Perfect Competition in the Short Run and Long Run Micro Unit III Chapter 21

Review: Perfectly Competitive Market Characteristics: There are many, many buyers and sellers in the market. The goods offered by the various sellers are largely the same. Firms can freely enter or exit the market. Producers and Consumers are relatively well-informed Buyers and sellers act independent.

Review: Perfectly Competitive Market As a result of its characteristics, the perfectly competitive market has the following outcomes: The actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given. A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker. Buyers and sellers must accept the price determined by the market.

Why are perfectly competitive firms price takers? A competitive market has many buyers and sellers trading identical products so that each buyer and seller is a price taker. Therefore, buyers and sellers must accept the price determined by the market.

Do Activity 3-6, Part A Why is P=AR? Why is P=MR? Because 𝐴𝑅=𝑇𝑅/𝑄=𝑃 Why is P=MR? Because the firm does not have to lower its price to sell an extra unit) Why is the TR curve an upward-sloping straight line that begins at the origin? If the firm sells no output, its TR is $0. The TR function is a straight line because the slope of the TR curve is ∆𝑇𝑅/∆𝑄, and we know MR is a constant value equal to the market price.

Do Activity 3-6, Part A What happens to the firm’s TR curve if the market price increases? The TR curve has a steeper slope because the firm’s MR also has increased. Why is the demand curve facing a perfectly competitive firm perfectly elastic? At the market price, the firm can sell all the product it wants. If it increases its price by even a tiny bit, it will sell no units because consumers will go to the many other firms charging the market price. Because this is the ultimate consumer response, it is called perfectly elastic.

Do Part B of Activity 3-6

Do Part C REMEMBER – A firm’s optimal quantity can be identified by following these three rules: Produce the output where TR most exceeds TC. Produce the output where MR equals (or last exceeds) MC. Produce the output where M𝜋 equals (or last exceeds) $0.

Finish up Part D

THE SHUT DOWN RULE What are the conditions under which a perfectly competitive firm is better off producing no output, rather than producing the quantity where MR = MC? A firm should shut down at the quantity where MR = MC if it finds: TR is less than TVC AR is less than AVC P is less than AVC

Activity 3-7: Four Possible Total Profit Positions of a Firm in Short-Run Equilibrium

Do Activity 3-7 Why is the firm’s supply curve upward sloping? Because the firm’s marginal costs increase as it produces more output, the firm must receive a higher price for extra units of output to be profitable. Why will the firm not produce any output if the market price drops below the firm’s AVC curve? If price is less than AVC, the firm should produce no output; it should shut down for this production period.

Moving from Short Run to Long Run Why do the AVC and ATC curves decrease and then increase as the firm increases its level of output?

Do Activity 3-8, Part A

A Perfectly Competitive Industry and Firm in Short-Run Equilibrium with Positive Total Profit Because the D line is above the ATC curve, we know the firm is earning a positive total profit at the market price of $25. There is nothing in the industry graph that tells us the industry is generating positive total profits at a price of $25; that information comes from the firm’s graph.

A Perfectly Competitive Industry and Firm in Short-Run Equilibrium with Positive Total Profit What will happen in the perfectly competitive market if firms are earning positive total profit? New firms will enter the market, the market supply will shift to the right, and the market price will decrease until it is equal to minimum value of the firm’s ATC curve. Since all firms will be earning $0 in economic profit, outside firms no longer have an incentive to enter the market.

The firm’s total profit is… Different Profit Possibilities for a Perfectly Competitive Firm in Short-Run Equilibrium MR=MC at… The firm’s total profit is… Point A positive (P > ATC). Point B $0 (P = ATC). Point C negative (P < ATC) but the firm should not shut down (P > ATC). Loss < TFC. Point D negative (P < ATC) and the firm is indifferent about shutting down (P=AVC). Loss = TFC. Point E negative (P < ATC) and the firm should shut down (P < AVC). Loss > TFC.

A Perfectly Competitive Firm in Long-Run Equilibrium A perfectly competitive firm in long-run equilibrium is both productively and allocatively efficient: Productive efficiency: P= ATC minimum Allocative efficiency: P=MC

LRE vs. LRS What is the difference between an industry’s long-run equilibrium (LRE) and its long-run supply (LRS) curve? The LRE is the price and quantity combination at which there is zero profit, based on a given level of market demand for the product. The LRS curve is the collection of LREs, each of which is based on a different level of market demand.

Do Activity 3-8, Part C

Cost-Constant Industry How is the LRS curve shaped in a cost-constant industry?

Increasing-Cost Industry How is the LRS curve shaped in a increasing-constant industry?

Decreasing-Cost Industry How is the LRS curve shaped in a decreasing-constant industry? Downward sloping

How a Perfectly Competitive Industry and Firm Respond to an Increase in Demand Assume the market price is $35 and that each firm breaks even at that price. The industry and the firm are in long-run equilibrium based on market demand D 1 . Now assume the market demand increases to D 2 . The market price increases to $40 and the firm’s MR curve shifts up, creating a positive total profit at the higher price.

How a Perfectly Competitive Industry and Firm Respond to an Increase in Demand The market supply curve will shift to the right as new firms enter the market, attracted by the presence of positive total profit. As supply increases, the market price decreases. If this is a constant-cost industry, the expansion of the industry continues until the supply curve becomes S 2 with the price back at its original level of $35. The firm’s MR curve shifts back to its original position and the firm breaks even again.

How a Perfectly Competitive Industry and Firm Respond to an Increase in Demand The industry’s long-run equilibrium based on D 1 is the combination of a price of $35 and a quantity of 60,000 units. The industry’s long-run equilibrium based on D 2 is the combination of a price of $35 and a quantity of 70,000 units. If you connect these two LRE points, you will have the horizontal LRS curve, which characterizes a constant-cost industry. While the output of an individual firm is unchanged, the total industry output increased from 60,000 units to 70,000 units because of the increase in the number of firms.

How a Perfectly Competitive Industry and Firm Respond to a Decrease in Demand Assume the market price is $35 and that each firm breaks even at that price. The industry and the firm are in long-run equilibrium based on market demand D 1 . Now assume the market demand decreases to D 2 . The market price decreases to $30 and the firm’s MR curve shifts down, creating a negative total profit at the lower price.

How a Perfectly Competitive Industry and Firm Respond to an Increase in Demand The market supply curve will shift to the left as firms leave the market, disenchanted by the presence of negative total profit. As supply decreases, the market price increases. If this is a constant-cost industry, the contraction of the industry continues until the supply curve becomes S 2 with the price back at its original level of $35. The firm’s MR curve shifts back to its original position and the firm breaks even again.

How a Perfectly Competitive Industry and Firm Respond to an Increase in Demand The industry’s long-run equilibrium based on D 1 is the combination of a price of $35 and a quantity of 60,000 units. The industry’s long-run equilibrium based on D 2 is the combination of a price of $30 and a quantity of 50,000 units. If you connect these two LRE points, you will have the horizontal LRS curve, which characterizes a constant-cost industry. While the output of an individual firm is unchanged, the total industry output decreased from 60,000 units to 50,000 units because of the decrease in the number of firms.

Do Activity 3-9