Chapter 13 Perfect Competition and the Supply Curve

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1 Goldwasser AP Microeconomics Chapter 13 Perfect Competition and the Supply Curve BEFORE YOU READ THE CHAPTER Summary This chapter develops the model of perfect competition and then uses this model to discuss a firm's selection of the profit-maximizing level of output. This model is also used to explore the short-run and long-run production decisions of the firm where these decisions are based on the firm's profitability. The chapter also explores the factors that determine the short-run and long-run industry supply curve for an industry. Chapter Objectives Objective #1. A perfectly competitive industry is an industry in which both the producers and consumers in that industry are price takers. A price-taking producer is one whose actions cannot affect the market price of the good sold. A price-taking firm can sell as many units of the good as it would like at the prevailing market price. A price-taking consumer is a consumer who cannot influence the market price of the good by their actions. The market price is therefore unaffected by the actions of either individual producers or individual consumers. For an industry to be perfectly competitive there must be many producers in that industry, and no one of these producers can have a large market share of the industry's output. For an industry to be perfectly competitive consumers must regard the products produced in that market as being equivalent. The product sold in a perfectly competitive industry is a standardized product or commodity, and consumers must view each producer's product as a perfect substitute for any other producer's product. Most perfectly competitive industries also have easy entry of new firms into the industry and exit of existing firms from the industry in the long run. This is referred to as free entry and exit. Objective #2 A firm's total revenue (TR) can be calculated by multiplying the level of production times the market price. The firm can then compare its total revenue with its total cost (TC) to find the level of output at which it maximizes profit. The profit-maximizing level of output for the firm is the level of output at which total revenue minus total cost results in the greatest positive number.

2 Objective #3 Marginal revenue (MR) is the change in total revenue divided by the change in output from selling another unit of the good. For a perfectly competitive firm, marginal revenue is constant and equals the market price, since the addition to total revenue the firm receives from selling another unit of the good equals the market price the firm receives for the good. Thus, the MR curve for a firm can be represented as a horizontal line intersecting the price axis at the market price. Figure 13.1 represents this concept: the firm is depicted in the left-hand graph, and the industry or the entire market for the good is represented in the right-hand graph. The market demand and market supply curves in the right-hand graph determine the market price (P) and market quantity (Q). The firm accepts this price since it is a price-taking firm. The horizontal line in the left-hand figure represents the marginal revenue the firm receives at any level of output. The firm's MR curve is also the firm's demand curve (d) since it can sell as many units of the good as it wishes to at the prevailing market price. Objective #4. Marginal analysis can be used to compute the profit-maximizing level of output. To do this analysis, marginal revenue and marginal cost must be calculated. Recall that marginal cost (MC) is the change in total cost divided by the change in output. The profit-maximizing level of output corresponds to that level of output at which marginal revenue equals marginal cost. Marginal revenue measures the addition to total revenue from selling one more unit of the good while marginal cost measures the addition to total cost from producing one more unit of the good. When marginal revenue is greater than marginal cost the firm's benefit from producing this last unit of output is greater than the cost of producing this last unit: the firm should expand output to include this unit of production. When marginal revenue is less than marginal cost the firm's benefit from producing another unit of output is less than the cost of producing this last unit: the firm should not expand output to include this

3 additional unit of production. It is only when marginal revenue equals marginal cost for the last unit of output produced that the firm earns its highest level of profit. The producer's optimal output rule states that profit is maximized by producing that level of output at which marginal revenue equals marginal cost for the last unit produced. That is, the firm should produce that level of output where MR = MC. This can be restated as: the firm's profitmaximizing level of output is where P = MC, since for the perfectly competitive firm P equals MR. Figure 13.2 illustrates the profit-maximizing level of output (q) for a perfectly competitive firm. Objective #5. The profit-maximization rule identifies the level of output that results in maximizing the firm's profit, but it does not tell the producer whether they should produce at all. To answer this question, the firm needs to look at whether it is profitable or unprofitable to produce. The decision to produce or not is based on the firm's economic profit and not its accounting profit. The cost curves that the firm uses to make its production decisions are cost curves that include all costs, implicit and explicit. Given the firm's cost curves, whether it is profitable or not to produce depends on whether the market price of the good is more or less than the firm's average total cost. The firm makes a profit whenever its total revenue is greater than its total cost. The firm breaks even whenever its total revenue is equal to its total cost. The firm incurs a loss whenever its total revenue is less than its total cost. The firm's profitability can also be expressed in terms of averages. Profit = TR - TC, and if both sides of this equation are divided by output (Q), this results in profit/q = TR/Q - TC/Q. TR/Q is average revenue, which for a perfectly competitive firm is the market price (P) since the average price for the price-taking firm exactly equals the market determined price. TC/Q is equal to the average total cost (ATC) of producing the level of output. This

4 equation provides a means for comparing the price of the good to the average total cost: when the price is greater than the average total cost, the firm earns a positive profit; when the price is equal to the average total cost, the firm breaks even; and when the price is less than the average total cost, the firm incurs a loss. Figure 13.3 illustrates three situations: a firm earning a positive economic profit (P > ATC), a firm earning zero economic profit (P = ATC), and a firm earning negative economic profit (P < ATC). The firm breaks even, or earns a zero economic profit, if the market price is equal to the minimum of the firm's average total cost; the firm earns a negative profit if the price is less than the minimum of the firm's average total cost; and the firm earns a positive profit if the price is greater than the minimum of the firm's average total cost. Figure 13.3 illustrates these three possibilities and the resultant profit situation for the firm. The minimum point of the average total cost is called the break-even price because it identifies the price at which the firm breaks even (earns a zero economic profit).

5 Objective #6. In the short run, a perfectly competitive firm incurs its fixed costs whether or not it produces, while it can reduce its variable costs by deciding not to produce. The firm would therefore want to base its production decision in the short run on whether it can cover its variable cost of production: when the firm's revenues do not cover all of its variable cost of production, then the firm will lose money on its fixed cost as well as some of its variable cost; when the firm's revenues cover all of its variable cost of production, then the firm will lose money only on that part of its fixed cost that the remaining revenue does not cover. In the short run, the firm will be willing to produce only if its revenue is sufficient to cover all of its variable cost of production. This concept can be summarized by the following guidelines: In the short run, when the market price is less than the minimum point of the firm's average variable cost (AVC) curve, then the firm should shut down and produce 0 units of output. Its short-run costs will therefore equal its fixed cost and the firm will minimize its losses. In the short run, when the market price is greater than or equal to the minimum point of the firm's AVC but is less than the minimum point of the ATC, then the firm should produce the level of output at which P = MC This level of output will result in negative economic profits in the short run, but these negative profits will be equal to or less than the firm's fixed cost. Figure 13.4 illustrates the short-run production decisions for these two possibilities.

6 Objective #7. The firm's short-run supply curve corresponds to the firm's MC curve when the market price is equal to or above the shut-down price (the minimum point of the AVC curve). The firm's short-run supply curve for market prices less than the shut-down price is the vertical axis: the firm will produce 0 units of output when the market price is less than the shut-down price. Objective #8. In the long run a firm can exit the industry or a new firm can enter the industry. Firms will exit the industry if the market price is consistently less than the breakeven price, or the minimum point of the firm's ATC curve. In other words, firms will exit the industry in the long run if they are consistently making negative economic profit in the short run. Firms will enter the industry if the market price is consistently greater than the breakeven price. That is, firms will enter the industry in the long run if existing firms are consistently making positive economic profit in the short run. Objective #9. The short-run industry supply curve shows the quantity that producers supply at each price, holding the number of producers constant at a given level. Objective #10. The long-run market equilibrium corresponds to the situation in which the quantity supplied equals the quantity demanded given that sufficient time has elapsed for producers to either enter or exit the industry. In the long-run market equilibrium, all existing producers and all potential producers have fully adjusted to their optimal long-run choices, and therefore there is no incentive for producers to either exit or enter the industry. Thus, the long-run industry supply curve shows the quantity supplied by the industry at each price, given that producers have had time to enter or exit the industry. In an industry that has constant costs across the industry, the long-run industry supply curve is perfectly elastic. The long-run industry supply curve can be drawn as a horizontal line at the break-even price. In an industry that has increasing costs across the industry, the long-run industry supply curve is upward sloping. This reflects the fact that some input is in limited supply, and as the industry expands, this results in higher prices for that input and therefore higher costs for the firms producing in that industry. Regardless of whether the industry is a constant-cost or increasing-cost industry, the longrun industry supply curve is flatter than the short-run industry supply curve. Entry of new firms in the long run results in greater levels of output and therefore lower prices than in the short run, and the exit of existing firms in the long run results in lower levels of output and therefore higher prices than in the short run.

7 Objective #11. Perfect competition leads to three conclusions about the cost of production and efficiency. When the perfectly competitive industry is in equilibrium, the value of marginal cost is the same for all firms. Since firms produce that output where marginal cost equals the market price, and since all firms are price takers, this implies that all firms must have the same marginal cost value in equilibrium. In the long run, all firms in a perfectly competitive industry earn zero economic profit due to free entry and exit. The existence of positive economic profits in the short run acts as an incentive for new firms to enter the industry. The existence of negative profits in the short run acts as an incentive for existing firms to exit the industry. This entry and exit continues until economic profits for all firms in the industry equal zero. The long-run market equilibrium in a perfectly competitive industry is efficient because there are no mutually beneficial transactions that are not exploited. In the long-run equilibrium in a perfectly competitive industry, costs are minimized and no resources are wasted. Key Terms Notes price-taking producer a producer whose actions have no effect on the market price of the good or service it sells. price-taking consumer a consumer whose actions have no effect on the market price of the good or service he or she buys. perfectly competitive market a market in which all participants are price-takers. perfectly competitive industry an industry in which all producers are price-takers. market share the fraction of the total industry output accounted for by a given producer's output. standardized product output of different producers regarded by consumers as the same good; also referred to as a commodity. commodity output of different producers regarded by consumers as the same good; also referred to as a standardized product. free entry and exit describes an industry that potential producers can easily enter or current producers can leave. marginal revenue the change in total revenue generated by an additional unit of output.

8 optimal output rule profit is maximized by producing the quantity of output at which the marginal revenue of the last unit produced is equal to its marginal cost. price-taking firm's optimal output rule the profit of a price-taking firm is maximized by producing the quantity of output at which the market price is equal to the marginal cost of the last unit produced. marginal revenue curve a graphical representation showing how marginal revenue varies as output varies. break-even price the market price at which a firm earns zero profits. shut-down price the price at which a firm ceases production in the short run because the market price has fallen below the minimum average variable cost. short-run individual supply curve a graphical representation that shows how an individual producer's profit-maximizing output quantity depends on the market price, taking fixed cost as given. industry supply curve a graphical representation that shows the relationship between the price of a good and the total output of the industry for that good. short-run industry supply curve a graphical representation that shows how the quantity supplied by an industry depends on the market price, given a fixed number of producers. short-run market equilibrium an economic balance that results when the quantity supplied equals the quantity demanded, taking the number of producers as given. long-run market equilibrium an economic balance in which, given sufficient time for producers to enter or exit an industry, the quantity supplied equals the quantity demanded. long-run industry supply curve a graphical representation that shows how quantity supplied responds to price once producers have had time to enter or exit the industry.

9 AFTER YOU READ THE CHAPTER Tips Tip #1. This chapter advances the use of cost concepts in analyzing firm behavior. You may find it helpful to work with the graphs depicting the short-run and longrun economic behavior of the perfectly competitive market: these graphs can serve as a roadmap for directing your analyses of how a firm responds to economic events. Students often find that a quick sketch of a representative firm and the industry provides insight into solving a challenging problem. Figure 13.5 illustrates an example of this type of quick sketch for a perfectly competitive industry in the short run. In this example, the firm is earning a negative economic profit since the price the good is sold for is less than the average total cost of producing the good. Here's the analysis for this sketch: the industry demand and supply curves determine the equilibrium price (P) in the market and the equilibrium market quantity (Q). Firms are price takers, so they will sell their output at P and their MR curve is a horizontal line drawn at that price. Firms will select their profit-maximizing level of output (q for the representative firm in our sketch) by producing the quantity at which MR = MC, or where P = MC. The firm can then calculate its profit by comparing its P to its ATC at the level of production that was chosen. In this example P < ATC, so the firm must be making negative economic profit. The shaded area in the graph represents this negative economic profit. Figure 13.5 could be redrawn to illustrate a short-run equilibrium where the representative firm earns positive economic profit, or it could be redrawn so that the representative firm earns zero economic profit. These three shortrun scenarios are important for you to be able to construct and understand: being able to construct the graph and read the graph is vital for your ability to understand this material.

10 Figure 13.6 provides a sketch of the long-run equilibrium in a perfectly competitive industry. (This is also the same sketch for a short-run situation where the representative firm earns zero economic profit.) In this example, the firm is earning a zero economic profit because the price the good is sold for is equal to the average total cost of producing the good. Here's the analysis for this sketch: the industry demand and supply curves determine the equilibrium price (P) in the market and the equilibrium market quantity (Q). Firms are price takers, so they will sell their output at P and their MR curve is a horizontal line drawn at that price. Firms will select their profitmaximizing level of output (q for the representative firm in our sketch) by producing the quantity at which MR = MC, or where P = Me. The firm can then calculate its profit by comparing its P to its ATC at the level of production that was chosen. In this example, P = ATC, so the firm must be making zero economic profit. Tip #2. In the short run in a perfectly competitive industry, there is no entry or exit of firms. Thus, positive or negative economic profits can persist in the short run. However, in the long run there is entry and exit. It is important to understand how this impacts the short-run situation for a perfectly competitive industry. Figure 13.7 analyzes the effect of the exit of firms in the long run. Here's the analysis: the representative firm is initially producing q and selling this output at P, resulting in the firm earning negative economic profit in the short run (this is the scenario we had for Figure 13.5). In the long run, some of the existing firms exit the industry due to these negative economic profits, and this causes the market supply curve to shift to the left, which causes the market price to rise to P 2 and the market quantity to fall to Q 2. The representative firm that remains in the industry now faces a higher price for its output and therefore a new MR curve (MR 2 ). The firm will select its profitmaximizing output by equating MR 2 to MC: the firm will produce q 2 units of the good. The firm will earn zero economic profit, since in the long run the industry will have firms exit until all remaining firms produce at their break-

11 even point. Notice that the firms that remain in the industry produce a higher level of output than they did initially (q 2 versus q), while the overall industry production of the good has fallen (Q 2 versus Q) due to firms exiting the industry. It is important to be able to construct these graphs and make the logical arguments implied by them. Make sure you study and work through these graphs until they are very familiar to you. Figure 13.8 is a graph that represents the long-run equilibrium adjustment when the representative firm earns a positive economic profit in the short run, thereby resulting in the entry of new firms in the long run. Here's the analysis: the representative firm is initially producing q and selling this output at P, resulting in the firm earning positive economic profit in the short run. In the long run, some new firms enter the industry due to these positive economic profits, causing the market supply curve to shift to the right, which causes the market price to fall to P 2 and the market quantity to rise to Q 2. The representative firm in the industry now faces a lower price for its output and therefore a new MR curve (MRz). The firm will select its profitmaximizing output by equating MR 2 to MC: the firm will produce q 2 units of the good. The firm will earn zero economic profit, since in the long run the industry will have firms enter until all firms in the industry produceat their break-even point. Notice that the firms in the industry produce a lower level of output than they did initially (q 2 versus q), while the overall industry production of the good has risen (Q 2 versus Q) due to firms entering the industry. It is important to be able to construct these graphs and make the logical arguments implied by them. Make sure you study and work through these graphs until they are very familiar to you.

12 Tip #3. This chapter relies again on marginal analysis, which is used by the firm to determine the profit-maximizing level of output. The firm bases its production decision on the addition to total revenue it gets from selling one more unit of the good (MR) versus the addition to total cost of producing one more unit of the good (MC). By this point in your study of economics, the concept of marginal analysis should be very familiar to you and something that you naturally consider when analyzing a situation or problem. Tip #4. The profitability conditions for a perfectly competitive firm can be summarized as follows: When P > minimum ATC or the break-even price, the firm earns a positive economic profit in the short run and firms enter the industry in the long run. When P = minimum ATC or the break-even price, the firm earns zero economic profit in the short run and firms do not enter or exit the industry in the long run. When P < minimum ATC or the break-even price, the firm earns a negative economic profit in the short run and firms exit the industry in the long run. Tip #5. The production conditions for a perfectly competitive firm can be summarized as follows: When P > minimum AVC or the shut-down price, the firm produces in the short run. If P > minimum ATC, the firm is covering all of its variable cost as well as its fixed cost of production. If P < minimum ATC but is still above the minimum AVC, the firm is covering all of its variable cost and part of its fixed cost. When P = minimum AVC or the shut-down price, the firm is indifferent between producing in the short run and shutting down in the short run. The firm's revenue is just enough to cover its variable cost of production. The firm's profit is thus equal to the negative of its fixed cost. When P < minimum AVC or the shut-down price, the firm shuts down production in the short run since it cannot cover its variable cost of production. The firm's profit when it produces 0 units of output in the short run is equal to the negative of its fixed cost.

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