12 CHAPTER S LIDES BY S OLINA L INDAHL Perfect Competition and the Supply Curve

SOME GOOD BLOGS AND OTHER SITES TO GET THE JUICES FLOWING: COPYRIGHT 2015 WORTH PUBLISHERS

What you will learn in this chapter  What a perfectly competitive market is and the characteristics of a perfectly competitive industry characteristics of a perfectly competitive industry  How a price-taking producer determines its profit – maximizing quantity of output price-taking producer profit – maximizing quantity of output  How to assess whether or not a producer is profitable and why an unprofitable producer may continue to operate in the short run why  Why industries behave differently in the short run and the long run behave differently in the short run and the long run  What determines the industry supply curve in both the short run and the long run industry supply curve short run and the long run COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents 1. There are many buyers and sellers, each with a small market share. Market share: the fraction of the total industry output accounted for by that producer’s output. This means both sellers and buyers are price- takers ; their actions have no effect on price. Each participant is a drop in the bucket. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Which of the following markets is likely to be the most competitive? a)Cable television b)Automobiles and trucks c)Oil refining d)Farm commodities COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents 2. The product is standardized across sellers. Standardized product (aka “commodity” ): Consumers regard different sellers’ products as equivalent. COPYRIGHT 2015 WORTH PUBLISHERS

IN ACTIONECONOMICS WHAT’S A STANDARDIZED PRODUCT? Are Korean kimchi producers’ claims to be believed? Is Japanese kimchi different (and inferior to the Korean ‘real thing’? As far as economists are concerned, the products are different only if the consumers believe them to be. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents A third likely feature: 3. Free entry and exit Free entry and exit: New producers can easily enter into an industry and existing producers can easily leave that industry. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Since each firm is a price-taker, each firm’s total revenue will be equal to price × quantity sold, or TR = P × Q And Profit = total revenue – total cost, or Profit = TR – TC But there is another way to think about it… COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents (When market price = $18) profit is highest at Q = 50, which is also the point where marginal cost = marginal revenue. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Marginal revenue: change in total revenue generated by an additional unit of output. MR = Δ TR / Δ Q For price-taking firms, MR is simply the good’s market price. Optimal output rule: Profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Why is profit maximized where MR = MC ? Each time the firm produces another unit, there are extra costs and extra revenues. If producing another unit adds more to revenue than cost, profit will increase. Because if MR > MC, producing more will add to profit. And if MR < MC, producing less will add to profit. Since MR = P for competitive firms, the profit- maximizing rule is: Choose the quantity of output where P = MC. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents As long as increasing production by one more unit creates more MR than MC, it makes sense to do it. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Reminder: In the short run, plant size is fixed. We focus here on short-run profit maximization at a given plant size. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents $ Price, cost of tree Quantity of trees MC MR= P E Profit-maximizing quantity Optimal point Market price COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents WHAT IF MARGINAL REVENUE AND MARGINAL COST AREN’T EXACTLY EQUAL? What do you do if there is no output level at which marginal revenue equals marginal cost? In that case, you produce the largest quantity for which marginal revenue exceeds marginal cost. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents *Recall we are using economic profit, which includes implicit costs. It is normal for a firm’s economic profit to be zero. If TR > TC, the firm is profitable. If TR = TC, the firm breaks even. If TR < TC, the firm incurs a loss. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents $ MC ATC MR= P C Break- even price Minimum-cost output Price, cost of tree Quantity of trees Minimum average total cost If the price is just high enough to cover ATC and if it chooses the Q where MR = MC, the firm will break even. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents The farm is profitable because P > min ATC ($14) MC Profit ATC MR= P C Z E Market price = $ $18.00 Price, cost of tree Quantity of trees Minimum average total cost Break- even price Optimal output Per-unit profit = $18 – $14.40 = $3.60 Total profit = $3.60 × 5 = $18.00 The ATC of producing 5 is $14.40 COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Profit = TR − TC = ( TR / Q − TC / Q ) × Q, or Profit = ( P − ATC ) × Q Break-even price of a price-taking firm is the market price at which it earns zero profit. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents If a firm is earning positive economic profit, it must be the case that: a)price is less than average cost. b)price is equal to average cost. c)price is equal to total cost. d)price is greater than average cost. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Ralph opened a small shop selling bags of trail mix. The price of the mix is $5, and the market for trail mix is very competitive. At what quantity will Ralph produce? a)7 b)10 c)14 d)18 COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Ralph opened a small shop selling bags of trail mix. When the price is $5, how much profit will Ralph make? a)$0 b)$14 c)$52 d)$68 COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents The farm’s per unit loss: $10.00 – $14.67 = –$4.67. Total loss: 3 × –$4.67 = approx. (–$14.00) MC Loss ATC MR= P C A Y Market price = $ $14.67 Price, cost of tree Quantity of trees Minimum average total cost Break- even price COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Losses don’t mean immediate shutdown. Remember, fixed costs must be paid whether or not the firm produces in the short run. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Firms will choose to produce (even at a loss) if they can cover their variable AND SOME of their fixed costs. Shortcut: Is the price at or below the shut- down price? Shut-down price: minimum average variable cost. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents A firm should stay open in the short run if it can cover its variable costs. DecisionFixed CostsVariable CostsRevenueProfit Shutdown$ –$100 Stay Open –75 He’ll stay in business… for now. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents If Gnomes-R-Us (a competitive firm) produces where the marginal cost curve intersects with the average total cost curve at its minimum point, the firm will earn: a)positive economic profits. b)zero economic profits. c)a short-run loss. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Should a competitive firm keep producing even if it faces short-run losses (and is producing at a point on its MC curve that is above the minimum AVC curve)? a)Yes, it is earning normal profits. b)Yes, because it covers its variable costs and some fixed costs. c)No, it should never incur losses. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents If the market price is $5, about how much will this firm produce? a)0 b)30 c)60 d)95 e)100 COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents …but will stop producing in the short run if the market price falls below the shut- down price $ MC ATC AVC C B A E Minimum average variable cost Short-run individual supply curve Shut-down price Price, cost of tree Quantity of trees A firm will produce at every price above minimum ATC where price intersects the MC curve… …so the MC curve (above shut-down price) is the firm’s supply curve. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents Summary: In the short run, a firm will produce if P > shutdown price (min AVC ). A firm will NOT produce if P < min AVC. COPYRIGHT 2015 WORTH PUBLISHERS

IN ACTIONECONOMICS FARMERS MOVE UP THEIR SUPPLY CURVES Increased ethanol demand raised the price of corn- so farmers are planting more and more (and buying more fertilizer, which is getting more expensive in return) Although farmers were taking a big gamble by cutting the size of their other crops to plant more corn, their decision made good economic sense. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents If P > break-even (min ATC ), firms are profitable. This profit attracts new entrants. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents The short-run industry supply curve: how the Q supplied by an industry depends on the market price (given a fixed number of producers) $ D Short-run industry supply curve, S E MKT Shut-down price Price, cost of tree Quantity of trees Market price A higher price means more firms are willing to supply. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents COPYRIGHT 2015 WORTH PUBLISHERS A market is in long-run 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 trees $ , $ D E C D Y Z MC ATC A B (a) Market (b) Individual firm E MKT D MKT C MKT S1S1 S3S3 S2S2 Price, cost of tree Quantity of trees Price, cost of tree Break- even price New firms enter as long as there is economic profit ( P > min ATC ).

Back to Table of contents The LRS shows how the quantity supplied responds to the price (once producers have had time to enter or exit the industry) D↑  P↑  profits  entry  S↑  P↓  back to zero profit (on LRS curve). MC ATC X Y 000 $18 14 Quantity MC ATC Z Y Price S1S1 D1D1 D2D2 S2S2 Y MKT X MKT Z MKT LRS QXQX QYQY QZQZ (a) Existing firm’s response to increase in demand (b) Short-run and long-run market response to increase in demand (a) Existing firm’s 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 COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents The long-run industry supply curve is always flatter—more elastic—than the short-run industry supply curve. Short-run industry supply curve, S Long-run industry supply curve, LRS Price Quantity This is because of entry and exit:  A higher price attracts new entrants in the long run, raising industry output and lowering price.  A fall in price induces existing producers to exit in the long run, reducing industry output and raising price. COPYRIGHT 2015 WORTH PUBLISHERS

Back to Table of contents ECONOMIC PROFIT, AGAIN Q: Why would a firm would want to enter an industry if the market price is only slightly greater than the break-even price? A: We are using economic profit as our measure, so if the market price is above the break-even level (no matter how slightly), the firm can earn more in this industry than it could elsewhere.

Back to Table of contents The long-run market equilibrium in a perfectly competitive industry with identical firms results in all firms: a)earning zero economic profit. b)producing the quantity associated with their break-even price. c)producing the profit-maximizing quantity at which MR = MC. d)All of the above statements are true. COPYRIGHT 2015 WORTH PUBLISHERS