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R. GLENN HUBBARD Economics FOURTH EDITION ANTHONY PATRICK O’BRIEN.

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1 R. GLENN HUBBARD Economics FOURTH EDITION ANTHONY PATRICK O’BRIEN

2 2 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Firms in Perfectly Competitive Markets CHAPTER 12 Chapter Outline and Learning Objectives 12.1Perfectly Competitive Markets 12.2How a Firm Maximizes Profit in a Perfectly Competitive Market 12.3Illustrating Profit or Loss on the Cost Curve Graph 12.4Deciding Whether to Produce or to Shut Down in the Short Run 12.5“If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run 12.6Perfect Competition and Efficiency

3 3 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall With sales of organically grown food increasing at a rate of 20 percent per year, more farmers have begun participating in farmers’ markets. The additional supply of produce, though, has forced down prices and many farmers have found that the profits they earn from selling in farmers’ markets is no longer higher than what they earn selling to supermarkets. Throughout the economy, entrepreneurs are continually introducing new products or new ways of selling products, which—when successful—enable them to earn economic profits in the short run. But in the long run, competition among firms forces prices to the level where they just cover the costs of production. AN INSIDE LOOK on page 422 discusses the steady decline in production and sales of organic food in the United Kingdom after 2008. Perfect Competition in Farmers’ Markets

4 4 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Are You an Entrepreneur? Were you an entrepreneur during your high school years? Perhaps you didn’t have your own store, but you may have worked as a babysitter, or perhaps you mowed lawns for families in your neighborhood. While you may not think of these jobs as being small businesses, that is exactly what they are. How did you decide what price to charge for your services? You may have wanted to charge $25 per hour to babysit or mow lawns, but you probably charged much less. As you read the chapter, think about the competitive situation you faced as a teenage entrepreneur and try to determine why the prices received by most people who babysit and mow lawns are so low. Economics in Your Life

5 5 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Firms in perfectly competitive industries are unable to control the prices of the products they sell and are unable to earn an economic profit in the long run because: (1) firms in these industries sell identical products, and (2) it is easy for new firms to enter these industries. Studying how perfectly competitive industries operate is the best way to understand how markets answer the fundamental economic questions discussed in Chapter 1: What goods and services will be produced? How will the goods and services be produced? Who will receive the goods and services produced?

6 6 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Table 12.1 The Four Market Structures Market Structure Characteristic Perfect Competition Monopolistic CompetitionOligopolyMonopoly Number of firmsMany FewOne Type of productIdenticalDifferentiatedIdentical or differentiated Unique Ease of entryHigh LowEntry blocked Examples of industries Growing wheat Growing apples Clothing stores Restaurants Manufacturing computers Manufacturing automobiles First-class mail delivery Tap water Most industries, though, are not perfectly competitive. In particular, any industry has three key characteristics, which economists use to classify into four market structures: 1. The number of firms in the industry 2. The similarity of the good or service produced by the firms in the industry 3. The ease with which new firms can enter the industry

7 7 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explain what a perfectly competitive market is and why a perfect competitor faces a horizontal demand curve. 12.1 LEARNING OBJECTIVE Perfectly Competitive Markets

8 8 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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 If any one wheat farmer has the best crop the farmer has ever had, or if any one wheat farmer stops growing wheat altogether, the market price of wheat will not be affected because the market supply curve for wheat will not shift by enough to change the equilibrium price by even 1 cent.

9 9 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 12.1 A Perfectly Competitive Firm Faces a Horizontal Demand Curve The Demand Curve for the Output of a Perfectly Competitive Firm A firm in a perfectly competitive market is selling exactly the same product as many other firms. Therefore, it can sell as much as it wants at the current market price, but it cannot sell anything at all if it raises the price by even 1 cent. As a result, the demand curve for a perfectly competitive firm’s output is a horizontal line. In the figure, whether a wheat farmer such as Bill Parker sells 6,000 bushels per year or 15,000 bushels has no effect on the market price of $4.

10 10 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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 The market demand curve for wheat has the normal downward-sloping shape, but the demand curve for the output of a single wheat farmer and any firm in a perfectly competitive market is a horizontal line. Your Turn: Test your understanding by doing related problem 1.6 at the end of this chapter. MyEconLab Farmer Parker is a price taker because he is selling wheat in a perfectly competitive market. With a horizontal demand curve for his wheat, he must accept the market price.

11 11 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 12.2 The Market Demand for Wheat versus the Demand for One Farmer’s Wheat In a perfectly competitive market, price is determined by the intersection of market demand and market supply. In panel (a), the demand and supply curves for wheat intersect at a price of $4 per bushel. An individual wheat farmer like Farmer Parker cannot affect the market price for wheat. Therefore, as panel (b) shows, the demand curve for Farmer Parker’s wheat is a horizontal line. To understand this figure, it is important to notice that the scales on the horizontal axes in the two panels are very different. In panel (a), the equilibrium quantity of wheat is 2.25 billion bushels, and in panel (b), Farmer Parker is producing only 15,000 bushels of wheat.

12 12 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explain how a firm maximizes profit in a perfectly competitive market. 12.2 LEARNING OBJECTIVE How a Firm Maximizes Profit in a Perfectly Competitive Market

13 13 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Profit Total revenue minus total cost. 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) The change in total revenue from selling one more unit of a product. For any level of output, a firm’s average revenue is always equal to the market price. This equality holds because total revenue equals price times quantity: (TR = P × Q) and average revenue equals total revenue divided by quantity: (AR = TR/Q) So, AR = TR/Q = (P × Q)/Q = P

14 14 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Number of Bushels (Q) Market Price (per bushel) (P) Total Revenue (TR) Average Revenue (AR) Marginal Revenue (MR) 0 1 2 3 4 5 6 7 8 9 10 $4 4 $0 4 8 12 16 20 24 28 32 36 40 — $4 4 — $4 4 Table 12.2 Farmer Parker’s Revenue from Wheat Farming For a firm in a perfectly competitive market, price is equal to both average revenue and marginal revenue.

15 15 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Quantity (bushels) (Q) Total Revenue (TR) Total Cost (TC) Profit (TR−TC) Marginal Revenue (MR) Marginal Cost (MC) 0 1 2 3 4 5 6 7 8 9 10 $0.00 4.00 8.00 12.00 16.00 20.00 24.00 28.00 32.00 36.00 40.00 $2.00 5.00 7.00 8.50 10.50 13.00 16.50 21.50 28.50 38.00 50.50 −$2.00 −1.00 1.00 3.50 5.50 7.00 7.50 6.50 3.50 −2.00 −10.50 — $4.00 4.00 — $3.00 2.00 1.50 2.00 2.50 3.50 5.00 7.00 9.50 12.50 Determining the Profit-Maximizing Level of Output Table 12.3 Farmer Parker’s Profits from Wheat Farming

16 16 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 12.3a The Profit-Maximizing Level of Output Farmer Parker maximizes his profit where the vertical distance between total revenue and total cost is the largest. This happens at an output of 6 bushels. This is one way of thinking about how Farmer Parker can determine the profit-maximizing quantity of wheat to produce.

17 17 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Notice that Farmer Parker’s marginal revenue (MR) is equal to a constant $4 per bushel. Farmer Parker maximizes profits by producing wheat up to the point where the marginal revenue of the last bushel produced is equal to its marginal cost, or MR = MC. In this case, at no level of output does marginal revenue exactly equal marginal cost. The closest Farmer Parker can come is to produce 6 bushels of wheat. He will not want to continue to produce once marginal cost is greater than marginal revenue because that would reduce his profits. This is another way of thinking about how Farmer Parker can determine the profit-maximizing quantity of wheat to produce. The marginal revenue curve for a perfectly competitive firm is the same as its demand curve. Figure 12.3b The Profit-Maximizing Level of Output

18 18 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall From the information in Table 12.3 and Figure 12.3, we can draw the following conclusions: 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. Both of these conclusions are true for any firm, whether or not it is in a perfectly competitive industry. We can draw one other conclusion about profit maximization that is true only of firms in perfectly competitive industries: For a firm in a perfectly competitive industry, price is equal to marginal revenue, or P = MR. So, we can restate the MR = MC condition as P = MC.

19 19 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Use graphs to show a firm’s profit or loss. 12.3 LEARNING OBJECTIVE Illustrating Profit or Loss on the Cost Curve Graph

20 20 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall We can express profit in terms of average total cost (ATC). Because profit is equal to total revenue minus total cost (TC) and total revenue is price times quantity, we can write the following: If we divide both sides of this equation by Q, we have or because TC/Q equals ATC. This equation tells us that profit per unit (or average profit) equals price minus average total cost. Finally, we obtain the equation for the relationship between total profit and average total cost by multiplying again by Q: This equation tells us that a firm’s total profit is equal to the quantity produced multiplied by the difference between price and average total cost.

21 21 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Showing a Profit on the Graph Figure 12.4 The Area of Maximum Profit A firm maximizes profit at the level of output at which marginal revenue equals marginal cost. The difference between price and average total cost equals profit per unit of output. Total profit equals profit per unit multiplied by the number of units produced. Total profit is represented by the area of the green- shaded rectangle, which has a height equal to (P − ATC) and a width equal to Q.

22 22 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Output per Day Total Cost 0$10.00 120.50 224.50 328.50 434.00 543.00 655.50 772.00 893.00 9119.00 Determining Profit-Maximizing Price and Quantity Solved Problem 12.3 Suppose that Andy sells basketballs in the perfectly competitive basketball market. The table shows his output per day and his costs: a.Suppose the current equilibrium price in the basketball market is $12.50. To maximize profit, how many basketballs will Andy produce? What price will he charge? And how much profit (or loss) will he make? Draw a graph to illustrate your answer. Label clearly Andy’s demand, ATC, AVC, MC, and MR curves; the price he is charging; the quantity he is producing; and the area representing his profit (or loss). b.Suppose the equilibrium price of basketballs falls to $6.00. Now how many basketballs will Andy produce? What price will he charge? And how much profit (or loss) will he make? Draw a graph to illustrate this situation, using the instructions in part (a). Solving the Problem Step 1: Review the chapter material.

23 23 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Determining Profit-Maximizing Price and Quantity Solved Problem 12.3 Step 2: Calculate Andy’s marginal cost, average total cost, and average variable cost. Andy will produce the level of output where marginal revenue is equal to marginal cost. We can calculate costs from the information given in the table to draw the required graph. Average total cost (ATC) equals total cost (TC) divided by the level of output (Q). Average variable cost (AVC) equals variable cost (VC) divided by output (Q). To calculate variable cost, recall that total cost equals variable cost plus fixed cost. When output equals zero, total cost equals fixed cost. In this case, fixed cost equals $10.00. Output per Day (Q) Total Cost (TC) Fixed Cost (FC) Variable Cost (VC) Average Total Cost (ATC) Average Variable Cost (AVC) Marginal Cost (MC) 0$10.00 $0.00——— 120.5010.0010.50$20.50$10.50 224.5010.0014.5012.257.254.00 328.0010.0018.009.336.003.50 434.0010.0024.008.506.00 543.0010.0033.008.606.609.00 655.5010.0045.509.257.5812.50 772.0010.0062.0010.298.8616.50 893.0010.0083.0011.6310.3821.00 9119.0010.00109.0013.2212.1126.00

24 24 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Step 3: Use the information from the table in Step 2 to calculate how many basketballs Andy will produce, what price he will charge, and how much profit he will earn if the market price of basketballs is $12.50. Andy’s marginal revenue is equal to the market price of $12.50. Marginal revenue equals marginal cost when Andy produces 6 basketballs per day. So, Andy will produce 6 basketballs per day and charge a price of $12.50 per basketball. Andy’s profits are equal to his total revenue minus his total costs. His total revenue equals the 6 basketballs he sells multiplied by the $12.50 price, or $75.00. So, his profit equals: $75.00 − $55.50 = $19.50. Step 4: Use the information from the table in Step 2 to illustrate your answer to part (a) with a graph. Determining Profit-Maximizing Price and Quantity Solved Problem 12.3

25 25 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Step 5: Calculate how many basketballs Andy will produce, what price he will charge, and how much profit he will earn when the market price of basketballs is $6.00. Referring to the table in Step 2, we can see that marginal revenue equals marginal cost when Andy produces 4 basketballs per day. He charges the market price of $6.00 per basketball. His total revenue is only $24.00, while his total costs are $34.00, so he will have a loss of $10.00. Step 6: Illustrate your answer to part (b) with a graph. Determining Profit-Maximizing Price and Quantity Solved Problem 12.3 Your Turn: For more practice, do related problems 3.3 and 3.4 at the end of this chapter. MyEconLab

26 26 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Don’t Let This Happen to You Remember That Firms Maximize Their Total Profit, Not Their Profit per Unit Your Turn: Test your understanding by doing related problem 3.5 at the end of this chapter. MyEconLab Only when the firm has expanded production to Q 2 will it have produced every unit for which marginal revenue is greater than marginal cost. At that point, it will have maximized profit.

27 27 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Whether a firm actually makes a profit at the level of output where marginal revenue equals marginal cost depends on the relationship of price to average total cost. There are three possibilities: 1. 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 a loss Illustrating When a Firm Is Breaking Even or Operating at a Loss

28 28 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 12.5 A Firm Breaking Even and a Firm Experiencing Losses In panel (b), price is below average total cost, and the firm experiences a loss. The loss is represented by the area of the red-shaded rectangle, which has a height equal to (ATC − P) and a width equal to Q. In panel (a), price equals average total cost, and the firm breaks even because its total revenue will be equal to its total cost. In this situation, the firm makes zero economic profit. Maximizing profit in some cases amounts to minimizing loss.

29 29 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Losing Money in the Medical Screening Industry Making the Connection The owner of California HeartScan would have broken even if the market price had been $495 per heart scan, but he suffered losses because the actual market price was only $250. Your Turn: Test your understanding by doing related problem 3.7 at the end of this chapter. MyEconLab

30 30 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explain why firms may shut down temporarily. 12.4 LEARNING OBJECTIVE Deciding Whether to Produce or to Shut Down in the Short Run

31 31 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Sunk cost A cost that has already been paid and cannot be recovered. In the short run, a firm experiencing a loss has two choices: 1. Continue to produce 2. Stop production by shutting down temporarily If a farmer has taken out a loan to buy land, the farmer is legally required to make the monthly loan payment whether he or she grows any wheat that season or not. The farmer has to spend those funds and cannot get them back, so the farmer should treat his or her sunk costs as irrelevant to his or her decision making. For any firm, whether total revenue is greater or less than variable costs is the key to deciding whether to shut down.

32 32 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall When to Pull the Plug on a Movie Solved Problem 12.4 When Walt Disney released the film Mars Needs Moms directed by Robert Zemeckis in March 2011, it did very poorly at the box office, earning less than a quarter of its cost to make. A year before its release, Disney executives were disappointed in its direction and immediately stopped production on the director’s next film. They did not, however, stop production on Mars Needs Moms, on which the company had already spent $100 million with $75 million more needed to reach completion. In March 2010, at the time the executives became concerned about the quality of the film, how should Disney have decided whether to finish Mars Needs Moms and release it? What role should the $100 million Disney executives had already spent on the film have played in their decision? Solving the Problem Step 1: Review the chapter material. Step 2: Use your knowledge of the role of sunk costs in decisions about whether to shut down to answer the question. The $100 million was a sunk cost, irrelevant to Disney’s decision: Whether Disney shut down the film or finished it and released it to theaters, the company would not be able to get that $100 million back. Disney should have completed the film if marginal revenue was expected to be greater than marginal cost, and it should have shut down the film if marginal cost were expected to be greater than marginal revenue. Your Turn: Test your understanding by doing related problems 4.8 and 4.9 at the end of this chapter. MyEconLab

33 33 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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 or, in symbols: If we divide both sides by Q, we have the result that the firm will shut down if: If a firm is experiencing a loss, it will shut down if its total revenue is less than its variable cost: The firm’s marginal cost curve is its supply curve only for prices at or above average variable cost. A perfectly competitive firm’s marginal cost curve also is its supply curve.

34 34 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 12.6 The Firm’s Short-Run Supply Curve The firm will produce at the level of output at which MR = MC. Because price equals marginal revenue for a firm in a perfectly competitive market, the firm will produce where P = MC. For any given price, we can determine the quantity of output the firm will supply from the marginal cost curve. In other words, the marginal cost curve is the firm’s supply curve. The firm will shut down if the price falls below average variable cost. The marginal cost curve crosses the average variable cost at the firm’s shutdown point. This point occurs at output level Q SD. For prices below P MIN, the supply curve is a vertical line along the price axis, which shows that the firm will supply zero output at those prices. The red line in the figure is the firm’s short-run supply curve.

35 35 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall The Market Supply Curve in a Perfectly Competitive Industry We can derive the market supply curve by adding up the quantity that each firm in the market is willing to supply at each price. In panel (a), one wheat farmer is willing to supply 15,000 bushels of wheat at a price of $4 per bushel. Figure 12.7 Firm Supply and Market Supply

36 36 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 12.7 Firm Supply and Market Supply The Market Supply Curve in a Perfectly Competitive Industry If every wheat farmer supplies the same amount of wheat at this price and if there are 150,000 wheat farmers, the total amount of wheat supplied at a price of $4 will equal 15,000 bushels per farmer × 150,000 farmers = 2.25 billion bushels of wheat. This is one point on the market supply curve for wheat shown in panel (b). We can find the other points on the market supply curve by determining how much wheat each farmer is willing to supply at each price. (Continued)

37 37 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explain how entry and exit ensure that perfectly competitive firms earn zero economic profit in the long run. 12.5 LEARNING OBJECTIVE “If Everyone Can Do It, You Can’t Make Money at It”: The Entry and Exit of Firms in the Long Run

38 38 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explicit Costs Water Wages Fertilizer Electricity Payment on bank loan $10,000 $15,000 $10,000 $5,000 $45,000 Implicit Costs Forgone salary Opportunity cost of the $100,000 she has invested in her farm $30,000 $10,000 Total cost$125,000 Economic Profit and the Entry or Exit Decision Table 12. 4 Farmer Gillette’s Costs per Year Economic profit A firm’s revenues minus all its costs, implicit and explicit.

39 39 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 12.8 The Effect of Entry on Economic Profits Economic Profit Leads to Entry of New Firms We assume that Farmer Gillette’s costs are the same as the costs of other carrot farmers. Initially, she and other farmers selling carrots in farmers’ markets are able to charge $15 per box and earn an economic profit. Farmer Gillette’s economic profit is represented by the area of the green box. Panel (a) shows that as other farmers begin to sell carrots in farmers’ markets, the market supply curve shifts to the right, from S 1 to S 2, and the market price drops to $10 per box.

40 40 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 12.8 The Effect of Entry on Economic Profits Economic Profit Leads to Entry of New Firms Panel (b) shows that the falling price causes Farmer Gillette’s demand curve to shift down from D 1 to D 2, and she reduces her output from 10,000 boxes to 8,000. At the new market price of $10 per box, carrot growers are just breaking even: Their total revenue is equal to their total cost, and their economic profit is zero. Notice the difference in scale between the graph in panel (a) and the graph in panel (b). (Continued)

41 41 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Figure 12.9a-b The Effect of Exit on Economic Losses Economic Losses Lead to Exit of Firms When the price of carrots is $10 per box, Farmer Gillette and other farmers are breaking even. A total quantity of 310,000 boxes is sold in the market. Farmer Gillette sells 8,000 boxes. Panel (a) shows a decline in the demand for carrots sold in farmers’ markets from D 1 to D 2 that reduces the market price to $7 per box. Panel (b) shows that the falling price causes Farmer Gillette’s demand curve to shift down from D 1 to D 2 and her output to fall from 8,000 to 5,000 boxes. At a market price of $7 per box, farmers have economic losses, represented by the area of the red box. As a result, some farmers will exit the market, which shifts the market supply curve to the left.

42 42 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Panel (c) shows that exit continues until the supply curve has shifted from S 1 to S 2 and the market price has risen from $7 back to $10. Panel (d) shows that with the price back at $10, Farmer Gillette will break even. In the new market equilibrium in panel (c), total sales of carrots in farmers’ markets have fallen from 310,000 to 270,000 boxes. Economic loss The situation in which a firm’s total revenue is less than its total cost, including all implicit costs. Figure 12.9c-d The Effect of Exit on Economic Losses

43 43 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall 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. The long-run average cost curve shows the lowest cost at which a firm is able to produce a given quantity of output in the long run. So, we would expect that in the long run, competition drives the market price to the minimum point on the typical firm’s long-run average cost curve.

44 44 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall FIGURE 12.10 The Long-Run Supply Curve in a Perfectly Competitive Industry Panel (a) shows that an increase in demand for carrots sold in farmers’ markets will lead to a temporary increase in price from $10 to $15 per box, as the market demand curve shifts to the right, from D 1 to D 2. The entry of new firms shifts the market supply curve to the right, from S 1 to S 2, which will cause the price to fall back to its long-run level of $10. Panel (b) shows that a decrease in demand will lead to a temporary decrease in price from $10 to $7 per box, as the market demand curve shifts to the left, from D 1 to D 2. The exit of firms shifts the market supply curve to the left, from S 1 to S 2, which causes the price to rise back to its long-run level of $10. The long-run supply curve (S LR ) shows the relationship between market price and the quantity supplied in the long run. In this case, the long-run supply curve is a horizontal line.

45 45 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Long-run supply curve A curve that shows the relationship in the long run between market price and the quantity supplied. In the long run, a perfectly competitive market will supply whatever amount of a good consumers demand at a price determined by the minimum point on the typical firm’s average total cost curve. Increasing-Cost and Decreasing-Cost Industries Industries with horizontal long-run supply curves are called constant-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.

46 46 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Economic profits are rapidly competed away in the iPhone apps store. In the Apple iPhone Apps Store, Easy Entry Makes the Long Run Pretty Short Making the Connection When firms earn economic profits in a market, other firms have a strong economic incentive to enter that market. This is exactly what happened with iPhone apps, first provided for Apple in mid-2008. Proving to be highly profitable in an instant, more than 25,000 apps were available in the iTunes store within a year. The cost of entering this market was very small. Anyone with the programming skills and the time to write an app could have it posted in the store. As a result of this enhanced competition, the ability to get rich quick with a killer app was quickly fading. In a competitive market, earning an economic profit in the long run is extremely difficult, as those so easily entering the market for iPhone apps soon learned. Your Turn: Test your understanding by doing related problem 5.9 at the end of this chapter. MyEconLab

47 47 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Explain how perfect competition leads to economic efficiency. 12.6 LEARNING OBJECTIVE Perfect Competition and Efficiency

48 48 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Productive efficiency The situation in which a good or service is produced at the lowest possible cost. Productive Efficiency The forces of competition will drive the market price to the minimum average cost of the typical firm. As we have seen, perfect competition results in productive efficiency. Managers of firms strive to earn an economic profit by reducing costs, but in a perfectly competitive market, other firms quickly copy ways of reducing costs. Therefore, in the long run, only the consumer benefits from cost reductions.

49 49 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall How Productive Efficiency Benefits Consumers Solved Problem 12.6 Writing in the New York Times on the technology boom of the late 1990s, Michael Lewis argued, “The sad truth, for investors, seems to be that most of the benefits of new technologies are passed right through to consumers free of charge.” a.What do you think Lewis means by the benefits of new technology being “passed right through to consumers free of charge”? Use a graph like Figure 12.8 to illustrate your answer. Solving the Problem Step 1: Review the chapter material. Step 2: Use the concepts from this chapter to explain what Lewis means. By “new technologies,” Lewis means new products—such as smart phones or LED television sets—or lower-cost ways of producing existing products. In either case, new technologies will allow firms to earn economic profits for a while, but these profits will lead new firms to enter the market in the long run. Step 3: Use a graph like Figure 12.8 to illustrate why the benefits of new technologies are “passed right through to consumers free of charge.”

50 50 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall How Productive Efficiency Benefits Consumers Solved Problem 12.6 LED televisions are being produced at the lowest possible cost, and productive efficiency is achieved. Consumers receive the new technology “free of charge” in the sense that they only have to pay a price equal to the lowest possible cost of production. Writing in the New York Times on the technology boom of the late 1990s, Michael Lewis argued, “The sad truth, for investors, seems to be that most of the benefits of new technologies are passed right through to consumers free of charge.”

51 51 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Step 4: Answer part (b) by explaining why the result in part (a) is a “sad truth” for investors. In the long run, firms only break even on their investment in producing high-technology goods, implying that investors in these firms are also unlikely to earn an economic profit in the long run. The entry of new firms competes away economic profit in the long run, but it benefits consumers by forcing prices down to the level of average cost. How Productive Efficiency Benefits Consumers Solved Problem 12.6 Your Turn: For more practice, do related problems 6.5, 6.6, and 6.7 at the end of this chapter. MyEconLab Writing in the New York Times on the technology boom of the late 1990s, Michael Lewis argued, “The sad truth, for investors, seems to be that most of the benefits of new technologies are passed right through to consumers free of charge.” b. Explain why this result is a “sad truth” for investors.

52 52 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Allocative Efficiency We know firms will supply all those goods that provide consumers with a marginal benefit at least as great as the marginal cost of producing them because: 1. 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 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.

53 53 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall Are You an Entrepreneur? At the beginning of the chapter, we asked you to think about why you can charge only a relatively low price for performing services such as babysitting or lawn mowing. We saw that firms selling products in competitive markets can’t charge prices higher than those being charged by competing firms, and the markets for babysitting and lawn mowing are very competitive. In most neighborhoods, there are many teenagers willing to supply these services. The price you can charge for babysitting may not be worth your while at age 20 but is enough to cover the opportunity cost of a 14-year-old eager to enter the market. So, in your career as a teenage entrepreneur, you may have become familiar with one of the lessons of this chapter: A firm in a competitive market has no control over price. Economics in Your Life

54 54 of 54 © 2013 Pearson Education, Inc. Publishing as Prentice Hall AN INSIDE LOOK Organic Farming on the Decline in the United Kingdom The market for organically grown corn. Figure 1 An individual farmer suffering an economic loss in the organic corn market. Figure 2


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