1. Slides prepared by Dr. Amy Peng, Ryerson University CHAPTER 7 PERFECT COMPETITION Part Two: Microeconomics of Product Markets

2. ©2007 McGraw-Hill Ryerson Ltd.Chapter 72 In this chapter you will learn: 7.1 The four basic market structures 7.2 The conditions required for perfectly competitive markets 7.3 How firms in perfect competition maximize profits or minimize losses 7.4 Why the marginal cost curve and supply curve of competitive firms are the same 7.5 About the firm’s profit maximization in the long run 7.6 About the efficiency of competitive markets

3. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.13 Four Market Structures Perfect Competition Monopoly Monopolistic Competition Oligopoly Oligopoly Market Structure Continuum PureCompetition PureMonopoly MonopolisticCompetition

4. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.24 Market Structure Continuum PureCompetition PureMonopoly MonopolisticCompetition Oligopoly Characteristics of Perfect Competition Very Large Numbers Standardized Product Price-Takers Easy Entry and Exit

5. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.25 Demand for a Firm in Perfect Competition Perfectly Elastic Demand Average, Total, and Marginal Revenue –average revenue = price –marginal revenue = price –total revenue = price x quantityIllustrated…

6. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.26 Product price, P (average revenue) Quantity demanded, Q Total Revenue, TR Marginal Revenue, MR 13100 1 2262 1313393 1314524 1315655 1316786 1317917 13181048 13191179 131101310 Product price, P (average revenue) Quantity demanded, Q Total Revenue, TR Marginal Revenue, MR 1310 1 2 3 4 5 6 7 8 9 10 ]131 ]131 ]131 ]131 ]131 ]131 ]131 ]131 ]131 ]131

7. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.27 Figure 7-1 The Demand and Revenue Curves for a Firm in Perfect Competition D = MR = AR TR 1179 1048 917 786 655 524 393 262 131 0 Quantity Demanded 2 4 6 8 10 12 Price and revenue Demand is perfectly elastic since the firm can sell as much output as it wants at the market price

8. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.38 Profit Maximization in the Short Run Purely competitive firm can maximize its profit (minimize its loss) only by adjusting output Two Approaches: total revenue-total cost approach marginal revenue-marginal cost approach

9. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.39 QTFCTVCTCTR Profit or Loss 0 1 2 3 4 5 6 7 8 9 10 QTFCTVCTCTR Profit or Loss 0$100 1100 2 3 4 5 6 7 8 9 10100 QTFCTVCTCTR Profit or Loss 0$100$ 0 110090 2100170 3100240 4100300 5100370 6100450 7100540 8100650 9100780 10100930 QTFCTVCTCTR Profit or Loss 0$100$ 0$ 100 110090190 2100170270 3100240340 4100300400 5100370470 6100450550 7100540640 8100650750 9100780880 101009301030 QTFCTVCTCTR Profit or Loss 0$100$ 0$ 100$ 0 110090190131 2100170270262 3100240340393 4100300400524 5100370470655 6100450550786 7100540640917 81006507501048 91007808801179 1010093010301310 QTFCTVCTCTR Profit or Loss 0$100$ 0$ 100$ 0$-100 110090190131- 59 2100170270262- 8 3100240340393+ 53 4100300400524+124 5100370470655+185 6100450550786+236 7100540640917+277 81006507501048+298 91007808801179+299 1010093010301310+280 p=$131p=$131

10. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.310 TCTRTR Maximum economic profit $299 Break-even point (normal profit) Break-even point Figure 7-2

11. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.311 Total Revenue-Total Cost Approach Profit = TR - TC Profit is maximized where the vertical distance between TR and TC is maximized Break-even points are where TR=TC Now, the marginal revenue-marginal cost approach…

12. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.312 QTFCTVCTC 0$100$ 0$ 100 110090190 2100170270 3100240340 4100300400 5100370470 6100450550 7100540640 8100650750 9100780880 101009301030 MC $ 90 80 70 60 80 90 110 130 150 ] ] ] ] ] ] ] ] ] Figure 7-3 MCMR $ 90$131 80131 70131 60131 80131 90131 110131 130131 150131 Should the firm produce the 1 st unit? What about the 2 nd unit? What about the 9 th unit? 9 units will maximize profits the same profit-maximizing result as with the TR-TC approach!

13. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.313 Marginal Revenue-Marginal Cost Approach Short run profit maximization occurs where MR=MC: 1.Rule applies only if producing is preferable to shutting down 2.Rule is an accurate guide to profit maximization for ALL firms 3.Rule can be restated as P=MC for purely competitive firms, since MR=P

14. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.314 MC ATC AVC AFC 9 131 Find the quantity where MR=MC 97.78 Find ATC Profit = 9 X (131 - 97.78) = 299

15. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.315 Loss-Minimizing Case Suppose price falls from $131 to $81…

16. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.316 QTFCTVCTC 0$100$ 0$ 100 110090190 2100170270 3100240340 4100300400 5100370470 6100450550 7100540640 8100650750 9100780880 101009301030 Figure 7-4 MCMR $ 90$81 8081 7081 6081 8081 9081 11081 13081 15081 ] ] ] ] ] ] ] ] ] Firm should produce the first 6 units

17. ©2007 McGraw-Hill Ryerson Ltd.Chapter 717 MC ATC AVC AFC81 91.67 Loss = 6 X (81 - 91.67) = -64.02 < TFC

18. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.318 Shutdown Case Suppose the price falls even further, to $71…

19. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.319 MC ATC AVC AFC71 94 Loss = 5 X (71 - 94) = -115>TFC 5 When price is below minimum AVC, the firm should shut down When price is below minimum AVC, the firm should shut down

20. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.420 P Q MC ATC Costs and revenues (dollars) At every price, the MR = MC point indicates the quantity being produced... At every price, the MR = MC point indicates the quantity being produced... AVC Figure 7-6 Marginal Cost and Short-Run Supply

21. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.421 P Q MC ATC Record the quantity being supplied for each price Costs and revenues (dollars) P3P3P3P3 MR 3 Q3Q3Q3Q3 AVC Marginal Cost and Short-Run Supply

22. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.422 P Q MC ATC MR 2 MR 3 P2P2P2P2 P3P3P3P3 Q2Q2Q2Q2 Q3Q3Q3Q3 At a lower price a lower quantity will be supplied At a lower price a lower quantity will be supplied Costs and revenues (dollars) AVC Marginal Cost and Short-Run Supply

23. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.423 P Q MC ATC MR 2 MR 3 MR 4 P2P2P2P2 P3P3P3P3 P4P4P4P4 Q3Q3Q3Q3 Q4Q4Q4Q4 At a higher price a higher quantity will be supplied At a higher price a higher quantity will be supplied Q2Q2Q2Q2 Costs and revenues (dollars) AVC Marginal Cost and Short-Run Supply

24. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.424 Q P P1P1P1P1 MC MR 1 AVC ATC MR 2 MR 3 MR 4 MR 5 P2P2P2P2 P3P3P3P3 P4P4P4P4 P5P5P5P5 Q2Q2Q2Q2 Q3Q3Q3Q3 Q4Q4Q4Q4 Q5Q5Q5Q5 Firm should not produce below P 2 Firm should not produce below P 2 Costs and revenues (dollars) Marginal Cost and Short-Run Supply

25. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.425 Q P P1P1P1P1 MC MR 1 AVC ATC MR 2 MR 3 MR 4 MR 5 P2P2P2P2 P3P3P3P3 P4P4P4P4 P5P5P5P5 Q2Q2Q2Q2 Q3Q3Q3Q3 Q4Q4Q4Q4 Q5Q5Q5Q5 Costs and revenues (dollars) Short-run supply curve (Above AVC) Short-run supply curve (Above AVC) Marginal Cost and Short-Run Supply

26. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.426 Marginal Cost and Short-run Supply Firm’s short-run supply curve is the portion of its MC curve above minimum AVC Diminishing Returns, Production Costs, and Product Supply Supply curve shifts: –A wage increase shifts the supply curve upward and to the left (decreasing in supply) –Technological progress would shift the supply curve downward to the right (increasing in supply)

27. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.427 MC AVC 8 D 8000 D $111 $111 1000 firms Industry Firm (price taker) Q QPP S=  MCs Figure 7-7 Competitive Equilibrium for a Firm and the Industry ATC EconomicProfitEconomicProfit

28. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.428 Table 7-4 Output Determination in Perfect Competition in the Short Run QuestionAnswer Should this firm produce? Yes, if P ≥ minimum ATC; this means that the firm is profitable or that its losses are less than its fixed cost What quantity should the firm produce? Produce where MR (=P) = MC; there, profit is maximized or loss is minimized Will production result in economic profits? Yes, if P > ATC (TR > TC)

29. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.529 Profit Maximization in the Long Run Assumptions: –Entry and Exit Only –Identical Costs –Constant-Cost Industry

30. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.530 The Goal of Our Analysis In the long run, p = minimum ATC Because: 1.Firms seek profit and avoid losses 2.Firms are free to enter and exit the industry

31. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.531 P Q MC P Q S1S1S1S1 Industry 1000 firms Firm (price taker) ATC MR $60$50$40 100 $60$50$40 100,000 D1D1D1D1 Figure 7-8 Entry Eliminates Economic Profits D2D2D2D2 Economic Profits

32. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.532 P Q MC P Q D1D1D1D1 S1S1S1S1 ATC MR $60$50$40 100 $60$50$40 D2D2D2D2 100,000 S2S2S2S2 Industry 110,000 firms Firm (price taker) Entry Eliminates Economic Profits 110,000 New Equilibrium with more firms

33. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.533 P Q MC P Q D1D1D1D1 S1S1S1S1 ATC MR $60$50$40 100 $60$50$40 100,000 Industry 1000 firms Firm (price taker) Figure 7-9 Exit Eliminates Losses D2D2D2D2 Economic Loss

34. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.534 P Q MC P Q D1D1D1D1 S1S1S1S1 ATC MR $60$50$40 100 90,000 D2D2D2D2 S3S3S3S3100,000 $60$50$40 Industry 90,000 firms Firm (price taker) Exit Eliminates Losses New equilibrium with fewer firms

35. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.535 Long-Run Equilibrium If price > min ATC –profits attract new firms –as S increases, price drops to min ATC If price < min ATC –losses cause firms to exit –as S decreases, price rises to min ATC So, in the long run, p = min ATC

36. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.536 Long-run Supply Crucial factor is whether the number of firms in the industry affects the costs of individual firms

37. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.537 Q P=$50 D1D1D1D1 Q1Q1Q1Q1 S1S1S1S1 Q2Q2Q2Q2 P Figure 7-10 Long-run Supply for a Constant- Cost Industry Is Horizontal D2D2D2D2 Demand increases P>$50 D2D2D2D2 Q2Q2Q2Q2 Profits attract new firms Price remains the same in the long run

38. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.538 P Q P=$50 D1D1D1D1 Q1Q1Q1Q1 Figure 7-11 Long-run Supply for an Increasing- Cost Industry Is Upsloping S1S1S1S1 Demand increases D2D2D2D2 P>>$50 Q2Q2Q2Q2 Profits attract new firms In the long run, greater supply is offered at a higher price

39. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.539 P Q P=$50 D1D1D1D1 Q1Q1Q1Q1 Long-run Supply for a Decreasing-Cost Industry Is Downsloping S1S1S1S1 Demand increases D2D2D2D2 P>$50 Profits attract new firms P<$50 Q2Q2Q2Q2 long-run S In the long run, greater supply is offered at a lower price

40. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.640 Figure 7-12 Pure Competition and Efficiency P Q P MR Q MC ATC Price = MC = Minimum ATC (normal profit) Price = MC = Minimum ATC (normal profit)

41. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.641 Productive Efficiency –P = Minimum ATC Allocative Efficiency –P = MC Pure Competition and Efficiency

42. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.642 Allocative Efficiency and Consumer and Producer Surplus Consumer Surplus is the difference between what the consumer is willing to pay and the market price Producer Surplus is the difference between the marginal cost of production and the market price At equilibrium, consumer and producer surplus is maximized

43. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.643 Figure 7-12 Long-Run Equilibrium: A Competitive Firm and Market P Q PePePePe QeQeQeQe Consumer Surplus Producer Surplus The sum of consumer and producer surplus is maximized

44. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.644 Productive Efficiency –P = Minimum ATC Allocative Efficiency –P = MC Dynamic Adjustments –purely competitive markets adjust to restore efficiency when disrupted by changes in the economy Pure Competition and Efficiency

45. ©2007 McGraw-Hill Ryerson Ltd.Chapter 7.645 The “Invisible Hand” Revisited The efficient allocation of resources in perfect competition comes about because businesses and resource suppliers seek to further their self-interest Both business profits and consumer satisfaction are maximized

46. ©2007 McGraw-Hill Ryerson Ltd.Chapter 746 Chapter Summary 7.1 Four Market Structures 7.2 Characteristics of Pure Competition and the Firm’s Demand Curve 7.3 Profit Maximization in the Short Run –MR ( = P) = MC ; TR – TC is the highest 7.4 Marginal Cost and Short-Run Supply –Firm’s short-run MC that Lies above its AVC 7.5 Profit Maximization in the Long Run 7.6 Pure Competition and Efficiency –P = ATC = MC