: what size of plant to build, once this has been built;
he is again in the short run. Under perfect competition, firms have free entry and exit and this can
happen only in the long run. This characteristic plays a very important role in the long run analysis of
competitive firms.
Even in the long run the objective is to maximize profits and all the inputs are variable. The manager
would produce till MR > MC and decrease output when MC> MR.
Profit maximizing equilibrium for a firm in the long run: Should you enter an industry where the industry
is making economic profits? Since all the inputs are variable, the manager decides the scale of
operation.LAC & LMC and the demand is a horizontal line given by the market.
The manager decides to put up a plant with size 240 units and make the maximum profit.
But as this firm decided to enter other firms are also lured by the profit and they drive the price down.
Long term competitive equilibrium for the Industry: While individual firm maximizes profit at MR = LMC,
the industry will be in equilibrium when there is no incentive for new firms to enter the market.
Economic profits attract other firms, supply increases, prices fall, all firms are producing at profit
maximizing level and they keep adjusting output till economic profits are eliminated and there is no
incentive for new firms to enter the market.
Economic losses induce some firms to leave the market, supply falls, price rises, and again all firms
adjust output levels to the point of no economic profits. Long run equilibrium needs two criteria:
1. MR = LMC, Price = LMC
2. Zero economic profit, Price = LAC
So equilibrium is at the point where LMC = LAC, at a plant size where SMC = ATC.
Long run supply for a perfectly competitive industry: In the short run when the amount of capital
and number of firms is fixed, increase in price causes industry to produce more. The fixed capital is
used more intensively and the firm hires more variable inputs to be able to get more output. Supply
curve is upward sloping.

However in the long run when the entry of new firms is possible, then the entry and exit of new/old
firms will continue till the economic profits are zero. This means that for all the points on the long
run supply curve economic profits are zero. We need to differentiate between increasing and
constant cost industries. For a constant cost industry the supply curve is a horizontal line, i.e. the
firm can produce at the efficient point of the LAC. In case of the increasing cost industry, the supply
curve is an upward sloping line i.e. to be able to supply more the firm needs a higher price.
Managers of firms in perfect competition will in the long run see their profits down to zero whether
in constant or increasing cost industry due the automatic adjustment process of entry and exit of
firms.
The manager will employ inputs up to the point where Price * MP = w, because if w > Price * MP,
then the manager will not be interested in employing another unit of input. Price * MP is MRP marginal
revenue product.
ARP = Price * AP if the price of the variable input rises above point of maximum ARP, then firm
minimizes losses by shutting down the firm.
Implementing the profit maximizing output decision:
1. Produce as long as Price => AVC
2. If production occurs up to the point of Price = SMC
3. So to be able to carry out this analysis we need the demand function, the average variable cost
function, the marginal cost function.
4. Step 1: In perfect competition the demand curve is horizontal where it is highly sensitive to price
and this does not allow the firm to change the price from the given market price.
5. Step 2: AVC cost function and the SMC function from the TC curve.
6. Step 3: Check the shutdown rule: Find the minimum point of the AVC function , as long as price
is equal to or greater than the minimum AVC, the firm should produce up to the output level of
Price = SMC.
7. Step 4: Find output level where Price = SMC
8. Step 5: Computation of profit or loss, Profit = TR TC = (P X Q) { ( AVC X Q) + TFC} if price is less
than AVC then profit is TFC.
Illustration: In mid December 2007, the manager of Beau Apparel was preparing the firms production
plan for first quarter of 2008. He needed the forecast on price of shirts in the first quarter. The prices he
got were high = Rs. 20 Medium = Rs. 15 and Low = Rs.10.
Based on the past seven years data the AVC has been estimated to be 20 0.003Q + 0.00000025Q2
Should the manager produce or shut down?
We use the SMC equation to find out minimum AVC.
So SMC = 20 0.006Q + 0.00000075Q2

The shutdown decision: When SMC = AVC, AVC is the lowest.

So 20 0.006Q + 0.00000075Q2 = 20 0.003Q + 0.00000025Q2
So Q = 6000 so AVCmin = 20 0.003(6000) + 0.00000025(6000)2= Rs. 11.
S the AVC reaches its minimum at 6000 units
The manager at Beau Apparel compared this with the different prices and finds out that he can produce
if the prices are Rs.20 & Rs.15 but not at Rs.10 because then the TR does not cover even the variable
costs.
The output decision: Where P = SMC, 20 = 20 0.006Q + 0.00000075Q2, Q = 0, 8000, so he should
produce 8000 units when price is Rs. 20 to maximize profits.
At P = Rs.15, 15 = 20 0.006Q + 0.00000075Q2
Q = 945 or 7055
To find out which output to choose, we can substitute these outputs in the AVC equation and find out
and we get AVC = Rs 17.39 when output is 945 units and
AVC = Rs. 11.28 when output is 7055 units
Total profit or loss: Profit = TR TC, when price = 20 = (20 * 8000) (20 0.003*8000 +
0.00000025(8000)2 +30000 = Rs 34000 and similarly at Rs. 15 and output 7055 profit and fixed costs Rs.
30000 = -Rs 3755
Imposition of tax: A one time tax imposition behaves like a fixed cost and affects the ATC and the AFC
and not affect the AVC and the MC in the short run period but in the long run as the perfect competition
firm produces at a level where price = LAC it will not be able to cover the costs and go out of business in
the long run. Market supply will shift to the left; in the new equilibrium output will be less at a higher
price. So the point is that in the short run a lump sum tax does not affect the MC & AVC and firms will
continue to produce the same output.
Profit tax: also behaves like the lump sum tax will not affect AVC & MC in the short run but in the long
run will make firms leave the market.
Specific sales tax: Rs 5 per output, will directly affect MC, being the supply curve it will move to the left
and amount being produced at the price will decrease. How much will price rise with tax, to the amount
of tax? Greater the elasticity of supply, smaller will be the burden of tax on supplier.