Economics 14 Principles of N. Gregory Mankiw Sixth Edition Having introduced the cost concepts in the previous chapter, we now begin to use those concepts to see how firms make production and pricing decisions in different market structures. In this chapter, we explore firm behavior under perfect competition. The next chapter covers the other extreme end of the competition spectrum—monopoly. The following two chapters cover the intermediate cases—oligopoly and monopolistic competition, respectively.

In this chapter, look for the answers to these questions: What is a perfectly competitive market? What is marginal revenue? How is it related to total and average revenue? How does a competitive firm determine the quantity that maximizes profits? When might a competitive firm shut down in the short run? Exit the market in the long run? What does the market supply curve look like in the short run? In the long run?

Introduction: A Scenario Three years after graduating, you run your own business. You must decide how much to produce, what price to charge, how many workers to hire, etc. What factors should affect these decisions? Your costs (studied in preceding chapter) How much competition you face We begin by studying the behavior of firms in perfectly competitive markets. 2

Characteristics of Perfect Competition 1. Many buyers and many sellers. 2. The goods offered for sale are largely the same. 3. Firms can freely enter or exit the market. Because of 1 & 2, each buyer and seller is a “price taker” – takes the price as given. “Firms can freely enter or exit the market” means there are no barriers or impediments to entry or exit. E.g., the government does not restrict the number of firms in the market. 3

The Revenue of a Competitive Firm Total revenue (TR) Average revenue (AR) Marginal revenue (MR): The change in TR from selling one more unit. TR = P x Q TR Q AR = = P ∆TR ∆Q MR = These revenue concepts are analogous to the cost concepts (TC, ATC, MC) in the previous chapter. 4

ACTIVE LEARNING 1 Calculating TR, AR, MR Fill in the empty spaces of the table. Q P TR AR MR $10 n/a 1 $10 $10 2 $10 This easy exercise requires students to apply the definitions from the previous slide. It also demonstrates that MR = P for a competitive firm. (The table in this exercise is similar to Table 1 in the chapter.) 3 $10 4 $10 $40 $10 5 $10 $50 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 1 Answers Fill in the empty spaces of the table. Q P TR = P x Q TR Q AR = ∆TR ∆Q MR = $10 $30 $20 $10 $0 n/a Notice that MR = P $10 1 $10 $10 2 $10 $10 3 $10 4 $10 $40 $10 5 $10 $50 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

MR = P for a Competitive Firm A competitive firm can keep increasing its output without affecting the market price. So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P. MR = P is only true for firms in competitive markets. 7

Profit Maximization What Q maximizes the firm’s profit? What Q maximizes the firm’s profit? To find the answer, “think at the margin.” If increase Q by one unit, revenue rises by MR, cost rises by MC. If MR > MC, then increase Q to raise profit. If MR < MC, then reduce Q to raise profit. 8

Profit Maximization Profit = MR – MC (continued from earlier exercise) Q TR TC Profit MR MC Profit = MR – MC At any Q with MR > MC, increasing Q raises profit. $0 45 33 23 15 9 $5 5 7 1 –$5 $10 12 10 8 6 $4 –2 2 4 $6 1 10 10 2 20 At any Q with MR < MC, reducing Q raises profit. 10 (The table on this slide is similar to Table 2 in the textbook.) For most students, seeing the complete table all at once is too much information. So, the table is animated as follows: Initially, the only columns displayed are the ones students saw at the end of the exercise in Active Learning 1: Q, TR, and MR. Then, TC appears, followed by MC. It might be useful to remind students of the relationship between MC and TC. Then, the Profit column appears. Students should be able to see that, at each value of Q, profit equals TR minus TC. The last column to appear is the change in profit. When the table is complete, we use it to show it is profitable to increase production whenever MR > MC, such as at Q = 0, 1, or 2. it is profitable to reduce production whenever MC > MR, such as at Q = 5. 3 30 10 4 40 10 5 50 9

MC and the Firm’s Supply Decision Rule: MR = MC at the profit-maximizing Q. At Qa, MC < MR. So, increase Q to raise profit. At Qb, MC > MR. So, reduce Q to raise profit. At Q1, MC = MR. Changing Q would lower profit. Q Costs MC Qb P1 MR Qa Q1 This slide is similar to Figure 1 in the chapter. I’ve omitted the AVC and ATC curves (which appear in Figure 1 in the chapter) because they are not needed at this point. 10

MC and the Firm’s Supply Decision If price rises to P2, then the profit-maximizing quantity rises to Q2. The MC curve determines the firm’s Q at any price. Hence, Costs MC P2 MR2 Q2 P1 MR Q1 the MC curve is the firm’s supply curve. Q 11

Shutdown vs. Exit Shutdown: A short-run decision not to produce anything because of market conditions. Exit: A long-run decision to leave the market. A key difference: If shut down in SR, must still pay FC. If exit in LR, zero costs. 12

A Firm’s Short-run Decision to Shut Down Cost of shutting down: revenue loss = TR Benefit of shutting down: cost savings = VC (firm must still pay FC) So, shut down if TR < VC Divide both sides by Q: TR/Q < VC/Q So, firm’s decision rule is: The shutdown rule, in plain English, says: If the cost of shutting down is less than the benefit, the firm should shut down. Shut down if P < AVC 13

A Competitive Firm’s SR Supply Curve The firm’s SR supply curve is the portion of its MC curve above AVC. Q Costs AVC If P > AVC, then firm produces Q where P = MC. MC ATC In edit mode, it looks like the text boxes are on top of each other. But in presentation mode, the text boxes display only one at a time. If P < AVC, then firm shuts down (produces Q = 0). 14

The Irrelevance of Sunk Costs Sunk cost: a cost that has already been committed and cannot be recovered Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice. FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down. So, FC should not matter in the decision to shut down. 15

A Firm’s Long-Run Decision to Exit Cost of exiting the market: revenue loss = TR Benefit of exiting the market: cost savings = TC (zero FC in the long run) So, firm exits if TR < TC Divide both sides by Q to write the firm’s decision rule as: The decision rule for whether to exit says: If the cost of exiting is greater than the benefit, the firm should exit. Exit if P < ATC 16

A New Firm’s Decision to Enter Market In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC. Divide both sides by Q to express the firm’s entry decision as: Enter if P > ATC Similarly, a prospective entrant compares the benefits of entering the market (TR) with the costs (TC), and enters if the benefits exceed the costs. 17

The Competitive Firm’s Supply Curve The firm’s LR supply curve is the portion of its MC curve above LRATC. Q Costs MC LRATC 18

ACTIVE LEARNING 2 Identifying a firm’s profit A competitive firm Determine this firm’s total profit. Identify the area on the graph that represents the firm’s profit. Q Costs, P MC ATC P = $10 MR 50 $6 Rather than tell students that profit equals (P – ATC) x Q, this exercise requires students to figure it out for themselves. If this exercise is too easy for your students, you can replace it with lecture slides that appear at the end of this file. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 2 Answers A competitive firm Q Costs, P Profit per unit = P – ATC = $10 – 6 = $4 MC ATC P = $10 MR 50 profit $6 The height of the rectangle is P – ATC, profit per unit. The width of the rectangle is Q, the number of units. The area of the rectangle = height x width = (profit per unit) x (number of units) = total profit. Total profit = (P – ATC) x Q = $4 x 50 = $200 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 3 Identifying a firm’s loss A competitive firm Determine this firm’s total loss, assuming AVC < $3. Identify the area on the graph that represents the firm’s loss. Q Costs, P MC ATC $5 Students who didn’t figure out the answer to the previous exercise should be able to get this one. If this exercise is too easy for your students, you can replace it with lecture slides that appear at the end of this file. Note that the statement “assuming AVC < $3” is needed to prevent shut-down, i.e. to insure that the firm produces Q=30 instead of Q=0. 30 P = $3 MR © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

ACTIVE LEARNING 3 Answers A competitive firm Q Costs, P Total loss = (ATC – P) x Q = $2 x 30 = $60 MC ATC $5 The height of the rectangle is ATC – P, loss per unit. The width of the rectangle is Q, the number of units. The area of the rectangle = height x width = (loss per unit) x (number of units) = total loss. 30 loss loss per unit = $2 MR P = $3 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

Market Supply: Assumptions 1) All existing firms and potential entrants have identical costs. 2) Each firm’s costs do not change as other firms enter or exit the market. 3) The number of firms in the market is fixed in the short run (due to fixed costs) variable in the long run (due to free entry and exit) In the real world, there are many markets in which assumptions (1) and (2) do not hold. We make them here for simplicity. Later in the chapter, we will see how our results change if we drop either of these assumptions. Assumption (3) is more reasonable: In the real world, it is much easier for firms to enter or exit in the long run than in the short run. 23

The SR Market Supply Curve As long as P ≥ AVC, each firm will produce its profit-maximizing quantity, where MR = MC. Recall from Chapter 4: At each price, the market quantity supplied is the sum of quantities supplied by all firms. 24

The SR Market Supply Curve Example: 1000 identical firms At each P, market Qs = 1000 x (one firm’s Qs) AVC One firm Q P (firm) Market Q P (market) MC S P3 P3 30 30,000 P2 P2 20 20,000 “Identical” means all firms have the same cost curves. Note: P1 is minimum AVC. At any price below P1, each firm will shut down, and market quantity supplied will equal zero. Hence, the market supply curve begins at price = P1 and Q = 10,000. P1 P1 10 10,000 25

Entry & Exit in the Long Run In the LR, the number of firms can change due to entry & exit. If existing firms earn positive economic profit, new firms enter, SR market supply shifts right. P falls, reducing profits and slowing entry. If existing firms incur losses, some firms exit, SR market supply shifts left. P rises, reducing remaining firms’ losses. 26

The Zero-Profit Condition Long-run equilibrium: The process of entry or exit is complete— remaining firms earn zero economic profit. Zero economic profit occurs when P = ATC. Since firms produce where P = MR = MC, the zero-profit condition is P = MC = ATC. Recall that MC intersects ATC at minimum ATC. Hence, in the long run, P = minimum ATC. 27

Why Do Firms Stay in Business if Profit = 0? Recall, economic profit is revenue minus all costs, including implicit costs like the opportunity cost of the owner’s time and money. In the zero-profit equilibrium, firms earn enough revenue to cover these costs accounting profit is positive Students often wonder why firms bother to stay in business if they make zero profit. The textbook gives a nice discussion of this, briefly summarized on this slide. 28

The LR Market Supply Curve In the long run, the typical firm earns zero profit. The LR market supply curve is horizontal at P = minimum ATC. One firm Q P (firm) Market Q P (market) MC LRATC P = min. ATC That the LR market supply curve is horizontal at P = min ATC will become more clear shortly, when students see the SR and LR effects of an increase in demand. long-run supply 29

SR & LR Effects of an Increase in Demand A firm begins in long-run eq’m… …but then an increase in demand raises P,… …leading to SR profits for the firm. …driving profits to zero and restoring long-run eq’m. Over time, profits induce entry, shifting S to the right, reducing P… One firm Market Q P (market) Q P (firm) S1 MC ATC S2 Profit D2 B P2 P2 Q2 D1 A C P1 long-run supply P1 This slide replicates Figure 8 from the textbook. In edit mode, the text boxes in the top part of the slide appear to be on top of each other. But in slide-show mode, the text boxes display one at a time. If students did not previously understand why the LR market supply curve is horizontal, this slide may help. Q1 Q3 30

Why the LR Supply Curve Might Slope Upward The LR market supply curve is horizontal if 1) all firms have identical costs, and 2) costs do not change as other firms enter or exit the market. If either of these assumptions is not true, then LR supply curve slopes upward. Here are two of the assumptions we made previously, when we began the process of deriving the LR market supply curve. 31

1) Firms Have Different Costs As P rises, firms with lower costs enter the market before those with higher costs. Further increases in P make it worthwhile for higher-cost firms to enter the market, which increases market quantity supplied. Hence, LR market supply curve slopes upward. At any P, For the marginal firm, P = minimum ATC and profit = 0. For lower-cost firms, profit > 0. The marginal firm is the firm that would exit the market if the price were any lower. 32

2) Costs Rise as Firms Enter the Market In some industries, the supply of a key input is limited (e.g., amount of land suitable for farming is fixed). The entry of new firms increases demand for this input, causing its price to rise. This increases all firms’ costs. Hence, an increase in P is required to increase the market quantity supplied, so the supply curve is upward-sloping. Another example: There’s a limited amount of beachfront property. An expansion of the beach resort industry will bid up the price of such property, and raises costs in the industry. 33

CONCLUSION: The Efficiency of a Competitive Market Profit-maximization: MC = MR Perfect competition: P = MR So, in the competitive eq’m: P = MC Recall, MC is cost of producing the marginal unit. P is value to buyers of the marginal unit. So, the competitive eq’m is efficient, maximizes total surplus. In the next chapter, monopoly: pricing and production decisions, deadweight loss, regulation. Recall from Chapter 7: a competitive market equilibrium is efficient. This chapter has shown why: P = MR under perfect competition, so P = MC in the competitive market equilibrium. Reviewing these concepts now sets the stage for the next few chapters, where firms with market power set their price above marginal cost, leading to market inefficiencies and a potential role for government intervention. 34

SUMMARY For a firm in a perfectly competitive market, price = marginal revenue = average revenue. If P > AVC, a firm maximizes profit by producing the quantity where MR = MC. If P < AVC, a firm will shut down in the short run. If P < ATC, a firm will exit in the long run. In the short run, entry is not possible, and an increase in demand increases firms’ profits. With free entry and exit, profits = 0 in the long run, and P = minimum ATC. © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.

profit-maximizing quantity A Firm With Profits Costs, P MC revenue per unit = P MR Q profit ATC profit per unit = P – ATC cost per unit = ATC This slide is “hidden” and will not display in your presentation. I have included it here in case you would like to substitute it for “Active Learning 2A.” The height of the rectangle is P – ATC, profit per unit. The width of the rectangle is Q, the number of units. The area of the rectangle = height x width = (profit per unit) x (number of units) = total profit. Q profit-maximizing quantity 36

loss-minimizing quantity A Firm With Losses Costs, P MC ATC cost per unit = ATC Q loss loss per unit This slide is “hidden” and will not display in your presentation. I have included it here in case you would like to substitute it for “Active Learning 3.” The height of the rectangle is ATC – P, loss per unit. The width of the rectangle is Q, the number of units. The area of the rectangle = height x width = (loss per unit) x (number of units) = total loss. revenue per unit = P MR Q loss-minimizing quantity 37