Firms in Perfectly Competitive Markets CHAPTER 12 Chapter Outline and Learning Objectives 12.1 Perfectly Competitive Markets 12.2 How a Firm Maximizes Profit in a Perfectly Competitive Market 12.3 Illustrating Profit or Loss on the Cost Curve Graph 12.4 Deciding Whether to Produce or to Shut Down in the Short Run 12.5 The Entry and Exit of Firms in the Long Run 12.6 Perfect Competition and Efficiency
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Firms in Perfectly Competitive Markets CHAPTER 12 Chapter Outline and Learning Objectives 12.1Perfectly Competitive Markets 12.2How a Firm Maximizes Profit.
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Firms in Perfectly Competitive Markets
CH
AP
TE
R
12
Chapter Outline and Learning Objectives
12.1 Perfectly Competitive Markets
12.2 How a Firm Maximizes Profit in a Perfectly Competitive Market
12.3 Illustrating Profit or Loss on the Cost Curve Graph
12.4 Deciding Whether to Produce or to Shut Down in the Short Run
• Entrepreneurs are continually introducing new products or new ways of selling products, which—when successful—enable them to earn economic profits in the short run.
• But in the long run, competition among firms forces prices to the level where they just cover the costs of production.
• Demand for organically grown food increased at a rate of 20 percent per year,
Prices rose
More farmers have begun participating in farmers’ markets.
• Supply increased,
• Prices dropped
• Profits from farmers’ markets is no longer higher than what they earn selling to supermarkets.
4. Price takers. Firms are unable to affect the market price.
A good crop from one wheat farmer, or if one wheat farmer stops growing wheat altogether, the market supply curve for wheat will not shift by enough to change the equilibrium price by even 1 cent.
Output
Price Firm
Output
Price Market
Perfect Competition (many small firms)• Market supply & demand determine price.• The firm’s demand will be perfectly elastic. • Firms can sell as much as they want at P• Above P, they lose business• Below P they lose revenue.
Profit is maximized by producingup to the point where the marginal revenue of the last bushel produced is equal to its marginal cost, or MR = MC. The closest Farmer Parker can come is to produce 6 bushels of wheat.
Once marginal cost is greater than marginal revenue profits begin to decline. .
a. Suppose the current equilibrium price in the basketball market is $12.50. To maximize profit, how many basketballs will Andy produce?
What price will he charge? And how much profit (or loss) will he make?
Draw a graph to illustrate your answer. Label clearly Andy’s demand, ATC, AVC, MC, and MR curves;the price he is charging; the quantity he is producing; and the area representing his profit (or loss).
Determining Profit-Maximizing Price and QuantityStep 1: Calculate Andy’s marginal cost, average total cost, and average variable cost.Andy will produce the level of output where marginal revenue is equal to marginal cost. We can calculate costs from the information given in the table to draw the required graph.Average total cost (ATC) equals total cost (TC) divided by the level of output (Q). Average variable cost (AVC) equals variable cost (VC) divided by output (Q). To calculate variable cost, recall that total cost equals variable cost plus fixed cost. When output equals zero, total cost equals fixed cost. In this case, fixed cost equals $10.00.
or Step 1: Calculate Andy’s marginal cost, and average total costAndy will produce the level of output where MR = MCAverage total cost (ATC) equals total cost (TC) divided by output
(Q).Output per
Day (Q)Total Cost
(TC)Average Total
Cost (ATC)Marginal
Cost (MC)Marginal
Revenue (MR)
0 $10.00 — —
1 20.50 $20.50 $10.50 $12.50
2 24.50 12.25 4.00 12.50
3 28.00 9.33 3.50 12.50
4 34.00 8.50 6.00 12.50
5 43.00 8.60 9.00 12.50
6 55.50 9.25 12.50 12.50
7 72.00 10.29 16.50 12.50
8 93.00 11.63 21.00 12.50
9 119.00 13.22 26.00 12.50
Step 2: MR = MC when Andy produces 6 basketballs per day. Profits per unit = MR – ATC at 6 units. (12.50 – 9.25 = 3.25). His total Profits equal per unit profits times output )3.25 x 6 = 19.50 or TR – TC = 6 x 12.50 – 55.50 = $75.00 − $55.50 = $19.50.
Suppose the equilibrium price of basketballs falls to $6.00.Now how many basketballs will Andy produce? What price will he charge? And how much profit (or loss) will he make? Draw a graph to illustrate this situation, using the instructions in part (a).
Andy will still produce the level of output where MR = MC, but MR = 6
Output per Day (Q)
Total Cost(TC)
Average Total Cost (ATC)
MarginalCost (MC)
Marginal Revenue (MR)
0 $10.00 — —
1 20.50 $20.50 $10.50 $6.00
2 24.50 12.25 4.00 6.00
3 28.00 9.33 3.50 6.00
4 34.00 8.50 6.00 6.00
5 43.00 8.60 9.00 6.00
6 55.50 9.25 12.50 6.00
7 72.00 10.29 16.50 6.00
8 93.00 11.63 21.00 6.00
9 119.00 13.22 26.00 6.00
Now MR = MC when Andy produces 4 basketballs per day. Profits per unit = MR – ATC at 4 units. (6 – 8.50 = -2.50). His total losses equal per unit losses times output )-2.50 x 4 = -10.00 or TR – TC = 4 x 6.00 – 34.00 = $24.00 − $34.00 = -$10.00.
Remember That Firms Maximize Their Total Profit, Not Their Profit per Unit
Only when the firm has expanded production to Q2 will it have produced every unit for which marginal revenue is greater than marginal cost. At that point, it will have maximized profit.
Price
Quantity
$6
$5
$4
$3
$2
$1
10 20 30 40 50 600
Price = Demand = MR
Operating at Minimum ATC
Equilibrium
ATCMC
Normal Profit
Earn economic profit MR (P) >
ATCMR (P) = ATC
Short Run Profits
Short Run Losses
Shut DownFirm can’t cover AVC, minimize
losses by shutting down
MR (P) < AVC
Output
Price Firm
MC
ATC
AVC
P3
Firm covers AVC, but not AFC:
MR (P) < ATC, but MR > AVC
MR
Entry or Exit?
Supply
Profits?
Case 1: Prices rise
Output
Price
Output
Price
• Consider the market for toothpicks. A new candy that sticks to teeth causes the market demand for toothpicks to increase from D1 to D2 … market price increases to
P2 …
MarketFirm
P1 P1
q1 Q1
D1
S1MC ATC
d1
An Increase in Market Demand
shifting the firm’s demand curve upward. At the higher price, firms expand output to q2 and earn short-run profits.• Economic profits will draw competitors into the industry, shifting the market supply curve from S1 to S2.
P2 d2
q2
D2
S2
Q2
P2
Output
Price
Output
Price
• After the increase in market supply, a new equilibrium is established at the original market price P1 and a larger rate of output (Q3).• As the market price returns to P1, the demand curve facing the firm returns to its original level.• In the long-run, economic profits are driven down to zero.
The Adjustment
MarketFirm
P1 P1
q1 Q1
D1
S1MC ATC
d1
P2 d2
q2
D2
S2
Q2
P2
Slr
Q3
d1
Price
Quantity
$6
$5
$4
$3
$2
$1
10 20 30 40 50 600
Price = Demand = MR
SR Profits
1. Price goes up
ATC
2. Firms enter, Supply increases3. Price goes down
4. No LR Profits
MC
Entry or Exit?
Supply
Case 2: Prices fall
Profits?
Output
Price
Output
Price
A Decrease in Demand
MarketFirm
P1 P1
q1 Q1
D1
S1MC ATC
d1
P2 d2
q2 Q2
P2
• If, instead, something causes market demand for toothpicks to decrease from D1 to D2 … the market price falls to
P2 shifting the firm’s demand curve downward, leading to a reduction in output to q2. The firm is now making losses.
• Short-run losses cause some competitors to exit the market, and others to reduce the scale of their operation, shifting the market supply curve from S1 to S2.
S2
D2
Output
Price
Output
Price
The Adjustment:
MarketFirm
P1 P1
q1 Q1
D1
S1MC ATC
P2 d2
d1
q2
D2
S2
Q2
P2
• After the decrease in market supply, a new equilibrium is established at the original market price P1 and a smaller rate of output Q3.• As the market price returns to P1, the demand curve facing the firm returns to its original level.• In the long-run, economic profit returns to zero.• Note the long-run market supply curve is flat Slr.
Q3
Slrd1
Price
Quantity
$6
$5
$4
$3
$2
$1
10 20 30 40 50 600
P = D = MRSR
Losses
1. Price goes down
ATC
2. Firms leave, Supply decreases3. Price goes up
4. No LR Losses
MC
Output
Price Firm
MC
ATC
AVC
• The marginal cost curve (MC) is the firm’s supply curve.
• At P2 MR = MC at q2.
• Below MC = AVC, the firm will shut down Output = 0 below P1,,
• At P3 MR = MC at q3.
The Supply Curve
P2
P3
q2 q3
P1
q1
MC is the firm’s
Supply Curve
Short Run Profits
Supply shifts out and price drops
Cause firms to enter the marketShort Run LossesCause firms to leave the marketSupply shifts in and price rises
• The two conditions necessary for long-run equilibrium in a price-taker market are depicted here.
• At the price established in the market, firms in the industry earn zero economic profit
• The quantity supplied and the quantity demanded must be equal in the market, as shown below at P1 with output Q1.
Output
Price Firm
P1
q1
MC ATC
d1
Long-run Equilibrium
Output
Price Market
P1
D
Ssr
Q1
An increase in Market Demand will lead to higher per-unit costs of production for all firms.
The long-run market supply curve in a increasing-cost industry is upward-
sloping.
a. The situation in which a good or service is produced at the lowest possible cost.
1. Productive Efficiency
b. The forces of competition will drive the market price to the minimum average cost of the typical firm.
c. Therefore, in the long run, only the consumer benefits from cost reductions.
b. Perfectly competitive firms produce up to the point where the price of the good equals the marginal cost of producing the last
unit.
MR = MC
a. Goods and services are produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.
Output
Price Firm
P1
q1
MC ATC
MR
In perfectly competitive markets, firmsa. can sell all of their output at the market price.b. produce differentiated products.c. can influence the market price by altering their output level.d. are large relative to the total market.
When we say that a firm is a price taker, we are indicating that thea. firm takes the price established in the market then tries to
increase that price through advertising.b. firm can change output levels without having any significant
effect on price.c. demand curve faced by the firm is perfectly inelastic.d. firm will have to take a lower price if it wants to increase the
number of units that it sells.
In perfectly competitive markets, individual firms have no control over price. Therefore, the firm’s marginal revenue curve is
a.a downward-sloping curve.b. indeterminate.c. constant at the market price of the product.d.precisely the same as the firm’s total revenue curve.
If marginal revenue exceeds marginal cost, a perfectly competitive firm shoulda. expand output. b. reduce output.c. lower its price. d. do both a and c.
When firms in a perfectly competitive market are temporarily able to charge prices that exceed their production costs,
a. the firms will earn long-run economic profit.b. additional firms will be attracted into the market until price falls to
the level of per-unit production cost.c. the firms will earn short-run economic profits that will be offset by
long-run economic losses.d. the existing firms must be colluding or rigging the market,
otherwise, they would be unable to charge such high prices.
expand output
Suppose a restaurant that is highly profitable during the summer months is unable to cover its total cost during the winter months. If it wants to maximize profits, the restaurant shoulda. shut down during the winter, even if it is able to cover its variable costs during that period.b. continue operating during the winter months if it is able to cover its variable costs.c. go a out of business immediately; losses should never be tolerated.d. lower its prices during the summer months.
This graph illustrates a firma.capable of earning economic profit.b.that is only able to break even when it maximizes profit.c.taking economic losses.d.that should shut down immediatelyThis graph depicts the cost curves of a firm in a perfectly competitive industry. At what output would the firm’s per-unit cost be at a minimum?a. 100 c. 150b. 125 d. an output > 150
For the above graph, if the market price is $30, what is the firm’s profit-maximizing output and maximum profit.a. output, 125; economic profit, zerob. output, 125; economic profit, between $1,000 and $1,250c. output, 150; economic profit, $1,500d. output, 150; economic profit, between $1,250 and $1,500