Ch 8: Profit Max Under Perfect Competition Three assumptions in p.c. model: 1) Price-taking: many small firms, none can affect mkt P by  ing Q  no mkt power. Firm can sell all it wants at mkt P so faces perfectly elastic (horizontal) product demand curve. 2) Product homogeneity: each firm produces nearly identical product  all are perfect substitutes. This assures there will be single mkt P 3) Free entry and exit: assures big number of firms in industry.

More on Perfect Competition Real-life examples mostly found in agriculture. Large # firms means  10 – 20 firms in industry. P.C. model is an ideal; serves as useful starting point. Additional assumption: –Firms’ goal is to maximize profits (good assumption given large # firms). –Principal-agent problems more in news lately; to be discussed later. –  -max goal extends beyond P.C. market structure.

Profit Maximization Define profit = TR – TC  (q) = R(q) – C(q), or  = R – C. q* represents firm’s  -max level of output. To achieve  -max: firm picks q* where difference between TR and TC is greatest. With graphs of TR and TC: max  where have greatest vertical distance between TR and TC.

Three Curves in Figure 8.1 TR: slope is MR TC: slope is MC.  function: see inverse U-shape: plots out vertical distance between TR and TC. Max  where: –1) TR – TC is largest –2) slope TR = slope TC; or – MR = MC. –3) Rule for all firms (PC or not): pick  -max q* where MR = MC.

Review Implications of Perfect Competition Keep terms straight: –Q = market output; –D = market demand; –q = firm output; –d = firm demand. Market D is downward sloping but demand curve faced by individual firm is perfectly elastic (horizontal). –Interpret: firm can sell all it wants to sell at the single market price. –In other words, its selection of q* has no impact on market price. –So: firm demand curve is same as its MR curve.

Further Implications of P. C. Model Recall under PC: firm’s demand curve is its MR curve. This means that P  MR. Profit-max rule for PC firm: Pick  -max q* where MC = MR = P. Also, since P  MR for each q, then P = MR = AR. Draw simple graph to see  - max q*.

FURTHER Details Revise rule: pick  -max q* where MR = MC AND MC is rising. –Recall: this rule applies to all firms, not just p.c. firms. Short Run profit for p.c. firm: P - ATC at q* = average profit per unit of q. Recall:  = TR – TC; So:  /q = TR/q – TC/q Avg.  = P – ATC. Total  at q* = q*  (P-ATC).

Firm’s SR Shutdown Decision Situation: What if, in the SR,  -max q* results in losses? Firm must choose (1) vs (2): 1) Continue producing at q* and incurring the full losses. 2) Shutdown in SR (I.e., produce q-0), which will reduce losses but firm still must pay FC and now have NO revenues.

SR Shutdown Rule At q*, firm must know:: –P, –ATC, and –AVC. Rule: –If   0 in SR (so P  ATC at q*): continuing producing q* as long as P  AVC. –In other words: continue to produce q* as long as firm is covering operating costs. –In LR: any negative profits will cause shutdown and exit from industry. (So: LR shutdown if P  ATC).

Exercise Coffee mug company: P = $8. Currently, q = 200; MC = $10 = ATC. If did have q=150, then: MC = $6 = AVC. Questions: With  -max goal: –1. Should firm stick with q=200, reduce, or increase? –2. Would shut-down be better?

Competitive Firm’s SR Supply Curve Supply Curve: shows q produced at each possible price. SR supply curve: the firm’s MC curve for all points where MC  AVC. –I.e.,  -max q* is where P  AVC. Remember “trigger” for shutdown in SR  implies that MC curve has an irrelevant part (where MC  AVC).

Firm’s Response to  Price of Input Consider:  price input  causes  MC at each q  shift up to left of MC curve. See Figure 8.7: –Start at P = $5 with MC 1 ; so q* = q 1. –Now:  price input causes  MC: –Shifts MC up to left. –Causes  q*.

SR Market Supply Curve Shows: amount of Q the industry will produce in SR at each possible price. Sum SR supply curves for firms using horizontal summation. That is: at each possible price, sum up total quantity supplied by each firm. See Figure 8.9. (Note that we are assuming that, for each firm, as q  es, individual MC curves no .).

Price Elasticity of Market Supply E S = %  Qs/1%  P = (  Q/Q) / (  P/P). E S  0 always because SMC slopes upward. If MC  a lot when  Q (or, costly to  Q), then E S is low. Extreme cases: –Perfectly inelastic S: vertical. When industry’s plant and equipment so fully utilized that greater output can be achieved only if new plants built. –Perfect elastic S: horizontal (MC no  when Q  )

Producer Surplus in SR Concept analogous to CS. For rising MC: P  MC for every unit of q except last one produced. For a firm (see Figure 8.11): –For all units produced (up to q*):sum the differences between mkt P and MC of production. –Measures area above MC schedule (S curve) and below mkt price.

LR Competitive Equilibrium If each firm earns zero economic , each firm is in LR equilibrium. Three conditions: –1. All firms in industry are profit- maximizing. –2. No firm has incentive to enter or leave industry (due to  = 0). –3. P is that which equates Q S = Q D in market.

Adjustment from SR to LR Equilibrium Firm starts in SR equilibrium. Positive profits induce new firms to entire industry so industry S curve shifts rightward. This causes market P to fall. This causes firm’s MR line to fall, until profits = 0 again. –Key: firms enter as long as P  ATC Note: in this case, MC no shift due to constant cost assumption. LR choice of q*: –where LMC = P = MR = LAC. –Key is LMC=LAC.

Economic Rent Economic Rent: –Difference between what a firm is willing to pay for an input and the minimum amount necessary to buy the input. For an industry: economic rent is same as LR producer surplus. For a fairly fixed factor (like land): bulk of payments for the factor is rent (so factor S curve is vertical). In LR in a competitive mkt: PS that firms earn for Q is the economic rent from all its scarce inputs. Presence of economic rent can explain why profits might persist in LR.

Industry’s LR Supply Curve Cannot just sum individual firms horizontally because as price  es, # firms in industry  es. Must connect the zero-profit points. Shape of LR supply curve: depends on whether (and in what direction) the  es in each firm’s q causes  es in input prices. –Constant cost industry: As q and Q , input prices no  so firm’s MC, AVC, and ATC NO shift as q changes. –Here, long run industry supply curve is flat (perfectly horizontal). –Example: coffee industry (land for growing coffee widely available).

Other Cost Structures Increasing cost industry –Example: oil industry (limited availability of easily accessible, large-volume oil fields, so to  q, firms costs rise too). –Result is upward-sloping long run industry supply curve. Decreasing cost industry –Example: automobile industry (AC falls as industry output rises) –Result is downward-sloping long run industry supply curve.

Exercise In an increasing cost industry starting in LR equilibrium: –What is the immediate and then long- run effect of a shift to the left in market demand? Show and discuss the process of return to LR equilibrium. 1. Will the market price rise, fall, or stay the same? 2. What are the effects on the long-run market quantity and the long-run firm quantity? 3. What is the shape of the long-run supply curve? 4. What would be different if the industry were a constant cost industry? Decreasing cost industry?