Twelfth Edition, Global Edition

Twelfth Edition, Global Edition
ECONOMICS Twelfth Edition, Global Edition Michael Parkin 1

12 Notes and teaching tips: 4, 6, 15, 23, 26, 40, 41, 45, 48, 57, 67, and 74. To view a full-screen figure during a class, click the expand button. To return to the previous slide, click the shrink button. To advance to the next slide, click anywhere on the full screen figure. Applying the principles of economics to interpret and understand the news is a major goal of the principles course. You can encourage your students in this activity by using the two features: Economics in the News and Economics in Action. (1) Before each class, scan the news and select two or three headlines that are relevant to your session today. There is always something that works. Read the headline and ask for comments, interpretation, discussion. Pose questions arising from it that motivate today’s class. At the end of the class, return to the questions and answer them with the tools you’ve been explaining. (2) Once or twice a semester, set an assignment, for credit, with the following instructions: (a) Find a news article about an economic topic that you find interesting. (b) Make a short bullet-list summary of the article. (c) Write and illustrate with appropriate graphs an economic analysis of the key points in the article. Use the Economics in the News features in your textbook as models. PERFECT COMPETITION 2

After studying this chapter, you will be able to:
Define perfect competition Explain how a firm makes its output decision Explain how price and output are determined in perfect competition Explain why firms enter and leave a market Predict the effects of technological change in a competitive market Explain why perfect competition is efficient 3

What Is Perfect Competition?
Perfect competition is a market in which Many firms sell identical products to many buyers. There are no restrictions to entry into the industry. Established firms have no advantages over new ones. Sellers and buyers are well informed about prices. The range of market types. Remind the students of what they learned in Chapter 9 about the spectrum of markets that range from perfect competition to monopoly. The perfect competition model serves as a benchmark and its predictions work in a wide range of real markets. Set the scene for appreciating the power of the perfect competition model with a physical analogy. Explain that physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the same trip, you need a fancier model! Economists use the model of “perfect competition” in a similar way to understand our economic world. Emphasize to students that although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition. 4

How Perfect Competition Arises Perfect competition arises when The firm’s minimum efficient scale is small relative to market demand, so there is room for many firms in the market. Each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm’s good they buy. 5

Price Takers In perfect competition, each firm is a price taker. A price taker is a firm that cannot influence the price of a good or service. No single firm can influence the price—it must “take” the equilibrium market price. Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic. Price taking. Be sure to spend a few minutes providing intuition to ensure that your students understand why firms in perfect competition are price takers: They can offer to sell for a lower price, but they’re giving profits away; and they can ask for a higher price, but no one will pay. You might like to note that if the market is not in equilibrium, the firm isn’t a price taker. If there is a shortage, firms can get away with a higher price and they ask for more. That’s how prices rise. If there is a surplus, firms offer a lower price to move their product. That’s how prices fall. But in equilibrium, there is nothing to do but take the going price. And competitive markets get to equilibrium fast. 6

Economic Profit and Revenue The goal of each firm is to maximize economic profit, which equals total revenue minus total cost. Total cost is the opportunity cost of production, which includes normal profit. A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P × Q. A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. 7

Figure 12.1 illustrates a firm’s revenue concepts. Part (a) shows that market demand and market supply determine the market price that the firm must take. 8

With the market price of $25 a sweater, the firm sells 9 sweater and makes total revenue of $225. Figure 12.1(b) shows the firm’s total revenue curve (TR). 10

The firm can sell any quantity it chooses at the market price, so marginal revenue equals the market price of $25. 11

Figure 12.1(c) shows the marginal revenue curve (MR), which is the demand curve for the firm’s product. 12

The demand for a firm’s product is perfectly elastic because one firm’s sweater is a perfect substitute for the sweater of another firm. The market demand is not perfectly elastic because a sweater is a substitute for some other good. 13

The Firm’s Decisions A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces. So the firm must decide: 1. How to produce at minimum cost 2. What quantity to produce 3. Whether to enter or exit a market We start by looking at the firm’s output decision. 14

The Firm’s Output Decision
A perfectly competitive firm chooses the output that maximizes its economic profit. One way to find the profit-maximizing output is to look at the firm’s total revenue and total cost curves. Figure 12.2 on the next slide looks at these curves along with the firm’s total profit curve. Do firms really choose the output that maximizes profit? It is useful to explain to your students that many big firms routinely make tables using spreadsheets of total revenue, total cost, and economic profit—and make graphs—similar to those in Figure But most firms, and certainly most small firms like Campus Sweaters knitting firm, don’t make such calculations. Nonetheless, they do make their decisions at the margin. They can figure out how much it will cost to hire one more worker and how much output that worker will produce. So they can figure out their marginal cost—wage rate divided by marginal product. They can compare that number with the price. They are choosing at the margin. 15

Part (a) shows the total revenue, TR, curve. Part (a) also shows the total cost curve, TC. Total revenue minus total cost is economic profit (or loss), shown by the curve EP in part (b). 16

At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs. At intermediate output levels, the firm makes an economic profit. 18

At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs because of diminishing returns. The firm maximizes its economic profit when it produces 9 sweaters a day. 19

Marginal Analysis and Supply Decision The firm can use marginal analysis to determine the profit-maximizing output. Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC. Figure 12.3 on the next slide shows the marginal analysis that determines the profit-maximizing output. 20

If MR > MC, economic profit increases if output increases. If MR < MC, economic profit decreases if output increases. If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized. 21

Temporary Shutdown Decision If the firm makes an economic loss, it must decide whether to exit the market or to stay in the market. If the firm decides to stay in the market, it must decide whether to produce something or to shut down temporarily. The decision will be the one that minimizes the firm’s loss. Temporary shutdown. In our experience, this topic is the hardest for the students to understand. You can help them with the intuition by pointing out that the rationale for temporary shutdown isn’t confined to perfect competition and that they can see the phenomenon right around the corner. Many restaurants close on Sunday evening and Monday. Many hairdressers close on Sunday and Monday. Why? Your students will easily figure out that total revenue is less than total variable cost and equivalently that price is less than average variable cost. The mechanics of the shutdown analysis will be a lot easier to explain once the students have thought about these real situations with which they are familiar. 23

Loss Comparisons The firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR). Economic loss = TFC + TVC − TR = TFC + (AVC − P) x Q If the firm shuts down, Q is 0 and the firm still has to pay its TFC. So the firm incurs an economic loss equal to TFC. This economic loss is the largest that the firm must bear. 24

The Shutdown Point A firm’s shutdown point is the price and quantity at which it is indifferent between producing the profit-maximizing quantity and shutting down. The shutdown point is at minimum AVC. This point is the same point at which the MC curve crosses the AVC curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily. At the shutdown point, the firm incurs a loss equal to total fixed cost (TFC). 25

Figure 12.4 shows the shutdown point. Minimum AVC is $17 a sweater. At $17 a sweater, the profit-maximizing output is 7 sweaters a day. The firm incurs a loss equal to the red rectangle. When to increase and when to decrease output. Students need repeated reminders that to determine whether a firm can increase profit by changing output, price, and marginal cost are the only things to consider. Questions that throw average total cost into the mix often cause confusion. 26

If the price of a sweater is between $17 and $20.14, … the firm produces the quantity at which marginal cost equals price. The firm covers all its variable cost and some of its fixed cost. It incurs a loss that is less than TFC. 28

The Firm’s Supply Curve A perfectly competitive firm’s supply curve shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same. Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve. But at a price below the shutdown point, the firm produces nothing. 29

The Firm’s Decision Figure 12.5 shows how the firm’s supply curve is constructed. If price equals minimum AVC, $17 a sweater, the firm is indifferent between producing nothing and producing at the shutdown point, T. 30

The Firm’s Decision If the price is $25 a sweater, the firm produces 9 sweaters a day, the quantity at which P = MC. If the price is $31 a sweater, the firm produces 10 sweaters a day, the quantity at which P = MC. The blue curve in part (b) traces the firm’s short-run supply curve. 32

Output, Price, and Profit in the Short Run
Market Supply in the Short Run The short-run market supply curve shows the quantity supplied by all firms in the market at each price when each firm’s plant and the number of firms remain the same. Figure 12.6 (on the next slide) shows the market supply curve of sweaters, when there are 1,000 sweater- producing firms identical to Campus Sweater. 33

Figure 12.6 shows the market supply curve. At the shutdown price ($17), some firms will produce the shutdown quantity (7 sweaters) and others will produce zero. At this price, the market supply curve is horizontal. 34

Short-Run Equilibrium Short-run market supply and market demand determine the market price and output. Figure 12.7 shows a short-run equilibrium. 36

A Change in Demand An increase in demand brings a rightward shift of the market demand curve: The price rises and the quantity increases. A decrease in demand brings a leftward shift of the market demand curve: The price falls and the quantity decreases. 38

Profits and Losses in the Short Run Maximum profit is not always a positive economic profit. To see if a firm is making a profit or incurring a loss compare the firm’s ATC at the profit-maximizing output with the market price. Figure 12.8 on the next slide shows the three possible profit outcomes. Classroom activity Check out Economics in Action: Production Cutback and Temporary Shutdown 40

In part (a) price equals average total cost and the firm makes zero economic profit (breaks even). Operating a business at zero economic profit. Students are often skeptical that a zero economic profit is an acceptable outcome for an entrepreneur. The key is to reinforce the meaning of normal profit. A rational decision is one that is based on a weighing of the full opportunity cost of each alternative against its full benefits—for a firm weighing the total revenue against the opportunity cost for each alternative. Opportunity cost includes the benefits from forgone opportunities as well as explicit costs. One of these forgone opportunities is that of the entrepreneur pursuing her/his next best activity. The value of this forgone opportunity is normal profit. So, when a firm makes zero economic profit, the entrepreneur earns normal profit and enjoys the same benefits as those available in the next best activity. There is no incentive to change to the next best activity. 41

In part (b), price exceeds average total cost and the firm makes a positive economic profit. 43

In part (c) price is less than average total cost and the firm incurs an economic loss—economic profit is negative. Operating a business at a loss. Students often have a hard time understanding why operating at an economic loss can be the best action. The key is to appreciate that: The firm’s short-run decisions are made after some irrevocable commitments have generated sunk costs. The firm considers only avoidable costs when making decisions. Unavoidable costs have no impact on the decision. So for the firm to produce, its revenues need only exceed avoidable costs, not total costs. The profit-maximization goal doesn’t require the firm to make a positive economic profit in the short run. 45

Output, Price, and Profit in the Long Run
In short-run equilibrium, a firm might make an economic profit, break even, or incur an economic loss. In long-run equilibrium, firms break even because firms can enter or exit the market. 47

Entry and Exit New firms enter an industry in which existing firms make an economic profit. Firms exit an industry in which they incur an economic loss. Figure 12.9 shows the effects of entry and exit. Classroom activity Check out Economics in Action: Entry and Exit Check out Economics in the News: Record Stores Exit 48

A Closer Look at Entry When the market price is $25 a sweater, firms in the market are making economic profit. 49

New firms have an incentive to enter the market. When they do, the market supply increases and the market price falls. 51

Firms enter as long as firms are making economic profits. In the long run, the market price falls until firms are making zero economic profit. 52

A Closer Look at Exit When the market price is $17 a sweater, firms in the market are incurring economic loss. 53

Firms have an incentive to exit the market. When they do, the market supply decreases and the market price rises. 55

Firms exit as long as firms are incurring economic losses. In the long run, the price continues to rise until firms make zero economic profit. 56

Changes in Demand and Supply as Technology Advances
An Increase in Demand An increase in demand shifts the market demand curve rightward. The price rises and the quantity increases. Starting from long-run equilibrium, firms make economic profits. Figure illustrates the effects of an increase in demand. Watching the work of the invisible hand. The power of the market to make firms respond to consumers’ changing demands becomes visible to the student in this section. When you teach this material, do the analysis with a specific (and current/recent) example with which the students can identify. Computers and ISPs are good for an increase in demand. Audio tapes are good for a decrease in demand. Classroom activity Check out Economics in the News: Perfect Competition in Smartphone Apps 57

The market demand curve shifts rightward, the market price rises, and each firm increases the quantity it produces. 58

The market price is now above the firm’s minimum average total cost, so firms make economic profit. 60

Economic profit induces some firms to enter the market, which increases the market supply and the price starts to fall. 61

As the price falls, the quantity produced by all firms starts to decrease and each firm’s economic profit starts to fall. 62

Eventually, enough firms have entered for the supply and increased demand to be in balance and firms make zero economic profit. Firms no longer enter the market. 63

The main difference between the initial and new long-run equilibrium is the number of firms in the market. More firms produce the equilibrium quantity. 64

A decrease in demand has the opposite effects to those just described and shown in Figure A decrease in demand shifts the demand curve leftward. The price falls and the quantity decreases. Firms incur economic losses. Economic loss induces exit. The short-run market supply curve shifts leftward. As the market supply decreases, the price stops falling and starts to rise. 65

With a rising price, each firm increases its output as it moves along up its marginal cost curve (supply curve). A new long-run equilibrium occurs when the price has risen to equal minimum ATC. Firms make zero economic profit, and firms have no incentive to exit the market. In the new equilibrium, a smaller number of firms produce the equilibrium quantity. 66

Technological Advances Change Supply Starting from a long-run equilibrium, when a new technology becomes available that lowers production costs, the first firms to use it make economic profit. But as more firms begin to use the new technology, market supply increases and the price falls. Figure illustrates the effects of an increase in supply. Classroom activity Check out Economics in the News: The Falling Cost of Sequencing DNA 67

Part (a) shows the market. Part (b) shows a firm using the original old technology. Firms are making zero economic profit. 68

When a new technology becomes available, the ATC and MC curves shift downward. Firms that use the new technology make economic profit. 70

Economic profit induces some new-technology firms to enter the market. The market supply increases and the price starts to fall. 71

With the lower price, old-technology firms incur economic losses. Some exit the market; others switch to the new technology. 72

Eventually all firms are using new technology. The market supply has increased and firms are making zero economic profit. 73

Competition and Efficiency
Efficient Use of Resources Resources are used efficiently when no one can be made better off without making someone else worse off. This situation arises when marginal social benefit equals marginal social cost. Pulling it all together In this section, you can show your students what they’ve learned and pull together the entire course to date. Begin by reiterating the two primary goals of this chapter and then note that you are now dealing with the second goal. Emphasize that the pressures of competition force self-interested firms to produce incredible long run results: Each firm produces at the lowest possible average total cost –at the minimum point of the long run average cost curve, Consumers pay the lowest possible price that keeps firms in business—P equals minimum ATC. Each firm uses the least-cost technology, Firms produce the efficient quantity—price, which equals marginal benefit equals marginal cost. The forces of competition, which Adam Smith called an invisible hand, guide firms to produce output and charge prices that maximize the value of our scarce resources. 74

Choices, Equilibrium, and Efficiency We can describe an efficient use of resources in terms of the choices of consumers and firms coordinated in market equilibrium. Choices A consumer’s demand curve shows how the best budget allocation changes as the price of a good changes. So at all points along their demand curves, consumers get the most value out of their resources. 75

If the people who consume the good are the only ones who benefit from the good, the market demand curve is the marginal social benefit curve. A competitive firm’s supply curve shows how the profit- maximizing quantity changes as the price of a good changes. So at all points along their supply curves, firms get the most value out of their resources. If the firms that produce the good bear all the costs of producing it, then the market supply curve is the marginal social cost curve. 76

Equilibrium and Efficiency In competitive equilibrium, resources are used efficiently— the quantity demanded equals the quantity supplied, so marginal social benefit equals marginal social cost. The gain from trade for consumers is measured by consumer surplus. The gain from trade for producers is measured by producer surplus. Total gains from trade equal total surplus. In long-run equilibrium total surplus is maximized. 77

Efficiency in the Sweater Market Figure 12.12(a) shows the market. Along the market demand curve D = MSB, consumers are efficient. Along the market supply curve S = MSC, producers are efficient. 78

At the market equilibrium, marginal social benefit equals marginal social cost. Resources are allocated efficiently. Total surplus is maximized. 80

In Fig (b), Campus Sweaters makes zero economic profit. Each firm in the market has the plant that enables it to produce at the lowest possible average total cost. Consumers are as well off as possible because the good cannot be produced at a lower cost and the price equals that least possible cost. 81

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