Chapter 12 Perfect Competition Givens in a perfectly competitive industry o There are many buyers and sellers each with a small market share the fraction of the total industry output accounted for by that producer s output o Both sellers and buyers are price takers their actions have no effect on price o Standardized product commodity consumers regard different sellers products as equivalent o Free entry and exit new producers can easily enter into an industry and existing producers can easily leave that industry Production and Profits o Since each firm is a price taker each firm s total revenue will be equal to the market price multiplied by the quantity sold Total revenue market price x quantity sold TR P x Q o Profit is total revenue minus total cost Profit TR TC o We can do profit maximization but we can also find this by marginal analysis Marginal Revenue and the Optimal Output Rule Marginal revenue is the change in total revenue generated by an additional unit of output o MR change in TR change in Q For the price taking firms MR is the good s market price Optimal output rule o 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 o Optimal production level is when MR MC Price o Why is profit maximized where MR MC Each time the firm produces another unit there are extra costs and extra revenues If producing another unit adds more to revenue than cost MR MC then profit will increase If producing another unit adds less to revenue than cost MR MC the profit will increase Since MR P for competitive firms the profit maximizing rule is choose the quantity of output such that P MC Costs and production in the short run As long as increasing production by one more unit creates more MR than MC it makes sense to do it Profit Maximizing Quantity of Output When is Production Profitable We are considering economic profit which includes implicit costs A firm s economic profit could be negative or positive o If TR TC the firm is profitable o If TR TC the firm breaks even o If TR TC the firm incurs a loss Profitability and the Market Price When TR TC that is the breakeven price If the price is just high enough to cover ATC and if it chooses the quantity where MR MC the firm will break even On the next graph the market price is increased to 18 o The firm is profitable because P the minimum ATC o Profit is the difference between market price and average total cost Calculating Total Costs and Profit Break even price of a price taking firm is the market price at which it earns zero profit o Minimum ATC Profit TR TC TR Q TC Q x Q P ATC x Q Loss When price is below ATC a loss is incurred You calculate loss with the same way you calculate profit Where Market P MC under the min ATC you draw a vertical line up from that intersection until it hits the ATC curve At that point is the price you should be selling for So for loss take market price minus the price you should be selling at this will be negative because the market price is lower than the optimal output price Then multiply the difference by the quantity at which MC Market P Therefore this follows P ATC x Q To stay or not to stay Losses don t mean immediate shutdown o Fixed costs must be paid whether or not the firm produces in the short run o Firms will produce if they cover their variable AND some of their fixed costs Shut down price is the minimum average variable cost o Min AVC A firm should stay open in the short run if it can cover its variable costs o They will incur a smaller negative profit than if they shutdown immediately Therefore o If market price is above min ATC the firm stays in business in short run and long run o If market price is below min ATC but above min AVC the business should keep producing short run but exit industry in long run o If the market price is below min AVC the business should stop producing immediately and exit the industry long term The Short Run Individual Supply Curve Where the MC curve intersects the AVC curve you can act as though the MC curve is the supply curve because underneath where they intersect you wouldn t produce in the short run and above where they intersect you will produce in the short run A firm will produce at every price above the price where AVC intersects the MC curve o At that point is when you can travel up the MC curve using it as a sort of supply curve A firm will stop producing in the short run if the market price falls below the shutdown price Should I stay or should I go In the short run o A firm will produce if P shutdown price min AVC o A firm will not produce if P shutdown price min AVC Summary of the Perfectly Competitive Profitability and Production Conditions The Industry Supply Curve Firms are profitable if o P break even price min ATC Profit attracts new entrants The short run industry supply curve shows the relationship between the price and the total output of an industry as a whole o Shows how the quantity supplied by an industry depends on the market price The Long Run Market Equilibrium In perfectly competitive markets no firms are making profit or loss in the long run New firms enter as long as there is economic profit P min ATC A market is in long run equilibrium when the quantity supplied equals the quantity demanded given that sufficient time has elapsed for entry into and exit from the industry to occur Comparing the Short Run and Long Run Industry Supply Curves The long run industry supply curve is always flatter more elastic than the shortrun industry supply curve Because of entry and exit A higher price attracts new entrants in the long run raising industry output and lowering price A fall in price induces existing producers to exit in the long run reducing industry output and raising price