1. 1 Perfect Competition Chapter 8 © 2006 Thomson/South-Western

2. 2 Terminology  An industry consists of all firms that supply output to a particular market, interchangeable with market  Many of the firm’s decisions depend on the structure of the market in which it operates  Market structure describes the important features of a market

3. 3 Market Structure  Number of suppliers  Product’s degree of uniformity  Do firms in the market supply identical products or are there differences across firms?  Ease of entry into the market  Can new firms enter easily or are they blocked by natural or artificial barriers?  Forms of competition among firms  Do firms compete only through prices or are advertising and product differences common as well?

4. 4 Perfectly Competitive Market Structure  Many buyers and sellers  Each buys and sells only a tiny fraction of the total amount exchanged in the market  Standardized or homogeneous product  Buyers and sellers are fully informed about the price and availability of all resources and products  Firms and resources are freely mobile  over time they can easily enter or leave the industry

5. 5 Perfect Competition  Individual participants have no control over the price  Price is determined by market supply and demand  the perfectly competitive firm is a price taker  it must “take” or accept, the market price  Firm is free to produce whatever quantity maximizes profit

6. 6 Exhibit 1: Market Equilibrium and the Firm’s Demand Curve in Perfect Competition Bushels of wheat per day $5 0 1,200,000 S D P r i c e p e r b u s h e l (a) Market Equilibrium P r i c e p e r b u s h e l $5 0 Bushels of wheat per day d 5 1015 (b) Firm’s Demand Market price of wheat of $5 per bushel is determined in the left panel by the intersection of the market demand curve and the market supply curve. Once the market price is established, farmer can sell all he or she wants at that market price  price taker

7. 7 Total Revenue Minus Total Cost  The firm maximizes economic profit by finding the rate of output at which total revenue exceeds total cost by the greatest amount  Total revenue is simply output times the price per unit  Exhibits 2 and 3 provide us with the needed information

8. 8 (1) (2) (3) = (1)  (2) (4) (5) (6) = (4) + (1) (7) = (3) - (4) Bushels of Marginal Wheat Revenue Total Total Marginal Average Economic per day (Price) Revenue Cost Cost Total Cost Profit or (q) (p) (TR = q  p) (TC) MC=  TC/  Q ATC = TC / q Loss = TR - TC 0 -- $0 $15.00 -- -$15.00 1 $5 5 19.75 $4.75$19.75 -14.75 2 5 10 23.50 3.75 11.75 -13.50 3 5 15 26.50 3.00 8.83 -11.50 4 5 20 29.00 2.50 7.25 -9.00 5 5 25 31.00 2.00 6.20 -6.00 6 5 30 32.50 1.50 5.42 -2.50 7 5 35 33.75 1.25 4.82 1.25 8 5 40 35.25 1.50 4.41 4.75 9 5 45 37.25 2.00 4.14 7.75 10 5 50 40.00 2.75 4.00 10.00 11 5 55 43.25 3.25 3.93 11.75 12 5 60 48.00 4.75 4.00 12.00 13 5 65 54.50 6.50 4.19 10.50 14 5 70 64.00 9.50 4.57 6.00 15 5 75 77.50 13.50 5.17 -2.50 16 5 80 96.00 18.50 6.00 -16.00 Exhibit 2: Short-Run Costs and Revenues

9. 9 Exhibit 3: Short-Run Profit Maximization $60 48 15 0 Total cost Total revenue (= $5 × q ) Maximum economic profit = $12 Bushels of wheat per day 5 71012 15 Total dollars (a) Total Revenue Minus Total Cost  At output less than 7 bushels and greater than 14 bushels, total cost exceeds total revenue  economic loss measured by the vertical distance between the two curves  Total revenue exceeds total cost between 7 and 14 bushels per day  economic profit is maximized at the rate of 12 bushels of wheat per day

10. 10 Marginal Revenue Equals Marginal Cost  Marginal revenue, MR, is the change in total revenue from selling another unit of output  Since the firm in perfect competition is a price taker, marginal revenue from selling one more unit is the market price  MR = P  Marginal cost is the change in total cost resulting from producing another unit of output

11. 11 (1) (2) (3) = (1)  (2) (4) (5) (6) = (4) + (1) (7) = (3) - (4) Bushels of Marginal Wheat Revenue Total Total Marginal Average Economic per day (Price) Revenue Cost Cost Total Cost Profit or (q) (p) (TR = q  p) (TC) MC=  TC/  Q ATC = TC / q Loss = TR - TC 0 -- $0 $15.00 -- -$15.00 1 $5 5 19.75 $4.75$19.75 -14.75 2 5 10 23.50 3.75 11.75 -13.50 3 5 15 26.50 3.00 8.83 -11.50 4 5 20 29.00 2.50 7.25 -9.00 5 5 25 31.00 2.00 6.20 -6.00 6 5 30 32.50 1.50 5.42 -2.50 7 5 35 33.75 1.25 4.82 1.25 8 5 40 35.25 1.50 4.41 4.75 9 5 45 37.25 2.00 4.14 7.75 10 5 50 40.00 2.75 4.00 10.00 11 5 55 43.25 3.25 3.93 11.75 12 5 60 48.00 4.75 4.00 12.00 13 5 65 54.50 6.50 4.19 10.50 14 5 70 64.00 9.50 4.57 6.00 15 5 75 77.50 13.50 5.17 -2.50 16 5 80 96.00 18.50 6.00 -16.00 Exhibit 2: Short-Run Costs and Revenues  The firm will increase quantity supplied as long as each additional unit adds more to total revenue that to total cost – as long as MR exceeds MC  MR exceeds MC for the first 12 bushels  Profit maximizer will limit output to 12 bushels per day

12. 12 Exhibit 3b: Short-Run Profit Maximization $5 4 0 15 Marginal cost Average total cost d = Marginal revenue = average revenue e a Profit Bushels of wheat per day 12 10 5 Dollars per unit (b) Marginal Cost Equals Marginal Revenue  The MC curve intersects the MR curve at point e, where output is 12 bushels per day  At rates of output less than 12 bushels, MR > MC – firm can increase profit by expanding output  At higher rates of output MC > MR – firm can increase profits by reducing output  Profit appears in the blue shaded rectangle and equals the price of $5 minus the average cost of $4, or $1 per bushel

13. 13 Marginal Revenue Equals Marginal Cost  Golden rule of profit maximization:  Generally, a firm will expand output as long as marginal revenue exceeds marginal cost and will stop expanding output before marginal cost exceeds marginal revenue

14. 14 Economic Profit in the Short Run  Because the perfectly competitive firm can sell any quantity for the same price per unit, marginal revenue is also average revenue  Average revenue, AR, equals total revenue divided by quantity  AR = TR / q  Regardless of the rate of output, the following equality holds along the firm’s demand curve  Market price = marginal revenue = average revenue

15. 15 Minimizing Short-Run Losses  Sometimes the price that the firm is required to “take” will be so low that no rate of output will yield an economic profit  Faced with losses at all rates of output, the firm has two options  It can continue to produce at a loss, or  Temporarily shut down  It cannot shut down in the short run because by definition the short run is a period too short to allow existing firms to leave or new firms to enter

16. 16 Exhibit 4: Minimizing Losses (1) (2) (3) = (1)  (2) (4) (5) (6) = (4) + (1) (7) (8) = (3) - (4) Bushels of Marginal Average Wheat Revenue Total Total Marginal Average Variable Economic per day (Price) Revenue Cost Cost Total Cost Cost Profit or (q) (p) (TR = q  p) (TC) MC=  TC/  Q ATC = TC /q AVC = TVC / q Loss = TR - TC 0 -- $0 $15.00 -- -- -$15.00 1 $3 3 19.75 $4.75$19.75 $4.75 -16.75 2 3 6 23.50 3.75 11.75 4.25 -17.50 3 3 9 26.50 3.00 8.83 3.83 -17.50 4 3 12 29.00 2.50 7.25 3.50 -17.00 5 3 15 31.00 2.00 6.20 3.20 -16.00 6 3 18 32.50 1.50 5.42 2.92 -14.50 7 3 21 33.75 1.25 4.82 2.68 -12.75 8 3 24 35.25 1.50 4.41 2.53 -11.25 9 3 27 37.25 2.00 4.14 2.47 -10.25 10 3 30 40.00 2.75 4.00 2.50 -10.00 11 3 33 43.25 3.25 3.93 2.57 -10.25 12 3 36 48.00 4.75 4.00 2.75 -12.00 13 3 39 54.50 6.50 4.19 3.04 -15.50 14 3 42 64.00 9.50 4.57 3.50 -22.00 15 3 45 77.50 13.50 5.17 4.17 -32.50 16 3 48 96.00 18.50 6.00 5.06 -48.00  Marginal revenue exceeds marginal cost for the first 12 bushels of wheat. Because of the lower price, total revenue is lower at all rates of output and economic profit has disappeared  column (8)  Column (8) indicates that the firm’s loss is minimized at $10 per day when 10 bushels are produced  the net gain of $5 total cost. Exhibit 5 illustrates this same conclusion graphically

17. 17 Exhibit 5: Minimizing Short-Run Losses $4.00 3.00 2.50 0 5 10 15 Marginal cost Average total cost d = Marginal revenue = average revenue Average variable cost e Loss Bushels of wheat per day Dollars per bushel b) Marginal Cost Equals Marginal Revenue $40 30 15 0 5 10 15 Total cost Total revenue (= $3 × q ) Minimum economic loss = $10 Bushels of wheat per day (a) Total Cost and Total Revenue Total dollars  In panel (a), Total revenue is lower because of the lower price  Total revenue now lies below the total cost curve at all output rates. The vertical distance between the two curves measures the loss at each rate of output  The vertical distance is minimized at an output rate of 10 bushels where the loss is $10 per day  Same result in panel b  Firm will produce rather than shut down if MR = MC at a rate of output where price equals or exceeds average variable cost  At point e, output is 10 bushels per day and the price of $3 exceeds the average variable cost of $2.50  Total economic loss shown by shaded area

18. 18 Shutting Down in the Short Run  As long as the loss that results from producing is less than the shutdown loss, the firm will remain open for business in the short run  If the average variable cost of production exceeds the price of all rates of output, the firm will shut down  A re-examination of previous exhibit indicates that if the price of wheat were to fall to $2 per bushel, average variable cost exceeds $2 at all rates of output

19. 19 Shutting Down in the Short Run  Shutting down is not the same as going out of business  In the short run, even a firm that shuts down keeps its productive capacity intact  that when demand increases enough, the firm will resume operation  If market conditions look grim and are not expected to increase, the firm may decide to leave the market  a long run decision

20. 20 Exhibit 6: Summary of Short-Run Output Decisions q1q1 0 Quantity per period d1d1 Average total cost Average variable cost 4 1 Marginal cost p1p1 Shutdown point 2 q2q2 p2p2 d2d2 q3q3 3 p3p3 d3d3 Break-even point q4q4 p4p4 d4d4 q5q5 p5p5 5 d5d5 Dollars per unit  At p 1, the firm will shut down rather than operate because price is below average variable cost at all output rates.  If the price is p 3, the firm will produce q 3 to minimize its loss while at p 4, the firm will produce q 4 to earn just a normal profit: break-even point  At p 2, the firm is indifferent: shutdown point  If the price rises to p 5, the firm will earn a short-run economic profit by producing q 5  The short-run supply curve is the upward- sloping portion of the marginal cost curve beginning at point 2.

21. 21 Short-Run Firm Supply Curve  As long as the price covers average variable cost, the firm will supply the quantity resulting from the intersection of its upward-sloping marginal cost curve and its marginal revenue, or demand curve  Thus, that portion of the firm’s marginal cost curve that intersects and rises above the lowest point on its average variable cost curve becomes the short-run firm supply curve

22. 22 Exhibit 7: Aggregating Individual Supply to Form Market Supply P r i c e p e r u n i t p' p 0 10 20 (a) Firm A S A Quantity per period Quantity per period Quantity per period Quantity per period p' p 0 30 60 (d) Industry, or market, supply (b) Firm B(c) Firm C p' p 0 10 20 p' p 0 10 20 S C S B S A + S B + S C = S  At a price below p, no output is supplied  At a price of p, each firm supplies 10 units: a market supply of 30 units  At a price of p', each firm supplies 20 units: a market supply of 60 units  The short-run industry supply curve is the horizontal sum of all firms’ short-run supply curves: horizontal summation of the firm level marginal cost curves

23. 23 Exhibit 8: Relationship Between Short-Run Profit Maximization and Market Equilibrium $5 4 0 5 10 12 Bushels of wheat per day (a) Firm d P r i c e p e r u n i t $5 0 1,200,000 ( b) Industry, or market D ATC AVC Profit ΣMC = S MC = s If there are 100,000 identical wheat farmers, their individual supply curves are summed horizontally to yield the market supply curve, panel b, where market price of $5 is determined. At this price, each farmer produces 12 bushels per day, as in panel a, for a total quantity supplied of 1,200,000 bushels per day Each farmer earns an economic profit of $12 per day as shown by the shaded rectangle.

24. 24 Perfect Competition in Long Run  Firms have time to enter and exit and to adjust their scale of their operations: there is no distinction between fixed and variable cost because all resources under the firm’s control are variable  Short-run economic profit will in the long run encourage new firms to enter the market and may prompt existing firms to expand the scale of their operations: the industry supply curve shifts rightward in the long run, driving down the price  New firms will continue to enter a profitable industry and existing firms will continue to increase in size as long as economic profit is greater than zero

25. 25 Exhibit 9: Long Run Equilibrium for the Firm and the Industry p 0 d Quantity per period MC ATC e LRAC q Dollars per unit p 0 Q Quantity per period Price per unit D (a) Firm(b) Industry, or market In the long run, market supply adjusts as firms enter or leave, or change their size. This process continues until the market supply intersects the market demand at a price that equals the lowest point on each firm’s long-run average cost curve, at point e with each firm producing q units. At point e, marginal cost, short-run average total cost and long-run average cost are all equal. S

26. 26 Exhibit 10: Long-Run Adjustment to an Increase in Demand 0 ATC MC LRAC Quantity per period (a) Firm 0 D a QaQa Quantity per period (b) Industry, or Market p S S* Dollars per unit Price per unit p d q d' D' p' q' p' b QbQb S' c QcQc  Initial point of equilibrium is a in panel b: individual firm supplies q units and earns a normal profit  Suppose market demand increases from D to D': market price increases in short run to p'  Firms respond by expanding output along the short-run supply curve – quantity supplied increases to q‘: economic profits attract new firms, market supply curve shifts to S' where it intersects D' at point c: price returns to initial equilibrium level  Demand curve facing the individual firm shifts back down from d' to d Profit

27. 27 Exhibit 11: Long-Run Adjustment to a Decrease in Demand (b) Industry, or Market Dollars per unit p p" 0 d MC ATC e LRAC Quantity per period (a) Firm 0 S Quantity per period QaQa D a p g S" QgQg q" d" Loss p" D" f QfQf S* Price per unit q  Initial long-run equilibrium shown by point a in the market and e for the firm  Market demand declines from D to D” – market price falls to p” – demand curve facing each firm drops to d” – firm responds by reducing its output to q” and market output falls to Q f : each firm faces a loss  In the long run some firms go out of business: market supply will decrease from S to S" – price increases back to p and the new market equilibrium is shown by point g. Market output has fallen to Q g and the remaining firms are just earning a normal profit as demand shifts back to d.

28. 28 Long-Run Industry Supply Curve  Beginning at an initial long-run equilibrium point, with demand shifting, we found two more long-run equilibrium points  Connecting these long-run equilibrium points yields the long-run industry supply curve, labeled S* in both of these exhibits  Shows the relationship between price and quantity supplied once firms fully adjust to any short-term economic profit or loss resulting from a shift in demand

29. 29 Constant-Cost Industry  Firm’s long-run average cost curve does not shift as industry output expands  Resource prices and other production costs remain constant in the long run as industry output increases or decreases  Each firm’s per-unit production costs are independent of the number of firms in the industry: the firm’s long- run average cost curve remains constant in the long run as firms enter or leave the industry  The industry uses such a small portion of the resources available that increasing industry output does not bid up resource prices  The long-run supply curve for a constant-cost industry is horizontal

30. 30 Increasing-Cost Industry  Firms in some industries encounter higher average costs as industry output expands in the long run  Firms in these increasing-cost industries find that expanding output bids up the prices of some resources or otherwise increases per-unit production costs: each firm’s cost curves shift upward

31. 31 Exhibit 12: An Increasing-Cost Industry p a 0 d a ATC MC a Quantity per period (a) Firm p a 0 S D a QaQa Quantity per period (b) Industry, or Market Dollars per unit Price per unit q The initial position of equilibrium is shown at point a, where the initial market demand and supply curves are D and S - the market price is p a and the market quantity Q a – the demand and marginal revenue curve facing each firm is d a – the firm produces q, average total cost is at a minimum: firm earns no economic profit in this long-run equilibrium

32. 32 Exhibit 12: An Increasing-Cost Industry p a 0 d a ATC MC a Quantity per period (a) Firm p a 0 S D a QaQa (b) Industry, or Market Dollars per unit Price per unit b b p b d qbqb b p D'D' b QbQb q Increase in market demand is shown by the shift from D to D‘, which intersects the short-run market supply curve S at point b: short-run equilibrium price p b and market quantity Q b – each firm’s demand curve shifts from d a up to d b – b in the left panel where the marginal cost curve intersects the new demand curve – each firm produces q b: economic profit equal to q b times the difference between the p b and the average total cost at that rate of output Quantity per period

33. 33 Exhibit 12: An Increasing-Cost Industry Dollars per unit p a 0 d a ATC MC a Quantity per period (a) Firm p a 0 S D a QaQa Quantity per period (b) Industry, or Market Price per unit b b p b d qbqb b p D' b QbQb q c c c c p d ATC' MC' p S' c QcQc The existence of economic profit attracts new entrants but because this is an increasing-cost industry, new entrants’ increased demand for resources drives up the costs of production and raises each firm’s marginal and average cost curves. In the left panel, MC and ATC shift up to MC' and ATC'. The entry of the new firms also shifts the short-run industry supply curve outward from S to S'  decline in the market price from b to c.

34. 34 Exhibit 12: An Increasing-Cost Industry p a 0 d a ATC MC a Quantity per period (a) Firm p a 0 S S* D a QaQa Quantity per period (b) Industry, or Market Dollars per unit Price per unit b b p b d qbqb b p D' b QbQb q c c c c p d ATC' MC' p S' c QcQc A combination of a higher production cost and a lower price squeezes economic profit to zero: S'. Market price does not fall back to initial equilibrium level because each firm’s ATC shifted up with the expansion of industry output. New long-run market equilibrium occurs at point c, and when points a and c are connected, we get the upward sloping long-run market supply curve shown as S*

35. 35 Perfect Competition and Efficiency  There are two concepts of efficiency used to judge market performance  Productive efficiency refers to producing output at the least possible cost  Allocative efficiency refers to producing the output that consumers value the most  Perfect competition guarantees both allocative and productive efficiency in the long run

36. 36 Productive Efficiency: Making Stuff Right  Productive efficiency occurs when the firm produces at the minimum point on its long-run average-cost curve  the market price equals the minimum average total cost  The entry and exit of firms and any adjustment in the scale of each firm ensure that each firm produces at the minimum point on its long-run average cost curve

37. 37 Allocative Efficiency: Making the Right Stuff  Occurs when firms produce the output that is most valued by consumers  The demand curve reflects the marginal value that consumers attach to each unit  the market price is the amount of money that people are willing and able to pay for the final unit they consume  In both the short run and the long run, the equilibrium price in perfect competition equals the marginal cost of supplying the last unit sold

38. 38 Allocative Efficiency  Marginal cost measures the opportunity cost of all resources employed by the firm to produce the last unit sold  Supply and demand curves intersect at the combination of price and quantity at which the marginal value, benefit that consumers attach to the final unit purchased, just equals the opportunity cost of the resources employed to produce that unit  There is no way to reallocate resources to increase the total utility consumers reap from production

39. 39 What’s So Perfect About Perfect Competition?  Market exchange benefits both consumers and producers  Recall that consumers garner a surplus from market exchange because the maximum amount they would be willing to pay for each unit of the good exceeds the amount they in fact pay

40. 40 Exhibit 13: Consumer Surplus and Producer Surplus $ 10 5 0 100,000 120,000 200,000 Producer surplus Consumer surplus D S m e Quantity per period  Consumer surplus is the area below the demand curve but above the market clearing price of $10  Producers also derive a net surplus from market exchange because the amount they receive for their output exceeds the minimum amount they would require to supply the amount  The short-run market supply curve is the sum of that portion of each firm’s marginal cost curve at or above the minimum point on its average variable cost, point m on the market supply curve S Dollars per unit

41. 41 Exhibit 13: Consumer Surplus and Producer Surplus  If price increases from $5 to $6, firms increase quantity supplied until marginal cost equals $6: output increases from 100,000 to 120,000 and total revenue increases from $500,000 to $720,000.  In the short run, producer surplus is total revenue minus variable cost of production.  Market clearing price is $10  Productive and allocative efficiency in the short run occurs at point e. $ 10 5 Producer surplus Consumer surplus D S m e Quantity per period Dollars per unit 0 100,000 120,000 200,000 6

42. 42 Producer Surplus  Not the same as economic profit  Any price that exceeds average variable cost will result in a short-run producer surplus, even though that price could result in a short- run economic loss  Ignores fixed cost, because fixed cost is irrelevant to the firm’s short-run production decision