CHAPTER 10
OPTIMUM OUTPUT OF A PERFECTLY COMPETITIVE FIRM
1.
2.
3.
4.
5.
6.
7.
1.
Introduction
Optimum Output Q—Total Revenue-Total Cost Approach
2.1. The Revenue Side
2.1.1. Total Revenue of a Firm Under Perfect Competition
2.1.2. Marginal Revenue of a Perfectly Competitive Firm
2.2. The Cost Side
2.3. The Optimum Q
Optimum Q—Marginal Revenue-Marginal Cost Approach
3.1. Using the Average Cost Curves to Determine the Firm’s Profit
3.1.1. Case I: The Firm is Making an Economic Profit
3.1.1.1. Economic Profit Revisited
3.1.2. Case II: The Firm is Breaking Even or Making a Normal Profit
3.1.2.1. What is a Normal Profit?
3.1.3. Case III: Negative Economic Profit (Economic Loss)
3.1.3.1. Should the Firm Shut Down when Incurring an Economic Loss?
3.1.4. Case IV: Economic Loss—Shut-Down Case
Marginal Cost—the Firm’s Short-Run Supply Curve
Industry (Market) Supply and Market Demand
5.1.
Market Equilibrium Price and Quantity
5.2.
Economic Profits will Attract More Resources to the Industry
5.3.
Entry of New Firms and Disappearance of Economic Profit
Long-Run Industry Supply—How Resources Are Allocated Under Perfect Competition
6.1.
Long-Run Industry Supply—Constant Cost Industry
6.2.
Long-Run Industry Supply—Increasing Cost Industry
Efficiency of Perfect Competition
Introduction
The firm’s function in the market place is to supply goods and services, and the only incentive for the firm to
continue production is making a profit. The firm’s profit is the difference between its receipts from selling the
products (total revenue) and the cost of producing them (total cost). The firm, in fact, is not just interested in
making a profit. The rational-behavior assumption requires that the firm maximize its profits. The firm’s total
revenue and total cost are both a function of the level of output Q, the quantity it produces and sells in the
marketplace. To maximize profits, therefore, the firm must determine the optimum or profit-maximizing (and in
some cases, loss minimizing) level of output.
The firm’s optimum output level can be determined in two ways: (1) the Total Revenue-Total Cost approach; and
(2) Marginal Revenue-Marginal Cost approach. The two should result in the same optimum Q. As by now you
should recognize, the marginal approach is the preferred one. That is the one which will be used in subsequent
analyses of the behavior of the firm.
2.
Optimum Output Q—Total Revenue-Total Cost Approach
2.1.
The Revenue Side
The firm is interested in maximizing its profits. Profit is defined as the difference between total revenue and total
cost: π = TR − TC. The firm’s total revenue is simply the product of price times the quantity produced and sold.
1
TR = P × Q
2.1.1. Total Revenue of a Firm Under Perfect Competition
What is perfect competition? When discussing the firm’s revenue, it is very important to recognize a central
assumption about the nature of the firm, the context in which the firm operates. The firm discussed in this chapter
is a representative firm in a perfectly competitive industry. Economists use a specific set of criteria to provide a
precise definition of “perfect competition”, or a “perfectly competitive industry”. These criteria are:
In a perfectly competitive industry,
 There are large number of firms. And, because there are many firms, each firm's output is a very small
fraction of the total output of the whole industry.
 All firms produce a homogeneous or standardized product. One firm's product cannot be distinguished from
another's. Farmer Smith’s wheat is the same as farmer Jones’ wheat.
 All firms are price takers. Each firm must abide by the price dictated by the market. A representative firm
cannot raise its price simply because no one will buy from it. There are other suppliers readily available who
sell the product at the going lower price. And it would not lower its price below the market price because it
can sell all it produces at the going higher market price—unless, of course, the owner of the firm is nuts. This
is why a perfectly competitive firm is said to be a "price taker".
 There are no barriers to entry of new firms to the industry. If there are profit opportunities in the industry,
new firms will enter the industry to take advantage of the higher (economic) profit. Also firms can freely exit
the industry, if there are better opportunities to use the resources somewhere else, that is, if the opportunity
cost of remaining in the industry becomes too high.
Because the firm in a perfectly competitive industry is a price taker, to increase its revenue, it is free only to
change the quantity variable Q in the total revenue function TR = P∙Q . Price P is therefore a parameter dictated to
the firm by the market; it cannot adjust it at will.
2.1.2. Marginal Revenue of a Perfectly Competitive Firm
Marginal revenue (MR) is the revenue earned from each additional unit of output sold. Note that for a competitive
firm, who must "take" the price dictated by the market, and can sell any number of units at that price, marginal
revenue is always equal to price. This important feature of marginal revenue for a perfectly competitive firm can
be shown by the fact that MR is the derivative of the linear TR function with respect to quantity.
TR = PQ
MR =
dTR
=P
dQ
Let, for example, P = $50. Then the derivative of TR = 50Q with respect to Q is MR = 50. Also note that, since
TR = PQ is a linear function, the derivative of TR, MR, is also the slope of the TR function.
MR =
dTR TR
=
dQ
Q
Table 10-1 shows the firm’s total revenue and marginal revenue for various levels of output
2
Q
P
TR
0
$50
$0
1
50
50
2
50
100
3
50
150
4
50
200
5
50
250
6
50
300
Table 10-1. Marginal revenue
schedule of a perfectly competitive
firm
Because a perfectly competitive firm
is a price taker, and each additional
unit is sold at the going market price,
marginal revenue is always equal to
the price.
MR
$50
50
50
50
50
50
Figure 10-1 shows the graph of the TR and MR curves.
350
TR = PQ
Marginal Revenue (dollars)
Total Revenue (dollars)
300
250
200
∆TR = 50
150
∆Q = 1
100
Slope = ∆TR ⁄ ∆Q = 50 = P
50
50
MR = P
0
0
1
2
3
Q
4
5
6
0
7
1
2
3
4
5
6
7
Q
Figure 10-1. Total Revenue Curve and Marginal Revenue Curve of a Perfectly Competitive Firm
Since a perfectly competitive firm can sell its output only at the going market price, each additional unit would
earn a marginal revenue which is equal to price. The MR curve is the constant slope of the linear TR curve.
Note that the TR curve is a linear curve rising with the number of units produced and sold. Marginal revenue,
however, is a horizontal line because the price for each additional unit (revenue received for each additional unit)
sold remains at the given market price level of $50.
We will use both the TR and MR curves in determining how a representative competitive firm maximizes its profit.
As mentioned, profit is the difference between TR and TC. We looked at TR. Now consider the firm's TC schedule
or TC curve.
3
2.2.
The Cost Side
In the previous chapter we learned that the firm's total cost (TC) is the sum of its total fixed cost (TFC) and total
variable cost (TVC).
TC = TFC + TVC
All cost schedules are related to (are functions of) the output level Q. Consider Bob’s perfectly competitive firm in
the schmoo industry with the following cubic total variable cost function:
TVC = 50Q − 12Q² + Q³
Let TFC = $100. Then,
TC = TFC + TVC = 100 + 50Q − 12Q² + Q³
Using the above cost function, Table 10-2 shows the cost figures for different levels of output. Also, assuming the
market price of schmoo of P = $50, the TR column in Table 10-2 shows Bob’s total revenue.
Q
0
1
2
3
4
5
6
7
8
9
10
11
2.3.
TVC
$0
39
60
69
72
75
84
105
144
207
300
429
TC
$100
139
160
169
172
175
184
205
244
307
400
529
TR = 50Q
$0
50
100
150
200
250
300
350
400
450
500
550
π = TR − TC
-$100
-89
-60
-19
28
75
116
145
156
143
100
21
Table 10-2. Total variable cost, total cost, total
revenue, and economic profit
The figures in the TVC column are obtained using
the cubic function
TVC = 50Q − 12Q² + Q³
The TC column provides the total cost data. It is
obtained by adding the fixed cost of $100 to TVC at
each output level.
Total revenue is TR = 50Q, where P = $50 is
dictated by the market to the firm.
The difference between TR and TC shown as
π = TR – TC
is the profit equation.
The Optimum Q
The firm maximizes profit by comparing TR to TC. The output level at which the difference between TR and TC is at
its maximum is the optimum output level. In Table 10-2 the highlighted optimum output level is Q = 8, at which
profit is maximized at π = 400 − 244 = 156.
Using simple calculus we can determine the optimum output from the profit equation or function π = TR – TC.
Given the total cost and total revenue functions above, first determine the profit function.
TC = 100 + 50Q − 12Q² + Q³
TR = 50Q
π = TR − TC
π = 50Q – (100 + 50Q – 12Q² + Q³)
π = −100 + 12Q² − Q³
To maximize the profit function, set the first derivative of the profit function with respect to Q equal to zero.
dπ
= 24Q − 3Q²
dQ
4
24Q − 3Q² = 0
Q(24 – 3Q) = 0
24 – 3Q = 0
Q=8
You may also use the quadratic formula to find the value for Q from 3Q² − 24Q = 0.
Q=
24  242  4  3  0
=8
23
The maximum profit is then:
π = 50(8) − 100 − 50(8) + 12(8)² − (8)³ = 156
Figure 10-2 shows that the vertical difference between TR and TC is the largest at Q = 8.
600
Figure 10-2. Optimum Quantity
Total Cost and Total Revenue (dollars)
550
TR
TC
500
450
400
400
350
Optimum quantity is the output level at which
profit , π = TR − TC, is maximized. Profit is
maximized where the vertical gap between TR
and TC is the largest. Mathematically this
occurs where the slope of the line tangent to
the TC curve is parallel to the TR line.
300
250
244
200
150
100
50
0
0
1
2
3
4
5
6
7
8
9
10 11 12
Q
3. Optimum Q—Marginal Revenue-Marginal Cost Approach
The more prevalent method to find the theoretical profit maximizing level of output of a firm in economics is to
use the marginal revenue-marginal cost approach. Figure 10-2 already provides the background for the MR-MC
approach. In Figure 10-2 note that the gap between MR and MC is maximum when the slope of the linear MR
function is equal to the slope of the line tangent to the TC curve—that is, when the TR line is parallel to the
tangent line. Mathematically speaking, the slope of a continuous function at any given point is the first derivative
of the function at that point. Since TR is a linear function, the slope of TR is constant at any point along the straight
line. The slope of the TC function, represented by the slope of line tangent to the TC function, however, varies
along the curve. We learned that the slope of the TR function is the marginal revenue, and the slope of the line
tangent to the TC curve is the marginal cost (the derivative of the TC function). In order for the slopes of the two
functions to be the same, then marginal revenue must equal to marginal cost.
We have already learned that in the marginalist approach to optimization marginal cost must equal marginal
benefit for the optimum choice. The choice decision here is: what quantity is the optimum quantity? The firm
5
must determine if any additional output would add to the total profit or reduce it. The firm must weigh the
revenue against the cost arising from the additional output, that is, the firm must compare the marginal revenue
against marginal cost. If MR from the additional output exceeds the MC, then the firm will increase output. The
optimum is Q achieved when MR = MC.
As explained above, for a perfectly competitive firm, marginal revenue is always equal to the price:
MR = P
Thus, the optimality condition for a perfectly competitive firm can be stated as:
P = MC
Knowing this, now we can show how the MR-MC approach can be used to determine the firm’s optimal output.
Table 10-3 compares the total revenue-total cost approach to the marginal revenue-marginal cost approach.
MC
Q
0
TC
$100
TR
$0
π = TR − TC
-$100
dTC ⁄ dQ
$50
1
139
50
-89
29
∆TC ⁄ ∆Q
MR = P
$50
$39
50
21
2
160
100
-60
14
3
169
150
-19
5
50
9
50
3
4
172
200
28
2
50
3
5
175
250
75
5
6
184
300
116
14
50
9
50
21
7
205
350
145
29
50
39
8
244
400
156
50
50
63
9
307
450
143
77
50
93
10
400
500
100
110
50
Table 10-3. The optimum output of a perfectly competitive firm
The optimum Q is that which maximizes the firm’s profit. If (theoretically) output is measured
in very small or fractional scale, then we can use the first derivative of the TC as the MC
function. Then the optimum Q is achieved when MC is exactly equal to MR or price. If output is
increased in discrete scale, then MC is measured as ∆TC ⁄ ∆Q. In that case the optimum Q is
achieved when the positive difference between MR and MC is the smallest.
As the table shows, both approaches provide an identical optimum Q = 8 units. Note again that when the gap
between TR and TC is at its maximum (maximum profit), the positive difference between MR and MC is at its
minimum. When the firm is producing less than 8 units, it would make sense to increase output because the price
received (MR) exceeds the cost (MC) of the producing the additional unit. This holds until the output level Q = 8 is
6
reached. At this point the total profit is $156, the maximum value in the profit column. Any further increase in Q
will entail a marginal cost which is greater than marginal revenue. The profit level will then fall from the maximum
of $156.
If output could be measured on a small, fractional scale, that is, if Q were divisible into very small units, then the
ultimate optimality condition, MR = MC can be achieved. The MR = MC optimum condition can be determined
algebraically and shown graphically.
We know MR and MC are each the first derivative of, respectively, TR and TC functions. We can therefore find
these derivatives, set them equal, and solve for Q.
TR = 50Q
TC = 100 + 50Q − 12Q2 + Q3
dTR
= 50
dQ
dTC
MC =
= 50 − 24Q + 3Q2
dQ
MR =
MR = MC
50 = 50 − 24Q + 3Q2
3Q2 − 24Q = 0
Using the quadratic formula, the optimum Q is:
Q=
24  24 2  4  3  0
=8
23
Figure 10-3 shows that both TR-TC and MR-MC yield the same optimum, profit maximizing, level of output.
7
600
Total Cost and Total Revenue (dollars)
550
TR
TC
500
Figure 10-3. Optimum quantity--TR/TC
versus MR/MC
In the lower panel, the optimum output
level is where MR = MC. The same
optimum output level in the upper panel
provides that the gap between TR and TC is
the largest.
450
400
400
350
300
250
244
200
150
100
50
0
Marginal cost and marginal revenue (dollars)
0
1
2
3
4
5
6
7
8
9
10 11 12
Q
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
MC
MR
0
3.1.
1
2
3
4
5
6
7
8
9
10 11 12
Q
Using the Average Cost Curves to Determine the Firm’s Profit
To use the MR-MC approach we need to include the other components of the model that are needed to compute
the firm’s profit or, as it may happen, losses. These components are the Average Total Cost (ATC) and the Average
Variable Cost (AVC). If the price at which each unit is sold (average revenue) is greater than ATC, then the firm
would be earning an economic profit. If it is lower than ATC, then the firm is incurring an economic loss.
Furthermore, as will be shown below, when the firm is incurring an economic loss, AVC will determine whether the
firm should continue operating even with a loss, or if it should shut down immediately. Sounds complicated?
Don’t worry, it will all be clear.
8
3.1.1. Case I: The Firm is Making an Economic Profit
Looking at the firm’s revenue/cost situation from the average, rather than total, perspective, the firm’s operations
are profitable if the price exceeds average total cost of producing the optimum quantity. In table 10-4, the
optimum quantity, where MC = P = $50, is Q = 8. At that output level ATC = $30.50. Therefore the firm is making a
profit of $50 − $30.50 = $19.50 per unit. The total profit is the $19.50 × 8 = $156.
Q
0
1
2
3
4
5
6
7
8
9
10
TC
$100
139
160
169
172
175
184
205
244
307
400
ATC
MC
$50
29
14
5
2
5
14
29
50
77
110
$139.00
80.00
56.33
43.00
35.00
30.67
29.29
30.50
34.11
40.00
P
$50
50
50
50
50
50
50
50
50
50
Table 10-4. Comparing ATC
to price—economic profit
per unit
At the optimum quantity of
Q = 8, the firm’s ATC is
$30.50, compared to the
price $50. The firm is making
a profit of $19.50 per unit, for
a total profit of: $19.50 × 8 =
$156
Figure 10-4 shows ATC, and MC curves on the cost side, and the horizontal MR = P curve on the revenue side. As
the diagram shows, the firm’s optimum output is Q = 8 units. This output is determined by the intersection of the
MR = P curve with MC. The firm sells each unit of output for $50. Therefore, its revenue per unit (or average
revenue) is $50, At Q = 8, ATC is $30.50 (see Table 10-4). The difference between ATC and price is the firm’s profit
per unit or average profit: $50 − $30.5 = $19.2. Total profit, π = $19.5 × 8 = $156, is shown as the area of the
rectangle ABCD.
Marginal Cost and Marginal Revenue (dollars)
160
150
140
MC
130
120
110
100
90
80
70
60
50
A
40
30
D
MR = P
B
ATC
C
20
10
0
0
1
2
3
4
5
6
7
8
9
10 11 12
Q
9
Figure 10-4. The firm earns an
economic profit if P > ATC
At the optimum quantity of Q = 8, the
price the firm receives (point B)
exceeds the ATC (point C). Profit per
unit is BC = P − ATC. Total profit is the
area of the rectangle ABCD,
3.1.1.1.
Economic Profit Revisited
In Figure 10-4, when the MR = P line intersects the MC curve at a point above the minimum ATC, the firm is making
an economic profit. Why the term “economic” profit? The meaning of economic profit is that the return to the
resources allocated for the production of the good in question is above the return on any other alternative
allocation. You may interpret economic profit in the following way as well: The opportunity cost of allocating the
firm’s resources to the good in question is the return forgone from the allocation to the next best alternative good.
Economic profit, therefore, means that the return on the existing allocation exceeds its opportunity cost.
3.1.2. Case II: The Firm is Breaking Even or Making a Normal Profit
Marginal Cost and Marginal Revenue (dollars)
When the price is equal to the minimum average total cost, then MC intersect MR = P at ATCMIN. In this situation
the firm is making zero economic profit. The firm is said to be breaking even. Figure 10-5 represents the breakeven optimum output. The optimum output is Q = 7, where P = MC = ATCMIN = $29.3. When the optimum output
is at the break-even point, the firm is said to be making a normal profit.
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
MC
Figure 10-5. The break-even case—the
firm earns zero economic profit, but
earns normal profit
At the optimum quantity of Q = 7, the
price the firm receives is equal to ATC.
The economic profit is, therefore, zero.
However, the firm is earning a normal
profit. Normal profit means a fair
return on the economic activity; a
return no greater than that could be
earned in the next best alternative.
ATC
MR = P
0
1
2
3
4
5
6
7
8
9
10 11 12
Q
3.1.2.1. What is a Normal Profit?
When the return on the existing allocation is equal to its opportunity cost, that is, when it is equal to the return on
the next best alternative allocation, the firm is making a normal profit. This is the return on investment that
should keep the owner of the firm satisfied. This means that the owners of the firm could do no better; they are
earning a fair return on their activity.
10
3.1.3. Case III: Negative Economic Profit (Economic Loss)
MC, MR, ATC, AVC (dollars)
When price is below the minimum ATC, the firm is not covering all of its costs. Therefore, the firm is incurring an
economic loss, meaning that the return on the activity is less than the return on the next best alternative. Or, the
return on the allocation of resources on the current activity is less than its opportunity cost. Figure 10-6 shows the
economic loss case.
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
MC
ATC
AVC
MR = P
0
1
2
3
4
5
6
7
8
9
Figure 10-6. The economic loss case.
At the optimum quantity of Q = 6.4, the
price the firm receives is less than ATC.
The firm is incurring an economic loss.
However, the firm should continue to
operate because it is covering part of
its fixed costs or long-term unavoidable
obligations.
Consider the TR and TC in the
diagram:
TR = $20 × 6.4 = $128
TC = $30 × 6.4 = $192
π = TR − TC = −$64
If the firm shuts down, it still would
have to cover its fixed costs of $100.
So by shutting down it would incur a
loss of $100, rather than $64 if it
continues to operate.
10 11 12
Q
An interesting and a very important question arises when the firm is incurring an economic loss:
3.1.3.1. Should the Firm Shut Down when Incurring an Economic Loss?
Since the return on the activity is less than the opportunity cost of the activity, should the firm shut down and
allocate its resources to an alternative which has a higher return? The answer in this case is no. It should continue
the operation in the short run. Why? The answer to this question lies in the firm’s fixed cost.
The firm’s total fixed cost, as we already know is $100. If the firm shuts down it will still have to cover its
contractual obligations. If it continues to operate, not only it will cover its variable (or operating) costs, but it will
also recover part of the fixed cost, thus minimizing its losses. In Figure 10-6, the price is P = $20, at which the
optimum quantity is Q = 6.4 units (fractional units are permitted in this example). The firm’s total revenue is
$20 × 6.4 = $128. Given the ATC of $30, the total cost is $30 × 6.4 = $192. The economic loss is
$128 − $192 = −$64. Since the loss is less than the fixed cost, the firm is covering a portion of its fixed cost
contractual obligations ($100 − $64 = $36). If the firm shuts down it will not be able to recover this portion of the
fixed costs. So its loss would be much greater.
When price is below the ATCMIN but above the AVCMIN, the firm is making an operating profit. As long as the firm
covers all of its variable costs (is making an operating profit) and recovers any part of its fixed costs, it should
continue to operate until the fixed costs are completely covered, and then shut down and exit the industry.
11
3.1.4. Case IV: Economic Loss—Shut-Down Case
When price falls so low that it is below the minimum average variable cost (AVCMIN), then the firm is unable to fully
pay for its variable inputs and, therefore, should shut down immediately. In Figure 10-7 the price of P = $10 is
below the firm’s minimum average variable cost. The economic loss is computed as follows:
TR = $10 × 5.6 = $56
TC = $32 × 5.6 = $179.2
π = TR − TC = −$123.2
MC, MR, ATC, AVC (dollars)
If the firm continues to operate, its total loss will be −$123.2. If it shuts down immediately, its total loss would be
limited to its total fixed cost of $100.
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
MC
ATC
AVC
Figure 10-7. The shut-down case.
When the price is below the AVC, the
firm should shut down. If the firm
shuts down, its economic loss would be
limited to the total fixed cost—Here
TFC = $100.
If it does not shut down, not only the
firm does not cover any of its fixed
costs, but also is unable to cover all of
its operating (variable) costs. In the
diagram:
TR = $10 × 5.6 = $56
TC = $32 × 5.6 = $179.2
π = TR − TC = −$123.2
MR = P
0
1
2
3
4
5
6
7
8
9
10 11 12
Q
4. Marginal Cost—the Firm’s Short-Run Supply Curve
As was repeatedly shown above, the firm determines the optimum level of output where the price line intersects
MC. Recall, from Chapter 3, that the supply curve was defined as various quantities of a good a firm is willing and
able to produce at different prices, ceteris paribus. Now you can see that the amount the firm is willing and able
to produce (the amount which would maximize profits or minimize losses) at different prices is determined by the
firm’s marginal cost curve. Thus, the firm’s short-run supply curve is the same as its MC curve.
As shown in Figure 10-8, when looking at the MC curve as the firm’s supply curve, you should note that only the
part of the MC curve that lies above the minimum AVC constitutes the firm’s supply curve. It was just explained
that when the price is less than the minimum AVC the firm should produce nothing and shut down.
12
MC, MR, ATC, AVC (dollars)
160
150
140
130
120
110
100
90
80
70
60
50
40
30
20
10
0
MC = S
P₂
Figure 10-8. The firm's supply curve is
its marginal cost curve.
The firm's supply curve is the MC curve
above the minimum AVC. Once the
price falls below P₀, the shut-down
point, losses exceed fixed costs and the
firm shuts down.
If the price is P₁ = $50, the quantity
supplied is 8. If the price rises to P₂,
quantity supplied will increase to 10.
P₁
AVC
P₀
0
1
2
3
4
5
6
7
8
9
10 11 12
Q
5. Industry (Market) Supply and Market Demand
5.1.
Market Equilibrium Price and Quantity
In Figure 10-9 the industry supply is shown as the horizontal sum of the MC curves of all the firms operating this
perfectly competitive industry. The industry (or market) supply together with the market demand determine the
market equilibrium price and quantity. The market equilibrium is the signal received by individual firms, according
to which each firm determines the optimum quantity it should produce. The independent decisions of all the
firms, along with the independent decisions of the buyers on the demand side, generates the equilibrium price.
This price is the benchmark which determines the optimum output of each firm. The essence of perfect
competition is that each individual firm has no influence on the price by itself. All firms are price takers.
5.2.
Economic Profits will Attract More Resources to the Industry
In Figure 10-9, the equilibrium price is above the ATCMIN. The representative firm is therefore making an economic
profit, shown as the shaded rectangle. Will this economic profit last for long? The answer is no. The
representative firm earns an economic profit only in the short-run. Here is where another one of the features of a
perfectly competitive industry comes into play. There are no barriers for the outside firms to enter this industry.
High economic profits will soon attract resources from elsewhere. What is the result? The answer is what comes
next.
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Figure 10-9. Industry supply is the horizontal sum of the MC curves of all the firms in this industry.
With the industry supply of S and the market demand of D, the equilibrium market quantity is 3,600 and
the equilibrium price is $80. At this price the representative firm is making and economic profit.
5.3.
Entry of New Firms and Disappearance of Economic Profit
When the representative firm is making an economic profit, the return on the resources in the industry is higher
than the return on the resources is in the alternative industries. If resources are free to move, they always go
where the profit is higher. If the profits are higher in the schmoo industry than in the gizmo industry, then
resources will flow from gizmo to schmoo industry. As shown in Figure 10-10, the flow of resources into the
schmoo industry will shift the schmoo industry supply to the right, thus reducing the price of schmoos. The fall in
prices will gradually squeeze the economic profit out until all economic profits are eliminated and only normal
profits remain. Thus, the return on resources in the schmoo industry fall to the same level as that in the gizmo
industry.
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Figure 10-10. Long run industry equilibrium--zero economic profit for the representative firm.
Referring back to Figure 10-9, at the equilibrium price of $80 the representative firm is making an economic
profit. This will attract new firms to the industry. The industry supply will shift to the right, bringing the
equilibrium price down to where it is equal to the ATC MIN of the representative firm. Once the zero
economic profit equilibrium price is reached entry of new firms will stop. The representative firm will make
a normal profit.
6. Long-Run Industry Supply—How Resources Are Allocated Under Perfect
Competition
The theoretical appeal of the perfectly competitive model rests on the notion of “efficiency of perfect
competition”. To get to this, first let’s consider how firms in the perfectly competitive schmoo industry respond to
market signals, and how the firms’ response leads to allocation of resource from one industry to another. This
signal is nothing other than the change in the price of schmoo. In Figure 10-11 Panel (a), Bob’s perfectly
competitive firm is responding to the price of $55 determined in the schmoo market in Panel (b) by the
intersection of D₀ and S₀ at point A. At the price of $55, given Bob’s MC schedule, he will produce 8.2 units of
schmoos per period. Since the market price is equal to Bob’s minimum ATC, he is making a normal (zero
economic) profit. At this stage the market is in a stable equilibrium and the representative firm is breaking even.
Now suppose schmoos become popular among consumers, causing the demand to increase, shift to the right, from
D₀ to D₁. Given the industry supply, which is the sum of existing firm’s short-run marginal cost curves, the increase
in demand will push the price schmoos up to $100, the intersection S₀ and D₁ at point B. Bob and other existing
firms in the schmoo industry will enjoy a high economic profit, because price is significantly higher than the ATC.
However, the market equilibrium at point B is not permanent. Firms outside the schmoo industry will be attracted
to the high economic profits in the schmoo industry. Since there are no barriers to entry, there will then be a
steady inflow of new firms to the schmoo industry.
In Panel (b), the inflow of new firms to the schmoo industry will shift the industry supply from S₀ steadily forward
to its final location of S₁. The intersection of S₁ and D₁ at point C will now result in a new equilibrium price and
quantity. Note that the new equilibrium price at point C is the same as that at point A. The market equilibrium
quantity has increased to about 8,200. In Panel (c), Bob’s (the representative firm) output shrinks back to the
original level of 8.2 units as the price falls from $100 back to the original break-even equilibrium level of $55.
15
Panel (a)
Bob's Firm
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Figure 10-11. Long Run Industry Supply--Constant Cost Industry.
Panel (b) shows the supply and demand in the schmoo industry. With D₀ and S₀, the equilibrium price is $55 and the market
equilibrium quantity is 4,800. At this price, in Panel (a) Bob, the representative firm, is breaking even.
With demand increasing to D₁, the equilibrium price rises to $100. At this price, Bob and all the existing firms will increase
their output from 8.2 to 9.7. Now Bob is making an economic profit.
The economic profit will attract new firms to the schmoo industry pushing the supply to the right. In Panel (b) supply shi fts
from S₀ to S₁. At the intersection of D₁ and S₁, the new equilibrium price is back to $55. The market equilibrium is 8,200. In Panel
(c), the falling price forces Bob to cut his production back to 8.2 units.
The long run industry supply (LRIS) is obtain by connecting points A and C in Panel (b). LRIS is perfectly elastic. This indicates
that the industry is a constant cost industry. The entry of new firms has not caused the price of factor inputs to rise, keeping the
cost curves of the representative firm the same as before.
6.1.
Long-Run Industry Supply—Constant Cost Industry
Going back to Panel (b) in Figure 10-11, the industry’s original equilibrium at point A was disturbed by an increase
in demand from D₀ to D₁. The high new equilibrium price at the intersection of D₁ and S₀ (point B) signaled outside
firms to enter the schmoo industry pushing the supply rightward to S₁. Thus, a new lower equilibrium price is
established at the intersection of S₁ and D₁ (point C). The line connecting point A and C depicts the long-run
industry supply (LRIS) curve. Here the long run industry supply curve is perfectly elastic. When the LRIS is
horizontal, the industry is called a constant cost industry. What does this mean?
A constant cost industry is a situation where as new firms enter the industry in response to a higher return, they
bring all the required resources or factor inputs with them. The existing firms, therefore, do not encounter a rise
in the price of factor inputs. Their costs thus remain unchanged or constant.
6.2.
Long-Run Industry Supply—Increasing Cost Industry
In some cases, as new firms enter the industry to take advantage of high profits, the new entrants must compete
with the existing firms for some factor inputs, thus bidding up the price of that input. For example, as the demand
for wine increases, pushing up the price of wine, more wineries will open up. However, the supply of land suitable
for vineyards may be limited. The price of vineyards thus will be bid up. Rent on land, as an implicit or explicit cost
of production, will rise, pushing up the production cost schedules for both the new and existing wineries.
In Figure 10-12, in Panel (b), the rise in demand for schmoos from D₀ to D₁ has pushed the price up to from $55 to
$100. New firms enter, pushing the industry supply to the right. However, unlike the constant-cost industry case,
the supply does shift far enough to lower the new equilibrium price back to $55. Instead, the new equilibrium
(point C) is established at price of $80. The reason for the comparatively higher price at point C can be observed
from the behavior of the individual firm’s cost curves in Panel (c). As the entry of new firms bid up the price of
factor inputs, the representative firm’s cost curves shift upward. The break-even price where the economic profit
is zero is achieved at a higher minimum ATC.
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The long-run industry supply curve, obtain by connecting points A and C in Panel (b) is no longer perfectly elastic; it
slopes upward.
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Figure 10-12. Long Run Industry Supply--Increasing Cost Industry.
Panel (b) shows the supply and demand in the schmoo industry. With D₀ and S₀, the equilibrium price is $55 and the market
equilibrium quantity is 4,800. At this price, in Panel (a) Bob, the representative firm, is breaking even.
With demand increasing to D₁, the equilibrium price rises to $100. At this price, Bob and all the existing firms will incr ease
their output from 8.2 to 9.7. Now Bob is making an economic profit.
The economic profit will attract new firms to the schmoo industry pushing the supply to the right. In Panel (b) supply shi fts
from S₀ to S₁. At the intersection of D₁ and S₁, the new equilibrium price is about $80. The market equilibrium is about 7, 000. In
Panel (c), Bob's cost curves have shifted higher because the entry of new firms into the industry has bid the price of factor inputs
up. Bob's new break-even output is slightly higher than the previous break-even output.
The long run industry supply (LRIS) is obtain by connecting points A and C in Panel (b). LRIS is upward sloping. This indicates
that the industry is and increasing cost industry. The entry of new firms has bid the price of factor inputs up, raising the cost
curves of the representative firm.
7. Efficiency of Perfect Competition
In the discussion of the long-run industry supply we observed how under perfect competition the free movement
of firms leads to the allocation of resources in different industries. Note that the initial equilibrium in the schmoo
industry [point A in Panel (a) of Figure 10-11 or Figure 10-12] was disturbed by change in demand. This change in
demand reflects the consumers’ preference. The producers respond to this change in consumer preference by
allocating more resources to the production of schmoo. The schmoo industry or market finally settles at a new
equilibrium point C. Let us observe some important features of the industry at this point.
 P = MC. In a perfectly competitive market, the equilibrium price equals marginal cost. We learned that
the industry supply S₁ is the combination of the marginal cost curves of all the firms in that industry. At
the intersection of D₁ and S₁ the price consumers are paying for schmoos is equal to the marginal cost of
producing that quantity of schmoos. This indicates that the right (optimal) amount of schmoos is being
produced. Note that the price consumers are willing to pay reflects the value they place or benefit they
receive from consuming the marginal unit (MB). If an amount lower than the equilibrium quantity of
schmoos is produced, marginal benefit would exceed marginal cost. Total benefit to consumers would
increase if more was produced. If price is less than marginal cost, then marginal cost exceeds the
marginal benefit. Total benefit would increase by producing less. Thus, the optimum quantity is that at
which MB = P = MC.
 P = ATCMIN. The quantity produced in the perfectly competitive market is not only optimal, but also is
produced at the lowest per unit cost possible, given the existing technology.
The efficiency criterion P = MC is also indicative of the fact that under perfect competition total surplus, consumer
surplus plus producer surplus, is maximized. All willing buyers and willing sellers have the opportunity for
transaction. No mutually beneficial transactions remain unfulfilled. And, one last point about the efficiency of
perfect competition: there is no deadweight loss of consumer and producer surplus.
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