Perfect Competition (3/23) Commodity: organic tomatoes 1. How many organic tomato farmers are there? 2. If one farmer increases or decreases output, is it really going to make a difference on price? 3. Are there any real differences between tomatoes from different farmers? 4. Does any one organic tomato farmer have a majority of the market share?

Perfect Competition The ONLY market structure where market supply and demand actually applies! Necessary characteristics: 1. Many buyers and sellers 2. Individuals (buyers and sellers) have no power to affect market price of product – PRICE TAKERS 3. Have identical products (tomatoes, wheat, etc) 4. Not one producer has a large market share 5. Free entry into/exit from market

Partner discussion: Are the following examples of perfectly competitive markets? 1.There are 2 producers of aluminum in the world, a good sold in many places. 2.The price of natural gas is determined by global supply and demand. A small share of that global supply is produced by a handful of companies located in the North Sea. 3.Dozens of designers sell high-fashion clothes. Each designer has a distinctive style and a loyal clientele. 4.There are many baseball teams in the US, one or two in each major city, and each selling tickets to its home- town events. No Yes No

Production and Profits 4 TR = price x quantity (TP)

When Is Production Profitable? If TR > TC, the firm is profitable. If TR = TC, the firm breaks even. If TR < TC, the firm incurs a loss.

Marginal revenue = price. Think about it! Profit-maximizing quantity of output: where MC = MR (the extra cost of producing one more is the same as the extra revenue generated by producing one more)

Last week’s practice (Marty and Magnificent Blooms): Add three more columns to the frozen yogurt and flower shop charts: “marginal revenue”, “total revenue”, and profit. The price of each cup of frozen yogurt is $3. The price of each flower arrangement is $20. Fill in those new columns, and determine the profit maximizing quantity of output for each business.

The new “happy spot”: Profit-maximizing (or loss- minimizing) quantity of output = MC = MR

Short-Run Costs for Jennifer and Jason’s Farm

When is production profitable? Depends on economic profit: a measure based on the opportunity cost of resources used in the business -- TR minus explicit and implicit costs Vs. Accounting profit = TR-TC We will assume that our cost totals include explicit and implicit costs, and profit totals are economic profit

The Price-Taking Firm’s Profit-Maximizing Quantity of Output The profit- maximizing point is where MC crosses MR curve (horizontal line at the market price): at an output of 5 bushels of tomatoes (the output quantity at point E) $ Price, cost of bushel Quantity of tomatoes (bushels) MC MR= P E Profit-maximizing quantity Optimal point Market price

The Break-Even Price $ MC ATC MR= P C Break even price Minimum-cost output Price, cost of bushel Quantity of tomatoes (bushels) Minimum average total cost At point C (the minimum average total cost), the market price is $14 and output is 4 bushels of tomatoes (the minimum-cost output). This is where MC cuts the ATC curve at its minimum. Minimum average total cost is equal to the firm’s break-even price.

Profitability and the Market Price The farm is profitable because price exceeds minimum average total cost, the break-even price, $14. The farm’s optimal output choice is (E)  output of 5 bushels. The average total cost of producing bushels is (Z on the ATC curve)  $14.40 The vertical distance between E and Z: farm’s per unit profit, $18.00 − $14.40 = $3.60 Total profit:5 × $3.60 = $ MC Profit ATC MR= P C Z E Market Price = $ $18 Price, cost of bushel Quantity of tomatoes (bushels) Minimum average total cost Break even price

Profitability and the Market Price The farm is unprofitable because the price falls below the minimum average total cost, $14. The farm’s optimal output choice is (A)  output of 3 bushels. The average total cost of producing bushels is (Y on the ATC curve)  $14.67 The vertical distance between A and Y: farm’s per unit loss, $14.67 − $10.00 = $4.67 Total profit:3 × $4.67 = approx. $ MC Loss ATC MR= P C A Y Market Price = $ $14.67 Price, cost of bushel Quantity of tomatoes (bushels) Minimum average total cost Break even price

Price = $18: Firm produces 5 units, is profiting Price = $14: Firm produces 4, is breaking even Price = $12: Firm produces 3.5, is incurring a loss, will stay in business in short run, exits industry in long run Price = $10 or less: Firm exits industry immediately $ MC ATC AVC C B A E Minimum average variable cost Short-run individual supply curve Price, cost of bushel Quantity of tomatoes (bushels)

Profit, Break-Even, Loss, Shut Down Decision Whenever P > ATC, the producer is profitable. Whenever P = ATC, the producer breaks even. Whenever AVC < P < ATC, the producer is unprofitable – should stay in business in the short run. Whenever P < AVC, the producer should shut down immediately.

Discuss: If a firm is unprofitable (if price is less than the minimum average total cost), in the short run, should that firm still stay in business? Why or why not?

The answer: sometimes it SHOULD still produce! The reason: FIXED COSTS still need to be paid for Ex: you rented a tractor for a year, your lease is a year long, etc Pay attention to VARIABLE COSTS: wages of workers can be saved by not producing If price falls below average variable cost, what happens?

Examples: Our business has a fixed cost of $20,000 per year. We incur an economic loss of $10,000 per year. In the short run: If we stay in business, we owe $10,000. If we close down, we owe $20,000. What should we do?

Our business has a fixed cost of $8000 per year. We incur an economic loss of $10,000 per year. In the short run: If we stay in business, we lose $10,000. If we close, we owe $8000. What should we do?

Kate’s Katering: Assume the catered meals industry is perfectly competitive. Her fixed cost is $100/day. Quantity of Meals VCFCTCAVCATCMC 0$ ,000

Quantity of Meals VCFCTCAVCATCMC 0$0$ ,

1.What is the break-even price? 2.What is the shut-down price? 3.Suppose that the price at which Kate can sell meals is $21 per meal. How many meals will she produce? In the short run, will Kate earn a profit? In the short run, should she produce or shut down? 4.Suppose that the price falls to $17 per meal. How many meals will she produce? In the short run, will Kate earn a profit? Should she produce or shut down? 5.Suppose the price falls to $13. In the short run, will Kate earn a profit? Should she produce or shut down?

1.What is the break-even price? $19.33 (min ATC) 2.What is the shut-down price? $15 (min AVC) 3.Suppose that the price at which Kate can sell meals is $21 per meal. In the short run, will Kate earn a profit? In the short run, should she produce or shut down? Will profit and produce 4.Suppose that the price falls to $17 per meal. In the short run, will Kate earn a profit? Should she produce or shut down? Will not profit, still produce 5.Suppose the price falls to $13. In the short run, will Kate earn a profit? Should she produce or shut down? Not profit, shut down now

The Short-Run Individual Supply Curve The short-run individual supply curve shows how an individual producer’s optimal output quantity depends on the market price, taking fixed cost as given. A firm will cease production in the short run if the market price falls below the shut-down price, which is equal to minimum average variable cost $ MC ATC AVC C B A E Minimum average variable cost Short-run individual supply curve Shut-down price Price, cost of bushel Quantity of tomatoes (bushels)

The Short-Run Individual Supply Curve $ MC ATC AVC C B A E Price, cost of bushel Quantity of tomatoes (bushels) How many bushels will be supplied at a price of $10? $14? $18? If there are 100 similar firms in the tomato industry, what will be MARKET supply at those prices? In your notebook, draw a market supply and demand graph with equilibrium price at $14. Leave room to the right of graph.

The side-by-side graphs If firm is breaking even (normal profits) – LONG RUN EQUILIBRIUM If firm is profiting or incurring a loss – SHORT RUN Ease of entry into/exit out of market:

1.Draw a market supply and demand graph for wheat at an equilibrium price of $20 and quantity at 1000 bushels. (Note: there are 100 individual identical firms in the industry.) 2.Draw a diagram for the perfectly competitive wheat farmer in LONG RUN EQUILIBRIUM. 3.Scenario: Increased wheat consumption has been proven to prevent heart disease. What will be affected initially: the market, or the firm? In what way? Illustrate this on the appropriate graph. 4.Are we still at long run equilibrium? 5.What will now happen to the firm? 6.Now what will happen to the market? 7.What is the final result?

Assume that the egg industry is perfectly competitive and is in long-run equilibrium. Draw a diagram that includes the side-by-side graphs for the individual egg firm and the egg market. The media has just released a study that shows a correlation between high cholesterol and egg consumption. Show the short-run behavior of the industry because of this, and explain how long-run equilibrium is reestablished.

TPFCVCTCMCAFCAVCATC

Industry Supply Curve The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers. short-run market equilibrium: quantity supplied equals the quantity demanded

2. The state of Maine has a very active lobster industry, which harvests lobsters during the summer months. During the rest of the year, lobsters can be obtained from other parts of the world but at a much higher price. Maine is also full of “lobster shacks”, roadside restaurants serving lobster that are open only during the summer. Explain why it is optimal for lobster shacks to operate only during the summer.

The Long-Run Industry Supply Curve A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur.

The Short-Run Market Equilibrium The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers. There is a short-run market equilibrium when the quantity supplied equals the quantity demanded, taking the number of producers as given $ D Short-run industry supply curve, S E MKT Shut-down price Price, cost of bushel Quantity of tomatoes (bushels) Market price

The Long-Run Market Equilibrium A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur. Quantity of tomatoes (bushels) $ , $ D E C D Y Z MC ATC A B (a) Market(b) Individual Firm E D C MKT S 1 S 3 S 2 Price, cost of bushel Quantity of tomatoes (bushels) Price, cost of bushel Break- even price MKT

The Effect of an Increase in Demand in the Short Run and the Long Run The LRS shows how the quantity supplied responds to the price once producers have had time to enter or exit the industry. D↑  P↑  non-zero profits  entry  S↑  P↓  back to zero profit (on LRS curve) MC ATC X Y 000 $18 14 Quantity MC ATC Z Y Price S 1 D 1 D 2 S 2 Y MKT X Z LRS Q X Q Y Q Z (a) Existing Firm Response to Increase in Demand (b) Short-Run and Long-Run Market Response to Increase in Demand (a) Existing Firm Response to New Entrants Price, cost Increase in output from new entrants An increase in demand raises price and profit. Long-run industry supply curve, Higher industry output from new entrants drive price and profit back down. Quantity

1. If the perfectly competitive price is currently below minimum average total cost, we can expect which of the following events in the long run? (A) The price will rise and each firm's output will fall as firms exit the industry. (B) Market equilibrium quantity will increase as firms exit the industry. (C) Nothing. The industry is currently in long-run equilibrium. (D) Profits will fall as the market price increases. (E) The price will rise to the break even point as firms exit the industry. 2. Which of the following is true in the long run in perfect competition? (A) P = MR = MC = ATC (B) P = MR = MC > ATC (C) P > MR = MC = ATC (D) P = MR > MC = ATC (E) P > MR = MC > ATC 3. Assume that a perfectly competitive industry producing a normal good is in long-run equilibrium. If average consumer income decreases, which of the following changes will occur? Short-Run PriceShort-Run Industry OutputMovement of Firms (A) IncreaseIncreaseEnter market (B) IncreaseDecreaseExit market (C) DecreaseIncreaseExit market (D) DecreaseDecreaseEnter market (E) DecreaseDecreaseExit market