1. ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 7: Perfect Competition

2. ©2012 The McGraw-Hill Companies, All Rights Reserved 2 Learning Objectives 1.Determine a perfectly competitive firm’s profit- maximizing output level and profit in the short run. 2.Show how economic profit and economic loss affect the allocation of resources across industries. 3.Explain the difference between economic profit and economic rent. 4.Use the theory of the invisible hand to analyze events in everyday life. 5.Understand and explain the relationship between a market equilibrium and a social optimum.

3. ©2012 The McGraw-Hill Companies, All Rights Reserved 3 Competition In the previous chapter we learned that the average total cost facilitates the profit- maximizing firm’s assessment of profitability This process, however, varies across different market structures  Market structures are usually defined by their level of competition  How competitive is a market?  Is a firm operating alongside others or alone?

4. ©2012 The McGraw-Hill Companies, All Rights Reserved 4 Perfectly (Pure) Competitive Market Perceived as unrealistic  Provides a benchmark in evaluating other market structures Characteristics of a perfectly competitive market 1. All firms sell the same standardized product 2. The market has many buyers and sellers, each of which buys or sells only a small fraction of the total quantity exchanged 3. Productive resources are mobile 4. Buyers and sellers are well informed

5. ©2012 The McGraw-Hill Companies, All Rights Reserved 5 Perfectly (Pure) Competitive Market All firms sell the same standardized product  Implies that buyers are willing to switch from one seller to another The market has many buyers and sellers, each of which buys or sells only a small fraction of the total quantity exchanged  Implies that individual buyers and sellers will be price takers

6. ©2012 The McGraw-Hill Companies, All Rights Reserved 6 Perfectly (Pure) Competitive Market Productive resources are mobile  Implies that sellers are able to obtain labor, capital, and other productive resources necessary to enter or leave a market Buyers and sellers are well informed  Implies that buyers and sellers are aware of the relevant opportunities available to them

7. ©2012 The McGraw-Hill Companies, All Rights Reserved 7 Profit-Maximizing Firms in Perfectly Competitive Markets Supply Curves  Most goods and services are produced by private firms  A profit-maximizing firm ‘s primary goal is maximize profit Profit = TR – TC  This primary goal + operating in a perfectly competitive market define the standard supply curves that we know and use

8. ©2012 The McGraw-Hill Companies, All Rights Reserved 8 Profit-Maximizing Firms in Perfectly Competitive Markets Demand Curves  How does a demand curve for a firm look like?  Demand is perfectly elastic  horizontal  Each firm can sell as much as it wants at the market price  Each firm is a price taker  A perfectly competitive firm has no control over the price  Its challenge becomes: what output level will allow it to maximize its profit taken into consideration a fixed price?

9. ©2012 The McGraw-Hill Companies, All Rights Reserved 9 Perfectly Competitive Firm's Demand

10. ©2012 The McGraw-Hill Companies, All Rights Reserved 10 Price = Marginal Cost: The Maximum Profit Condition Assume that firm produces 200 bottles a day  By producing the 201 st bottle the firm will increase its profit by 20  10 = 10 cents per day  Assume that firm produces 300  If the firm then contracted its output by 1 it would cut its costs by 30 cents while losing only 20 cents in revenue

11. ©2012 The McGraw-Hill Companies, All Rights Reserved 11 Price = Marginal Cost: The Maximum Profit Condition At a price of $0.20, the firm produces 260 bottles Profit is TR – TC  TR = 0.2 * 260 = $52  TC = 0.12 * 260 = $31.2 Profit is $52 - $31.2 = $20.8 Note that the minimum value of the firm’s AVC curve is $0.07  If the price falls below 7 cents the firm would shut down in the SR

12. ©2012 The McGraw-Hill Companies, All Rights Reserved 12 Price = Marginal Cost: The Maximum Profit Condition Firms might be earning losses instead  When P < ATC, the firm loses (P – ATC) per unit of output  Total losses are the rectangle whose height is ATC – P and whose width is Q  Losses = (ATC – P) (Q) ($0.10 – $0.08) (180) = $3.60

13. ©2012 The McGraw-Hill Companies, All Rights Reserved 13 Responses to Profits and Losses If a firm is covering its variable cost, it can stay in the market in the SR  If a firm would like to stay in the market in the LR, it must cover all costs: explicit and implicit costs A firm that earns no more than a normal profit has managed only to cover the opportunity cost of the resources  A firm that makes a positive economic profit earns more than the opportunity cost of the invested resources

14. ©2012 The McGraw-Hill Companies, All Rights Reserved 14 Responses to Profits and Losses Markets in which firms are earning an economic profit tend to attract additional resources  More firms want to enter the market  Market supply is expected to increase Markets in which firms are experiencing economic losses tend to lose resources  Firms want to leave the market  Market supply is expected to decrease

15. ©2012 The McGraw-Hill Companies, All Rights Reserved 15 Responses to Economic Profits Markets with excess profits attract resources P 2 Quantity (000s of bushels/year) Price $/bu MC 130 ATC 1.20 Typical Corn Farm Price $/bu 2 Quantity (M of bushels/year) S D 65 Corn Industry Economic Profit: $104,000

16. ©2012 The McGraw-Hill Companies, All Rights Reserved 16 Shrinking Economic Profits Supply increases P Quantity (000s of bushels/year) Price $/bu MC 130 ATC Typical Corn Farm Price $/bu 2 Quantity (M of bushels/year) S D 65 Corn Industry Economic Profit: $50,400 S' 1.50 95 120 1.08

17. ©2012 The McGraw-Hill Companies, All Rights Reserved 17 Market Equilibrium Zero economic profits P Quantity (000s of bushels/year) Price $/bu MC 130 ATC Typical Corn Farm Price $/bu 2 Quantity (M of bushels/year) S D 65 Corn Industry S' 1.50 115 1 S" 90

18. ©2012 The McGraw-Hill Companies, All Rights Reserved 18 Responses to Profits The initial equilibrium price was above the minimum value of ATC, giving rise to positive economic profits  Incentive for other firms to enter the market  Supply increases  Equilibrium price decreases until the incentive to enter the market disappear  P = minimum AVC  What if the price went below the minimum AVC?

19. ©2012 The McGraw-Hill Companies, All Rights Reserved 19 Economic Losses Resources leave 1.05 Quantity (M of bushels/year)Quantity (000s of bushels/year) 70 0.75 P 90 ATC MC S D 60 Price $/bu 0.75 Price $/bu Typical Corn Farm Corn Industry Economic Loss: $21,000

20. ©2012 The McGraw-Hill Companies, All Rights Reserved 20 Market Equilibrium No economic losses Quantity (M of bushels/year)Quantity (000s of bushels/year) 70 0.75 P 90 ATC MC S D 60 Price $/bu 1 S' 40

21. ©2012 The McGraw-Hill Companies, All Rights Reserved 21 Responses to Losses Condition: P > minimum AVC  TR = 0.75 * 70 = $52,500  TC = 1.05 * 70 = $73,500  Total losses = $21,000  Incentive for some firms to leave the market  Supply decrease  Price increase until incentive to leave the market disappear

22. ©2012 The McGraw-Hill Companies, All Rights Reserved 22 Responses to Profits and Losses Assumptions  Firms are free to enter and leave the market  Inputs can be purchased in any quantities at fixed prices  All firms employ similar standardized production methods Final outcome: zero economic profit  Do firms want zero economic profit?  The zero economic profit is a consequence of price movements following entry and exit of firms

23. ©2012 The McGraw-Hill Companies, All Rights Reserved 23 Long Run Equilibrium The fact that a new firm could enter or leave the market at any time means  Production can always be augmented or reduced in the long run at a cost of $1 per bushel  Long run supply curve us horizontal at $1 = min AVC  Both long run MC and long run ATC are constant at $1

24. ©2012 The McGraw-Hill Companies, All Rights Reserved 24 Long Run Equilibrium In the long run, corn costs $1/bu regardless of the size of the industry Quantity (M of bushels/year)Quantity (000s of bushels/year) 1.00 D S P MCATC Price $/bu

25. ©2012 The McGraw-Hill Companies, All Rights Reserved 25 Long Run Equilibrium Two attractive features of perfect competition long run equilibrium  Market outcome is efficient in the long run  The value to buyers of the last unit is $1 per bushel, which is exactly the same as the long-run marginal cost of producing it  Market outcome can be described as fair  Buyers pay the cost incurred by suppliers

26. ©2012 The McGraw-Hill Companies, All Rights Reserved 26 Applied Example: Too many stylists and too few aerobics instructors Initial equilibrium:  All suppliers are currently earning zero economic profit What if preferences change?  Longer hair and increased physical fitness

27. ©2012 The McGraw-Hill Companies, All Rights Reserved 27 Short-Run Adjustments Price ($/haircut) Haircuts/dayClasses/day Price ($/class) S D 500 15 200 10 D S 350 15 D' 12 D' 300 Haircut MarketAerobics Market

28. ©2012 The McGraw-Hill Companies, All Rights Reserved 28 Short-Run Adjustments MC H QHQH ATC H Price ($/haircut) Q' H 15.5 0 12 Economic loss MC A QAQA ATC A Price ($/class) Q' A 15 11 Economic profit Typical Hair Salon Typical Aerobics Studio

29. ©2012 The McGraw-Hill Companies, All Rights Reserved 29 Short-Run Adjustments Because of change in preferences  Demand shifts in each market  Haircut market  lower equilibrium price  economic losses  some hair salons exit the market  price goes back to original equilibrium but now with lower equilibrium quantity  Aerobics market  higher equilibrium price  economic profits  some Aerobics studios enter the market  price goes down to original equilibrium but now with higher equilibrium quantity

30. ©2012 The McGraw-Hill Companies, All Rights Reserved 30 The Importance of Free Entry and Exit From previous examples we have seen that entry and exit of firms play a crucial role in the final outcome of the market Barrier to entry: any force that prevents firms from entering a new industry  Legal constraints / Practical factors No less important than the freedom to enter a market is the freedom to leave  Firms discover that if a market is difficult to leave, they become reluctant to enter new markets  Barriers to exit thus become barriers to entry

31. ©2012 The McGraw-Hill Companies, All Rights Reserved 31 Economic Rent Economic profits tend toward zero, yet people get rich  How is that possible?  Distinction between economic rent and profit Economic rent is the portion of a payment to a factor of production that exceeds the owner's reservation price  The case of the talented chef  Unique talent for cooking  In equilibrium, pay the chef the increase in revenue from his talent

32. ©2012 The McGraw-Hill Companies, All Rights Reserved 32 Economic Rent: Talented Chef Assume: a city has 100 restaurants / 99 have “normal chefs” and 1 has a “talented chef”  Each chef receives $30,000 yearly salary  The 100 th restaurant can charge 50% more for each meal  The 99 restaurants each earn $300,000 in TR per year (ensuring a zero economic profit)  The 100 th restaurant’s TR is 50% more  $450,000  How much is the 100 th restaurant willing to pay the “talented chef”?

33. ©2012 The McGraw-Hill Companies, All Rights Reserved 33 Economic Rent: Talented Chef Competition will ensure that the “talented chef's” pay is $180,000 per year  $30,000 = what would he make from other restaurants  $150,000 = profit attributed to the “talented chef”  As such, $150,000 = economic rent to the “talented chef”  The owner of the 100 th restaurant will earn zero economic profit What if the owner of the 100 th restaurant paid $60,000 to the “talented chef” and kept the remaining $120,000 as profits?

34. ©2012 The McGraw-Hill Companies, All Rights Reserved 34 Invisible Hand Adam Smith argued that although the entrepreneur “intends only his own gain,” he is “led by an invisible hand to promote an end which was no part of his intention.” As Smith saw it, even though self-interest is the prime mover of economic activity, the end result is an allocation of goods and services that serves society’s collective interests remarkably well. The invisible hand, in short, is about all the good things that can happen because of the Incentive Principle

35. ©2012 The McGraw-Hill Companies, All Rights Reserved 35 Invisible Hand in the Supermarket Short check-out lines get longer – quickly  Information is freely available Start in the shortest line  Observe the pace of all lines  Decide whether to switch  Most shoppers would do the same, the short line seldom remains shorter for long

36. ©2012 The McGraw-Hill Companies, All Rights Reserved 36 Invisible Hand and Cost-Saving Innovations Competitive firms are price takers  Cost management required Innovation lowers cost for one firm  Profits increase by amount of cost savings  Information is freely available Industry costs decrease Equilibrium price decreases by amount of costs savings  No excess profits Competition among firms ensures that the resulting cost savings will be passed along to consumers in the long run

37. ©2012 The McGraw-Hill Companies, All Rights Reserved 37 Shipping Innovation: Example 40 companies compete in trans-Atlantic shipping  Cost per trip is $500,000 One firm innovates to save $20,000 in fuel per trip  Short-run economic profit Over time, competitors copy the innovation  Industry costs decrease by $20,000  Equilibrium price decrease by $20,000 In the long run, no firm earns excess profits

38. ©2012 The McGraw-Hill Companies, All Rights Reserved 38 Invisible Hand in an Istanbul Cab: Regulated Market Istanbul regulates the number of cabs  Issues a limited number of licenses  Allows licenses to be bought and sold privately Unregulated market has 15,000 cabs and each costs $25,000 City issues 13,000 licenses  Price of a cab $28,000 With restricted supply, price of a cab ride goes up  Cabs make excess profits 13 SRSR 28 Price (000s$/cab) Cabs (000s cabs) 15 D S 25

39. ©2012 The McGraw-Hill Companies, All Rights Reserved 39 Value of a Taxi License Total costs of operation are $40,000 per year plus cost of license Total revenue is $60,000 per year  $20,000 per year implicit cost of license ownership Find the amount you would pay today to receive $20,000 per year forever  Depends on the interest rate  At 6% interest, the value of a license is $333,333 If the license sells for $333,333, there are no excess profits from operating a cab

40. ©2012 The McGraw-Hill Companies, All Rights Reserved 40 Invisible Hand and Irrigation Program Textile workers and tenant farmers each earn $8,000 Government program doubles revenue  Short-term economic profits  Land rents increase as farmers enter industry Program benefits only land owners in the long run and not farmers Land Other Explicit Costs Normal Profit Total Revenue Economic Profit Before$5,000$3,000$8,000$16,000$0 Short Run$5,000$3,000$8,000$32,000$16,000 Long Run$21,000$3,000$8,000$32,000$0

41. ©2012 The McGraw-Hill Companies, All Rights Reserved 41 Invisible Hand and Socially Optimal Outcome There are only three ways to earn a big payoff:  To work especially hard  To have some unusual skill, talent, or training  To be lucky Markets work best when  Buyers' marginal benefits = sellers' marginal costs AND  Society's marginal benefits = society's marginal costs  Individual behavior may benefit the individual more than it does for the society