In the situation you describe (price = marginal cost), it may be impossible for the firm to make a profit; all it can do is minimise its losses, so that it “only” loses its fixed costs. However, since suppliers are making losses, the number of suppliers will contract i.e. this is not an equilibrium situation.
True, there are idealized models of “perfectly competitive markets” where all fixed costs, costs of entry, costs of capital etc are negligible. In that case, price will stay at marginal cost in equilibrium. But “competitive markets” are a bit more general than “perfectly competitive markets”.
A slightly more detailed analysis looks at the “capacity” of the suppliers. Suppliers tend to have a marginal cost curve which is fairly flat over a certain range, but then climbs like a sheer cliff when they hit capacity. If every supplier is producing at or near to capacity, no-one makes extra profit from producing more; price is then determined by the demand curve (I.e. at what price will customers demand the current capacity?) Further, at equilibrium, supplier projects which aim to increase capacity will show up as NPV negative (because they are not expected to recover fixed costs, capital costs etc.) So these projects won’t happen, and the equilibrium is maintained.
It’s assuming the fixed costs can be recuperated. Large fixed costs don’t mess up the equilibrium, if a firm can exit the industry and sell its initial investment at a comparable price to what they bought it for. It’s large fixed investments that can’t be liquidated that cause the problems.
In the situation you describe (price = marginal cost), it may be impossible for the firm to make a profit; all it can do is minimise its losses, so that it “only” loses its fixed costs.
The price=marginal cost is a consequence of homogeneous products (technically, of the fact that each individual firm faces a flat demand curve). The rate of profit is connected with ease of entry and exit. These are two separate things.
It’s assuming the fixed costs can be recuperated… if a firm can exit the industry and sell its initial investment at a comparable price to what they bought it for
That sounds like assuming no depreciation and no cost of capital, right?
Otherwise, imagine a firm considers increasing its capacity via investing in a productive asset, for an upfront cost A. There is a depreciation rate d, and a cost of capital (interest, dividends etc) of c. If the firm sells the asset after r years, then its sale value in year r will be something like A x (1 - d)^r, and the present terminal value will be something like A x ((1 -d)/(1+c))^r.
So in the business pan, the firm should assume a fixed cost not strictly of A, but rather of A x (1 - ((1-d)/(1+c))^r). If (d+c)r is roughly 1 or more then this will be about A; only if (d+c)r is much less than 1 can this cost be ignored.
As | understand it, it assumes no or low depreciation, but says nothing about the cost of capital. The definition of “profit” that I’ve been using is “extra profit to the company after all investors have been paid at the rate the market would demand, and employee and entrepreneurs have been reimbursed for their time and effort”.
What about fixed operating expenses, such as the insurance on the capital investment? (Or equivalently, the cost of the risk associated with owning it)
That is ignoring the fixed costs.
In the situation you describe (price = marginal cost), it may be impossible for the firm to make a profit; all it can do is minimise its losses, so that it “only” loses its fixed costs. However, since suppliers are making losses, the number of suppliers will contract i.e. this is not an equilibrium situation.
True, there are idealized models of “perfectly competitive markets” where all fixed costs, costs of entry, costs of capital etc are negligible. In that case, price will stay at marginal cost in equilibrium. But “competitive markets” are a bit more general than “perfectly competitive markets”.
A slightly more detailed analysis looks at the “capacity” of the suppliers. Suppliers tend to have a marginal cost curve which is fairly flat over a certain range, but then climbs like a sheer cliff when they hit capacity. If every supplier is producing at or near to capacity, no-one makes extra profit from producing more; price is then determined by the demand curve (I.e. at what price will customers demand the current capacity?) Further, at equilibrium, supplier projects which aim to increase capacity will show up as NPV negative (because they are not expected to recover fixed costs, capital costs etc.) So these projects won’t happen, and the equilibrium is maintained.
It’s assuming the fixed costs can be recuperated. Large fixed costs don’t mess up the equilibrium, if a firm can exit the industry and sell its initial investment at a comparable price to what they bought it for. It’s large fixed investments that can’t be liquidated that cause the problems.
The price=marginal cost is a consequence of homogeneous products (technically, of the fact that each individual firm faces a flat demand curve). The rate of profit is connected with ease of entry and exit. These are two separate things.
That sounds like assuming no depreciation and no cost of capital, right?
Otherwise, imagine a firm considers increasing its capacity via investing in a productive asset, for an upfront cost A. There is a depreciation rate d, and a cost of capital (interest, dividends etc) of c. If the firm sells the asset after r years, then its sale value in year r will be something like A x (1 - d)^r, and the present terminal value will be something like A x ((1 -d)/(1+c))^r.
So in the business pan, the firm should assume a fixed cost not strictly of A, but rather of A x (1 - ((1-d)/(1+c))^r). If (d+c)r is roughly 1 or more then this will be about A; only if (d+c)r is much less than 1 can this cost be ignored.
As | understand it, it assumes no or low depreciation, but says nothing about the cost of capital. The definition of “profit” that I’ve been using is “extra profit to the company after all investors have been paid at the rate the market would demand, and employee and entrepreneurs have been reimbursed for their time and effort”.
Who would want to buy the equipment to get into an industry with zero profit opportunity?
What about fixed operating expenses, such as the insurance on the capital investment? (Or equivalently, the cost of the risk associated with owning it)