After studying this chapter you will be able to ! Define perfect competition ! Explain how firms make their supply decisions and why they sometimes shut down temporarily and lay Off workers ! Explain how price and output in an industry are determined and why firms enter and leave the industry ! Predict the effects off change in demand and of a technological advance ! Explain why perfect competition is efficient The Busy Bee The busy bee pollinates plants and beekeepers rent their hives to farmers.
Across the United States from Vermont to California, a arise is killing off bees and the rent farmers pay for hives has more than doubled. How does competition in beekeeping and other industries affect prices and profits? We study a fiercely competitive market in this chapter. We explain the changes in price and output as the firms in perfect competition respond to changes in demand and technological advances. What Is Perfect Competition? Perfect competition is an industry in which SC] Many firms sell identical products to many buyers. 0 There are no restrictions to entry into the industry. SC] Established firms have no advantages over new ones. 0 Sellers and buyers are well informed about prices. How perfect Competition Arises Perfect competition arises: 50 When firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the industry. And when each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy from. Price Takers In perfect competition, each firm is a price taker.
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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 rice. 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. 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 x Q.
A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. Figure 1 1. 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. Figure 1 1. 1(b) shows the firm’s total revenue curve (TRY) -??the relationship between total revenue and quantity sold. Figure 1 1. 1(c) shows the marginal revenue curve (MR.). The firm can sell any quantity it chooses at the market price, so marginal revenue equals price and the demand curve for the firm’s product is horizontal at the market price.
The demand for the firm’s product is perfectly elastic because one of Candy’s sweaters 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. The Firm’s Decisions in Perfect Competition A perfectly competitive firm faces novo constraints: 1 . A market constraint summarized by the market price and the firm’s revenue curves. 2. A technology constraint summarized by firm’s product curves and cost curves (like those in Chapter 10).
The goal of the firm is to make maximum economic profit, given the constraints it faces. So the firm must make four decisions: Two in the short run and two in the long run. Short-Run Decisions In the short run, the firm must decide: 1 . Whether to produce or to shut down temporarily. 2. If the decision is to produce, what quantity to produce. Long-Run Decisions In the long run, the firm must decide: 1. Whether to increase or decrease its plant size. 2. Whether to stay in the industry or leave it Profit-Maximizing Output 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 the total revenue and total cost curves. Figure 1 1. 2 on the next slide looks at these curves along with the firm’s total profit curve. The Firm’s Decisions in Perfect Competition Part (a) shows the total revenue, TRY, curve. Part (a) also shows the total cost curve, ETC, which is like the one in Chapter 10. Total revenue minus total cost is economic profit (or loss), shown by the curve PEP in part (b). 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.
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. Marginal Analysis The firm can use marginal analysis to determine the approximating 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, MAC. Figure 1 1. 3 on the next slide shows the marginal analysis that determines the profit-maximizing output.
If MAC, economic profit increases if output Increases. If MR. In part (b), price exceeds average total cost and the firm makes a positive economic profit. In part (c) price is less than average total cost and the firm incurs an economic loss-??economic profit is negative. The Firm’s Short-Run Supply Curve A perfectly competitive firm’s short run 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 there is a price below which the firm produces nothing and shuts down temporarily. Temporary Plant SSH outdone If price is less than the minimum average variable cost, the firm shuts down temporarily and incurs an economic loss equal to total fixed cost. This economic loss is the largest that the firm must bear. Fifth firm were to produce just 1 unit Of Output at a price below minimum average variable cost, it would incur an additional (and avoidable) loss. The shutdown point is the output and price at which the firm just covers its total variable cost.
This point is where average variable cost is at its minimum. It is also the point at which the marginal cost curve crosses the average variable cost curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily. It incurs a loss equal to total fixed cost from either action. If the price exceeds minimum average variable cost, the firm produces the quantity at which marginal cost equals Price exceeds average variable cost, and the firm covers all its variable cost and at least part of its fixed cost. Short-Run Supply Curve Figure 1 1. Shows how the firm’s short-run supply curve is constructed. If price equals minimum average variable cost, SSL 7 in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T. If the price is $25, the firm day, the quantity at which If the price is $31 , the firm produces 10 sweaters a The blue curve in part (b) traces the firm’s short-run supply curve. Short-Run Industry Supply Curve The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant.
Figure 1 1. 6 shows the supply curve for an industry that has 1,000 firms like Candy’s. The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price. At a price equal to minimum average variable cost-??the shutdown price the industry supply curve is perfectly elastic cause some firms will produce the shutdown quantity and others will produces zero. Output, Price, and Profit in Perfect Short-Run Equilibrium Short-run industry supply and industry demand determine the market price and output.
Figure 1 1. 7 shows a short-run equilibrium. A Change in Demand An increase in demand bring a rightward shift of the industry demand curve: the price rises and the quantity increases. A decrease in demand bring a left;rd shift of the industry demand curve: the price falls and the quantity decreases. Long-Run Adjustments In short-run equilibrium, a firm may make an economic refit, break even, or incur an economic loss. Which of these outcomes occurs determines how the industry adjusts in the long run.
In the long run, the firm may: 50 Enter or exit an industry Change its plant size 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 1 1. 8 on the next slide shows the effects of entry and exit. Effects of Entry As new firms enter an industry, industry supply increases. The industry supply curve shifts rightward. The price falls, the quantity increases, and he economic profit Of each firm decreases. The Effects of Exit As firms exit an industry, industry supply decreases. Hafts leftward. The price rises, the quantity decreases, and the economic loss of each firm remaining in the industry decreases. Changes in Plant Size A firm changes its plant size whenever doing so is profitable. If average total cost exceeds the minimum long-run average cost, the firm changes its plant size to lower average costs and increase economic profit. Figure 1 1. 9 on the next slide shows the effects of changes in plant size. If the price is $25 a sweater, the firm is making zero economic profit with the current plant.
Output, price, and profit in perfect But if the LIRA curve is sloping downward at the current output, the firm can increase profit by expanding the plant. As the plant size increases, the firm’s short-run supply increases, the average total cost falls, and its economic profit increases.