Graphing Perfect Competition Micro: Econ: 23 59 Module Graphing Perfect Competition KRUGMAN'S MICROECONOMICS for AP* Margaret Ray and David Anderson

What you will learn in this Module: How to evaluate a perfectly competitive firm’s situation using a graph. How to determine a perfect competitor’s profit or loss. How a firm decides whether to produce or shut down in the short run. The purpose of this module is to show the profit-maximizing output decision in a graph of the perfectly competitive firm. In this graph we can see if economic profits or losses exist in the short run, where firms would break even and where firms would choose to shut down in the short run.

Perfect Competition Graphs How is this perfectly competitive firm doing? Is it earning a profit or a loss? MC The goal for this module is to be able to evaluate and draw graphs of perfect competitive firms and determine/show if they are earning a profit or loss (or a normal profit). ATC P=D

Perfect Competition Graphs Profit maximizing output = 5 Profit per unit is ($8 - $6) = $2 Profit is profit per unit times the number of units. $2 x 5 = $10 MC The firm produces Q=5 because that is the output where P=MR=MC. We can see this in the graph. Per-unit profit is the difference between the price of the product and the cost of producing it (on average).  Π per unit = (P – ATC) = $8 - $6 = $2 Total profit is the profit per unit times the number of units sold:   Π = (P – ATC) x Q = $2 x 5 = $10 If we look at the graph, it’s possible to see profit as a rectangle. The area of a rectangle is length*width. The length of the rectangle in the graph below is Q=5 and the width is equal to ($8 - $6) = $2. So the area of the “profit rectangle” is ($2)*(5) = $10. If we look at the graph from the previous module, it’s possible to see profit in the graph as a rectangle. The area of a rectangle is length x width. ATC P=D

Perfect Competition Graphs A firm earning a profit. MC ATC P=D

Perfect Competition Graphs A firm experiencing a loss. ATC P Q* MC P=MR=d=AR $ Output Loss This graph shows how to draw a negative economic profit (or loss). The firm still produces Q* where P=MR=MC. The only thing that differs in this graph is that the price has fallen below the ATC curve. Instead of a “profit rectangle”, it could be described as a “loss rectangle”.

Perfect Competition Graphs A firm earning a normal profit. ATC P=ATC Q* MC P=MR=d=AR $ Output This graph shows the situation where economic profit is equal to zero. We have described this before as a normal profit. This “break-even” outcome occurs when the profit-maximizing output Q* is at the point where P=MR=MC=ATC. This can only happen at the minimum of the ATC curve. When P=ATC, the rectangle of profit or loss does not exist.   Note: this price is called the “break-even” price and the minimum of the ATC curve is called the “break-even point”.

The Short-run Production Decision When a firm is earning negative profits (a loss), will it continue to produce in the short run? Compare the losses from producing at P = MC with the losses from shutting down (producing 0) The shut-down rule Shut down iff; TR < TVC P < AVC If the price of the product is so low and losses are being incurred, why would a firm continue to produce where P=MR=MC?    Intuitive approach:   Consider what happens when the firm produces the profit-maximizing quantity. Two things happen when you produce; one good, one bad. 1. Good: Total Revenue is earned 2. Bad: cost is incurred. Specifically, Total Variable Cost is incurred. So the firm must weigh the revenue dollars coming in, against the cost dollars going out. If TR>=TVC, the firm should continue to produce. On a per-unit basis, this is P>=AVC. By producing the firm is minimizing losses because it is earning enough to cover all of the TVC and part of the TFC. How low must the price fall before shutting down becomes the right thing to do? Look at the shut-down decision again on a per-unit basis. If P<AVC, shut down.

Perfect Competition Graphs The shut-down price ATC P=ATC Q* MC P=MR=d=AR $ Output If the price falls below the minimum of the AVC curve, the firm should shut down. Where P=AVC is known as the shut-down price.   At any price above Point A in the graph above, the firm will produce where P=MC. At any price below Point A, the firm will supply nothing. If price increases, output will increase along the MC curve. If the price decreases, but still lies above Point A, output will decrease along the MC curve. In other words, above Point A the MC curve serves as the supply curve for the perfectly competitive firm. AVC A Shut-down Price

The Long Run When a firm is earning negative profits (a loss), in the long run, it will exit the industry. The firm cannot change fixed costs in the short run. However, if the market price is consistently below the break-even price for a significant amount of time, eventually the firm will decide to exit the industry. Exit is different from shutting-down in the short run. Exit means that all fixed inputs have been sold off in the long run. The firm no longer exists.   On the other hand, if the price was consistently above the break-even price for a while, eventually new firms would want to enter the market. In the long run, new firms would be able to acquire the necessary capital inputs and join the existing firms. Remember that under the assumptions of perfect competition, there is nothing to prevent the long-run entry or exit of firms.