Market Structures: Perfect Competition

1. AP Economics Mr. Bordelon Market Structures:Perfect Competition

2. Production and Profits • Optimal output rule. Profit is maximized by producing the quantity at which MR of last unit produced is equal to MC. • ALWAYS FOR ALL MARKET STRUCTURES MR = MC

3. Price-Taking Firm’s Optimal Output Rule Price equals MC at price-taking firm’s optimal quantity of output. Price-taking firm’s profit is maximized by producing the quantity of output at which the market price is equal to the marginal cost of the last unit produced. In English: Firms in perfect competition will max out their profit by producing an amount where the market price equals marginal cost. Why?

4. Price-Taking Firm’s Optimal Output Rule For price-takers, MR = market price. Price takers can’t influence market price (key characteristics of perfect competition). Remember, there are too many competitors for a firm to try and control price. It can’t lower the market price by selling more or raise it by selling less. In perfect competition, any marginal revenue made by making one more will always be the market price.

5. Price-Taking Firm’s Optimal Output Rule In this case, 5 bushels of tomatoes is the profit-maximizing output. This is the level of output where MC rises from a level below market price (16) to a level above market price (20), going through the market price (18). Another way to think about it is that a firm will produce until its costs exceed revenue, in this case, 6 bushels. And in case you were wondering, you betcha we can graph all this out!

6. Price-Taking Firm’s Profit-Maximizing Quantity of Output Notice that when we graph out the MC curve (supply) and MR curve (demand), they intersect at 5 bushels, point E. This is the equilibrium price and quantity, and also the optimal output for producers. As a price-taker, firms have MR curves that are horizontal at the market price. What kind of curve is this?

7. Price-Taking Firm’s Profit-Maximizing Quantity of Output As a price-taker, firms have MR curves that are horizontal at the market price. This is a perfectly elastic demand curve. Translating this for economics, these farmers can sell all they want at the market price, and they can’t affect the market price, no matter how much they sell. This perfectly elastic demand curve is representative of the perfectly competitive market structure. MR = P = D, and even average revenue (R/Q). P = AR for every unit sold at the same price.

8. Profitable Production • Whether or not a business should continue operation is whether it turns an economic profit, not an accounting profit. • Economic profit includes all opportunity costs, but accounting profit does not. • Businesses can make positive accounting profits, but negative economic profits. • Unless otherwise stated, assume numbers given are geared towards economic profit.

9. Profitable Production Figuring out whether the firm is earning a profit depends on whether the market price is more or less than the firm’s minimum ATC. (Woo hoo! ATC is back, baby!) Notice the title of the table as “short-run,” but fixed costs are not listed. In these type of tables, FCs are a given—they will not change in the short run.

10. Profitable Production In this particular graph, the market price is $14, and we’ve graphed out the ATC from the table on the previous slide, and the MC from the first table. In this scenario, ATC, MC and MR intersect at the market price of $14 and 4 bushels, point C. The 4 bushels is the minimum-cost output. Is there a profit being made here?

11. Profitable Production Is there a profit being made here? Π = TR – TC If TR > TC, profit! If TR = TC, breaks even. If TR < TC, no profit (sad panda). In this scenario, if the market price is $14, then the tomato farmers are simply breaking even.

12. Profitable Production Is there a profit being made here? We can also look at it on a per unit basis. Π/Q = TR/Q – TC/Q Π/Q = P – ATC Revenue per unit is average revenue (AR), which is also P. Cost per unit is ATC. If P > ATC, profit! If P = ATC, breaks even. If P < ATC, no profit (more sad pandas). In this scenario, if the market price is $14, then the tomato farmers are simply breaking even.

13. Profitable Production—SUMMARY • In the short run, businesses will maximize profit by producing the quantity of output at which MC = MR. • A perfectly competitive firm is a price-taker, so it can sell as many units of output as it would like at the market price. • For a perfectly competitive firm, it will always be true that MR = P. • The firm is profitable, or breaks even, so long as market price is greater than, or equal to, average total cost.

14. Perfect Competition Graphs This graph is based on the original table introduced in this PowerPoint. Remember the general rules: If P > ATC, profit! If P = ATC, breaks even. If P < ATC, no profit. Here, the market price is $18, with the profit-maximizing quantity at 5 bushels, point E. This is where MR = MC. At 5 bushels, ATC is $14.40 per bushel, point Z. In this case, market price is greater than minimum ATC, point C, and thus, the tomato farm is making a profit!

15. Perfect Competition Graphs Total profit in this case is represented by the shaded rectangle. Why? Look at it as a matter of per unit. Π = TR – TC Π/Q = TR/Q – TC/Q TR/Q is equal to P, and ATC = TC/Q Π = (P – ATC) x Q In this case, Π = ($18 - $14.40) x 5 Π = ($3.60) x 5 Π = $18

16. Perfect Competition Graphs Π = (P – ATC) x Q Π = ($14 – 14) x 5 Π = ($0) x 5 Π = $0 In this case, the firm is not making a profit, but not losing any either. This is referred to as “breaking even.”

17. Perfect Competition Graphs Here, the market price is $10, with the profit-maximizing quantity at 3 bushels, point A. This is where MR = MC. At 3 bushels, ATC is $14.67 per bushel, point Y. In this case, minimum ATC is greater than market price, and thus, the tomato farm is making a loss.

18. Perfect Competition Graphs Total loss is indicated by the shaded rectangle. Π= (P – ATC) x Q Π = ($14.67 – 10) x 3 Π = ($4.67) x 3 Π = $14 (rounded) In this case, the firm is making a loss of $14 when the market price is $10.

19. Short-Run Production • FC is irrelevant to any decision about whether to produce or shut down in the short run. • VC on the other hand is essential. We can’t touch FC in the short run. However, we can eliminate variable cost by not producing. • In the short run, sometimes the firm should produce even if P < minimum ATC. • TC includes FC, which can only be changed in long run. In short run, FC must still be paid regardless. • But VC…well, we can shut it down.

20. Short-Run Production Shut down EVERYTHING

21. Shut-Down Price • The shut-down price equals the minimum AVC. • Businesses will stop production in the short run if market price falls below the shut-down price. • Two scenarios: • P ≥ minimum AVC • P < minimum AVC

22. Shut-Down Price With the data in the table, we’ve looked at the MC curve at market prices of $18, $14 and $10. At point E, where P = $18, the tomato farm is profitable. P > ATC at $18. At point C, where P = $14, the tomato farm is breaking even. P = ATC at $14. At point A, where P = $10, the tomato farm is operating at a loss. P < ATC at $10.

23. Shut-Down Price P ≥ minimum AVC. In this case, the firm should produce in the short run. At points C and E, the business is maximizing profit or minimizing loss by choosing its output level whereMC = MR. At $18, the profit was $18. At $14, the profit was $0. The firm should continue to produce according to economic profit.

24. Shut-Down Price P < minimum AVC. In this case, P tomato farm is getting per unit doesn’t cover its VC. The tomato farm should shut down. There is no level of output where TR would cover VC. We can eliminate VC by not producing—minimizing the loss. Still have to pay the FC.

25. Shut-Down Price P < minimum AVC At point A, the business can minimize its loss by ceasing production. MC = MR, but as P = minimum AVC, the business can’t make enough money to cover its costs. At $10, the profit was -$14. The firm should cease production.

26. Shut-Down Price P < minimum AVC But what about point B? Should a business continue production here? Here the market price of $12 is between the break even price of $14 and the shut-down price of $10—between the minimum AVC and minimum ATC. Clearly at $12, we’re operating at a loss, as MR is less than ATC. Still, we’re covering the AVC and some of the AFC. If we shut down, we will end up with no VC, but still have to pay the full FC. Shutting down in this case would cause a greater loss. In short, we should continue production.

27. Supply and Demand Short-run individual supply curve. Shows individual firm’s profit-maximizing level of output depends on market price, taking fixed cost as given. Represented by the MC. Demand. In this case, represented by the MR.

28. Supply and Demand At market prices equal to or above shut-down price, firm’s short-run supply curve corresponds to MC. At market prices below the minimum AVC, the firm shuts down, and output drops to zero in the short run.

29. Fixed Costs • In the long run, firms will enter an industry if the market price is consistently more than the break-even price—minimum ATC. • In the long run, firms will exit an industry if the market price is consistently less than the break-even price—minimum ATC.

30. Summary

31. Long Run and Perfect Competition • Industry supply curve. Relationship between price and total output of an industry as a whole. • Short-run industry supply curve. Shows how the quantity supplied by an industry depends on the market price, given a fixed number of firms. • Long-run industry supply curve. Shows how the quantity supplied responds to the price once producers have had time to enter or exit the industry.

32. Short-Run Industry Supply Curve In the short-run, the number of firms in an industry is fixed—no entry or exit. In creating the curve, S, for adding up the total output of all suppliers, we assume that all businesses are alike. In this case, at $10, the shut-down price, no firms will produce at that price. They can’t meet the AVC. At prices above $10, the short-run industry supply (SRIS) curve slopes upward, in line with the law of supply. Each farm will produce an amount where MC = MR (market price).

33. Short-Run Industry Supply Curve Here, if market price is $18, these farms will produce 500 bushels of tomatoes. The market demand curve crosses the SRIS at EMKT. This is the short-run market equilibrium, where quantity supplied equals quantity demanded. In the long run, however, we can expect this graph to change as businesses enter and exit the industry.

34. Long-Run Industry Supply Curve • The focus on the long-run is on entry and exit. • Entry: Firms will enter an industry when existing firms are making a profit. P > ATC • Exit: Firms will leave an industry when they are not making a profit. P < ATC

35. Long-Run Industry Supply Curve • Recall that changes in supply can shift the supply curve. • If firms enter a market, this causes a change in population. This change would cause an increase in supply, shifting to the right. • If firms leave a market, this causes a change in population. This change would cause a decrease in supply, shifting to the left.

36. Long-Run Industry Supply Curve If firms enter a market, this causes a change in population. This change would cause an increase in supply, shifting to the right. As supply (S) increases, while demand (D) remains constant, equilibrium has to change, from EMKT to DMKT. This lowers the market price from $18 to $16. As more firms enter, S will increase, lowering the market price to a new equilibrium at CMKT at $14.

37. Long-Run Industry Supply Curve Recall that $14 in this scenario is our break even price. It is at this point that firms will stop entering. No profit is being made (normal profit), so there’s no incentive to enter. CMKT is the long-run market equilibrium (LRME). LRME is where QD equals QS, given sufficient time for entry into and exit from the industry.

38. Long-Run Industry Supply Curve Take a look at it from the individual firm’s perspective. Initially, before firms enter, we’re at $18 for P with output at 5. The profit is represented by rectangle A. These profits will cause other firms to enter. As those firms enter, the market price drops to $16. When that happens, the drop in price causes profits to drop. This drop in profits is represented by rectangle B (striped). As firms continue to enter, price will drop to the break even price, and that’s where entry will stop. Now, let’s combine the graphs.

39. Long-Run Industry Supply Curve Notice that the changes in the short-run industry supply graph correspond to changes in the short-run individual supply graph.

40. Effect of an Increase in Demand in the Short Run and the Long Run Panels (a) and (c) show existing firms’ responses in the short-run, and panel (b) shows the market response in the short-run and the long run.

41. Effect of an Increase in Demand in the Short Run and the Long Run Focusing on panel (b), D1 and S1 are the initial curves, with equilibrium at XMKT. XMKT is both short- and long-run equilibrium because equilibrium price of $14 leads to zero economic profit. At zero economic profit, there is no entry into or exit from the market. This corresponds to point X in panel (a).

42. Effect of an Increase in Demand in the Short Run and the Long Run Focusing on panel (b), assume that D1 increases to D2. In that case, in the short run, industry output moves along S1, with new equilibrium at YMKTat S1 and D2. The market price increases from $14 to $18. This corresponds to the movement from X to Y in panel (a), as existing firms now make a profit thanks to the increase in market price.

43. Effect of an Increase in Demand in the Short Run and the Long Run Focusing on panel (b), YMKT is not long run equilibrium. $18 is higher than minimum ATC—existing firms are making economic profit. This causes new firms to enter the industry. In the long run, S1 (SRIS) shifts to S2, causing equilibrium to shift to ZMKT. Price drops back to $14, increasing output. XMKT and ZMKT are both short-run and long-run equilibrium.

44. Effect of an Increase in Demand in the Short Run and the Long Run Focusing on panel (c), as firms enter the market, price drops from Y ($18) to Z ($14). As price drops, so does production (Hey! Law of supply!). All firms in the industry are now producing at Z, which is the minimum of the ATC here (remember, normal profit). Looking at (b), the increase in quantity from QX to QZ is from new entrants into the market.

45. Effect of an Increase in Demand in the Short Run and the Long Run The line crossing through XMKT and ZMKT is the long-run industry supply curve. It shows how quantity supplied responds to price once there is enough time to enter/exit the industry.

46. Effect of an Increase in Demand in the Short Run and the Long Run Here, the LRS is horizontal at $14, perfectly elastic in the long run. Given enough time to enter or exit, firms will supply any quantity that consumers demand at a price of $14. This is referred to as constant costs across the industry. Each firm, whether old or new, faces the same cost structure/curve.

47. Long-Run Industry Supply Curve • Not all industries have perfectly elastic supply curves—some have curves that reflect some inelasticity. • In that case, as an industry expands, the price of inputs increases. The cost structure becomes higher than it was when the industry was smaller. • These industries have increasing costs across the industry.

48. Long-Run Industry Supply Curve • Some industries have long-run industry supply curves to slope downward. Here, the cost structure for firms becomes lower. • This indicates decreasing costs across the industry.

49. Long-Run Industry Supply Curve Regardless of the costs across the industry, long-run price elasticity of supply is higher than short-run whenever there is free entry and exit. High prices caused by an increase in demand attracts entry by new firms. This results in an increase in output throughout the industry, and price will decrease over time. The low price caused by a decrease in demand causes existing firms to exit, leading to a decrease output and an increase in price over time.

50. Production and Efficiency inLong-Run Equilibrium for Perfect Competition • Equilibrium: Value of MC is the same for all firms. All firms produce the quantity where MC = MR or P. As price-takers, they all face the same market price. • Free entry and exit: Every firm has normal profit in long-run equilibrium. Each firm produces the quantity that minimizes ATC. TC of producing the output is minimized in perfect competition. • Efficiency: All mutually beneficial transactions occur—no deadweight loss.