© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. Fernando & Yvonn Quijano Prepared by: Chapter 11 Firms in Perfectly Competitive Markets

© 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 2 of 48 Perfect Competition in the Market for Organic Apples 11.1Define a perfectly competitive market and explain why a perfect competitor faces a horizontal demand curve. 11.2Explain how a firm maximizes profits in a perfectly competitive market. 11.3Use graphs to show a firm’s profit or loss. 11.4Explain why firms may shut down temporarily. 11.5Explain how entry and exit ensure that perfectly competitive firms earn zero economic profit in the long run. 11.6Explain how perfect competition leads to economic efficiency. Learning Objectives The process of competition is at the heart of the market system and is the focus of this chapter.

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 3 of 37 Firms in Perfectly Competitive Markets MARKET STRUCTURE CHARACTERISTIC PERFECT COMPETITION MONOPOLISTIC COMPETITIONOLIGOPOLYMONOPOLY Number of firms Type of product Ease of entry Examples of industries Many Identical High Wheat Apples Many Differentiated High Selling DVDs Restaurants Few Identical or differentiated Low Manufacturing computers Manufacturing automobiles One Unique Entry blocked First-class mail delivery Tap water Table 11-1 The Four Market Structures

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 4 of 37 Learning Objective 11.1 Perfectly competitive market A market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market. Price taker A buyer or seller that is unable to affect the market price. A Perfectly Competitive Firm Cannot Affect the Market Price Perfectly Competitive Markets

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 5 of 37 Learning Objective 11.1 FIGURE 11-1 A Perfectly Competitive Firm Faces a Horizontal Demand Curve Perfectly Competitive Markets The Demand Curve for the Output of a Perfectly Competitive Firm

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 6 of 37 Learning Objective 11.1 FIGURE 11-2 The Market Demand for Wheat versus the Demand for One Farmer’s Wheat Don’t Let This Happen to YOU! Don’t Confuse the Demand Curve for Farmer Parker’s Wheat with the Market Demand Curve for Wheat Perfectly Competitive Markets The Demand Curve for the Output of a Perfectly Competitive Firm

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 7 of 37 How a Firm Maximizes Profit in a Perfectly Competitive Market Learning Objective 11.2 Profit Total revenue minus total cost. Profit = TR – TC Revenue for a Firm in a Perfectly Competitive Market Average revenue (AR) Total revenue divided by the quantity of the product sold. Marginal revenue (MR) Change in total revenue from selling one more unit of a product.

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 8 of 37 How a Firm Maximizes Profit in a Perfectly Competitive Market Learning Objective 11.2 Table 11-2 Farmer Parker’s Revenue from Wheat Farming NUMBER OF BUSHELS (Q) MARKET PRICE (PER BUSHEL) (P) TOTAL REVENUE (TR) AVERAGE REVENUE (AR) MARGINAL REVENUE (MR) $4 4 $ $4 4 - $4 4 Revenue for a Firm in a Perfectly Competitive Market

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 9 of 37 How a Firm Maximizes Profit in a Perfectly Competitive Market Learning Objective 11.2 Determining the Profit-Maximizing Level of Output Table 11-3 Farmer Parker’s Profits from Wheat Farming QUANTITY (BUSHELS) (Q) TOTAL REVENUE (TR) TOTAL COSTS (TC) PROFIT (TR-TC) MARGINAL REVENUE (MR) MARGINAL COST (MC) $ $ –$ –0.50 — $ — $

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 10 of 37 How a Firm Maximizes Profit in a Perfectly Competitive Market Learning Objective 11.2 Determining the Profit-Maximizing Level of Output FIGURE 11-3 The Profit-Maximizing Level of Output

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 11 of 37 How a Firm Maximizes Profit in a Perfectly Competitive Market Learning Objective 11.2 Determining the Profit-Maximizing Level of Output 1 The profit-maximizing level of output is where the difference between total revenue and total cost is the greatest. 2 The profit-maximizing level of output is also where marginal revenue equals marginal cost, or MR = MC. From the information in Table 11-3 and Figure 11-3, we can draw the following conclusions:

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 12 of 37 Illustrating Profit or Loss on the Cost Curve Graph Learning Objective 11.3 Profit = (P x Q)  TC Profit = (P  ATC)Q or

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 13 of 37 Learning Objective 11.3 Showing a Profit on the Graph FIGURE 11-4 The Area of Maximum Profit Illustrating Profit or Loss on the Cost Curve Graph

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 14 of 37 Solved Problem 11-3 Determining Profit-Maximizing Price and Quantity Learning Objective 11.3 OUTPUT PER DAY TOTAL COST MARGINAL COST 0$10.00― $

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 15 of 37 Learning Objective 11.3 Illustrating Profit or Loss on the Cost Curve Graph Don’t Let This Happen to YOU! Remember That Firms Maximize Total Profit, Not Profit per Unit

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 16 of 37 Learning Objective P > ATC, which means the firm makes a profit. 2 P = ATC, which means the firm breaks even (its total cost equals its total revenue). 3 P < ATC, which means the firm experiences losses. Illustrating When a Firm Is Breaking Even or Operating at a Loss Illustrating Profit or Loss on the Cost Curve Graph

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 17 of 37 Learning Objective 11.3 FIGURE 11-5 A Firm Breaking Even and a Firm Experiencing Losses Illustrating When a Firm Is Breaking Even or Operating at a Loss Illustrating Profit or Loss on the Cost Curve Graph

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 18 of 37 Learning Objective 11.3 Losing Money in the Medical Screening Industry Making the Connection

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 19 of 37 Deciding Whether to Produce or to Shut Down in the Short Run Learning Objective Continue to produce 2 Stop production by shutting down temporarily Sunk cost A cost that has already been paid and that cannot be recovered. In the short run, a firm suffering losses has two choices:

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 20 of 37 Learning Objective 11.3 When to Close a Laundry Making the Connection Keeping a business open even when suffering losses can sometimes be the best decision for an entrepreneur in the short run.

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 21 of 37 Deciding Whether to Produce or to Shut Down in the Short Run Learning Objective 11.4 Shutdown point The minimum point on a firm’s average variable cost curve; if the price falls below this point, the firm shuts down production in the short run. The Supply Curve of a Firm in the Short Run Total revenue < Variable cost, P × Q < VC P < AVC or, in symbols: If we divide both sides by Q, we have the result that the firm will shut down if:

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 22 of 37 Learning Objective 11.4 FIGURE 11-6 The Firm’s Short-Run Supply Curve Deciding Whether to Produce or to Shut Down in the Short Run The Supply Curve of a Firm in the Short Run

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 23 of 37 Learning Objective 11.4 FIGURE 11-7 Firm Supply and Market Supply Deciding Whether to Produce or to Shut Down in the Short Run The Market Supply Curve in a Perfectly Competitive Industry

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 24 of 37 “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run Learning Objective 11.5 Economic Profit and the Entry or Exit Decision Table Farmer Moreno’s Costs per Year EXPLICIT COSTS Water Wages Organic fertilizer Electricity Payment on bank loan $10,000 $15,000 $10,000 $5,000 $45,000 IMPLICIT COSTS Foregone salary Opportunity cost of the $100,000 she has invested in her farm Total Cost $30,000 $10,000 $125,000 Economic profit A firm’s revenues minus all its costs, implicit and explicit.

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 25 of 37 Learning Objective 11.5 Economic Profit Leads to Entry of New Firms FIGURE 11-8 The Effect of Entry on Economic Profits “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run Economic Profit and the Entry or Exit Decision

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 26 of 37 Learning Objective 11.5 FIGURE 11-9 The Effect of Exit on Economic Losses Economic Losses Lead to Exit of Firms “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run Economic Profit and the Entry or Exit Decision

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 27 of 37 Learning Objective 11.5 FIGURE 11-9 The Effect of Exit on Economic Losses (continued) Economic Losses Lead to Exit of Firms “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run Economic Profit and the Entry or Exit Decision

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 28 of 37 Learning Objective 11.5 Economic loss The situation in which a firm’s total revenue is less than its total cost, including all implicit costs. Long-Run Equilibrium in a Perfectly Competitive Market Long-run competitive equilibrium The situation in which the entry and exit of firms has resulted in the typical firm breaking even. Economic Losses Lead to Exit of Firms “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run Economic Profit and the Entry or Exit Decision

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 29 of 37 Learning Objective 11.5 FIGURE The Long-Run Supply Curve in a Perfectly Competitive Industry “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run The Long-Run Supply Curve in a Perfectly Competitive Market

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 30 of 37 Learning Objective 11.5 Long-run supply curve A curve that shows the relationship in the long run between market price and the quantity supplied. Increasing-Cost and Decreasing-Cost Industries Industries with upward-sloping long run supply curves are called increasing-cost industries. Industries with downward-sloping long-run supply curves are called decreasing-cost industries. “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run The Long-Run Supply Curve in a Perfectly Competitive Market

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 31 of 37 Learning Objective 11.6 The Decline of Apple Production in New York State Making the Connection When apple growers in New York State stopped breaking even, many sold their land to housing developers.

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 32 of 37 Perfect Competition and Efficiency Learning Objective 11.6 Productive efficiency The situation in which a good or service is produced at the lowest possible cost. Productive Efficiency

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 33 of 37 Solved Problem 11-6 How Productive Efficiency Benefits Consumers Learning Objective 11.6

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 34 of 37 Perfect Competition and Efficiency Learning Objective The price of a good represents the marginal benefit consumers receive from consuming the last unit of the good sold. 2 Perfectly competitive firms produce up to the point where the price of the good equals the marginal cost of producing the last unit. 3 Therefore, firms produce up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Allocative Efficiency Firms will supply all those goods that provide consumers with a marginal benefit at least as great as the marginal cost of producing them.

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 35 of 37 Perfect Competition and Efficiency Learning Objective 11.6 Allocative efficiency A state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Allocative Efficiency

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 36 of 37 An Inside LOOK Why Are Organic Farmers Worried about Wal-Mart? Wal-Mart’s Organic Offensive

Chapter 11: Firms in Perfectly Competitive Markets © 2008 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien, 2e. 37 of 37 Allocative efficiency Average revenue (AR) Economic loss Economic profit Long-run competitive equilibrium Long-run supply curve Marginal revenue (MR) K e y T e r m s Perfectly competitive market Price taker Productive efficiency Profit Shutdown point Sunk cost