Perfectly Competitive Market
In a perfectly competitive market, numerous small firms sell identical products, enabling them to have no control over prices. This unique market structure is defined by features such as homogeneous goods, no barriers to entry or exit, many buyers and sellers, and perfect information about prices and technology.
For instance, our exercise focuses on 1,000 identical firms in the concrete pipe industry, each producing the same fraction of total market output. This illustrates a key trait of such a market—firms being 'price takers', adjusting output levels rather than prices to meet market equilibrium. In these markets, long-run adjustments ensure firms can only earn normal profits, as any deviations are corrected by changes in supply due to entry or exit of firms.
Long-Run Equilibrium
The term long-run equilibrium in microeconomics refers to a state in a market where all firms are earning zero economic profits, meaning they cover all their opportunity costs, but there is no incentive for new entrants or current participants to leave. This occurs when the market price stabilizes at a point where it equals the minimum of the average cost.
For companies in the concrete pipe industry described in the exercise, long-run equilibrium occurs when the market supply matches market demand, and firms' output levels and the price are static. This is achieved when firms' marginal costs equal the market price and average costs, enabling them to break even in the long run.
Capital-Labor Ratio
The capital-labor ratio is an expression of the amount of capital employed per unit of labor. In the realm of microeconomics, it helps understand how firms combine resources to produce goods and services. The ideal ratio is determined by the costs of capital (machinery, equipment, etc.) and labor (workers).
When these costs change, firms react by altering the capital-labor ratio to minimize costs and maximize productivity. In our exercise, when the cost of labor (wage, w) increased relative to the cost of capital (v), firms adjusted by using relatively more capital than labor, moving from a 1:1 to a 2:1 ratio.
Marginal Cost
The concept of marginal cost is central to microeconomics—it signifies the cost of producing one additional unit of a good. For companies in perfectly competitive markets, setting the price of their product equal to marginal cost is optimal.
In our exercise, firms calculate marginal cost based on the change in required inputs (capital and labor) resulting from a small change in output. When input prices are stable, marginal cost remains constant; however, if, for example, wages increase, the marginal cost curve will shift upwards, reflecting the additional expenses incurred to produce each additional unit.
Production Function
A production function illustrates how a firm transforms inputs, like capital (K) and labor (L), into output (q). It provides crucial insights into the efficiency of input usage and the potential for increasing output. The production function specified in the exercise, \( q = VKL \), signifies that the output of concrete pipes (q) increases proportionately with the amount of capital and labor employed, assuming V is a constant technology parameter.
This functional form assumes constant returns to scale, as doubling both capital and labor will double the output. The firm's goal is to determine the most cost-effective combination of K and L to maximize profits, taking into consideration input prices and the production function itself.
Market Demand
The term market demand reflects the total quantity of a product that consumers in a market are willing and able to purchase at different prices. The market demand curve, inversely related to price, slopes downward, illustrating that lower prices generally increase quantity demanded.
The market demand equation provided in the exercise, \( Q = 400,000 - 100,000 P \), represents how the total demand for concrete pipes decreases as the price (P) increases. This relationship is pivotal for firms when determining production levels and setting prices in the market to achieve equilibrium.
Substitution Effect
The substitution effect occurs when a change in the price of an input, like labor or capital, leads a firm to use more of the cheaper input relative to the more expensive one. This concept is captured in our exercise when the wage rate (w) doubled, prompting firms to substitute labor with capital, since capital became relatively cheaper.
It's notable that in the context of a firm's production, the substitution effect adjusts the capital-labor ratio in response to wage changes, with the firm seeking to use their budget in the most efficient way to minimize costs and maintain production.
Output Effect
The output effect refers to the alteration in the quantity of output a firm produces in response to a change in the price of an input. As the wage increased in the exercise, firms faced higher production costs, leading to a higher marginal cost and, consequently, a decrease in the output produced at the original price. This output effect, in tandem with the substitution effect, determines the new market equilibrium in terms of quantities of labor hired, output produced, and the overall market quantity demanded.
The concrete pipe industry's reaction in the exercise, where firms reduced their labor demand due to the increased wage, serves as an illustrative example of the output effect at play in practical scenarios.
