Firms in Perfectly Competitive Markets CHAPTER 12 Chapter Outline and Learning Objectives...

Firms in Perfectly Competitive Markets

CH

AP

TE

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12

Chapter Outline and Learning Objectives

12.1 Perfectly Competitive Markets

12.2 How a Firm Maximizes Profit in a Perfectly Competitive Market

12.3 Illustrating Profit or Loss on the Cost Curve Graph

12.4 Deciding Whether to Produce or to Shut Down in the Short Run

12.5 The Entry and Exit of Firms in the Long Run

12.6 Perfect Competition and Efficiency

Pure Competition

Monopolistic Competition

OligopolyMonopoly

http://www2.coca-cola.com/presscenter/nr_20040225_corporate_don_knauss.html

http://www.gm.com/

http://www.fridays.com/main_nonflash.html

Pure Competition

Monopolistic Competition Oligopoly Monopoly

Number of Firms

Barriers to Entry

Non-price Competition

Price Taker/Maker

Product type

Many small Many small A few large one

Diff or Homog oneDifferentiatedHomogeneous

large largenonenone

maker makertaker/seekertaker

yes yesyesno

Considers action or reaction of other firms

Need to stress differences?

Long run profits possible?

Ability to influence market price?

As important as price?

• Entrepreneurs are continually introducing new products or new ways of selling products, which—when successful—enable them to earn economic profits in the short run.

• But in the long run, competition among firms forces prices to the level where they just cover the costs of production.

• Demand for organically grown food increased at a rate of 20 percent per year,

Prices rose

More farmers have begun participating in farmers’ markets.

• Supply increased,

• Prices dropped

• Profits from farmers’ markets is no longer higher than what they earn selling to supermarkets.

Perfect Competition in Farmers’ Markets

© 2013 Pearson Education, Inc. Publishing as Prentice Hall

Perfectly competitive market:

1. many buyers and sellers,

2. all firms selling identical products,

3. no barriers to new firms entering the market.

4. Price takers. Firms are unable to affect the market price.

A good crop from one wheat farmer, or if one wheat farmer stops growing wheat altogether, the market supply curve for wheat will not shift by enough to change the equilibrium price by even 1 cent.

Output

Price Firm

Output

Price Market

Perfect Competition (many small firms)• Market supply & demand determine price.• The firm’s demand will be perfectly elastic. • Firms can sell as much as they want at P• Above P, they lose business• Below P they lose revenue.

P

Marketdemand

Marketsupply

Firm’sdemand

P

Firms must take the market price


Profit = Total revenue - total cost.

Average revenue (AR) - TR / Quantity sold = Price

Marginal revenue (MR) The change in total revenue from selling one more unit of a product, also = Price

AR = MR = Price = Demand


Number of Bushels

(Q)

Market Price(per bushel)

(P)

Total Revenue

(TR)

Average Revenue

(AR)

Marginal Revenue

(MR)

0

1

2

3

4

5

6

$4

4

4

4

4

4

4

$0

4

8

12

16

20

24

—

$4

4

4

4

4

4

—

$4

4

4

4

4

4

Farmer Parker’s Revenue from Wheat Farming

AR = MR = Price


Quantity(bushels)

(Q)

TotalRevenue

(TR)

TotalCost(TC)

Profit(TR−TC)

Marginal Revenue

(MR)

Marginal Cost(MC)

0

1

2

3

4

5

6

7

8

9

10

$0.00

4.00

8.00

12.00

16.00

20.00

24.00

28.00

32.00

36.00

40.00

$2.00

5.00

7.00

8.50

10.50

13.00

16.50

21.50

28.50

38.00

50.50

−$2.00

−1.00

1.00

3.50

5.50

7.00

7.50

6.50

3.50

−2.00

−10.50

— $4.00

4.00

4.00

4.00

4.00

4.00

4.00

4.00

4.00

4.00

—

$3.00

2.00

1.50

2.00

2.50

3.50

5.00

7.00

9.50

12.50

Determining the Profit-Maximizing Level of Output

Maximum Profit, or MR = MC


Maximum ProfitProfit is maximized

where the vertical distance between total revenue and total cost is the largest.

This happens at an output of 6 bushels.


MR = $4 per bushel.

Profit is maximized by producingup to the point where the marginal revenue of the last bushel produced is equal to its marginal cost, or MR = MC. The closest Farmer Parker can come is to produce 6 bushels of wheat.

Once marginal cost is greater than marginal revenue profits begin to decline. .

MR = MC


Conclusions:

1.The profit-maximizing level of output:a. where TR – TC is the greatest.b. where MR = MC.

2. In a perfectly competitive industry, P = MR.

So, we can restate the MR = MC condition as P = MC.


Showing a Profit on the Graph

A firm maximizes profit where MR = MC.

Price - average total cost = profit per unit of output.

Total profit is equal to P – ATC time quantity of output.

The green-shaded rectangle, which has a height equal to (P − ATC) and a width equal to Q.


Output per Day

Total Cost

0 $10.00

1 20.50

2 24.50

3 28.50

4 34.00

5 43.00

6 55.50

7 72.00

8 93.00

9 119.00

Determining Profit-Maximizing Price and Quantity

a. Suppose the current equilibrium price in the basketball market is $12.50. To maximize profit, how many basketballs will Andy produce?

What price will he charge? And how much profit (or loss) will he make?

Draw a graph to illustrate your answer. Label clearly Andy’s demand, ATC, AVC, MC, and MR curves;the price he is charging; the quantity he is producing; and the area representing his profit (or loss).


Determining Profit-Maximizing Price and QuantityStep 1: Calculate Andy’s marginal cost, average total cost, and average variable cost.Andy will produce the level of output where marginal revenue is equal to marginal cost. We can calculate costs from the information given in the table to draw the required graph.Average total cost (ATC) equals total cost (TC) divided by the level of output (Q). Average variable cost (AVC) equals variable cost (VC) divided by output (Q). To calculate variable cost, recall that total cost equals variable cost plus fixed cost. When output equals zero, total cost equals fixed cost. In this case, fixed cost equals $10.00.

Outputper Day

(Q)

TotalCost(TC)

FixedCost(FC)

VariableCost(VC)

AverageTotal Cost

(ATC)

AverageVariable

Cost (AVC)

MarginalCost(MC)

0 $10.00 $10.00 $0.00 — — —

1 20.50 10.00 10.50 $20.50 $10.50 $10.50

2 24.50 10.00 14.50 12.25 7.25 4.00

3 28.00 10.00 18.00 9.33 6.00 3.50

4 34.00 10.00 24.00 8.50 6.00 6.00

5 43.00 10.00 33.00 8.60 6.60 9.00

6 55.50 10.00 45.50 9.25 7.58 12.50

7 72.00 10.00 62.00 10.29 8.86 16.50

8 93.00 10.00 83.00 11.63 10.38 21.00

9 119.00 10.00 109.00 13.22 12.11 26.00


or Step 1: Calculate Andy’s marginal cost, and average total costAndy will produce the level of output where MR = MCAverage total cost (ATC) equals total cost (TC) divided by output

(Q).Output per

Day (Q)Total Cost

(TC)Average Total

Cost (ATC)Marginal

Cost (MC)Marginal

Revenue (MR)

0 $10.00 — —

1 20.50 $20.50 $10.50 $12.50

2 24.50 12.25 4.00 12.50

3 28.00 9.33 3.50 12.50

4 34.00 8.50 6.00 12.50

5 43.00 8.60 9.00 12.50

6 55.50 9.25 12.50 12.50

7 72.00 10.29 16.50 12.50

8 93.00 11.63 21.00 12.50

9 119.00 13.22 26.00 12.50

Step 2: MR = MC when Andy produces 6 basketballs per day. Profits per unit = MR – ATC at 6 units. (12.50 – 9.25 = 3.25). His total Profits equal per unit profits times output )3.25 x 6 = 19.50 or TR – TC = 6 x 12.50 – 55.50 = $75.00 − $55.50 = $19.50.


MR = MC when Andy produces 6 basketballs per day.

Andy’s profits are equal to his marginal revenue minus his average total costs times his output. ($12.50 – 9.25) x 6 = $19.50.

Graphing Profits


Output per Day

Total Cost

0 $10.00

1 20.50

2 24.50

3 28.50

4 34.00

5 43.00

6 55.50

7 72.00

8 93.00

9 119.00

Suppose the equilibrium price of basketballs falls to $6.00.Now how many basketballs will Andy produce? What price will he charge? And how much profit (or loss) will he make? Draw a graph to illustrate this situation, using the instructions in part (a).


Andy will still produce the level of output where MR = MC, but MR = 6

Output per Day (Q)

Total Cost(TC)

Average Total Cost (ATC)

MarginalCost (MC)

Marginal Revenue (MR)

0 $10.00 — —

1 20.50 $20.50 $10.50 $6.00

2 24.50 12.25 4.00 6.00

3 28.00 9.33 3.50 6.00

4 34.00 8.50 6.00 6.00

5 43.00 8.60 9.00 6.00

6 55.50 9.25 12.50 6.00

7 72.00 10.29 16.50 6.00

8 93.00 11.63 21.00 6.00

9 119.00 13.22 26.00 6.00

Now MR = MC when Andy produces 4 basketballs per day. Profits per unit = MR – ATC at 4 units. (6 – 8.50 = -2.50). His total losses equal per unit losses times output )-2.50 x 4 = -10.00 or TR – TC = 4 x 6.00 – 34.00 = $24.00 − $34.00 = -$10.00.


MR = MC when Andy produces 4 basketballs per day.

Andy’s losses are equal to his marginal revenue minus his average total costs times his output. ($6.00 – 8.50) x 4 = -$10.00.

Graphing Losses


Remember That Firms Maximize Their Total Profit, Not Their Profit per Unit

Only when the firm has expanded production to Q2 will it have produced every unit for which marginal revenue is greater than marginal cost. At that point, it will have maximized profit.

Price

Quantity

$6

$5

$4

$3

$2

$1

10 20 30 40 50 600

Price = Demand = MR

Operating at Minimum ATC

Equilibrium

ATCMC

Normal Profit

Earn economic profit MR (P) >

ATCMR (P) = ATC

Short Run Profits

Short Run Losses

Shut DownFirm can’t cover AVC, minimize

losses by shutting down

MR (P) < AVC

Output

Price Firm

MC

ATC

AVC

P3

Firm covers AVC, but not AFC:

MR (P) < ATC, but MR > AVC

MR

Entry or Exit?

Supply

Profits?

Case 1: Prices rise

Output

Price

Output

Price

• Consider the market for toothpicks. A new candy that sticks to teeth causes the market demand for toothpicks to increase from D1 to D2 … market price increases to

P2 …

MarketFirm

P1 P1

q1 Q1

D1

S1MC ATC

d1

An Increase in Market Demand

shifting the firm’s demand curve upward. At the higher price, firms expand output to q2 and earn short-run profits.• Economic profits will draw competitors into the industry, shifting the market supply curve from S1 to S2.

P2 d2

q2

D2

S2

Q2

P2

Output

Price

Output

Price

• After the increase in market supply, a new equilibrium is established at the original market price P1 and a larger rate of output (Q3).• As the market price returns to P1, the demand curve facing the firm returns to its original level.• In the long-run, economic profits are driven down to zero.

The Adjustment

MarketFirm

P1 P1

q1 Q1

D1

S1MC ATC

d1

P2 d2

q2

D2

S2

Q2

P2

Slr

Q3

d1

Price

Quantity

$6

$5

$4

$3

$2

$1

10 20 30 40 50 600

Price = Demand = MR

SR Profits

1. Price goes up

ATC

2. Firms enter, Supply increases3. Price goes down

4. No LR Profits

MC

Entry or Exit?

Supply

Case 2: Prices fall

Profits?

Output

Price

Output

Price

A Decrease in Demand

MarketFirm

P1 P1

q1 Q1

D1

S1MC ATC

d1

P2 d2

q2 Q2

P2

• If, instead, something causes market demand for toothpicks to decrease from D1 to D2 … the market price falls to

P2 shifting the firm’s demand curve downward, leading to a reduction in output to q2. The firm is now making losses.

• Short-run losses cause some competitors to exit the market, and others to reduce the scale of their operation, shifting the market supply curve from S1 to S2.

S2

D2

Output

Price

Output

Price

The Adjustment:

MarketFirm

P1 P1

q1 Q1

D1

S1MC ATC

P2 d2

d1

q2

D2

S2

Q2

P2

• After the decrease in market supply, a new equilibrium is established at the original market price P1 and a smaller rate of output Q3.• As the market price returns to P1, the demand curve facing the firm returns to its original level.• In the long-run, economic profit returns to zero.• Note the long-run market supply curve is flat Slr.

Q3

Slrd1

Price

Quantity

$6

$5

$4

$3

$2

$1

10 20 30 40 50 600

P = D = MRSR

Losses

1. Price goes down

ATC

2. Firms leave, Supply decreases3. Price goes up

4. No LR Losses

MC

Output

Price Firm

MC

ATC

AVC

• The marginal cost curve (MC) is the firm’s supply curve.

• At P2 MR = MC at q2.

• Below MC = AVC, the firm will shut down Output = 0 below P1,,

• At P3 MR = MC at q3.

The Supply Curve

P2

P3

q2 q3

P1

q1

MC is the firm’s

Supply Curve

Short Run Profits

Supply shifts out and price drops

Cause firms to enter the marketShort Run LossesCause firms to leave the marketSupply shifts in and price rises

• The two conditions necessary for long-run equilibrium in a price-taker market are depicted here.

• At the price established in the market, firms in the industry earn zero economic profit

• The quantity supplied and the quantity demanded must be equal in the market, as shown below at P1 with output Q1.

Output

Price Firm

P1

q1

MC ATC

d1

Long-run Equilibrium

Output

Price Market

P1

D

Ssr

Q1

An increase in Market Demand will lead to higher per-unit costs of production for all firms.

The long-run market supply curve in a increasing-cost industry is upward-

sloping.

a. The situation in which a good or service is produced at the lowest possible cost.

1. Productive Efficiency

b. The forces of competition will drive the market price to the minimum average cost of the typical firm.

c. Therefore, in the long run, only the consumer benefits from cost reductions.

Output

Price Firm

P1

q1

MC ATC

MR


2. Allocative Efficiency

b. Perfectly competitive firms produce up to the point where the price of the good equals the marginal cost of producing the last

unit.

MR = MC

a. Goods and services are produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.

Output

Price Firm

P1

q1

MC ATC

MR

In perfectly competitive markets, firmsa. can sell all of their output at the market price.b. produce differentiated products.c. can influence the market price by altering their output level.d. are large relative to the total market.

When we say that a firm is a price taker, we are indicating that thea. firm takes the price established in the market then tries to

increase that price through advertising.b. firm can change output levels without having any significant

effect on price.c. demand curve faced by the firm is perfectly inelastic.d. firm will have to take a lower price if it wants to increase the

number of units that it sells.

In perfectly competitive markets, individual firms have no control over price. Therefore, the firm’s marginal revenue curve is

a.a downward-sloping curve.b. indeterminate.c. constant at the market price of the product.d.precisely the same as the firm’s total revenue curve.

If marginal revenue exceeds marginal cost, a perfectly competitive firm shoulda. expand output. b. reduce output.c. lower its price. d. do both a and c.

When firms in a perfectly competitive market are temporarily able to charge prices that exceed their production costs,

a. the firms will earn long-run economic profit.b. additional firms will be attracted into the market until price falls to

the level of per-unit production cost.c. the firms will earn short-run economic profits that will be offset by

long-run economic losses.d. the existing firms must be colluding or rigging the market,

otherwise, they would be unable to charge such high prices.

expand output

Suppose a restaurant that is highly profitable during the summer months is unable to cover its total cost during the winter months. If it wants to maximize profits, the restaurant shoulda. shut down during the winter, even if it is able to cover its variable costs during that period.b. continue operating during the winter months if it is able to cover its variable costs.c. go a out of business immediately; losses should never be tolerated.d. lower its prices during the summer months.

This graph illustrates a firma.capable of earning economic profit.b.that is only able to break even when it maximizes profit.c.taking economic losses.d.that should shut down immediatelyThis graph depicts the cost curves of a firm in a perfectly competitive industry. At what output would the firm’s per-unit cost be at a minimum?a. 100 c. 150b. 125 d. an output > 150

For the above graph, if the market price is $30, what is the firm’s profit-maximizing output and maximum profit.a. output, 125; economic profit, zerob. output, 125; economic profit, between $1,000 and $1,250c. output, 150; economic profit, $1,500d. output, 150; economic profit, between $1,250 and $1,500

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