Firm Behavior Under Perfect Competition Mr. Griffin AP Econ Micro II B MHS

Fill in the Blanks Firms Maximize Profit at the quantity where the difference between Total ________ and ________ Cost is greatest. At this profit-maximizing level of output , _________ = _________.

Fill in the Blanks Firms Maximize Profit at the quantity where the difference between Total Revenue and Total Cost is greatest. At this profit-maximizing level of output , MR = MC.

Perfect Competition Defined Many small firms and customers Standardized (homogeneous) product Free entry and exit of firms (in long run) Well-informed producers and consumers

The Competitive Firm Perfect competition Firm is a price taker. Price is set in the market. Firm is too small to affect the market.

The Competitive Firm The Firm’s Demand Curve under Perfect Competition Perfectly Elastic (Horizontal) Can sell as much as it wants at the market price.

Demand Curve for a Firm under Perfect Competition Industry supply curve S Price per Bushel in Chicago C B A E Industry demand curve $3 $3 Firm’s demand curve 1 2 3 4 100 200 300 400 Truckloads of Corn Sold by Farmer Jasmine per Year Total Sales in Chicago in Thousands of Truckloads per Year (a) (b)

DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Perfectly Elastic Demand Price Taker Role Total Revenue = P x Q Average Revenue = P Marginal Revenue = P For example...

DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Product Price (P) (Average Revenue) Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $131 $ 0

DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Product Price (P) (Average Revenue) Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $131 131 1 $ 0 131 ] $131

DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Product Price (P) (Average Revenue) Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $131 131 1 2 $ 0 131 262 ] $131 131 ]

DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Product Price (P) (Average Revenue) Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $131 131 1 2 3 $ 0 131 262 393 ] $131 131 ] ]

DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Product Price (P) (Average Revenue) Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $131 131 1 2 3 4 $ 0 131 262 393 524 ] $131 131 ] ] ]

DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Product Price (P) (Average Revenue) Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $131 131 1 2 3 4 5 6 7 8 9 10 $ 0 131 262 393 524 655 786 917 1048 1179 1310 ] $131 131 ] ] ] ]

DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER Product Price (P) (Average Revenue) Graphically Presented… Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $131 131 1 2 3 4 5 6 7 8 9 10 $ 0 131 262 393 524 655 786 917 1048 1179 1310 ] $131 131 ] ] ] ]

TR D = MR DEMAND, MARGINAL REVENUE, AND TOTAL REVENUE IN PURE COMPETITION 1179 1048 917 786 655 524 393 262 131 TR Price and revenue D = MR 1 2 3 4 5 6 7 8 9 10 Quantity Demanded (sold)

The Competitive Firm Short-Run Equilibrium for the Perfectly Competitive Firm Marginal revenue = Price Profit-maximizing level of output: MC = MR So, a perfectly competitive firm should maximize profit by producing the output where Price = Marginal Cost

The Competitive Firm D = MR = AR at all levels of output D = MR = AR = MC at the equilibrium level of output

Short-Run Equilibrium of the Perfectly Competitive Firm MC AC Revenue and Cost per Bushel B A $3.00 D = MR = AR 2.25 1.50 50,000 Bushels of Corn per Year

S-R Equilibrium of Competitive Firm w/ Lower Price Revenue and Cost per Bushel MC AC A B $2.25 1.50 D = MR = P 30,000 Bushels of Corn per Year

Two Approaches... The Decision Process: Should the firm produce? SHORT RUN PROFIT MAXIMIZATION Two Approaches... First: Total Revenue - Total Cost Approach The Decision Process: Should the firm produce? What quantity should be produced? What profit or loss will be realized? The Decision Rule: Produce in the short-run if the firm can realize 1) a profit (or) 2) a loss less than its fixed costs

Applied Graphically… Two Approaches... The Decision Process: SHORT RUN PROFIT MAXIMIZATION Applied Graphically… Two Approaches... First: Total Revenue - Total Cost Approach The Decision Process: Should the firm produce? What quantity should be produced? What profit or loss will be realized? The Decision Rule: Produce in the short-run if the firm can realize 1) a profit (or) 2) a loss less than its fixed costs

Can you see the profit maximization? TOTAL REVENUE-TOTAL COST APPROACH Can you see the profit maximization? Total Fixed Cost Total Variable Cost Price: $131 Total Product Total Cost Total Revenue Profit 1 2 3 4 5 6 7 8 9 10 $ 100 100 $ 0 90 170 240 300 370 450 540 650 780 930 $ 100 190 270 340 400 470 550 640 750 880 1030 $ 0 131 262 393 524 655 786 917 1048 1179 1310 - $100 - 59 - 8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280

Graphing Total Cost & Revenue TOTAL REVENUE-TOTAL COST APPROACH Total Fixed Cost Total Variable Cost Price: $131 Total Product Total Cost Total Revenue Profit Graphing Total Cost & Revenue 1 2 3 4 5 6 7 8 9 10 $ 100 100 $ 0 90 170 240 300 370 450 540 650 780 930 $ 100 190 270 340 400 470 550 640 750 880 1030 $ 0 131 262 393 524 655 786 917 1048 1179 1310 - $100 - 59 - 8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280

Total Revenue Total Cost TOTAL REVENUE-TOTAL COST APPROACH Break-Even Point (Normal Profit) $1,800 1,700 1,600 1,500 1,400 1,300 1,200 1,100 1,000 900 800 700 600 500 400 300 200 100 Total Revenue Maximum Economic Profits $299 Total revenue and total cost Total Cost Break-Even Point (Normal Profit) 1 2 3 4 5 6 7 8 9 10 11 12 13 14

MR = MC Rule Two Approaches... SHORT RUN PROFIT MAXIMIZATION Two Approaches... First: Total Revenue - Total Cost Approach Second: Marginal Revenue - Marginal Cost Approach MR = MC Rule Three Characteristics of MR=MC Rule: The rule applies only if producing is preferred to shutting down Rule applies to all markets Rule can be restated P=MC

The same profit maximizing result! MARGINAL REVENUE-MARGINAL COST APPROACH Average Fixed Cost Average Variable Cost Average Total Cost Price = Marginal Revenue Total Economic Profit/Loss Total Product Marginal Cost The same profit maximizing result! 1 2 3 4 5 6 7 8 9 10 $100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 $90.00 85.00 80.00 75.00 74.00 77.14 81.25 86.67 93.00 $190.00 135.00 113.33 100.00 94.00 91.67 91.43 93.75 97.78 103.00 90 80 70 60 110 130 150 $ 131 131 - $100 - 59 - 8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280

Graphically Average Fixed Cost Average Variable Cost Average Total MARGINAL REVENUE-MARGINAL COST APPROACH Average Fixed Cost Average Variable Cost Average Total Cost Price = Marginal Revenue Total Economic Profit/Loss Total Product Marginal Cost Graphically 1 2 3 4 5 6 7 8 9 10 $100.00 50.00 33.33 25.00 20.00 16.67 14.29 12.50 11.11 10.00 $90.00 85.00 80.00 75.00 74.00 77.14 81.25 86.67 93.00 $190.00 135.00 113.33 100.00 94.00 91.67 91.43 93.75 97.78 103.00 90 80 70 60 110 130 150 $ 131 131 - $100 - 59 - 8 + 53 + 124 + 185 + 236 + 277 + 298 + 299 + 280

Profit Maximization Position MARGINAL REVENUE-MARGINAL COST APPROACH Profit Maximization Position $200 150 100 50 Economic Profit MC $131.00 MR ATC Cost and Revenue AVC $97.78 1 2 3 4 5 6 7 8 9 10

MR = MC Optimum Solution MARGINAL REVENUE-MARGINAL COST APPROACH Profit Maximization Position $200 150 100 50 Economic Profit MC MR = MC Optimum Solution $131.00 MR ATC Cost and Revenue AVC $97.78 1 2 3 4 5 6 7 8 9 10

If the price is lowered from $131 to $81… MARGINAL REVENUE-MARGINAL COST APPROACH Loss Minimization Position If the price is lowered from $131 to $81… the MR=MC rule still applies …but the MR = MC point changes.

Loss Minimization Position MARGINAL REVENUE-MARGINAL COST APPROACH Loss Minimization Position $200 150 100 50 Economic Loss MC ATC Cost and Revenue AVC $91.67 MR $81.00 1 2 3 4 5 6 7 8 9 10

Short-Run Shut Down Point MARGINAL REVENUE-MARGINAL COST APPROACH Short-Run Shut Down Point $200 150 100 50 MC ATC Cost and Revenue AVC MR $71.00 Minimum AVC is the Shut-Down Point 1 2 3 4 5 6 7 8 9 10

Marginal Cost & Short-Run Supply MARGINAL REVENUE-MARGINAL COST APPROACH Marginal Cost & Short-Run Supply Observe the impact upon profitability as price is changed Quantity Supplied Maximum Profit (+) Or Minimum Loss (-) Price $151 131 111 91 81 71 61 10 9 8 7 6 $+480 +299 +138 -3 -64 -100

Marginal Cost & Short-Run Supply MARGINAL REVENUE-MARGINAL COST APPROACH Marginal Cost & Short-Run Supply Break-even (Normal Profit) Point MC P5 MR5 ATC MR4 P4 Cost and Revenue, (dollars) AVC P3 MR3 P2 MR2 MR1 P1 Do not Produce – Below AVC Q2 Q3 Q4 Q5 Quantity Supplied

Marginal Cost & Short-Run Supply MARGINAL REVENUE-MARGINAL COST APPROACH Marginal Cost & Short-Run Supply Yields the Short-Run Supply Curve Supply MC P5 MR5 MR4 P4 Cost and Revenue, (dollars) P3 MR3 P2 MR2 MR1 P1 No Production Below AVC Q2 Q3 Q4 Q5 Quantity Supplied

Supply Curve to the Left MARGINAL REVENUE-MARGINAL COST APPROACH Marginal Cost & Short-Run Supply MC2 S2 Cost and Revenue, (dollars) MC1 AVC1 Quantity Supplied S1 AVC2 Higher Costs Move the Supply Curve to the Left

Marginal Cost & Short-Run Supply MARGINAL REVENUE-MARGINAL COST APPROACH Marginal Cost & Short-Run Supply Cost and Revenue, (dollars) MC1 AVC1 Quantity Supplied S1 Lower Costs Move the Supply Curve to the Right MC2 S2 AVC2

The Competitive Firm “Takes” its Price from the Industry Equilibrium SHORT-RUN COMPETITIVE EQUILIBRIUM The Competitive Firm “Takes” its Price from the Industry Equilibrium S= MC’s P P Economic Profit ATC S=MC D $111 $111 AVC D Q 8 Q 8000 Firm (price taker) Industry

How about the long-run? The Competitive Firm “Takes” its SHORT-RUN COMPETITIVE EQUILIBRIUM The Competitive Firm “Takes” its Price from the Industry Equilibrium S= MC’s How about the long-run? P P Economic Profit ATC S=MC D $111 $111 AVC D Q Q 8 8000 Firm (price taker) Industry

Assumptions... Entry and Exit Only Identical Costs for Firms PROFIT MAXIMIZATION IN THE LONG RUN Assumptions... Entry and Exit Only Identical Costs for Firms Constant-Cost Industry = Entry and exit of firms does not affect firms’ cost curves

Goal of the Analysis Price = Minimum ATC Long-Run Equilibrium - The PROFIT MAXIMIZATION IN THE LONG RUN Goal of the Analysis Price = Minimum ATC Long-Run Equilibrium - The Zero Economic Profit Model

Firm Industry Temporary profits and the reestablishment PROFIT MAXIMIZATION IN THE LONG-RUN Temporary profits and the reestablishment of long-run equilibrium S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 MC ATC MR D1

Firm Industry An increase in demand increases profits. Economic PROFIT MAXIMIZATION IN THE LONG RUN An increase in demand increases profits. Economic Profits S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 MC ATC MR D2 D1

Firm Industry New competitors increase supply and lower PROFIT MAXIMIZATION IN THE LONG RUN New competitors increase supply and lower prices decrease economic profits. Zero Economic Profits S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 S2 MC ATC MR D2 D1

Firm Industry Decreases in demand, Losses, and the PROFIT MAXIMIZATION IN THE LONG RUN Decreases in demand, Losses, and the Reestablishment of Long-Run Equilibrium S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 MC ATC MR D1

Firm Industry A decrease in demand creates losses. Economic Losses P Q PROFIT MAXIMIZATION IN THE LONG RUN A decrease in demand creates losses. Economic Losses S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 MC ATC MR D1 D2

Firm Industry Competitors with losses decrease supply and PROFIT MAXIMIZATION IN THE LONG RUN Competitors with losses decrease supply and prices return to zero economic profits. S3 Return to Zero Economic Profits S1 P Q 100 100,000 Industry Firm (price taker) $60 50 40 MC ATC MR D1 D2

CONSTANT COST INDUSTRY LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY Constant Cost Industry Perfectly Elastic Long-Run Supply Graphically...

CONSTANT COST INDUSTRY LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY P P1 P2 P3 Z3 Z1 Z2 =$50 S D3 D1 D2 Q Q3 Q1 Q2 90,000 100,000 110,000

CONSTANT COST INDUSTRY LONG-RUN SUPPLY IN A CONSTANT COST INDUSTRY How does an increasing cost industry differ? P P1 P2 P3 Z3 Z1 Z2 =$50 S D3 D1 D2 Q Q3 Q1 Q2 90,000 100,000 110,000

INCREASING COST INDUSTRY LONG-RUN SUPPLY IN A INCREASING COST INDUSTRY Increasing Cost Industry = Firms’ ATC curves shift upward as firms enter and downward as firms exit. Therefore...

INCREASING COST INDUSTRY LONG-RUN SUPPLY IN AN INCREASING COST INDUSTRY P S P1 P2 P3 $55 50 45 Y2 Y1 Y3 D3 D1 D2 Q Q3 Q1 Q2 90,000 100,000 110,000

INCREASING COST INDUSTRY LONG-RUN SUPPLY IN AN INCREASING COST INDUSTRY How does a decreasing cost industry differ? P S P1 P2 P3 $55 50 45 Y2 Y1 Y3 D3 D1 D2 Q Q3 Q1 Q2 90,000 100,000 110,000

DECREASING COST INDUSTRY LONG-RUN SUPPLY IN A DECREASING COST INDUSTRY Decreasing Cost Industry = Firms’ ATC curves shift downward as firms enter and upward as firms exit.

What is the long- run competitive equilibrium?

LONG-RUN EQUILIBRIUM FOR A COMPETITIVE FIRM MC ATC Price P MR Price = MC = Minimum ATC (normal profit) Q Quantity

Productive Efficiency PURE COMPETITION AND EFFICIENCY Productive Efficiency Price = Minimum ATC Allocative Efficiency Price = MC Underallocation Price > MC Overallocation Price < MC

efficiently allocated PURE COMPETITION AND EFFICIENCY Productive Efficiency Resources are efficiently allocated under competition. Price = Minimum ATC Allocative Efficiency Price = MC Underallocation Price > MC Overallocation Price < MC

Maximum Total Surplus Productive Efficiency Allocative Efficiency PURE COMPETITION AND EFFICIENCY Productive Efficiency Maximum Total Surplus Price = Minimum ATC Allocative Efficiency Price = MC Underallocation Price > MC Overallocation Price < MC

Productive Efficiency PURE COMPETITION AND EFFICIENCY Productive Efficiency Price = Minimum ATC Allocative Efficiency Price = MC Underallocation Price > MC Overallocation Price < MC

Perfect Competition and Economic Efficiency In the long run, competitive firms are driven to produce at the minimum point of their average total cost curves. In this case, output is produced at the lowest possible cost to society.

Review: What do I need to know about perfect competition for the AP Exam?

PURE COMPETITION P = MR The firm’s DEMAND CURVE is perfectly ELASTIC MR = MC  The firm maximizes profit P = ATC Long Run (NORMAL PROFITS) PRODUCTIVE EFFICIENCY P = min ATC  Firm is forced to operate with maximum productive efficiency. (Least-Cost Method Production) ALLOCATIVE EFFICIENCY P = MC There is an optimal allocation of resources.

Pure Competition The Market Individual firm P S P MR=D=AR=P2 p2 qe q2 Q Q The Market Individual firm

Firm showing Economic Profit ATC P MC MR=MC MR=D=AR=P $131 Per unit profit Revenue Economic Profit $97.78 ATC AVC Q1 Q

Firm showing Economic Loss P Per unit loss ATC MC MR=MC MR=D=AR=P Economic Loss ATC $81 Revenue AVC Q2 Q

Price = MC = MR = Minimum ATC Long-run Equilibrium For A Competitive Firm MC Price ATC MR=D=AR=P Pe Price = MC = MR = Minimum ATC (normal profit) Qe Quantity

Competitive Firm Supply Curve ATC MC P MR5 Breakeven point (normal profit ) MR4 MR3 AVC MR2 Shutdown point MR1 Q