Perfect CompetitionProduction and ProfitUsing Marginal AnalysisWhen is Production Profitable?The Short-Run Production DecisionOptimal Firm SizeThe Industry Supply CurveThe Industry Supply Curve in the Short RunThe Industry Supply Curve in the Long RunEcon 101: Principles of MicroeconomicsChapter 13 - Perfect Competition and the Supply CurveFall 2010Herriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 1 / 27Outline1Perfect Competition2Production and ProfitUsing Marginal AnalysisWhen is Production Profitable?The Short-Run Production DecisionOptimal Firm Size3The Industry Supply CurveThe Industry Supply Curve in the Short RunThe Industry Supply Curve in the Long RunHerriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 2 / 27OverviewIn the previous chapter, we characterized the production function forthe firm and the implications for the firm’s typical cost structure.In this chapter, we use that information to infer the firm’s supplyfunction in a perfectly competitive market.We will seewhat factors determine the profitability of the firm and whyunprofitable firms may choose to operate in the short-runwhy industries behave differently in the short run versus the long run.First, however, we will need to more carefully define what is meant bya perfectly competitive market.In chapter 3, we introduced the notion of a competitive market,characterizing as one in which there are many buyers and sellers ofthe same good or service.This is the essence of what is meant by a competitive market, but wewant highlight what is important about this basic definition.Herriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 3 / 27Perfect CompetitionPerfect CompetitionA perfectly competitive market has two necessary characteristics:1All market participants (consumers and producers) must beprice-takers.- A price-taking producer is one who views their actions as havingno-effect on the market price of the good.- This is usually due to the fact the none of the producers have a largemarket share- The firm’s market share is the fraction of total industry output- Examples of price-taking producers would include grain farmers andlocal gasoline stations- There are, of course, many examples of industries in which producersare not price-taking- A price-taking consumer is one who views their actions as havingno-effect on the market price of the good or service.- This is typically the case.- However, in some markets, firms are the “consumers” of the goodproduced and far from price-takers.2The industry output is a standardized product; i.e., a product thatconsumers view as the same good regardless of which firm produces it.Herriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 4 / 27Perfect CompetitionFree Entry and ExitWhile not necessary, most perfectly competitive markets are alsocharacterized by free entry and exitAn industry has free entry and exit when new producers can easilyenter into the industry and existing producers can easily leave.While a new seller must always incur some start-upA perfectly competitive market has no significant barriers to discouragenew entrantsAny firm wishing to enter can do business on the same terms as firmsthat are already thereIn some markets there are significant barriers to entry, includingLegal barriers (e.g., e.g., taxi medallions in New York City)patentssignificant economies of scale, which may give existing firms a costadvantage over new entrantsIn some markets there are significant barriers to exit, includingplant closing lawsunion agreementsHerriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 5 / 27Production and ProfitThe Firm’s ProfitThe firm’s profit is defined as:Profit = Total Revenues − Total Costs = TR − TC (1)whereTR = Price × quantity = P × Q (2)Keep in mind that we are still talking about economic profit here, sothat the cost include all of the opportunity costs for the firm.Herriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 6 / 27Production and ProfitJennifer and Jason’s Organic Tomato FarmThe text considers an tomato farm, that can sell its tomatoes at$18 perbushel, TR and TC given byOutput Total Revenue Total Cost Profit(bushels) (TR) (TC) (TR-TC)0$0$14 -$141$18$30 -$122$36$36$03$54$44$104$72$56$165$90$72$186$108$92$167$126$116$10Herriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 7 / 27Production and ProfitJennifer and Jason’s Organic Tomato FarmThe text considers a tomato farm, that can sell its tomatoes at$18 perbushel, TR and TC given byOutput Total Revenue Total Cost Profit(bushels) (TR) (TC) (TR-TC)0$0$14 -$141$18$30 -$122$36$36$03$54$44$104$72$56$165$90$72$186$108$92$167$126$116$10Herriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 8 / 27Production and Profit Using Marginal AnalysisUsing Marginal AnalysisThe firm’s profit maximizing output level can also be found by usingthe principle of marginal analysis- The optimal amount of an activity is the level at which marginalbenefit (MB) equals marginal cost (MC)The MB to the firm of producing one more unit of their good is theincreased revenue they receive; i.e., their marginal revenue.- The marginal revenue (MR) is the change in total revenue generated byone additional unit of output; i.e.,MR =Change in Total RevenueChange in quantity of output=∆TR∆Q(3)Thus, for the profit maximizing firm, the optimal output rule if itproduces at all is to produce additional output level as long asMR ≥ MC (4)If possible, production should stop at the point where MR = MCHerriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 9 / 27Production and Profit Using Marginal AnalysisJennifer and Jason’s Organic Tomato FarmThe text considers an tomato farm, that can sell its tomatoes at$18 perbushel, TR and TC given byOutput Profit Marginal Marginal Net Gain(bushels) TR TC (TR-TC) Rev. (MR) Cost (MC) MR - MC0$0$14 -$141$18$30 -$12$18$16$22$36$36$0$18$6$123$54$44$10$18$8$104$72$56$16$18$12$65$90$72$18$18$16$26$108$92$16$18$20 -$27$126$116$10$18$24 -$6Herriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 10 / 27Production and Profit Using Marginal AnalysisGraphically, for the Price Taking FirmHerriges (ISU) Ch. 13 Perfect Competition and Supply Fall 2010 11 / 27Production and Profit Using Marginal AnalysisNotes on the Optimal OutputNotice that, for Jennifer and Jason’s Farm, their production levels arediscrete, so there is not a point at which MR = MC .In this case, they should continue to produce as long as
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