CHAPTER
9
Perfect Competition:
Short Run and Long Run
1
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
1
Features of a Perfectly Competitive
Market
1. There are many firms.
2. The product is standardized, or
homogeneous.
3. Firms can freely enter or leave the
market in the long run.
4. Each firm takes the market price as
given.
2
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Short-run Output Decision

The firm’s objective is to produce the
level of output that will maximize profit.

Economic profit = total revenue minus
total economic cost.


Total revenue = price x quantity sold.
The cost structure of the business firm is
the same as the one we studied earlier.
3
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Firm’s Total Cost Structure
(Reviewed)
The shape of the total cost
curve comes from
diminishing returns in the
short run.
STC  TFC  STVC
Total
Short-run
= Fixed
Total Cost
Cost
Short-run
+ Total
Variable Cost
Output:
Rakes per
Minute
Fixed
Cost
Q
0
1
2
3
4
5
6
7
8
9
10
FC
36
36
36
36
36
36
36
36
36
36
36
Total
Sho
Variable Short-run Ma
Cost
Total Cost
C
TVC
0
8
12
15
20
27
36
48
65
90
130
STC
36
44
48
51
56
63
72
84
101
126
166
4
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
S
The Revenue Structure of the
Competitive Business Firm


The perfectly competitive firm is a
price-taking firm. This means that the
firm takes the price from the market.
As long as the market remains in
equilibrium, the firm faces only one
price—the equilibrium market price.
5
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Computing the Total Revenue of a
Price-taker
Price ($)
Total
Revenue
($)
C o s t in $
Output:
Rakes per
Minute
Total Revenue
250
200
150
Q
0
1
2
3
4
5
6
7
8
9
10
P
25
25
25
25
25
25
25
25
25
25
25
© 2001 Prentice Hall Business Publishing
TR
0.00
25.00
50.00
75.00
100.00
125.00
150.00
175.00
200.00
225.00
250.00
100
50
0
0
1
2
3
4
5
6
7
8
9
10
Output: Rakes per minute
Since the perfectly competitive firm
faces a constant price, the shape of
its total revenue is an upwardsloping line. Total revenue changes
only with changes in the quantity6
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
sold.

The Totals Approach to Profit
Maximization

To maximize profit, a
producer finds the largest
gap between total revenue
and total cost.
Output:
Rakes per
Minute
Total
Revenue
($)
Short-run
Total Cost
Profit
Q
0
1
2
3
4
5
6
7
8
9
10
TR
0.00
25.00
50.00
75.00
100.00
125.00
150.00
175.00
200.00
225.00
250.00
STC
36
44
48
51
56
63
72
84
101
126
166
-36
-19
2
24
44
62
78
91
99
99
84
P
7
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Marginal Approach

The other way to decide how much
output to produce involves the marginal
principle.
Marginal PRINCIPLE
Increase the level of an activity if its marginal benefit
exceeds its marginal cost, but reduce the level if the
marginal cost exceeds the marginal benefit. If
possible, pick the level at which the marginal benefit
equals the marginal cost.
8
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Marginal Revenue

The benefit of producing and selling
rakes is the revenue the firm collects.
If the firm sells one more rake, total
revenue increases by $25.
Marginal benefit = marginal revenue =
market price
9
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Marginal Rule for Profit
Maximization

A firm maximizes profit
in accordance with the
marginal principle—by
setting marginal
revenue (or market
price) equal to
marginal cost.
Output:
Rakes per
Minute
Marginal
Revenue =
Price ($)
Short-run
Marginal
Cost
Profit
Q
0
1
2
3
4
5
6
7
8
9
10
P
25
25
25
25
25
25
25
25
25
25
25
SMC
8
4
3
5
7
9
12
17
25
40
-36
-19
2
24
44
62
78
91
99
99
84
10
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Ou
Rak
Mi
1
Profit Maximization Using the
Marginal Approach
11
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Economic Profit

Profit per unit equals
revenue per unit (or
price) minus cost per
unit (or average total
cost).
($25 - $14) = 11

Total economic profit
equals:
(price – average cost)
x quantity produced
($25 - $14) x 9 = $99
12
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Shut-down Decision


The firm should continue to operate if the
benefit of operating (total revenue) exceeds
the cost of operating, or total variable cost.
TR = (P x Q) must be greater than STVC = SAVC x
Q, therefore,
• If P > SAVC, the firm should continue to
operate
• If P < SAVC, the firm should shut down
13
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Shut-down Decision

The firm suffers a loss, but
since price is greater than
average variable cost, the
firm continues to operate.

When price drops to
$9, the firm adjusts
output down to 6
rakes per minute to
maintain P=SMC.

The average variable
cost of producing 6
rakes per minute is
$6.
14
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Shut-down Decision


The firm’s shutdown price is the
price at which the
firm is indifferent
between operating
and shutting
down.
At $5, P = SAVC. Above this price, the firm is better off
continuing to produce at a loss. Below this price, the
firm is better off shutting down because it could not
recover its operating cost.
15
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Short-run Supply Curve

The firm’s short-run supply
curve shows the relationship
between the market price and the
quantity supplied by the firm over
a period of time during which one
input—the production facility—
cannot be changed.
16
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Short-run Supply Curve



The short-run supply curve is
the firm’s SMC curve rising
above the minimum point on
the SAVC curve.
For any price above
the shut-down price,
the firm adjusts
output along its
marginal cost curve
as the price level
changes.
Below the shut-down
price, quantity
supplied equals zero.
17
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Market Supply Curve

The short-run market supply curve shows the
relationship between the market price and the quantity
supplied by all firms in the short run.
18
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Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
A Market in Long-run Equilibrium
A market reaches a long-run equilibrium when three
conditions hold:
1. The quantity of the product supplied equals the
quantity demanded
2. Each firm in the market maximizes its profit, given
the market price
3. Each firm in the market earns zero economic profit,
so there is no incentive for other firms to enter the
market
19
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
A Market in Long-run Equilibrium


In short-run equilibrium, quantity
supplied equals quantity demanded
and each firm in the market maximizes
profit.
In addition to the conditions above, in
long-run equilibrium the typical firm
earns zero economic profit so there is
no further incentive for firms to enter
the market.
20
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
A Market in Long-run Equilibrium

In long-run equilibrium, price equals marginal cost
(the profit-maximizing rule), and price equals
short-run average total cost (zero economic profit).
21
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Long-run Supply Curve for an
Increasing-cost Industry

An increasing-cost industry is an industry
in which the average cost of production
increases as the total output of the industry
increases.

The average cost increases as the industry
grows for two reasons:

Increasing input prices

Less productive inputs
22
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Industry Output and Average
Production Cost
Number of
Firms
Industry
Output
Rakes per
Firm
Typical
Cost for
Typical
Firm
50
100
150
350
700
1,050
7
7
7
$70
84
96

Average
Cost per
Rake
$10
12
14
The rake industry is an increasing-cost industry because
the average cost of production increases as the total
output of the industry increases.
23
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Drawing the Long-run Market Supply
Curve
Each point on the
long-run supply curve
shows the quantity of
rakes supplied at a
particular price (i.e.,
at a price of $12, 100
firms produce 700
rakes).
 The long-run
industry supply
curve is positivelysloped for an
24
increasing
cost
O’Sullivan & Sheffrin

© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
An Increase in Demand and the
Incentive to Enter

An increase in market demand puts upward pressure on
price. As price increases, there is an opportunity to earn
profit in the short run, and the industry attracts new
firms.
25
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Long-run Effects of an Increase
in Demand

In the short-run, firms
respond to the
increase in demand
by adjusting output in
their existing
production facilities,
and the price adjusts
from $12 to $17.
26
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
The Long-run Effects of an Increase
in Demand


In the long run, after
new firms enter,
equilibrium settles at
$14.
The new price is a
higher price than the
price before the
increase in demand
(increasing cost
industry).
27
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Long-run Supply Curve for an
Constant-cost Industry

In a constant-cost industry, firms
continue to buy inputs at the same prices.

The long-run supply curve is horizontal at
the constant average cost of production.

After the industry expands, the industry
settles at the same long-run equilibrium
price as before.
28
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin
Long-run Supply Curve for the Ice
Industry

An increase in
the demand for
ice increases the
price of ice to $5
per bag.

In the long-run,
the price of ice
returns to its
original level.
29
© 2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
O’Sullivan & Sheffrin