1. PERFECT COMPETITION: A MODEL Learning Objectives 1. Explain what economists mean by perfect competition. 2. Identify the basic assumptions of the model of perfect competition and explain why they imply price taking behavior. • Market structure can range from perfect competition and one end of the continuum to monopoly at the other. Perfect competition is a model of the market based on the assumption that a large number of firms produce identical goods consumed by a large number of buyers. 1.1 Assumptions of the Model • • • • • Price takers are individuals or firms who must take the market price as given. Identical goods A large number of buyers and sellers Ease of entry and exit Complete information 1.2 Perfect Competition and the Real World • • • • The perfectly competitive model has strong assumptions. When we use the model we assume market forces determine prices. We can understand most markets by applying the supply and demand model. With this framework we can see how competition affect firms, consumer, and markets. 2. OUTPUT DETERMINATION IN THE SHORT RUN Learning Objectives 1. Show graphically how an individual firm in a perfectly competitive market can use total revenue and total cost curves or marginal revenue and marginal cost curves to determine the level of output that will maximize its economic profit. 2. Explain when a firm will shut down in the short run and when it will operate even if it is incurring economic losses. 3. Derive the firm’s supply curve from the firm’s marginal cost curve and the industry supply curve from the supply curves of individual firms. 2.1 Price and Revenue $0.70 Price per pound $0.60 S $0.50 $0.40 TR = $0.40*10 = $4 $0.30 $0.20 D $0.10 $0.00 0 • 10 Millions of pounds of radishes per month 20 Total revenue is a firm’s output multiplied by the price at which it sells that output. EQUATION 2.1 TR P Q Total Revenue, Marginal Revenue, and Average Revenue $0.80 $4,000 TR, P=$0.40 $3,600 TR, P=$0.60 0.60 = MR = AR = P $3,200 $2,800 Total revenue Slope=0.6 $2,400 TR, P=$0.20 $2,000 Slope=0.4 $1,600 $1,200 Slope=0.2 Price, MR, and AR (per pound) $0.60 0.40 = MR = AR = P $0.40 0.20 = MR = AR = P $0.20 $800 $400 $0 $0.00 Pounds of radishes per month Pounds of radishes per month Price, Marginal Revenue, and Average Revenue • • Marginal revenue is the increase in total revenue from a one-unit increase in quantity. Average revenue is total revenue divided by quantity. EQUATION 2.1 • TR P Q AR P Q Q Marginal revenue, price, and demand for the perfectly competitive firm Price, Marginal Revenue, and Average Revenue A perfectly competitive firm faces a horizontal demand curve. 2.2 Economic Profit in the Short Run $4,000 $3,600 Total Cost $3,200 2,680 $2,800 1,742 $2,000 The slope of a line drawn tangent to the total cost curve at 6,700 pounds is equal to 0.4, which is also equal to the slope of the total revenue curve. The slope of the total cost curve is marginal cost; the slope of the total revenue curve is marginal revenue. $938 $2,400 $1,600 6,700 $1,200 $800 1,500 Total revenue, total cost Total Revenue Economic profit, which equals total revenue minus total costs, is maximized at an output of 6,700 pounds of radishes per month $400 $0 0 1000 2000 3000 4000 5000 6000 7000 Pounds of radishes per month 8000 9000 10000 $0.70 $0.70 $0.60 $0.60 $0.50 $0.40 $0.30 $0.20 $0.10 MC $0.50 MR $0.40 $0.30 0.26 Profit = $938 ATC $0.20 0 10 Millions of pounds of radishes per month 20 6,700 $0.10 $0.00 • Producing to maximize economic profit. $0.14 Total revenue, total cost Total revenue, total cost 2.3 Applying the Marginal Decision Rule $0.00 0 1000 2000 3000 4000 5000 6000 7000 Pounds of radishes per month Economic profit per unit is the difference between price and average total cost. 2.4 Economic Losses in the Short run Economic loss is the amount by which a firm’s total cost exceeds its total revenue. Producing to minimize $0.70 $0.70 $0.60 $0.60 Total revenue, total cost $0.50 $0.40 A fall in demand $0.30 $0.20 economic loss. Producing to maximize economic profit. $0.50 MR1 $0.40 ATC $0.30 AVC 0.23 $0.20 .018 0.18 MC Total loss = $222.20 MR2 0.14 $0.10 $0.10 $0.00 $0.00 2.1 10 Millions of pounds of radishes per month 4,444 Total revenue, total cost • 0 1000 2000 3000 4000 5000 6000 Pounds of radishes per month 7000 2.4 Economic Losses in the Short run • The shutdown point is the minimum level of average variable cost, which occurs at the intersection of the marginal cost curve and the average variable cost curve. $0.70 $0.70 $0.60 $0.60 Shutting down to minimize economic loss Total revenue, total cost $0.50 $0.40 $0.30 $0.20 $0.50 $0.40 ATC $0.30 AVC $0.20 0.14 $0.10 $0.10 $0.00 $0.00 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 Millions of pounds of radishes per month MR3 1,700 Total revenue, total cost MC 0 1000 2000 3000 4000 5000 6000 Pounds of radishes per month 7000 2.5 Marginal Cost and Supply $25 $25 Panel (a) One firm MC $20 Industry supply $15 AVC $10 $5 Price per call Price per call $20 Panel (b) Market $15 $10 $5 $0 14 Calls per day 17 19 $0 280 330 Thousands of calls per day 380 3. PERFECT COMPETITION IN THE LONG RUN Learning Objectives 1. Distinguish between economic profit and accounting profit. 2. Explain why in long-run equilibrium in a perfectly competitive industry firms will earn zero economic profits. 3. Describe the three possible effects on the costs of the factors of production that expansion or contraction of a perfectly competitive industry may have and illustrate the resulting longrun industry supply curve in each case. 4. Explain why under perfection competition output prices will change by less than the change in production cost in the short run, but by the full amount of the change in production cost in the long run. 5. Explain the effect of a change in fixed cost on price and output in the short run and in the long run under perfect competition. 3.1 Economic Profit and Economic Loss • • Economic versus accounting concepts of profit and loss – Explicit costs are changes that must be paid for factors of production such as labor and capital. – Accounting profit is profit computed using only explicit costs. – Implicit cost is a cost that is included in the economic concept of opportunity cost but that is not an explicit cost. The long run and zero economic profits Eliminating Economic Profits in the Long Run When firms enter supply shifts right and MR shifts down $0.70 S1 Price per pound $0.60 $0.50 $0.40 S2 $0.30 $0.22 $0.20 $0.10 $0.60 MC $0.50 MR1 $0.40 Profit = $938 $0.30 0.26 $0.22 $0.20 ATC MR2 $0.10 6,700 P, MR, ATC, and MC per pound $0.70 D $0.00 $0.00 0 10 13 Millions of pounds of radishes per month 20 0 1000 2000 3000 4000 5000 6000 Pounds of radishes per month 7000 Eliminating Economic Losses in the Long Run Price per pound S2 P2 S1 P1 P, MR, ATC, and MC per pound When firms exit supply shifts left and MR shifts up MC ATC C1 P2 MR2 Loss P1 MR1 D Q2 Q1 Millions of pounds of radishes per month q1 q2 Pounds of radishes per month 3.1 Economic Profit and Economic Loss • Entry, Exit, and Production Costs – Constant-cost industry are changes that must be paid for factors of production such as labor and capital. – Increasing-cost industry is profit computed using only explicit costs. – Decreasing-cost industry is a cost that is included in the economic concept of opportunity cost but that is not an explicit cost. – Long-run industry supply curve is a curve that relates the price of a good or service to the quantity produced after all long-run adjustments to a price change have been completed. 3.1 Economic Profit and Economic Loss Long-Run Supply Curves in Perfect Competition Price SIC SCC SDC Quantity per period 3.2 Changes in Demand and in Production Cost An increase in demand increases profitability which leads to an increase in supply. S2 B Price per bushel $2.30 1.70 A C D2 P, MR, ATC, and MC per bushel S1 MC ATC B? $2.30 MR2 1.70 A? MR1 D1 Q1 Q2 Q3 Bushels of oats per period q1 q2 Bushels of oats per period 3.2 Changes in Demand and in Production Cost