• Three assumptions in p.c. model:
• 1)
Price-taking : many small firms, none can affect mkt P by
 ing Q
 no mkt power. Firm can sell all it wants at mkt P so faces perfectly elastic (horizontal) product demand curve.
• 2
) Product homogeneity : each firm produces nearly identical product
 all are perfect substitutes. This assures there will be single mkt P
• 3)
Free entry and exit: assures big number of firms in industry.

• Real-life examples mostly found in agriculture.
• Large # firms means 
10 – 20 firms in industry.
• P.C. model is an ideal; serves as useful starting point.
•
Additional assumption:
– Firms’ goal is to maximize profits
(good assumption given large # firms).
– Principal-agent problems more in news lately; to be discussed later.
– 
-max goal extends beyond P.C. market structure.

• Define profit = TR – TC
• 
(q) = R(q) – C(q), or
• 
= R – C.
• q* represents firm’s 
-max level of output.
•
To achieve

-max : firm picks q* where difference between
TR and TC is greatest.
• With graphs of TR and TC: max
 where have greatest vertical distance between TR and TC.

• TR: slope is MR
• TC: slope is MC.
•  function: see inverse U-shape: plots out vertical distance between
TR and TC.
•
Max
 where:
– 1) TR – TC is largest
– 2) slope TR = slope TC; or
–
MR = MC.
– 3) Rule for all firms (PC or not):
• pick

-max q* where MR = MC.

• Keep terms straight:
– Q = market output;
– D = market demand;
– q = firm output;
– d = firm demand.
•
Market D is downward sloping but demand curve faced by individual firm is perfectly elastic
(horizontal).
– Interpret: firm can sell all it wants to sell at the single market price.
– In other words, its selection of q* has no impact on market price.
– So: firm demand curve is same as its
MR curve.

•
Recall under PC: firm’s demand curve is its MR curve.
• This means that P 
MR.
•
Profit-max rule for PC firm:
Pick

-max q* where MC = MR = P .
• Also, since P 
MR for each q, then P = MR = AR.
• Draw simple graph to see 
max q*.

• Revise rule : pick

-max q* where
MR = MC AND MC is rising.
– Recall: this rule applies to all firms, not just p.c. firms.
• Short Run profit for p.c. firm :
• P - ATC at q* = average profit per unit of q.
• Recall: 
= TR – TC; So:
• 
/q = TR/q – TC/q
•
Avg.

= P – ATC.
• Total
 at q* = q*

(P-ATC).

•
Situation : What if, in the SR,

-max q* results in losses?
•
Firm must choose (1) vs (2):
• 1) Continue producing at q* and incurring the full losses.
• 2) Shutdown in SR (I.e., produce q-0) , which will reduce losses but firm still must pay FC and now have NO revenues.

• At q*, firm must know::
– P,
– ATC, and
– AVC.
• Rule :
– If
 
0 in SR (so P

ATC at q*): continuing producing q* as long as
P

AVC.
– In other words: continue to produce q* as long as firm is covering operating costs.
–
In LR : any negative profits will cause shutdown and exit from industry. (So:
LR shutdown if P

ATC).

• Coffee mug company: P = $8.
•
Currently , q = 200;
• MC = $10 = ATC.
•
If did have q=150, then:
• MC = $6 = AVC.
•
Questions : With

-max goal:
– 1. Should firm stick with q=200, reduce, or increase?
– 2. Would shut-down be better?

•
Supply Curve : shows q produced at each possible price.
•
SR supply curve
: the firm’s
MC curve for all points where
MC

AVC.
– I.e., 
-max q* is where P

AVC.
• Remember “trigger” for shutdown in SR
 implies that
MC curve has an irrelevant part
(where MC

AVC).


• Consider:  price input
 causes

MC at each q
 shift up to left of MC curve.
• See Figure 8.7:
– Start at P = $5 with MC
1
; so q*
= q
1
.
– Now:  price input causes

MC:
– Shifts MC up to left.
– Causes  q*.

• Shows: amount of Q the industry will produce in SR at each possible price.
• Sum SR supply curves for firms using horizontal summation.
• That is: at each possible price, sum up total quantity supplied by each firm.
• See Figure 8.9.
• (Note that we are assuming that, for each firm, as q
 es, individual MC curves no

.).

•
• E
S
= %

Qs/1%

P
= (

Q/Q) / (

P/P).
• E
S

0 always because SMC slopes upward.
• If MC  a lot when

Q (or, costly to

Q), then E
S is low.
•
Extreme cases:
–
Perfectly inelastic S : vertical.
• When industry’s plant and equipment so fully utilized that greater output can be achieved only if new plants built.
–
Perfect elastic S : horizontal (MC no
 when Q

)

• Concept analogous to CS.
• For rising MC: P 
MC for every unit of q except last one produced.
• For a firm (see Figure 8.11):
– For all units produced (up to q*):sum the differences between mkt P and MC of production.
– Measures area above MC schedule (S curve) and below mkt price.

• If each firm earns zero economic

, each firm is in LR equilibrium.
•
Three conditions:
– 1. All firms in industry are profitmaximizing.
– 2. No firm has incentive to enter or leave industry (due to

= 0).
– 3. P is that which equates
Q S = Q D in market.

• Firm starts in SR equilibrium.
• Positive profits induce new firms to entire industry so industry S curve shifts rightward.
• This causes market P to fall.
• This causes firm’s MR line to fall, until profits = 0 again.
– Key: firms enter as long as P 
ATC
• Note: in this case, MC no shift due to constant cost assumption.
•
LR choice of q*:
– where LMC = P = MR = LAC.
– Key is LMC=LAC.

• Economic Rent :
– Difference between what a firm is willing to pay for an input and the minimum amount necessary to buy the input.
•
For an industry : economic rent is same as LR producer surplus.
• For a fairly fixed factor (like land): bulk of payments for the factor is rent (so factor S curve is vertical).
• In LR in a competitive mkt: PS that firms earn for Q is the economic rent from all its scarce inputs.
• Presence of economic rent can explain why profits might persist in
LR.

• Cannot just sum individual firms horizontally because as price
 es, # firms in industry
 es. Must connect the zero-profit points.
•
Shape of LR supply curve : depends on whether (and in what direction) the
 es in each firm’s q causes  es in input prices.
– Constant cost industry : As q and Q

, input prices no
 so firm’s MC, AVC, and ATC NO shift as q changes.
– Here, long run industry supply curve is flat (perfectly horizontal).
–
Example: coffee industry (land for growing coffee widely available).

•
Increasing cost industry
– Example: oil industry (limited availability of easily accessible, large-volume oil fields, so to
 q, firms costs rise too).
– Result is upward-sloping long run industry supply curve.
•
Decreasing cost industry
– Example: automobile industry
(AC falls as industry output rises)
– Result is downward-sloping long run industry supply curve.

• In an increasing cost industry starting in LR equilibrium:
– What is the immediate and then longrun effect of a shift to the left in market demand? Show and discuss the process of return to LR equilibrium.
• 1. Will the market price rise, fall, or stay the same?
• 2. What are the effects on the long-run market quantity and the long-run firm quantity?
• 3. What is the shape of the long-run supply curve?
• 4. What would be different if the industry were a constant cost industry? Decreasing cost industry?