Perfect Competition

14 Perfect Competition CHECKPOINTS

Checkpoint 14.1 Checkpoint 14.2 Checkpoint 14.3 Clicker version Problem 1 Problem 1 Problem 1 Problem 2 Problem 2 Clicker version Problem 2 Clickerversion Problem 3 Problem 3 Clicker version Problem 3 Problem 4 Clickerversion Problem 4 Problem 5

Practice Problem 1 Sarah’s Salmon Farm produced 1,000 fish last week. The marginal cost was $30 a fish, average variable cost was $20 a fish, and the market price was $25 a fish. Did Sarah maximize profit? If Sarah did not maximize profit and if nothing has changed, will she increase or decrease the number of fish she produces to maximize her profit this week? CHECKPOINT 14.1

Solution Profit is maximized when marginal cost equals marginal revenue. In perfect competition, marginal revenue equals the market price and is $25 a fish. Because marginal cost exceeded marginal revenue, Sarah did not maximize profit. To maximize profit, Sarah will decrease her output until marginal cost falls to $25 a fish. CHECKPOINT 14.1

Study Plan Problem Sarah’s Salmon Farm produced 1,000 fish last week. The marginal cost was $30 a fish, average variable cost was $20 a fish, and the market price was $25 a fish. Did Sarah maximize profit? If not, and nothing has changed, will she increase or decrease the this week? A. Not maximizing; increase Maximizing; not change C. Maximizing; increase D. Not maximizing; decrease CHECKPOINT 14.1

Practice Problem 2 Trout farming is a perfectly competitive industry and all trout farms have the same cost curves. When the market price is $25 a fish, farms maximize profit by producing 200 fish a week. At this output, average total cost is $20 a fish, and average variable cost is $15 a fish. Minimum average variable cost is $12 a fish. If the price falls to $20 a fish, will the trout farm produce 200 fish a week? Why or why not? CHECKPOINT 14.1

Solution The marginal cost increases as the farm produces more fish. To lower its marginal cost from $25 to $20 a fish, the farm cuts production. Because the price exceeds minimum average variable cost, which is $12 a fish, she will cut production but still produce fish. If the price falls to from $25 to $20 a fish, the farm will produce fewer than 200 fish a week. CHECKPOINT 14.1

Study Plan Problem Trout farming is perfectly competitive and all farms have the same costs. When the market price is $25 a fish, farms maximize profit by producing 200 fish a week. Average total cost is $20 a fish, and average variable cost is $15 a fish. Minimum average variable cost is $12 a fish. If the price falls to $20 a fish, the trout farm will _______. A.produce fewer than 200 fish a week B. continue to produce 200 fish a week C. produce more than 200 fish a week D. stop producing until the price returns to $25 a fish CHECKPOINT 14.1

Practice Problem 3 Trout farming is a perfectly competitive industry and all trout farms have the same cost curves. When the market price is $25 a fish, farms maximize profit by producing 200 fish a week. At this output, average total cost is $20 a fish, and average variable cost is $15 a fish. Minimum average variable cost is $12 a fish. If the price falls to $12 a fish, what will the trout farm do? CHECKPOINT 14.1

Solution If the price falls to $12 a fish, farms cut production to the quantity at which marginal cost equals $12. But, because $12 is minimum average variable cost, this price puts farms at the shutdown point. Farms are indifferent between producing the profit-maximizing output (something less than 200 fish a week) and shutting down (producing nothing). CHECKPOINT 14.1

Study Plan Problem Trout farming is perfectly competitive and all farms have the same costs. When the market price is $25 a fish, farms maximize profit by producing 200 fish a week. Average total cost is $20 a fish, and average variable cost is $15 a fish. Minimum average variable cost is $12 a fish. If the price falls to $12 a fish, the farm will ______. A. produce the profit-maximizing output B. shut down C. continue to produce 200 fish a week D. attempt to raise the price back to $25 a fish E. produce either the profit-maximizing output or nothing CHECKPOINT 14.1

Practice Problem 4 Trout farming is a perfectly competitive industry and all trout farms have the same cost curves. When the market price is $25 a fish, farms maximize profit by producing 200 fish a week. At this output, average total cost is $20 a fish, and average variable cost is $15 a fish. Minimum average variable cost is $12 a fish. What are two points on the trout farm’s supply curve? CHECKPOINT 14.1

Solution One point on the farmer’s supply curve is the profit-maximizing output of 200 fish a week when the market price is at $25 a fish. Another point on the farmer’s supply curve is the shutdown point—output is zero when the market price is $12 a fish or the profit-maximizing output at $12 a fish. CHECKPOINT 14.1

Practice Problem 5 BHP Billiton to axe 6,000 jobs The price of coal has fallen to $125 a ton after a six-year climb that reached $300 a ton. BHP Billiton, part of Anglo-American, will cut production in 2009 by 10–15 percent, lay off 6,000 workers, and close some mines for six months. Source: FT.com, January 21, 2009 As BHP responded to the fall in price, how did its marginal cost change? What is minimum average variable cost in the mines that closed? CHECKPOINT 14.1

Solution Marginal cost decreased from $300 a ton to $125 a ton. The mines that closed temporarily were at the shutdown point, so minimum average variable cost is $125 a ton. CHECKPOINT 14.1

Study Plan Problem Trout farming is perfectly competitive and all farms have the same costs. When the market price is $25 a fish, farms maximize profit by producing 200 fish a week. Average total cost is $20 a fish, and average variable cost is $15 a fish. Minimum average variable cost is $12 a fish. Two points on the farm’s supply curve are ______. A. 200 fish at $9 a fish; 0 fish at $25 a fish B. 200 fish at $25 a fish; 0 fish at $9 a fish C. 200 fish at $20 a fish; 0 fish at $15 a fish D. 200 fish at $25 a fish; 0 fish at $15 a fish E. 200 fish at $15 a fish; 0 fish at $9 a fish CHECKPOINT 14.1

Practice Problem 1 Tulip growing is a perfectly competitive industry, and all tulip growers have the same cost curves. The market price of tulips is $25 a bunch, and each grower maximizes profit by producing 2,000 bunches a week. The average total cost of producing tulips is $20 a bunch, and the average variable cost is $15 a bunch. Minimum average variable cost is $12 a bunch. What is the economic profit that each grower is making in the short run? CHECKPOINT 14.2

Solution The figure illustrates the situation when a grower produces 2,000 bunches a week. The grower’s marginal revenue equals the market price ($25). The grower produces 2,000 bunches and is maximizing profit. That is, marginal cost equals marginal revenue at 2,000 bunches a week. CHECKPOINT 14.2

The market price ($25) exceeds the average total cost ($20), so growers are making an economic profit of $5 a bunch. The economic profit on 2,000 bunches is $10,000 a week. CHECKPOINT 14.2

Practice Problem 2 Tulip growing is a perfectly competitive industry, and all tulip growers have the same cost curves. The market price of tulips is $25 a bunch, and each grower maximizes profit by producing 2,000 bunches a week. The average total cost of producing tulips is $20 a bunch, and the average variable cost is $15 a bunch. Minimum average variable cost is $12 a bunch. What is the price at the grower’s shutdown point? CHECKPOINT 14.2

Solution The grower will shut down temporarily if the price falls so that it cannot cover its total variable cost (the cost of its labor). The price at the shutdown point equals minimum average variable cost, which is $12 a bunch. CHECKPOINT 14.2

Practice Problem 3 Tulip growing is a perfectly competitive industry, and all tulip growers have the same cost curves. The market price of tulips is $25 a bunch, and each grower maximizes profit by producing 2,000 bunches a week. The average total cost of producing tulips is $20 a bunch, and the average variable cost is $15 a bunch. Minimum average variable cost is $12 a bunch. What is the grower’s economic profit at the shutdown point? CHECKPOINT 14.2

Solution At the shutdown point, the grower incurs an economic loss equal to total fixed cost. What is TFC? When 2,000 bunches a week are grown, ATC is $20 a bunch and AVC is $15 a bunch. So when 2,000 bunches a week are grown, AFC is $5 a bunch. CHECKPOINT 14.2

Total fixed cost equals $10,000 a week—$5 a bunch x 2,000 bunches a week. So at the shutdown point, the grower incurs an economic loss equal to $10,000 a week. CHECKPOINT 14.2

Practice Problem 4 Corn hits record high price Corn prices have surged 80 percent in the past year, driven up by a global rush for grains to feed people and livestock and to make biofuel. Source: USA Today, June 26, 2008 Explain why the price of corn surged in the short run. Explain how the farmer’s marginal revenue, marginal cost of producing corn, economic profit on a ton of corn, and the farmer’s economic profit changed. CHECKPOINT 14.2

Solution An increase in the market demand for corn increased the market price. The market for corn is competitive, so the farmer’s marginal revenue equals the market price. The marginal revenue increased. The farmer maximizes profit by producing the quantity at which marginal revenue equals marginal cost. Because marginal revenue has increased, the farmer increases the quantity produced. CHECKPOINT 14.2

As the farmer increases the quantity produced, he moves up along his MC curve. Economic profit on a ton of corn (the market price minus the marginal cost of producing it) increases. In the short run, economic profit increases. CHECKPOINT 14.2

Practice Problem 1 Tulip growing is a perfectly competitive industry, and all tulip growers have the same cost curves. The market price of tulips is $15 a bunch, and each grower maximizes profit by producing 1,500 bunches a week. The average total cost of producing tulips is $21 a bunch. Minimum average variable cost is $12 a bunch, and the minimum average total cost is $18 a bunch. What is a grower’s economic profit in the short run and how does the number of tulip growers change in the long run? CHECKPOINT 14.3

Solution The market price ($15) is less than average total cost ($21), so the tulip grower is incurring an economic loss in the short run. Because the market price exceeds minimum average variable cost, the grower continues to produce. Economic loss equals the loss per bunch ($6) multiplied by 1,500 bunches, which equals $9,000. CHECKPOINT 14.3

Because growers are incurring economic losses in the short run, some growers will exit the industry in the long run. So in the long run, there will be fewer tulip growers. CHECKPOINT 14.3

Practice Problem 2 Tulip growing is a perfectly competitive industry, and all tulip growers have the same cost curves. The market price of tulips is $15 a bunch, and each grower maximizes profit by producing 1,500 bunches a week. The average total cost of producing tulips is $21 a bunch. Minimum average variable cost is $12 a bunch, and the minimum average total cost is $18 a bunch. In the long run, what is the market price and what is the grower’s economic profit? CHECKPOINT 14.3

Solution As some farms stop growing tulips, the market supply of tulips decreases and the market price rises. Growers will continue to exit the industry until economic losses are eliminated. In the long run, the price will be such that economic profit is zero. In long-run equilibrium, the price will be $18 a bunch. CHECKPOINT 14.3

Study Plan Problem Tulip growing is a perfectly competitive industry. The market price is $15 a bunch, and each grower maximizes profit by producing 1,500 bunches a week. The ATC is $21 a bunch, minimum AVC is $12 a bunch, and minimum ATC is $18 a bunch. In the long run, the price is ___ and a grower makes ___. A. $18 a bunch; zero economic profit B. $57 a bunch; positive economic profit C. $15 a bunch; zero economic profit D. $18 a bunch; positive economic profit E. $21 a bunch; zero economic profit CHECKPOINT 14.3

Practice Problem 3 Cotton farmers face a formidable foe The growing season has just begun and already pigweed is spreading quickly, towering above the cotton plants, and crowding out the sunlight. This is a new breed of pigweed that is resistant to powerful herbicides. Scientists estimate that thousands of acres have already been plowed back, and that it could cost $20 an acre to fend off the weed. Source: USA Today, July 18, 2008 How will the cost of growing cotton change? What effect will this weed have on the cotton market in the short run? CHECKPOINT 14.3

In the long run, will farmers switch to growing cotton or switch from cotton to some other crop? How will the cotton market change in the long run? CHECKPOINT 14.3

Solution To produce any cotton, farmers will have to incur the cost of spraying—$20 an acre. This cost is a fixed cost, so the farmer’s marginal cost does not change. With acres of cotton already plowed back, the market supply of cotton will decrease in the short run and the market price will rise. To maximize profit, farmers produce the quantity at which marginal revenue equals marginal cost. With a higher price and no change in marginal cost, farmers with a crop will make positive economic profit. CHECKPOINT 14.3

Because farmers with a crop make positive economic profit, new farmers will enter the cotton-growing industry. As new farmers enter the market, the market price of cotton will fall. New farmers will continue to enter the market and the price will continue to fall until farmers are making zero economic profit. In long-run equilibrium, cotton farmers will make zero economic profit. CHECKPOINT 14.3

Perfect Competition