1. Chapter 8Slide 1 Perfectly Competitive Markets Market Characteristics 1)Price taking: the individual firm sells a very small share of total market output and so cannot influence market price. The individual consumer buys too small a share of output to have any impact on the price. 2)Product homogeneity: the products of all firms are perfect substitutes. 3)Free entry and exit: Buyers can easily switch from one supplier to another. Suppliers can easily enter or exit a market.

2. Chapter 8Slide 2 Profit Maximization Do firms maximize profits? Possibility of other objectives  Revenue maximization  Dividend maximization  Short-run profit maximization Implications of non-profit objective  Over the long-run investors would not support the company  Without profits, survival unlikely

3. Chapter 8Slide 3 Marginal Revenue, Marginal Cost and π Maximization Determining the profit maximizing level of output Profit ( ) = Total Revenue - Total Cost Total Revenue (R) = Pq Total Cost (C) = Cq Therefore:

4. Chapter 8Slide 4 Profit Maximization in the Short Run 0 Cost, Revenue, Profit ($s per year) Output (units per year) R(q) Total Revenue Slope of R(q) = MR

5. Chapter 8Slide 5 0 Cost, Revenue, Profit $ (per year) Output (units per year) Profit Maximization in the Short Run C(q) Total Cost Slope of C(q) = MC Why is cost positive when q is zero?

6. Chapter 8Slide 6 Comparing R(q) and C(q) Output levels: 0 - q 0 :  C(q)> R(q): negative profit  FC + VC > R(q)  MR > MC Output levels: q 0 - q *  R(q)> C(q)  MR > MC: higher profit at higher output. Profit is increasing 0 Cost, Revenue, Profit ($s per year) Output (units per year) R(q) C(q) A B q0q0 q*q* Marginal Revenue, Marginal Cost and π Maximization

7. Chapter 8Slide 7 Comparing R(q) and C(q) Output level: q *  R(q)= C(q)  MR = MC  Profit is maximized R(q) 0 Cost, Revenue, Profit $ (per year) Output (units per year) C(q) A B q0q0 q*q* Marginal Revenue, Marginal Cost and π Maximization

8. Demand and MR Faced by a Competitive Firm Output (bushels) Price $ per bushel Price $ per bushel Output (millions of bushels) d$4 100200100 FirmIndustry D $4

9. Chapter 8Slide 9 The competitive firm’s demand  Individual firm sells all units for $4 regardless of their level of output.  If the firm tries to raise price, sales are zero.  If the firm tries to lower price, he cannot increase sales  P = D = MR = AR  Profit Maximization: MC(q) = MR = P Marginal Revenue, Marginal Cost and π Maximization

10. Chapter 8Slide 10 q0q0 Lost profit for q 1 < q * Lost profit for q 2 > q * q1q1 q2q2 A Competitive Firm making a Positive Profit: SR 10 20 30 40 Price ($ per unit) 01234567891011 50 60 MC AVC ATC AR=MR=P Output q*q* At q * : MR = MC and P > ATC D A B C q 1 : MR > MC and q 2 : MC > MR and q 0 : MC = MR but MC falling

11. Chapter 8Slide 11 Would this producer continue to produce with a loss? A Competitive Firm Incurring Losses: SR Price ($ per unit) Output AVC ATC MC q*q* P = MR B F C A E D At q * : MR = MC and P < ATC Losses = (P- AC) q * or ABCD

12. Chapter 8Slide 12 Choosing Output in the Short Run Summary of Production Decisions Profit is maximized when MC = MR If P > ATC the firm is making profits. If AVC < P < ATC the firm should produce at a loss. If P < AVC < ATC the firm should shut-down.

13. Chapter 8Slide 13 A Competitive Firm’s Short-Run Supply Curve Price ($ per unit) Output MC AVC ATC P = AVC What happens if P < AVC? P2P2 q2q2 P1P1 q1q1 The firm chooses the output level where MR = MC, as long as the firm is able to cover its variable cost of production.

14. Chapter 8Slide 14 Price ($ per unit) MC Output AVC ATC P = AVC P1P1 P2P2 q1q1 q2q2 S = MC above AVC A Competitive Firm’s Short-Run Supply Curve Shut-down

15. Chapter 8Slide 15 MC 2 q2q2 Input cost increases and MC shifts to MC 2 and q falls to q 2. MC 1 q1q1 The Response of a Firm to a Change in Input Price Price ($ per unit) Output $5 Savings to the firm from reducing output

16. Chapter 8Slide 16 MC 3 Industry Supply in the Short Run $ per unit 024810571521 MC 1 S The short-run industry supply curve is the horizontal summation of the supply curves of the firms. Quantity MC 2 P1P1 P3P3 P2P2 Question: If increasing output raises input costs, what impact would it have on market supply?

17. Chapter 8Slide 17 The Short-Run Market Supply Curve Elasticity of Market Supply Perfectly inelastic short-run supply arises when the industry’s plant and equipment are so fully utilized that new plants must be built to achieve greater output. Perfectly elastic short-run supply arises when marginal costs are constant.

18. Chapter 8Slide 18 A D B CProducerSurplus Alternatively, VC is the sum of MC or ODCq *. R is P x q * or OABq *. Producer surplus = R - VC or ABCD. Producer Surplus for a Firm Price ($ per unit of output) OutputAVCMC0 P q*q*q*q* At q * MC = MR. Between 0 and q, MR > MC for all units.

19. Chapter 8Slide 19 Producer Surplus in the Short-Run The Short-Run Market Supply Curve

20. Chapter 8Slide 20 D P*P*P*P* Q*Q*Q*Q* ProducerSurplus Market producer surplus is the difference between P* and S from 0 to Q *. Producer Surplus for a Market Price ($ per unit of output) OutputS

21. Chapter 8Slide 21 q1q1 A B C D In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD. Output Choice in the Long Run Price ($ per unit of output) Output P = MR $40 SAC SMC In the long run, the plant size will be increased and output increased to q 3. Long-run profit, EFGD > short run profit ABCD. q3q3 q2q2 G F $30 LAC E LMC

22. Chapter 8Slide 22 q1q1 A B C D Output Choice in the Long Run Price ($ per unit of output) Output P = MR $40 SAC SMC Question: Is the producer making a profit after increased output lowers the price to $30? q3q3 q2q2 G F $30 LAC E LMC

23. Chapter 8Slide 23 Choosing Output in the Long Run Zero-Profit If R > wL + rK, economic profits are positive If R = wL + rK, zero economic profits, but the firm is earning a normal rate of return; indicating the industry is competitive If R < wL + rK, consider going out of business Long-Run Competitive Equilibrium

24. S1S1 Output $ per unit of output $ per unit of output $40 LAC LMC D S2S2 P1P1 Q1Q1 q2q2 FirmIndustry $30 Q2Q2 P2P2 Profit attracts firms Supply increases until profit = 0

25. Chapter 8Slide 25 Choosing Output in the Long Run Long-Run Competitive Equilibrium 1) MC = MR 2)P = LAC  No incentive to leave or enter  Profit = 0 3) Equilibrium Market Price

26. Chapter 8Slide 26 Choosing Output in the Long Run Questions 1)Explain the market adjustment when P < LAC and firms have identical costs. 2)Explain the market adjustment when firms have different costs. 3) What is the opportunity cost of land?

27. Chapter 8Slide 27 Choosing Output in the Long Run Economic Rent = the difference between what firms are willing to pay for an input minus the minimum amount necessary to obtain it. An Example: Two firms, A & B, both own their land A is located on a river which lowers A’s shipping cost by $10,000 compared to B. The demand for A’s river location will increase the price of A’s land to $10,000 Economic rent = $10,000  $10,000 - zero cost for the land Economic rent increases; Economic profit of A = 0

28. Chapter 8Slide 28 The shape of the long-run supply curve depends on the extent to which changes in industry output affect the prices the firms must pay for inputs. To determine long-run supply, we assume: All firms have access to the available production technology. Output is increased by using more inputs, not by invention. The market for inputs does not change with expansions and contractions of the industry. The Industry’s Long-Run Supply Curve

29. A P1P1 AC P1P1 MC q1q1 D1D1 S1S1 Q1Q1 C D2D2 P2P2 P2P2 q2q2 B S2S2 Q2Q2 Economic profits attract new firms. Supply increases to S 2 and the market returns to long-run equilibrium. LR Supply in a Constant-Cost Industry Output $ per unit of output $ per unit of output SLSL Q 1 increase to Q 2. Long-run supply = S L = LRAC. Change in output has no impact on input cost.

30. LR Supply in an Increasing-Cost Industry Output $ per unit of output $ per unit of output S1S1 D1D1 P1P1 LAC 1 P1P1 SMC 1 q1q1 Q1Q1 A SLSLSLSL P3P3 SMC 2 Due to the increase in input prices, long-run equilibrium occurs at a higher price. LAC 2 B S2S2 P3P3 Q3Q3 q2q2 P2P2 P2P2 D1D1 Q2Q2

31. S2S2 B SLSL P3P3 Q3Q3 SMC 2 P3P3 LAC 2 Due to the decrease in input prices, long-run equilibrium occurs at a lower price. LR Supply in a Decreasing-Cost Industry Output $ per unit of output $ per unit of output P1P1 P1P1 SMC 1 A D1D1 S1S1 Q1Q1 q1q1 LAC 1 Q2Q2 q2q2 P2P2 P2P2 D2D2