Question

n addition to supply and demand, price theories arise from examining the profit desires of individual firms. Consider a firm with some market power that is not earning an economic profit, nor earning an economic loss. Suppose this firm is able to decrease its costs. Show how the firm would best respond to this decrease in costs, and explain why the firm will tend to benefit in the short run. Then, assume other firms enter this market with very close substitute products, and present a new diagram that you can use to explain why consumers will tend to benefit from firm reductions in costs in the long run.

Answer 1

When a Firm which has a significant market power, is having break even revenues then its price level must be equal to the level of the average cost. This firm with significant market power will have the AR and MR curve facing downwards and will have a relatively inelastic demand. In such a case the demand curve will look like :

When the cost of the firm decreases, the Marginal cost curve will shift downwards and so will the Average cost. Since the firm was able to earn only normal profits till now, the decrease in the level of costs will allow the firm to have some supernormal profits.

As we can see from the comparision of the two figures that as the cost component of the firm decreases, the firm will be able to set prices at a lower level than it previously did. It also benefits the consumer as they are able to get more quantity of output than they were able to get before. Due to decrease in costs, the firm will thus decrease the price and offer more quantity than before. Decrease in costs will also allow the firm to earn supernormal profits in the short run, which will provide the firm a much needed incentive to continue production.

When new firms enter the market with very close substitutes, the demand curve of the firm will tend to be more elastic, as the consumer now have many other options to choose from. The demand curve of the firm will thus look like this:

We see that the AR and MR curves have become flatter than before. As a result of which the MC curve will touch the MR curve at a much lower portion of MR, thereby increasing the level of output provided by the firm in the market. Also, we see that the price level is almost same as before, the only change being the decrease in the level of profits, as the flatter portion of AR at which point the price is set will correspond to increasing portion of AC.

As a result of this change the market demand and supply curve will be as follows:

Here we see that, the entry of new firms and decrease in cost component of the firm, has resulted in increasing the overall market supply. Given the Market demand, increase in market supply has resulted in decrease in price of the goods and increase in the quantity of the good in the market. So the consumers get directly benefite from this as they now have to pay less than before and they can get greater quantity of output than before. This will also tend to increase the consumer surplus in the market. So in the long run, we can see that increase in profit component of a firm due to cost reduction, attracted other similar firms to enter in the market, as a result of which the supply in the market increased and the price of the good decreased. Consumers thus get benefited due to increased consumer surplus, decreased prices and greater variety to choose from.