Mod 58: Introduction to Perfect Competition

Key Economic Concepts For This Module: • Perfectly competitive firms are price takers. They cannot affect the price of their product; it is set in the market. • To maximize profit, the firm must produce the quantity of output where marginal revenue is equal to marginal cost, or where MR=MC. • Because the market price is a constant in perfect competition, it is also true that P=MR for the producer. This modifies the optimal output rule such that: P=MR=MC. • Even if the firm has found the output where P=MR=MC, it may not provide positive economic profits. Economic profits and losses are determined by comparing total revenue to total cost. • If total revenue is greater than total cost, economic profit is positive. If total revenue is less than total cost, economic profit is negative. If total revenue is equal to total cost, economic profit is zero (break even). • Likewise, a firm can compare per-unit profit to per-unit cost to determine whether economic profits are positive, negative, or zero. • If price is greater than average total cost, economic profits are positive. If price is less than average total cost, economic profits are negative. If price is equal to average total cost, economic profit is zero. MR=MC 4/4/2019 5:38 AM

Module Organization I. Production and Profits A. When is Production Profitable? 4/4/2019 5:38 AM

I. Production and Profits Produce the quantity where MR=MC and profit will be maximized. 4/4/2019 5:38 AM

I. Production and Profits MR=MC 4/4/2019 5:38 AM

I. Production & Profits MR=MC 4/4/2019 5:38 AM

I. Production & Profits Two Important aspects of P=MR line: • Average revenue (AR) = TR/Q. When the firm is a price taker, AR = PQ/Q = P. • Because the firm cannot raise or lower the price, the horizontal P=MR=AR line also serves as demand curve for the firm. A horizontal demand curve as described in an early module as perfectly elastic—it appears to the firm as perfectly elastic because they are a price taker. 4/4/2019 5:38 AM

A. When is Production Profitable Economic Profit is equal to: Profit = TR – TC Looking at this simple equation we can see that if: • TR > TC, Profit > 0. • TR < TC, Profit < 0. • TR = TC, Profit = 0. Another very useful way to determine if profits are positive or negative is to look at profit on a per-unit, or average basis. 4/4/2019 5:38 AM

A. When is Production Profitable MR=MC--OUTPUT TR > TC, the firm is profitable. TR = TC, the firm breaks even. TR < TC, the firm incurs a loss. MR=MC--Output P > ATC, the firm is profitable. P = ATC, the firm breaks even. P < ATC, the firm incurs a loss. 4/4/2019 5:38 AM

A. When is Production Profitable Duffka’s Economics Consultant Maximizing Profit Duffka’s Economics Consultant produces economics consultation in a perfectly competitive market. The market price of services is $9 each. He employs variable inputs like labor and raw materials to the fixed input of his small office. • Use the optimal output rule to find the level of output that maximizes his economic profit in the short run. • Calculate his economic profit or loss. • Now assume that the market price of his services fell to $6 each. MR ($9) =MC (?)=Profit Max Output (?) $9 6 6 TR= $54 ($9 X6)- TC=$39 =$15 economic profit 5 2 MR ($6)>MC($5)= Output 4 5 7 9 15 19 4/4/2019 5:38 AM

Practice Quiz 1. At what level of output does the firm maximize profit?  4 2. At the profit-maximizing quantity of output, is the firm profitable, does it just break even, or does it earn a loss? Break even-normal profit 3. At what output does diminishing marginal returns begin? Between 1 & 2 Which curve represents the firms short run supply curve? MC 4/4/2019 5:38 AM

Practice Question # 5 5. A perfectly competitive firm will maximize profit at the quantity at which the firm’s marginal revenue equals a. price. b. average revenue. c. total cost. d. marginal cost. e. demand. 4/4/2019 5:38 AM

Practice Question # 6 6. Which of the following is correct for a perfectly competitive firm? I. The marginal revenue curve is the demand curve. II. The firm maximizes profit when price equals marginal cost. III. The market demand curve is horizontal. a. I only b. II only c. III only d. I and II only e. I, II, and III 4/4/2019 5:38 AM

Practice Question #7 7. A firm is profitable if a. TR < TC. b. AR < ATC. c. MC < ATC. d. ATC < P. e. ATC > MC. 4/4/2019 5:38 AM

Practice Question # 8 8. If a firm has a total cost of $200, its profit-maximizing level of output is 10 units, and it is breaking even (that is, earning a normal profit), what is the market price? a. $200 b. $100 c. $20 d. $10 e. $2 4/4/2019 5:38 AM

Practice Question #9 9. What is the firm’s profit if the price of its product is $5 and it produces 500 units of output at a total cost of $1,000? a. $5,000 b. $2,500 c. $1,500 d. −$1,500 e. −$2,500 4/4/2019 5:38 AM

APE U3 L3 A27 Output Total Cost Marginal Cost $55 1 $85 2 $110 3 $130 Figure 27.1: Calculate Figure 27.2: Graph 1. As output increases, MC decreases, reaches a min. and then increases. 2. DMR, as variable inputs are added to fixed inputs, output increases as a fast rate (MP increases), so the MC of that output decrease. But when MP falls , the MC of producing that output will increase. Figure 27.2 Plotting MC of Yo-Yo’s Output Total Cost Marginal Cost $55 1 $85 2 $110 3 $130 4 $160 5 $210 $30 P=Cost MC=S $25 $20 $30 $50 Output increasing 4/4/2019 5:38 AM Output=Q

APE U3 L3 A27 Figure 27.3: Q Fixed Var. Total MC AFC AVC ATC Profit Maximization Rule: MR=MC Profit if P > ATC 2. Loss Minimize if P < ATC and P >AVC 3. If P < AVC SHUT DOWN APE U3 L3 A27 Figure 27.3: Q Fixed Var. Total MC AFC AVC ATC 1 100 10 110 10 100 10 110 2 100 16 116 6 50 8 58 3 100 21 121 5 33.33 7.00 40.33 4 100 26 126 5 25 6.50 31.50 5 100 30 130 4 20 6 26 6 100 36 136 6 16.67 6 22.67 7 100 45.50 145.50 9.50 14.29 6.50 20.79 8 100 56 156 10.50 12.50 7.00 19.50 9 100 72 172 16.00 11.11 8.00 19.11 10 100 90 190 18.00 10.00 9.00 19.00 11 100 109 209 19.00 9.09 9.90 19.00 12 100 130 230 21.00 8.33 10.83 19.16 13 100 160 260 30.00 7.69 12.31 20.00 Minimum AVC Minimum ATC 4/4/2019 5:38 AM

APE U3 L3 A27 PART B: A) Variable cost B) To increase output, the firm must hire more variable inputs (labor). So the cost of this input (VC) must increase. B/C FC’s are constant, regardless of the level of output. D) The difference between the TC curve and the VC curve is FC, which is constant. 4/4/2019 5:38 AM

APE U3 L3 A27 Figure 27.4 and 27.5: Graphs a. AFC decreases b/c total fixed cost is constant. To get AFC, one divides FC by Q, so AFC must decrease. AVC decreases and then increases. When MC is < AVC, AVC decreases. When MC is > AVC, AVC increases. ATC decreases and then increases. When MC < ATC, ATC decreases. When MC > ATC, ATC increases. 4/4/2019 5:38 AM

APE U3 L3 A27 Figure 27.5 (cont) Part B: d. MC decreases and then increases. B/c of increasing returns and then diminishing returns. e. At the minimum of AVC & ATC. If MC is less than average cost, average cost falls. If MC is greater than average cost, average cost will rise, so they are equal when average cost is at its minimum. f. Fixed costs don’t change, and MC is the change in costs divided by the change in output. Change in VC always equals the change in TC. 4/4/2019 5:38 AM

APE U3 L3 A27 27.5 Part C: 5. TR=P x Q. The total amount of money brought in from the sale of a good or service. 6. MR=Change in TR/change in Q. The additional revenue brought in by the sale of one or more unit of output. 7. Average revenue TR/Q 4/4/2019 5:38 AM

APE U3 L3 A27 Price Quantity Total Revenue Marginal Revenue $10 1 2 $20 3 $30 4 $40 $10 $10 $10 27.6 Part D: 8. They are the same 9. B/c the firm can sell all it wants at the equilibrium price. It can’t sell more by lowering its price; only its profits would decline b/c its revenue fell but costs remain the same. 10. P = MR. Firm produces where MR = MC or P = MC. 4/4/2019 5:38 AM

APE U3 L3 A27 Part E: 11. Graph 12. P = $21.50 a. Slightly less than 12, b/c it is at this point where MR = MC b. Economic profit c. Profit of about $2.42 d. Profit of approximately $28 $2.42 x 11.51 = $27.83 4/4/2019 5:38 AM

APE U3 L3 A27 Part E: 13. P of $10.50 a. About 7.5 b/c P = MC or MR = MC at this output. b. Economic loss c. Loss of $9.50 ($20-$10.50=$9.50) d. Loss of $71.25 ($9.50X7.5=$71.25) e. Stay open. P>AVC or TR >TVC. Firm can operate and cover all its variable costs and some fixed costs. If it shuts down, it will have to pay all fixed costs out-of-pocket, so it minimizes losses by producing. 4/4/2019 5:38 AM

APE U3 L3 A27 Part E: 14. P of $5.00 a. Zero b/c P=MR below AVC. The firm’s revenue is not covering its variable costs, so the firm will shut down. b. Shut down. It cannot cover its VCs, so it will lose less money by shutting down than by continuing. 4/4/2019 5:38 AM

APE U3 L3 A27 15. If output is such that MR<MC, if a firm increases output, then MR will be greater than MC and TR will increase more than TC so profits will increase. If MC>MR, if a firm decreases production, then the total cost will decrease more than TR decreases, so profits will increase. Therefore, profits are maximized where MR=MC at an output level. 16. Price is constant. MR is change in TR/change in Q, but if P is constant, then change in TR will always be constant. 17. B/c the firm cannot control the price at which it sells the product but takes the price as given by the industry and determines how much output to produce. MR=MC 4/4/2019 5:38 AM

APE 27 4/4/2019 5:38 AM

Key Economic Concepts For This Module--Review: • Perfectly competitive firms are price takers. They cannot affect the price of their product; it is set in the market. • To maximize profit, the firm must produce the quantity of output where marginal revenue is equal to marginal cost, or where MR=MC. • Because the market price is a constant in perfect competition, it is also true that P=MR for the producer. This modifies the optimal output rule such that: P=MR=MC. • Even if the firm has found the output where P=MR=MC, it may not provide positive economic profits. Economic profits and losses are determined by comparing total revenue to total cost. • If total revenue is greater than total cost, economic profit is positive. If total revenue is less than total cost, economic profit is negative. If total revenue is equal to total cost, economic profit is zero (break even). • Likewise, a firm can compare per-unit profit to per-unit cost to determine whether economic profits are positive, negative, or zero. • If price is greater than average total cost, economic profits are positive. If price is less than average total cost, economic profits are negative. If price is equal to average total cost, economic profit is zero. MR=MC 4/4/2019 5:38 AM