Profit, Loss, and Perfect Competition Chapter 9 Profit, Loss, and Perfect Competition

Chapter Objectives After reading this chapter you will be familiar with: Marginal Revenue. Profit maximization and loss minimization. The characteristics of perfect competition. The perfect competitor in the short run and long run. The short-run and long-run supply curves. Economic efficiency. Economic profits and accounting profits.

Total Revenue and Marginal Revenue Hypothetical Revenue Schedule Recall TR = P x Q Marginal revenue (MR): the increase in total revenue when output sold goes up by 1 unit.

Graphing Demand and Marginal Revenue

Economic and Accounting Profits Accounting profits: what is left over from total revenue after a firm has paid all of its explicit cost. Explicit cost = cost of doing business rent, wages, cost of goods sold, fuel, taxes, etc. Total Revenue $ 4,300,000 – Total Cost (explicit cost) 3,750,000 Accounting Profit 550,000

Economic and Accounting Profits Economic profits: what is left over from accounting profits after a firm has subtracted its implicit cost. Implicit cost are a firm’s opportunity cost (the forgone value of the next-best alternative). Suppose you have invested $100,000 of your own money in your business. You could have earned $15,000 interest on this money. Instead of you and your spouse working 12 hours a day, 7 days a week, both could have earned $70,000 working for someone else. ($15,000 + $70,000 = $85,000 implicit cost) Accounting profit $ 85,000 – Explicit cost 85,000 Economic Profit 0

Economic and Accounting Profits Why stay in business if your economic profits are zero? You are still making accounting profits. You wouldn’t do any better if you invested your money elsewhere and worked for someone else. You are your own boss by having your own business.

Economic and Accounting Profits When economic profits become negative, particularly if losses are substantial and appear permanent, more and more people will close their businesses. They will go to work for someone else. They will go into a different business. Market supply decreases and forces prices up. This process continues until people stop getting out. But with economic profit (short run), more people are attracted to this type of business. Market supply increases and forces prices down. This process continues until people stop getting in. Economic profits are zero at this point (long run). No one else wants to enter or leave. We will see this graphically in a few minutes.

Profit Maximization and Loss Minimization Profit Maximization Point: MC = MR This occurs somewhere between 5 and 6 units. We are assuming output can be produced in tenths or one hundredth of a unit (in reality, units of output can be in the thousands).

Profit Maximization and Loss Minimization Output MR MC 1 $500 $ --- 2 500 500 3 500 300 4 500 200 5 500 300 6 500 550 7 500 860 Profit Maximization Point: MC = MR (also loss minimization) The most profitable output is where the MC curve crosses the D, MR curve. This occurs at an output of 5.87 units. Total Profit = (P – ATC) x Output or (P – ATC) x Q* Try solving for profit here  ($500 - $465) x 5.75 = $201.25

The Shut-Down and Break-Even Points In the SR, this firm will not accept any price below $101. In the LR, this firm will not accept any price below $125.50.

Four Rules In the short run: In the long run: If the price is below the shut-down point, the firm will shut down. If the price is above the shut-down point, the firm will operate. In the long run: If the price is below the break-even point, the firm will go out of business. If the price is above the break-even point, the firm will stay in business.

Questions for Further Discussion What is Q* when Price = $25? Q* is where MC = MR Q* = 7.9 Calculate profit Profit = (P – ATC) x Q* ($25 – $17) x 7.9 Profit = $63.20

Finding the Firm’s Short-Run and Long-Run Supply Curves The firm’s SR supply curve begins at the shut-down point and follows the MC curve upward. The firm’s LR supply curve begins the break-even point and follows the MC curve upward.

Efficiency and Profit Maximization How much is the firm’s most efficient output? This occurs where Q = 10, the minimum point on the ATC (which is the break-even point). How much is the most profitable output? This occurs at an output of 11 which is where MC = MR.

Definition of Perfect Competition The 1st of four competitive modes. A theoretical model that does not exist in the real world. Serves as the standard by which we will measure the next three competitive models. Monopoly Monopolistic Competition Oligopoly Perfect competition is a market structure with: many well-informed buyers and sellers (perfect knowledge). identical products. no barriers to entering or leaving the market (perfect mobility). no firm is large enough to influence the price.

The Perfect Competitor’s Demand Curve A perfectly elastic firm D curve The intersection of the industry S & D curves sets the market price. Individual firm must accept this going price– is a “price taker”. So P* = $6

The Perfect Competitor in the Short Run In the short run, the perfect competitor may make a profit or take a loss.

The Perfect Competitor in the Long Run In the long run, the perfect competitor breaks even How do we then get to the long run where the firm is breaking even?

Going from Taking a Loss in the Short Run to Breaking Even in the Long Run At a price of $6, the firm is losing money and so are other firms in the industry.

Going from Taking a Loss in the Short Run to Breaking Even in the Long Run Some firms leave the industry in the LR, reducing supply, and thus raising the price to $8. Firms now charge $8, breaking even.

Going from Making a Profit in the Short Run to Breaking Even in the Long Run At a price of $10, the firm is making a profit and so are other firms in the industry.

Going from Making a Profit in the Short Run to Breaking Even in the Long Run New firms enter the industry in the LR, raising supply, and thus lowering the price to $8. Firms now charge $8, breaking even.

The Perfect Competitor in the Long Run Again, in the long run, the perfect competitor breaks even.

Summary: Perfect Competition In the long run the perfect competitor is forced to operate at the break-even point. This means it is operating at peak efficiency. The price it gets is just equal to the minimum point of its ATC (the break-even point). It charges the lowest price and operates most efficiently.

Third Method of Calculating Profit and Loss Profit (or loss) is the area of the rectangle (box) between the D curve and the ATC curve. Profit: EF (70) x FG ($12.50) = $875 Loss: JK (600) x KL ($2.00) = – 1,200

The Perfect Competitor: A Price Taker not a Price Maker A firm operates at peak efficiency when it produces at the lowest possible cost: Or the minimum point of its ATC curve (the break-even point). In the long run, the most profitable output is also at the minimum point of is ATC curve because this will be where MC = MR. Because of the degree of competition, the perfect competitor is forced to operate at peak efficiency. Other forms of competition do not force firms to operate at peak efficiency.

Efficiency, Price, and Profit A firm operates at peak efficiency when it produces at the lowest possible cost (min ATC).

Current Issue: The Internet Effect: A More Perfect Knowledge and Lower Prices The internet has moved entire markets much closer to the ideal of perfect knowledge. The internet has also lowered the barrier to entry in many markets bringing us much closer to the ideal of perfect competition for many goods and services. With customer now able to instantaneously find the available prices for many goods and services, many companies find no choice but to lower prices.