1 © 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.

2 Introduction to Perfect Competition Market structure –Number of suppliers –Product’s degree of uniformity –Ease of entry into the market –Forms of competition among forms A firm’s decisions –How much to produce; what price to charge –Depend on the structure of the market © 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.

Perfectly Competitive Market Perfect competition –Many buyers and sellers –Commodity; standardized product –Fully informed buyers and sellers –No barriers to entry Individual buyer or seller –No control over price –Price takers 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.

Demand under Perfect Competition Market price –Determined by supply and demand Demand curve facing one supplier –Horizontal line at the market price –Perfectly elastic 4 © 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.

Demand under Perfect Competition Price taker –Firm that faces a given market price Its quantity supplied has no effect on that price –Perfectly competitive firm that decides to produce Must accept, or “take,” the market price 5 © 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.

Exhibit 1 6 Market equilibrium & firm’s demand curve in perfect competition Price per bushel $5 D S (a) Market equilibrium Price per bushel $5 d (b) Firm’s demand 1,200,000Bushels of wheat per day 0 15Bushels of wheat per day 0510 In panel (a), the market price of $5 is determined by the intersection of the market demand and market supply curves. A perfectly competitive firm can sell any amount at that price. The demand curve facing the perfectly competitive firm is horizontal at the market price, as shown by demand curve d in panel (b). © 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.

Short Run Profit Maximization Maximize economic profit –Quantity at which total revenue exceeds total cost by the greatest amount Total revenue, TR Total cost, TC Profit = TR – TC If TR > TC: economic profit If TC > TR: economic loss 7 © 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.

Short Run Profit Maximization Marginal revenue, MR Average revenue, AR –Total revenue divided by quantity MR = P = AR –Along a perfectly competitive firm’s demand curve Marginal cost, MC 8 © 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.

Short Run Profit Maximization Maximize economic profit: –Increase production as long as each additional unit adds more to TR than TC Golden rule –Expand output: MR>MC –Stop before MC>MR 9 © 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.

Exhibit 2 10 Maximizing Short-Run Profit for a Perfectly Competitive Firm © 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.

Exhibit 3 11 Short-run profit maximization for a perfectly competitive firm Total cost Total revenue (=$5 × q) Total dollars $ Bushels of wheat per day Dollars per bushel $5 4 Bushels of wheat per day (a) Total revenue minus total cost (b) Marginal cost equals marginal revenue Average total cost d = Marginal revenue = Average revenue Marginal cost Maximum economic profit = $12 In panel (a), the total revenue curve for a perfectly competitive firm is a straight line with a slope of 5, the market price. Total cost increases with output, first at a decreasing rate and then at an increasing rate. Economic profit is maximized where total revenue exceeds total cost by the greatest amount, which occurs at 12 bushels of wheat per day. a e Profit In panel (b), marginal revenue is a horizontal line at the market price of $5. Economic profit is maximized at 12 bushels of wheat per day, where marginal revenue equals marginal cost (point e). That profit equals 12 bushels multiplied by the amount by which the market price of $5 exceeds the average total cost of $4. Economic profit is identified by the shaded rectangle. © 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.

Minimizing Short-Run Losses Total cost, TC = FC+VC Shut down in short run: pay fixed cost If TC<TR: economic loss –Produce if TR>VC (P>AVC) Revenue covers variable costs and a portion of fixed cost Loss < fixed cost –Shut down (short run) if TR<VC (P<AVC) Loss = FC 12 © 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.

Exhibit 4 13 Minimizing Short-Run Losses for a Perfectly Competitive Firm © 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.

Exhibit 5 14 Short-Run Loss Minimization for a Perfectly Competitive Firm Total cost Total revenue (=$3 × q) Total dollars $ Bushels of wheat per day (a) Total revenue minus total cost (b) Marginal cost equals marginal revenue Average total cost d = Marginal revenue = Average revenue Marginal cost Minimum economic loss = $10 Because total cost always exceeds total revenue in panel (a), the firm suffers a loss no matter how much is produced. The loss is minimized where output is 10 bushels per day. Panel (b) shows that marginal revenue equals marginal cost at point e. The loss is equal to output of 10 multiplied by the difference between average total cost ($4) and price ($3). Because price exceeds average variable cost ($2.50), the firm is better off continuing to produce in the short run, since revenue covers some fixed cost. e Loss Bushels of wheat per day Dollars per bushel $ Average variable cost © 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.

Firm & Industry Short-Run S Curves Short-run firm supply curve –How much firms supply in the short run –Upward sloping portion of firm’s MC curve –Above minimum AVC curve Short-run industry supply curve –Quantity supplied by industry at each price in the short run –Horizontal sum of all firms’ short-run supply curves 15 © 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.

Exhibit 6 16 Summary of a perfectly competitive firm’s short-run output decisions Average total cost Average variable cost Marginal cost d1d1 d2d2 d3d3 d4d4 d5d q2q2 q3q3 q4q4 q5q5 q1q1 Quantity per period p2p2 p1p1 p3p3 p4p4 p5p5 0 Dollars per unit Shutdown point Break-even point At p 4, the firm produces q 4 and just breaks even, earning a normal profit, because p 4 equals average total cost. Finally, at p 5, the firm produces q 5 and earns an economic profit. The firm’s short-run supply curve is that portion of its marginal cost curve at or rising above the minimum point of average variable cost (point 2). Firm’s short run S curve At price p 1, the firm produces nothing because p 1 is less than the firm’s average variable cost. At price p 2, the firm is indifferent between shutting down or producing q 2 units of output, because in either case, the firm suffers a loss equal to its fixed cost. At p 3, it produces q 3 units and suffers a loss that is less than its fixed cost. © 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.

Exhibit 7 17 Aggregating individual supply curves of perfectly competitive firms to form the market supply curve 1020 Quantity per period 0 p p’ Price per unit sAsA (a) Firm A p p’ sBsB (b) Firm B 1020 Quantity per period 0 p p’ sCsC (c) Firm C 3060 Quantity per period 0 p p’ s A + s B + s C = S (d) Industry, or market, supply At price p, each firm supplies 10 units of output & market supplies 30 units. In general, the market supply curve in panel (d) is the horizontal sum of the individual firm supply curves s A, s B, and s C. © 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.

Firm Supply & Market Equilibrium Short run, perfect competition –Market converges to equilibrium P and Q –Firm Max profit Min loss Shuts down temporarily 18 © 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.

Exhibit 8 19 Short-Run Profit Maximization and Market Equilibrium in Perfect Competition (a) Firm d (b) Industry, or market 1,200,000 Bushels of wheat per day 0 12 Bushels of wheat per day 0510 MC = s ATC AVC Dollars per unit $5 4 Price per unit $5 Profit ∑ MC = S D The market supply curve S in panel (b) is the horizontal sum of the supply curves of all 100,000 firms in this perfectly competitive industry. The intersection of S with the market demand curve D determines the market price of $5. That price, in turn, determines the height of the perfectly elastic demand curve facing the individual firm in panel (a). That firm produces 12 bushels per day (where marginal cost equals marginal revenue of $5) and earns economic profit in the short run of $1 per bushel, or $12 in total per day. © 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.

Perfect Competition in Long Run Long run –Firms enter/exit the market –Firms adjust scale of operations Until average cost is minimized –All resources are variable 20 © 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.

Perfect Competition in Long Run Economic profit in short run –New firms enter the market in long run –Existing firms expand in long run –Market supply increases Price decreases Economic profit disappears Firms break even 21 © 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.

Perfect Competition in Long Run Economic loss in short run –Some firms exit the market in long run –Some firms reduce scale in long run –Market supply decreases Price increases Economic loss disappears Firms break even 22 © 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.

Zero Economic Profit in Long Run Firms enter, leave, change scale Market: –S shifts; P changes Firm –d(P=MR=AR) shifts –Long run equilibrium MR=MC =ATC=LRAC Normal profit Zero economic profit 23 © 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.

Exhibit 9 24 Long-run equilibrium for a firm & industry in perfect competition (a) Firm d (b) Industry, or market Q Quantity per period 0 q Quantity per period 0 MC ATC Dollars per unit p Price per unit p S D LRAC In long-run equilibrium, the firm produces q units of output per period and earns a normal profit. At point e, price, marginal cost, marginal revenue, short-run average total cost, and long-run average cost are all equal. There is no reason for new firms to enter the market or for existing firms to leave. As long as the market demand and supply curves remain unchanged, the industry will continue to produce a total of Q units of output at price p. e © 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.

Long-Run Adjustment Effects of an Increase in Demand –Short run P increases; d increases Firms increase quantity supplied Economic profit –Long run New firms enter the market S increases, P decreases Firm’s d curve decreases Normal profit 25 © 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.

Exhibit Long-run Adjustment in Perfect Competition to an Increase in Demand (a) Firm d (b) Industry, or market MC ATC S D LRAC D’ a b Price per unit p p’ QaQa Quantity per period 0QbQb QcQc Dollars per unit p p’ d’ q Quantity per period 0q’ Profit An increase in market demand from D to D’ in panel (b) moves the short-run market equilibrium point from a to b. Output increases to Q b, and price rises to p. The price rise shifts up the individual firm’s demand curve from d to d’ in panel (a). The firm responds to the higher price by increasing output to q and earns economic profit identified by the shaded rectangle. Economic profit attracts new firms to the industry in the long run. Market supply shifts right to S’ in panel (b), pushing the market price back down to p. In panel (a), the firm’s demand curve shifts back down to d, erasing economic profit. The short-run adjustment is from point a to point b in panel (b), but the long-run adjustment is from point a to point c. S’ c S* © 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.

Long-Run Adjustment Effects of a Decrease in Demand –Short run P decreases; d decreases Firms decrease quantity supplied Economic loss –Long run Firms exit the market S decreases, P increases Firm’s d curve increases Normal profit 27 © 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.

Exhibit Long-Run Adjustment in Perfect Competition to a Decrease in Demand (a) Firm d (b) Industry, or market MC ATC S D LRAC D’’ a f Price per unit p p’’ QgQg Quantity per period 0QfQf QaQa Dollars per unit p p’’ d’’ q Quantity per period 0q’’ Loss A decrease of demand to D” in panel (b) disturbs the long-run equilibrium at point a. The price drops to p” in the short run; output falls to Q f. In panel (a), the firm’s demand curve shifts down to d. Each firm cuts output to q” and suffers a loss. As firms leave the industry in the long run, the market supply curve shifts left to S”. Market price rises to p as output falls further to Q g. At price p, the remaining firms once again earn a normal profit. Thus, the short-run adjustment is from point a to point f in panel (b); the long-run adjustment is from point a to point g. S’’ g S* © 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.

Long-Run Industry Supply Curve Short run –Change quantity supplied along MC curve Long run industry supply curve, S* –After firms fully adjust Constant-cost industries –LRAC doesn’t shift with output –Long run S* curve for industry: straight horizontal line 29 © 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.

Increasing Cost Industries –Average costs increase as output expands Effects of an increase in demand –Short run P increases; d increases Firms increase q; Economic profit –Long run New firms enter the market; Market: S increases; P decreases Firm: MC and ATC increase; d curve decreases; Zero economic profit 30 © 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.

Exhibit Long-Run Adjustment for an Increasing-Cost Industry (a) Firm dada (b) Industry, or market MC ATC S D D’ a b QaQa Quantity per period 0QbQb QcQc dbdb q Quantity per period 0qbqb S’ c Price per unit papa pbpb pcpc Dollars per unit papa pbpb pcpc S* dcdc a b ATC’ MC’ c An increase in demand to D’ in panel (b) disturbs the initial equilibrium at point a. Short-run equilibrium is at point b, where D’ intersects the short-run market supply curve S. At the higher price p b, the firm’s demand curve shifts up to d b, and its output increases to q b in panel (a). At point b, the firm is now earning economic profit, which attracts new firms. As new firms enter, input prices get bid up, so each firm’s marginal and average cost curves rise. New firms increase the short-run market supply curve from S to S’. The intersection of the new market supply curve, S’, with D’ determines the market price, p c. At p c, individual firms are earning a normal profit. Point c shows the long-run equilibrium. By connecting long-run equilibrium points a and c in panel (b), we obtain the upward-sloping long-run market supply curve S* for this increasing-cost industry. © 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.

Perfect Competition & Efficiency Productive efficiency: Making Stuff Right –Produce output at the least possible cost Min point on LRAC curve P = min average cost in long run Allocative efficiency: Making the Right Stuff –Produce output that consumers value most Marginal benefit = P = Marginal cost Allocative efficient market 32 © 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.

Perfect Competition Consumer surplus –Consumers pay less (P) –Than they are willing to pay (along D curve) Producer surplus –Producers are willing to accept less (along S curve; MC) –Than what they are receiving (P) 33 © 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.

Perfect Competition Gains from voluntary exchange –Consumer and producer surplus –Productive and allocative efficiency –Maximum social welfare Social welfare –Overall well-being of people in the economy –Maximized when: marginal cost of production = marginal benefit to consumers 34 © 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.

Exhibit Consumer Surplus and Producer Surplus for Perfectly Competitive Market 0100, , ,000 Quantity per period $ Dollars per unit S D e m Consumer surplus Producer surplus Consumer surplus is represented by the area above the market-clearing price of $10 per unit and below the demand curve; it appears as the blue triangle. Producer surplus is represented by the area above the short-run market supply curve and below the market-clearing price of $10 per unit; it appears as the gold area. At a price of $5 per unit, there would be no producer surplus. At a price of $6 per unit, producer surplus would be the gold shaded area between $5 and $6. A price of $5 just covers each firm’s average variable cost. © 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.