12 c h a p t e r t w e l v e Firms in Perfectly Competitive Markets 12.1 A Perfectly Competitive Market 12.2 An Individual Price Taker’s Demand Curve 12.3 Profit Maximization 12.4 Short-Run Profits and Losses 12.5 Long-Run Equilibrium 12.6 Long-Run Supply CHICAGO BOARD OF TRADE At the Chicago Board of Trade (CBOT), prices are set by thousands of buyers interacting with thousands of sellers. The goods in question are standardized (e.g., grade A winter wheat) and information is readily available. Every buyer and seller in the market knows the price, the quantity, and the quality of the wheat available. Transaction costs are negligible. For example, if a news story breaks on an infestation in the cotton crop, the price of cotton will rise immediately. CBOT price information is used to determine the value of some commodities throughout the world. W I L S O N , J A M I E 5 0 5 1 B U Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 323 Firms in Perfectly Competitive Markets A firm must answer two critical questions: What price should we charge for the goods and services we sell, and how much should we produce? The answers to these two questions will depend on the market structure. The behavior of firms will depend on the number of firms in the market, the ease with which firms can enter and exit the market, and the ability of firms to differentiate their products from those of other firms. There is no typical industry. An industry might include one firm that dominates the market, or it might consist of thousands of smaller firms that each produce a small fraction of the market supply. Between these two end points are many other industries. However, because we cannot examine each industry individually, we break them into four main categories: perfect competition, monopoly, monopolistic competition, and oligopoly. In a perfectly competitive market, the market price is the critical piece of information that a firm needs to know. A firm in a perfectly competitive market can sell all it wants at the market price. A firm in a perfectly competitive market is said to be a price taker, because it cannot appreciably affect the market price for its output or the market price for its inputs. For example, suppose a Washington apple grower decides that he wants to get out of the family business and go to work for Microsoft. Because he Wmay be one of 50,000 apple growers in the United States, his decision will not appreciably change the price of the apples, the production of I apples, or the price of inputs. L S O N , A Perfectly Competitive Market What are the characteristics of a firm in a perfectly competitive market? 12.1 What is a price taker? J A A Perfectly Competitive Market M This chapter examines perfect competition, a market structure characterized by (1) many I buyers and sellers, (2) identical (homogeneous) products, and (3) easy market entry and exit. E Let’s examine these characteristics in greater detail. 5 In a perfectly competitive market, there are many buyers and sellers, perhaps thousands or 0 conceivably millions. Because each firm is so small in relation to the industry, its production decisions have no impact on the market—each5regards price as something over which it has no control. For this reason, perfectly competitive 1 firms are called price takers: They must take the price given by the market because their influence on price is insignificant. If the price B individual wheat farmers will receive $5 a of wheat in the wheat market is $5 a bushel, then bushel for their wheat. Similarly, no single buyer U of wheat can influence the price of wheat, because each buyer purchases only a small amount of wheat. We will see how this relationship works in more detail in Section 12.2. © Flying Colours Ltd/Jupiterimages Many Buyers and Sellers Why do they call firms in a perfectly competitive market price takers? Identical (Homogeneous) Products Consumers believe that all firms in perfectly competitive markets sell identical (or homogeneous) products. For example, in the wheat market, we are assuming it is not possible to determine any significant and consistent qualitative differences in the wheat produced by different farmers. Wheat produced by Farmer Jones looks, feels, smells, and tastes like that Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 324 PART 4 Households and Market Structure BRUCE HEINEMANN/GETTY IMAGES produced by Farmer Smith. In short, a bushel of wheat is a bushel of wheat. The products of all the firms are considered to be perfect substitutes. Easy Entry and Exit Product markets characterized by perfect competition have no significant barriers to entry or exit. Therefore it is fairly easy for entrepreneurs to become suppliers of the product or, if they are already producers, to stop supplying the product. “Fairly easy” does not mean that any person on the street can instantly enter the business but rather that the financial, legal, educational, and other barriers to entering the business are modest, enabling large numbers of people to overcome the barriers and enter the business, if they so desire, in any Can the owner of this orchard charge a noticeably given period. If buyers can easily switch from one seller to another higher price for apples of similar quality to those and sellers can easily enter or exit the industry, then they have met the sold at the orchard down the road? What if she perfectly competitive condition of easy entry and exit. Because of this charges a lower price for apples of similar quality? How many apples can she sell at the market price? easy market entry, perfectly competitive markets generally consist of a W of small suppliers. large number A perfectly competitive market is approximated most closely in highly organized marI kets for securities and agricultural commodities, such as the New York Stock Exchange or L the Chicago Board of Trade. Wheat, corn, soybeans, cotton, and many other agricultural products are sold in perfectly S competitive markets. Although all the criteria for a perfectly competitive market are rarely What are the three Omet, a number of markets come close to satisfying them. characteristics of a perfectly Even when all the assumptions don’t hold, it is important to note that studying the model competitive market? N because many markets resemble perfect competition—that of perfect competition is useful is, markets in which firms face, highly elastic (flat) demand curves and relatively easy entry and exit. The model also gives us a standard of comparison. In other words, we can make comparisons with the perfectly competitive model to help us evaluate what is going on in J the real world. SECTION QUIZ A M I E 1. Perfectly competitive markets tend to have a ____ number of sellers and a(n) ____ entry. a. large; easy 5 0 c. small; easy d. small; difficult 5 In perfectly competitive markets, products are ____ and sellers are ____. 1 a. homogeneous; price takers B b. homogeneous; price searchers U c. substantially different; price takers b. large; difficult 2. d. substantially different; price searchers. 3. Perfectly competitive markets have ____ sellers, each of which produces a ____ share of industry output. a. few; substantial b. few; small c. many; substantial d. many; small (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 325 Firms in Perfectly Competitive Markets S E C T I O N Q U I Z (Cont.) 4. Which of the following is false about perfect competition? a. Perfectly competitive firms sell homogeneous products. b. A perfectly competitive industry allows easy entry and exit. c. A perfectly competitive firm must take the market price as given. d. A perfectly competitive firm produces a substantial fraction of the industry output. e. All of the above are true. 5. An individual, perfectly competitive firm a. may increase its price without losing sales. b. is a price maker. c. has no perceptible influence on the market price. d. sells a product that is differentiated from those of its competitors. 1. Why do firms in perfectly competitive markets involve homogeneous goods? W I Why does the fact that perfectly competitive firms are small relative to the market make them price takers? L S O N , 2. Why does the absence of significant barriers to entry tend to result in a large number of suppliers? Answers: 1. a 2. a 3. d 4. d 3. 5. c An Individual Price Taker’s J Demand Curve A Why won’t individual price takers raise or lower their prices? Can individual price takers sell all they want at the market price? M I E 12.2 Will the position of individual price takers’ demand curves change when market price changes? 5 An Individual Firm’s Demand Curve 0 In perfectly competitive markets, buyers and sellers 5 must accept the price that the market determines, so they are said to be price takers. The market price and output are determined by 1 curves, as seen in Exhibit 1(b). As we stated the intersection of the market supply and demand earlier, perfectly competitive markets have manyBbuyers and sellers and the goods offered for sale are essentially identical. Consequently, no buyer or seller can influence the market price. U They take the market price as given. For example, no single consumer of wheat can influence the market price of wheat because each buyer purchases such a small percentage of the total amount sold in the wheat market. Likewise, each wheat farmer sells relatively small amounts of almost identical wheat, so the farmer has little control over wheat prices. Individual wheat farmers know that they cannot dispose of their wheat at any figure higher than the current market price; if they attempt to charge a higher price, potential buyers will simply make their purchases from other wheat farmers. Further, the farmers certainly would not knowingly charge a lower price, because they could sell all they want at the market price. Likewise, in a perfectly competitive market, individual sellers can change their outputs, and it will not alter the market price. The large number of sellers who are selling identical products Can an individual wheat farmer influence the market price of wheat? Can an individual consumer of wheat influence the market price of wheat? Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 326 PART 4 section 12.2 exhibit 1 Households and Market Structure Market and Individual Firm Demand Curves in a Perfectly Competitive Market a. Individual Firm Demand Curve b. Market Supply and Demand Curve Price Market price and output determined here. $5 Firm's Demand Curve d S $5 Firm is a price taker —must take market price © Cengage Learning 2013 0 100 200 Quantity of Wheat (bushels) 0 D 150 Quantity of Wheat (millions of bushels) W I L S make this situation possible. Each O producer provides such a small fraction of the total supply that a change in the amount he offers does not have a noticeable effect on market equilibrium price. In a perfectly competitiveN market, then, an individual firm can sell as much as it wishes to place on the market at the prevailing price; the demand, as seen by the seller, is perfectly elastic. , At the market price for wheat, $5, the individual farmer can sell all the wheat he wishes. Because each producer provides only a small fraction of industry output, any additional output will have an insignificant impact on market price. The firm’s demand curve is perfectly elastic at the market price. Why is the perfectly competitive firm’s demand curve perfectly elastic? It is easy to construct the demand curve for an individual seller in a perfectly competitive market. Remember, she won’t charge more than the market price because no one will buy it, J she can sell all she wants at the market price. Thus, the and she won’t charge less because farmer’s demand curve is horizontal A over the entire range of output that she could possibly produce. If the prevailing market price of the product is $5, the farmer’s demand curve will be M represented graphically by a horizontal line at the market price of $5, as shown in Exhibit 1(a). In short, both consumersI and producers are price takers in the perfectly competitive market. Consumers, for the most part, are price takers. Consumers cannot generally affect E the the prices they pay. However, in a number of market situations the producer can affect the market price and we will study those in the following chapters. 5 0 A Change in Market Price and the Firm’s 5 Demand Curve 1 To say that under perfect competition producers regard price as a given is not to say that B price is constant. The position of the firm’s demand curve varies with every change in the market price. In Exhibit 2, weUsee that when the market price for wheat increases, say as a What happens to the perfectly competitive firm’s demand curve if there is an increase in the market price? result of an increase in market demand, the price-taking firm will receive a higher price for all its output. Or when the market price decreases, say as a result of a decrease in market demand, the price-taking firm will receive a lower price for all its output. In effect, sellers are provided with current information about market demand and supply conditions as a result of price changes. It is an essential aspect of the perfectly competitive model that sellers respond to the signals provided by such price movements, so they must alter their behavior over time in the light of actual experience, revising their production decisions to reflect changes in market price. In this respect, the perfectly competitive model is straightforward; it does not assume any knowledge on the part of individual buyers and sellers about market demand and supply—they only have to know the price of the good they sell. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 section 12.2 exhibit 2 327 Firms in Perfectly Competitive Markets Market Prices and the Position of a Firm’s Demand Curve $6 d2 $6 $5 d1 $5 D1 0 0 Quantity (firm) D2 © Cengage Learning 2013 Price S Q1 Q2 Quantity (market) The position of the firm’s demand curve will vary with every change in the market price. 1. W I L SECTION QUIZ S Which of the following is false? O a. A perfectly competitive firm cannot sell at N any price higher than the current market price and would not knowingly charge a lower price, because it could sell all it wants at the market price. , b. In a perfectly competitive market, individual sellers can change their output without altering the market price. c. In a perfectly competitive industry, the firm’s demand curve is downward sloping. J A When market demand shifts ____________, a perfectly competitive firm’s demand curve shifts ____________. M a. rightward; upward I b. rightward; downward E c. leftward; upward d. The perfectly competitive model does not assume any knowledge on the part of individual buyers and sellers about market demand and supply—they only have to know the price of the good they sell. 2. d. leftward; downward e. Both (a) and (d) are correct. 5 0 a. never 5 b. when the market demand curve shifts 1 numbers c. when new producers enter the industry in large B d. when either (b) or (c) occurs In a market with perfectly competitive firms, U the market demand curve is ____________ and the 3. When will a perfectly competitive firm’s demand curve shift? 4. demand curve facing each individual firm is ____________. a. upward sloping; horizontal b. downward sloping; horizontal c. horizontal; downward sloping d. horizontal; upward sloping e. horizontal; horizontal (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 328 PART 4 Households and Market Structure S E C T I O N Q U I Z (Cont.) 1. Why would a perfectly competitive firm not try to raise or lower its price? 2. Why can we represent the demand curve of a perfectly competitive firm as perfectly elastic (horizontal) at the market price? 3. How does an individual perfectly competitive firm’s demand curve change when the market price changes? 4. If the marginal cost facing every producer of a product shifted upward, would the position of a perfectly competitive firm’s demand curve be likely to change as a result? Why or why not? Answers: 1. c 2. e 3. c 4. b 12.3 Profit Maximization W I What is marginal revenue? L What is average revenue? Why does the firm maximize profits where marginal revenue equals marginal cost? S O N Revenues in a Perfectly Competitive Market , The objective of the firm is to maximize profits. To maximize profits, the firm wants to proWhat is total revenue? duce the amount that maximizes the difference between its total revenues and total costs. In this section, we will examine the J different ways to look at revenue in a perfectly competitive market: total revenue, average revenue, and marginal revenue. total revenue (TR) the product price times the quantity sold A M Total Revenue I E that the firm receives from the sale of its products. Total Total revenue (TR) is the revenue revenue from a product equals the price of the good (P) times the quantity (q) of units sold (TR = P × q). For example, if a farmer sells 10 bushels of wheat a day for $5 a bushel, his total revenue is $50 ($5 × 105bushels). (Note: We will use the lowercase letter q to denote the single firm’s output and reserve 0 the uppercase letter Q for the output of the entire market. For example, q would be used to represent the output of one lettuce grower, while Q 5 would be used to represent the output of all lettuce growers in the lettuce market.) 1 B Average RevenueUand Marginal Revenue average revenue (AR) total revenue divided by the number of units sold marginal revenue (MR) the increase in total revenue resulting from a one-unit increase in sales Average revenue (AR) equals total revenue divided by the number of units of the product sold (TR ÷ q, or [P × q] ÷ q). For example, if the farmer sells 10 bushels at $5 a bushel, total revenue is $50 and average revenue is $5 per bushel ($50 ÷ 10 bushels). Thus, in perfect competition, average revenue is equal to the price of the good. Marginal revenue (MR) is the additional revenue derived from the production of one more unit of the good. In other words, marginal revenue represents the increase in total revenue that results from the sale of one more unit (MR = ∆TR ÷ ∆q). In a perfectly competitive market, because additional units of output can be sold without reducing the price of the product, marginal revenue is constant at all outputs and equal to average revenue. For Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 section 12.3 329 Firms in Perfectly Competitive Markets Revenues for a Perfectly Competitive Firm Marginal Revenue (MR = ∆TR/∆q) Quantity (q) Price (P) Total Revenue (TR = P × q) Average Revenue (AR = TR/q) 1 $5 $ 5 $5 2 5 10 5 3 5 15 5 4 5 20 5 5 5 5 25 5 5 $5 5 example, if the price of wheat per bushel is $5, the marginal revenue is $5. Because total revenue is equal to price multiplied by quantity (TR = P × q), as we add one additional unit of output, total revenue will always increase by the amount of the product price, $5. Marginal revenue facing a perfectly competitive firm is equal to the price of the good. W In perfect competition, then, we know that marginal revenue, average revenue, and price I are clearly illustrated in the calculations are all equal: P = MR = AR. These relationships presented in Exhibit 1. L © Cengage Learning 2013 exhibit 1 How does a perfectly competitive firm decide how much to produce and at what price? S O How Do Firms Maximize Profits? N Now that we have discussed the firm’s cost curves (in Chapter 11) and its revenues, we are , firm’s profits equal its total revenues minus ready to see how a firm maximizes its profits. A section 12.3 A firm maximizes profits by producing the quantity where MR # MC at q*. The importance of equating marginal revenue 0 and marginal cost is seen in Exhibit 2. As output expands beyond 5 zero up to q*, the marginal revenue derived from each unit of the expanded output exceeds the marginal cost of1 that unit of output, so the expansion of output creates additional profB its. This addition to profit is shown as the leftmost shaded U section in Exhibit 2. As long as marginal revenue exceeds marginal cost, profits continue to grow. For example, if the firm decides to produce q1, the firm sacrifices potential profits, because the marginal revenue from producing more output is greater than the marginal cost. Only at q*, where MR = MC, is the output level just right—not too large, not too small. Further expansion of output beyond q* will lead to losses on the additional output (i.e., decrease the firm’s overall profits), because MC > MR. For example, if the firm produces q2, the firm incurs losses on the output produced Price I E Equating Marginal Revenue and Marginal Cost 5 Finding the Profit-Maximizing Level of Output exhibit 2 MC Lost profit q 2 ! q* Lost profit q 1 " q* $5 0 P # MR q1 q* q2 Quantity of Wheat (bushels per year) At any output below q*—at q1, for example—the marginal revenue (MR) from expanding output exceeds the added costs (MC) of that output, so additional profits can be made by expanding output. Beyond q*—at q2, for example— marginal costs exceed marginal revenue, so output expansion is unprofitable and output should be reduced. The profit-maximizing level of output is at q*, where the profit-maximizing output rule is followed—the firm should produce the level of output where MR = MC. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 its total costs. However, at what output level must a firm produce and sell to maximize profits? In all types of market environments, the firm will maximize its J profits at the output that maximizes the difference betweenA total revenue and total cost, which is at the same output level at which M marginal revenue equals marginal cost. 330 PART 4 section 12.3 © Cengage Learning 2013 exhibit 3 Households and Market Structure Cost and Revenue Calculations for a Perfectly Competitive Firm Quantity (1) Total Revenue (2) Total Cost (3) Profit (TR – TC) (4) 0 $ 0 $ 2 $–2 1 5 4 1 2 10 7 3 3 15 11 4 4 20 16 4 5 25 22 3 profit-maximizing level of output a firm should always produce at the output where MR = MC Marginal Revenue ΔTR/Δq) (5) Marginal Cost (ΔTC/Δq) (6) Change in Profit (MR – MC) (7) $5 $2 $3 5 3 2 5 4 1 5 5 0 5 6 –1 beyond q*; the firm should reduce its output. Only at output q*, where MR = MC, can we find the profit-maximizing level of output. Be careful not to make the mistake of focusing on profit per unit rather than total profit. That is, you might think that at Wq1, if MR is much greater than MC, the firm should not produce more because the profit per unit is high at this point. However, that would be a mistake I profits as long as MR > MC—that is, all the way to q*. because a firm can add to its total L S We can use the data from the table in Exhibit 3 to find Farmer Jones’s profit-maximizing position. O revenue and marginal cost, respectively. The first bushel of Columns 5 and 6 show the marginal wheat that Farmer Jones produces N has a marginal revenue of $5 and a marginal cost of $2; so producing that bushel of wheat increases profits by $3 ($5 − $2). The second bushel of wheat pro, duced has a marginal revenue of $5 and a marginal cost of $3; so producing that bushel of wheat The Marginal Approach Should we focus on profit per unit or total profit? increases profits by $2 ($5 − $3). Farmer Jones wants to produce those units and more. That is, as long as marginal revenue exceeds J marginal cost, producing and selling those units add more to revenues than to costs; in other words, they add to profits. However, once he expands producA Farmer Jones’s costs are less than his marginal revenues, and tion beyond four units of output, his profits begin to fall. Clearly,M Farmer Jones should not produce beyond four bushels of wheat. Let’s take another look at profit maximization, using the table in Exhibit 3. Comparing I columns 2 and 3—the calculations of total revenue and total cost, respectively—we see that E at output levels of three or four bushels, where he will Farmer Jones maximizes his profits make profits of $4. In column 4—profit—you can see that there is no higher level of profit at any of the other output levels. Producing five bushels would reduce profits by $1, because 5 the marginal cost, $6. Consequently, Farmer Jones would marginal revenue, $5, is less than not produce this level of output. 0 If MR > MC, Farmer Jones should increase production; if MR < MC, Farmer Jones should decrease production. 5 In the next section we will use the profit-maximizing output rule to see what happens 1 the price to fall below average total cost and even below when changes in the market cause average variable costs. We will B introduce the three-step method to determine whether the firm is making an economic profit, minimizing its losses, or should be temporarily shut down. U SECTION QUIZ 1. The marginal revenue of a perfectly competitive firm a. decreases as output increases. b. increases as output increases. c. is constant as output increases and is equal to price. d. increases as output increases and is equal to price. (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 331 Firms in Perfectly Competitive Markets S E C T I O N Q U I Z (Cont.) 2. A perfectly competitive firm seeking to maximize its profits would want to maximize the difference between a. its marginal revenue and its marginal cost. b. its average revenue and its average cost. c. its total revenue and its total cost. d. its price and its marginal cost. e. either (a) or (d). 3. If a perfectly competitive firm’s marginal revenue exceeded its marginal cost, a. it would cut its price in order to sell more output and increase its profits. b. it would expand its output but not cut its price in order to increase its profits. c. it would raise its price and expand its output to increase its profits. d. none of the above would be true. 4. Which of the following is true? W b. Average revenue is total revenue divided byI the quantity sold. c. Marginal revenue is the change in total revenue L from the sale of an additional unit of output. d. In a competitive industry, the price of the good equals both the average revenue and the marginal revenue. S e. All of the above are true. O N How is total revenue calculated? How is average revenue derived from total revenue? , a. Total revenue is price times the quantity sold. 1. 2. 3. How is marginal revenue derived from total revenue? 4. Why is marginal revenue equal to price for a perfectly competitive firm? J A M I E Answers: 1. c 2. c 3. b 4. e Short-Run Profits and Losses 12.4 5 How do we determine whether a firm is 0 making zero economic profits? How do we determine whether a firm is 5 Why doesn’t a firm produce when price is experiencing an economic loss? 1 below average variable cost? B In the previous section, we discussed how to determine the profit-maximizing output level for a perfectly competitive firm. How do we know U whether a firm is actually making ecoHow do we determine whether a firm is generating an economic profit? nomic profits or losses? The Three-Step Method What Is the Three-Step Method? Determining whether a firm is generating economic profits, economic losses, or zero economic profits at the profit-maximizing level of output, q*, can be done in three easy steps. First, we will walk through these steps, and then we will apply the method to three situations for a hypothetical firm in the short run in Exhibit 1. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 332 PART 4 section 12.4 Households and Market Structure Short-Run Profits, Losses, and Zero Economic Profits exhibit 1 a. Economic Profit Price P* ! $6 ATC ! 5 P " ATC at q* Economic Profit b. Economic Loss MC Economic Loss ATC P ! MR Total Profit ATC ! $5 © Cengage Learning 2013 P*! 4 0 q* ! 120 c. Zero Economic Profits Price P # ATC at q* Quantity Profit-Maximizing Output 0 Total Loss Price MC ATC P ! MR q* ! 80 P ! ATC at q* MC Zero Economic Profit P* ! ATC ! $4.90 Quantity Loss-Minimizing Output 0 ATC P ! MR q* ! 100 Quantity Profit-Maximizing Output In (a), the firm is earning short-run economic profits of $120. In (b), the firm is suffering losses of $80. In (c), the firm is making zero economic profits, with the price just equal to the average total cost in the short run. 1. 2. 3. W I Find where marginal revenue equals marginal cost and proceed straight down to the horizontal quantity axis toLfind q*, the profit-maximizing output level. At q*, go straight up to the S demand curve and then to the left to find the market price, P*. Once you have identified P* and q*, you can find total revenue at the profitO maximizing output level, because TR = P × q. The last step is to find theNtotal cost. Again, go straight up from q* to the average total cost (ATC) curve and then left to the vertical axis to compute the average total , cost per unit. If we multiply average total cost by the output level, we can find the total cost (TC = ATC × q). If total revenue is greater than J total cost at q*, the firm is generating economic profits. If total revenue is less than total cost at Aq*, the firm is generating economic losses. If total revenue is equal to total cost at q*, there are zero economic profits (or a normal rate of return). Alternatively, to find totalMeconomic profits, we can take the product price at P* and subtract the average total costI at q*. This will give us per-unit profit. If we multiply this by output, we will arrive at total economic profit (P* – ATC) × q* = Total economic profit. E Remember, the cost curves include implicit and explicit costs—that is, we are covering the opportunity costs of our resources. Therefore, even with zero economic profits, no tears should be shed, because the firm 5 is covering both its implicit and explicit costs. Because firms are also covering their implicit costs, or what they could be producing with these resources 0 sometimes call this zero economic profit a normal rate of in another endeavor, economists return. That is, the owners are5doing as well as they could elsewhere, in that they are getting the normal rate of return on the resources they invested in the firm. 1 B The Three-Step Method in Action U Exhibit 1 shows three different short-run equilibrium Why do economists sometimes call a zero economic profit a normal rate of return? positions; in each case, the firm is producing at a level where marginal revenue equals marginal cost. Each of these alternatives shows that the firm is maximizing profits or minimizing losses in the short run. Assume that three alternative prices—$6, $5, and $4—are available for a firm with given costs. In Exhibit 1(a), the firm receives $6 per unit at an equilibrium level of output (MR = MC) of 120 units. Total revenue (P × q*) is $6 × 120, or $720. The average total cost at 120 units of output is $5, and the total cost (ATC × q*) is $600. Following the three-step method, we can calculate that this firm is earning a total economic profit of $120. Or we can calculate total economic profit by using the following equation: (P* – ATC) × q* = ($6 – $5) × 120 = $120. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 Firms in Perfectly Competitive Markets 333 In Exhibit 1(b), the market price has fallen to $4 per unit. At the equilibrium level of output, the firm is now producing 80 units of output at an average total cost of $5 per unit. The total revenue is now $320 ($4 × 80), and the total cost is $400 ($5 × 80). We can see that the firm is now incurring a total economic loss of $80. Or we can calculate total economic profit by using the following equation: (P* – ATC) × q* = ($4 – $5) × 80 = –$80. In Exhibit 1(c), the firm is earning zero economic profits, or a normal rate of return. The market price is $4.90, and the average total cost is $4.90 per unit for 100 units of output. In this case, economic profits are zero, because total revenue, $490, minus total cost, $490, is equal to zero. This firm is just covering all its costs, both implicit and explicit. Or we can calculate total economic profit by using the following equation: (P* – ATC) × q* = $4.90 – $4.90 × 100 = $0. Evaluating Economic Losses in the Short Run A firm generating an economic loss faces a tough choice: Should it continue to produce or should it shut down its operation? To make this decision, we need to add another variable to our discussion of economic profits and losses: average variable cost. Variable costs are costs that W vary with output—for example, wages, raw material, transportation, and electricity. If a firm I cannot generate enough revenues to cover its variable costs, it will have larger losses if it operates than if it shuts down (when losses are equal L to fixed costs). That is, the firm will shut down if its total revenue (p × q) is less than its variable costs (VC). If we divide p × q by q, we get p, S a profit-maximizing firm will shut down. and if we divide VC by q we get AVC, so if p < AVC, Thus, a firm will not produce at all unless the price O is greater than its average variable cost. Operating at a Loss N , Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 Price At price levels greater than or equal to the average variable cost, a firm may continue to doesn’t a firm just shut operate in the short run even if its average total cost—variable and fixed costs—is not com- Why down whenever it is making pletely covered. That is, the firm may continueJto operate even though it is experiencing an economic losses? economic loss. Why? Because fixed costs continue whether A the firm produces or not; it is better to earn enough to cover section 12.4 Short-Run Losses: Price a portion of fixed costs than to earn nothing atMall. exhibit 2 Above AVC but Below ATC For example, a restaurant may decide to Istay open for lunch even with few customers if its revenues can cover Efixed—rent, variable costs. Many of a restaurant’s costs are P !AVC Firm should not insurance, kitchen appliances, pots, pans, tableware, and so shut down. on. These are sunk costs in the short run, so shutting down 5 for lunch would not reduce these costs. 0 whether or The restaurant’s lunch decision hinges on MC not the revenue from the few lunchtime customers ATC 5 can cover AVC the variable costs like staff and extra food. If the restaurant 1 P P " MR owner cannot cover the variable costs at lunchtime, she shuts Shutdown Point it down for lunch. B 0 Similarly, a grocery store may stay open all night even q U if it anticipates only a few customers. To the person on the Quantity street, this may look unprofitable. However, the relevant (firm) question to the store owner is not whether all the costs can In this case, the firm operates in the short run be covered, but whether the additional sales from staying but incurs a loss because P < ATC. Nevertheless, P > AVC, and revenues cover variable costs open all night cover the variable costs of electricity, staff, and and partially defray fixed costs. This firm will extra food. Many businesses that are “failing” may continue leave the industry in the long run unless prices to operate because they can cover their variable costs and at are expected to rise in the near future; but in least part of their fixed costs, like rent. the short run, it continues to operate at a loss as In Exhibit 2, price is less than average total cost but long as P > AVC, the shutdown point. more than average variable cost. In this case, the firm 334 PART 4 Households and Market Structure section 12.4 exhibit 3 Short-Run Losses: Price Below AVC ISTOCKPHOTO.COM/SLOBO Price P "AVC Firm should shut down. P P ! MR 0 Quantity Because its average variable cost exceeds price at all levels of output, this firm would cut its losses by discontinuing production. section 12.4 exhibit 4 W I L in the short run, but at a loss. To shut down Sproduces would make this firm worse off, because it can cover at Oleast some of its fixed costs with the excess of revenue over Nits variable costs. , The Firm’s Short-Run Supply Curve Short-Run Supply MC The Decision to Shut Down ATC Price AVC PMIN Firms shut down if P ! AVC. 0 q Shutdown Quantity JExhibit 3 illustrates a situation in which the price a firm is able to obtain for its product is below its average variable Acost at all ranges of output. In this case, the firm is unable Mto cover even its variable costs in the short run. Because the is losing even more than the fixed costs it would lose if it I firm shut down, it is more logical for the firm to cease operations. EHence, if P < AVC, the firm can cut its losses by shutting down. If price is less than average variable cost, the firm’s losses would be smaller if it shut down and stopped producing. That is, if P < AVC, the firm is better off producing zero output. Hence, the firm’s short-run supply curve is the marginal cost curve above average variable cost. 5 0The Short-Run Supply Curve 5As we have just seen, at all prices above the minimum AVC, a firm produces in the short run even if average total cost 1(ATC) is not completely covered; at all prices below the Bminimum AVC, the firm shuts down. The firm produces above the minimum AVC even if it is incurring economic losses because it can still earn U all its average variable cost and a portion of its fixed enough in total revenues to cover Is the shutdown rule (P < AVC) related to a perfectly competitive firm’s supply curve? short-run supply curve the portion of the MC curve above the AVC curve costs, which is better than not producing and earning nothing at all. In graphical terms, the short-run supply curve of an individual competitive seller is identical to the portion of the MC curve that lies above the minimum of the AVC curve. As a cost relation, this curve shows the marginal cost of producing any given output; as a supply curve, it shows the equilibrium output that the firm will supply at various prices in the short run. The thick line in Exhibit 4 is the firm’s supply curve—the portion of MC above its intersection with AVC. The declining portion of the MC curve has no Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 Shutdown Point Why might a restaurant stay open at lunch even though there are only a few customers? © Cengage Learning 2013 ATC AVC MC chapter 12 335 Firms in Perfectly Competitive Markets COURTESY OF ROBERT L. SEXTON significance for supply, because if the price falls below the average variable cost, the firm is better off shutting down—producing no output. The shutdown point is at the minimum point on the average variable cost curve where the output level is qShut Down. Beyond the point of lowest AVC, the marginal costs of successively larger amounts of output are progressively greater, so the firm will supply larger and larger amounts only at higher prices. Deriving the Short-Run Market Supply Curve The short-run market supply curve is the summation of all the individual firms’ supply curves (that is, the portion of the firms’ MC Because the demand for summer camps will be above AVC) in the market. Because the short run is too brief for new lower during the off-season, it is likely that revenues may be too low for the camp to cover its variable firms to enter the market, the market supply curve is the summation costs, and the owner will choose to shut down. of existing firms. For example, in Exhibit 5, at P1, each of the 1,000 the owner will still have to pay the fixed W of wheat per day Remember, identical firms in the industry produces 500 bushels costs: property tax, insurance, the costs associated at point a, in Exhibit 5(a); and the quantity supplied in the market with the building and land. However, if the camp is I not in operation during the off-season, the owner is 500,000 bushels of wheat, point A, in Exhibit 5(b). We can again L will at least not have to pay the variable costs: sum horizontally at P2; the quantity supplied for each of the 1,000 S at point b in Exhibit salaries for the camp staff, food, and electricity. identical firms is 800 bushels of wheat per day 5(a), so the quantity supplied for the industryO is 800,000 bushels of wheat per day, point B in Exhibit 5(b). Continuing this process gives N In a market of 1,000 identical wheat short-run market us the market supply curve for the wheat market. supply curve farmers, the market supply curve is 1,000 times , the quantity supplied by each firm, as long the horizontal summation of the individual firms’ supply as the price is above AVC. curves in the market exhibit 5 P2 P1 P a AVC 0 500 5 Individual Firm 0 Supply (MC) b5 1 B U 800 Quantity of Wheat (bushels per day) b. Market Supply Curve for Wheat Price per Bushel Price per Bushel a. Individual Firm Supply Curve for Wheat Market Supply P2 P1 P B B A A AVC 0 500,000 800,000 Quantity of Wheat (bushels per day) The short-run supply curve is the horizontal summation of the individual firms’ supply curves (each firm’s marginal cost curve above AVC), shown in (a). In a market of 1,000 identical wheat farmers, the market supply curve is 1,000 times the quantity supplied by each firm, shown in (b). Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 section 12.4 J A M I Deriving the Short-Run Market Supply Curve E PART 4 Reviewing the Short-Run Output Decision Exhibit 6 shows the firm’s short-run output at these various market prices: P1, P2, P3, and P4. At the market price of P1, the firm would not cover its average variable cost—the firm would produce zero output, because the firm’s losses would be smaller if it shut down and stopped producing. At the market price of P2, the firm would produce at the loss-minimizing output of q2 units. It would operate rather than shut down, because it could cover all its average variable costs and some of its fixed costs. At the market price of P3, the firm would produce q3 units of output and make zero economic profit (a normal rate of return). At the market price W of P4, the firm would produce q4 units of output and I be making short-run economic profits. what you’ve learned Q Evaluating section 12.4 The Short-Run Output Decision exhibit 6 MC ATC P4 P3 P2 P1 AVC d4, mr4 d3, mr3 d2, mr2 d1, mr1 © Cengage Learning 2013 what you’ve learned Households and Market Structure Price 336 Shutdown Point 0 q2q3q4 Quantity L S O Short-Run N , Economic Losses A COURTESY OF ROBERT L. SEXTON Lei-ann is one of many florists in a mediumsize urban area. That is, we assume that she worksJ in a market similar to a perfectly competitive A market and operates, of course, in the short run. Lei-ann’s cost and revenue information is shown inM Exhibit 7. Based on this information, what shouldI Lei-ann do in the short run, and why? E Fixed costs are unavoidable unless the firm5 goes out of business. Lei-ann really has two decisions in the short run—either to operate or to shut0 down temporarily. In Exhibit 7, we see that Lei-ann5 makes $2,000 a day in total revenue, but her daily 1 costs (fixed and variable) are $2,500. She has to pay her workers, pay for fresh flowers, and pay for theB fuel used by her drivers in picking up and deliver-U ing flowers. She must also pay the electricity bill to heat her shop and keep her refrigerators going to protect her flowers. That is, every day, poor Lei-ann is losing $500; but she still might want to operate the shop despite the loss. Why? Lei-ann’s average variable cost (comprising flowers, transportation, fuel, daily wage earners, and so on) amounts to If Lei-ann cannot cover her fixed costs, will she continue to operate? $1,500 a day; her fixed costs (insurance, property taxes, rent for the building, and refrigerator payments) are $1,000 a day. Now, if Lei-ann does not operate, she will save on her variable cost—$1,500 a day—but she will be out the $2,000 a day she makes in revenue from selling her flowers. Thus, every day she operates, she is better off than if she had not operated at all. That is, if the firm can cover the average variable cost, it is better off operating than (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 Evaluating Short-Run Economic Losses (Cont.) not operating. But suppose Lei-ann’s VC were $2,100 a day. Then Lei-ann should not operate, because every day she does, she is $100 worse off than if she shut down altogether. In short, a firm will shut down if TR < VC or (P × q) < VC. If we divide both sides by q, the firm will shut down if P < AVC or (P × q)/q < VC/q. picks up, her prices and marginal revenue will rise, and she may have a chance to make short-run economic profits. section 12.4 exhibit 7 Why does Lei-ann even bother operating if she is making a loss? Perhaps the economy is in a recession and the demand for flowers is temporarily down, but Lei-ann thinks things will pick up again in Wdemand the next few months. If Lei-ann is right and SECTION QUIZ Lei-ann’s Daily Revenue and Cost Schedule Total Revenue Total Costs $2,000 2,500 Variable Costs 1,500 Fixed Costs 1,000 I L S O N , 1. If a perfectly competitive firm’s marginal revenue exceeded its marginal cost, J A c. it is currently earning economic profits. M d. both (a) and (c) are true. I e. both (b) and (c) are true. E at an output in which A perfectly competitive firm maximizes its profit a. it would cut its price in order to sell more output and increase its profits. b. it would expand its output but not cut its price in order to increase its profits. 2. a. total revenue exceeds total cost by the greatest dollar amount. 5 0 d. all of the above are true. 5 In perfect competition, at a firm’s short-run profit-maximizing (or loss minimizing) output, 1 a. its marginal revenue equals zero. B cost. b. its price could be greater or less than average c. its marginal revenue will be falling. U b. marginal cost equals the price. c. marginal cost equals marginal revenue. 3. d. both (b) and (c) will be true. 4. The minimum price at which a firm would produce in the short run is the point at which a. price equals the minimum point on its marginal cost curve. b. price equals the minimum point on its average variable cost curve. c. price equals the minimum point on its average total cost curve. d. price equals the minimum point on its average fixed cost curve. (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 what you’ve learned 337 Firms in Perfectly Competitive Markets 338 PART 4 Households and Market Structure S E C T I O N Q U I Z (Cont.) 5. A profit-maximizing perfectly competitive firm would never knowingly operate at an output level at which a. it would lose more than its total fixed costs. b. it was not earning a positive economic profit. c. it was not earning a zero economic profit. d. it was not earning an accounting profit. 6. If a perfectly competitive firm finds that price is greater than AVC but less than ATC at the quantity where its marginal cost equals the market price, a. the firm will produce in the short run but may eventually go out of business. b. the firm will produce in the short run, and new entrants will tend to enter the industry over time. c. the firm will immediately shut down. d. the firm will be earning economic profits. e. both b and d are true. 7. The short-run supply curve of a perfectly competitive firm is W b. its MC curve above the minimum point of AVC. I c. its MC curve above the minimum point of ATC. L d. none of the above. S O How is the profit-maximizing output quantity determined? How do we determine total revenue and total cost forN the profit-maximizing output quantity? If a profit-maximizing, perfectly competitive firm is earning a profit because total revenue exceeds total cost, why , a. its MC curve. 1. 2. 3. must the market price exceed average total cost? 4. If a profit-maximizing, perfectly competitive firm is earning a loss because total revenue is less than total cost, why must the market price be less than average total cost? J A M Why would a profit-maximizing, perfectly competitive firm shut down rather than operate if price was less than its average variable cost? I Why would a profit-maximizing, perfectly competitive firm continue to operate for a period of time if price was E greater than average variable cost but less than average total cost? 5. If a profit-maximizing, perfectly competitive firm is earning zero economic profits because total revenue equals total cost, why must the market price be equal to the average total cost for that level of output? 3. b 4. b 5. a 6. a 7. b 12.5 2. d 7. Answers: 1. b 6. 5 0 5 1 B U Long-Run Equilibrium When an industry is earning profits, will it encourage the entry of new firms? Why do perfectly competitive firms make zero economic profits in the long run? Economic Profits and Losses Disappear in the Long Run Do economic profits and losses provide incentives for perfectly competitive firms to enter or exit? If farmers are able to make economic profits producing wheat, what will their response be in the long run? Farmers will increase the resources that they devote to the lucrative business of producing wheat. Suppose Farmer Jones is making an economic profit (he is Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 section 12.5 Profits Disappear with Entry exhibit 1 a. Individual Firm Economic Profits P1 > ATC at q1 b. Market S1 MC S2 ATC P1 d1, mr1 ATC P2 d2, mr2 Price Price 339 Firms in Perfectly Competitive Markets P1 P2 0 q2 0 q1 Quantity Q1 Q2 Quantity As the industry-determined price of wheat falls in (b), Farmer Jones’s marginal revenue curve shifts downward from mr1 to mr2 in (a). A new profit-maximizing (MC = MR) point is reached at q2. When the price is P1, Farmer Jones is making a profit, because P1 > ATC. When the market supply increases, causing the market price to fall to P2, Farmer Jones’s profits disappear, because P2 = ATC. W I L S O earning an above-normal rate of return) producing wheat. To make even more profits, he may take land out of producing other crops and plant more wheat. Other farmers or N people who are holding land for speculative purposes may also decide to plant wheat on , their land. ANDY BUTTERTON/PA PHOTOS/LANDOV As word gets out that wheat production is proving profitable, it will cause a supply response—the market supply curve will shift to J the right as more firms enter the industry and existing firms expand, as shown in Exhibit 1(b). With this shift, the quantity of wheat AIt may take a year or even longer, of course, supplied at any given price is greater than before. for the complete supply response to take place,M simply because it takes some time for information on profit opportunities to spread and still more time to plant, grow, and harvest the I wheat. Note that the effect of increasing supply, other things being equal, is a reduction in the equilibrium price ofEwheat. Suppose that, as a result of the supply response, the price of wheat falls from P1 to P2. The impact of the change in the market price of wheat, over which Farmer Jones has absolutely5no control, is simple. If his costs don’t change, he moves from making 0 a profit (P1 > ATC) to zero economic profits (P2 = ATC), as shown in Exhibit 1(a). In 5 long-run equilibrium, perfectly competitive firms make zero economic profits. Remember, a zero economic profit means1that the firm actually earns a normal return on the use of its capital.B Zero economic profit is an equilibrium or stable situation because any positive economic (above-normal) profit signals resources into U the industry, beating down prices and therefore revenues to the firm. Any economic losses signal resources to leave the industry, causing supply reductions that lead to increased prices and higher firm In the late 1990s, when organic food was in its infancy, revenues for the remaining firms. For example, in Exhibit 2 we see a an organic apple grower could sell apples at a much firm that continues to operate despite its losses—ATC is greater than higher price than regular apples. A price that covered P1 at q1. With losses, however, some firms will exit the industry, causmore than its cost of production—an economic profit. Today, there are many more organic farmers, increasing the market supply curve to shift from S1 to S2 and driving up the ing market supply and decreasing the market price market price to P2. This price increase reduces the losses for the firms and moving firms toward zero economic profits— remaining in the industry, until the losses are completely eliminated normal rate of return. at P2. The remaining firms will maximize profits by producing at q2 Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 D 340 PART 4 section 12.5 Households and Market Structure Losses Disappear with Exit exhibit 2 a. Individual Firm Economic Losses ATC ! P1 at q1 b. Market S2 MC ATC P2 d2, mr2 P1 d1, mr1 S1 P2 Price Price ATC P1 D © Cengage Learning 2013 0 0 q2 q1 Quantity Q1 Quantity W I L S O N , units of output, where profits and losses are zero. Only at When firms in the industry suffer losses, some firms will exit in the long run, shifting the market supply curve to the left from S1 to S2. This shift causes market price to rise from P1 to P2 and market output to fall from Q1 to Q2. When the price is P1, the firm is incurring a loss, because ATC is greater than P1 at q1. When the market supply decreases from S1 to S2, it causes the market price to rise and the firm’s losses disappear, because P2 = ATC. section 12.5 exhibit 3 The Long-Run Competitive Equilibrium Price MC $10 © Cengage Learning 2013 Q2 e SRATC LRATC P ! MR zero economic profits is there no tendency for firms to either enter or leave the industry. J A MThe Long-Run Equilibrium for the I Competitive Firm EThe long-run competitive equilibrium for a perfectly competi- tive firm is illustrated graphically in Exhibit 3. At the equilibpoint, e (where MC = MR), short-run and long-run 5rium average total costs are also equal. The average total cost curves 0touch the marginal cost and marginal revenue (demand) 0 q* 5curves at the equilibrium output point. Because the marginal revenue curve is also the average revenue curve, average revQuantity of Wheat 1enue and average total cost are equal at the equilibrium point. (bushels per year) In the long run in perfect competition, a stable BThe long-run equilibrium in perfect competition depicted in 3 has an interesting feature. Note that the equilibrium situation or equilibrium is achieved when ecoUExhibit nomic profits are zero. In this case, at the profitoutput occurs at the lowest point on the average total cost maximizing point where MC = MR, short-run and curve. As you may recall, this occurs because the marginal cost long-run average total costs are equal. Industry curve must intersect the average total cost curve at the latter wide supply shifts would change prices and avercurve’s lowest point. Hence, the equilibrium condition in the age revenue, wiping out any losses or profits that long run in perfect competition is for each firm to produce develop in the short run and leading to the situation at the output that minimizes average total cost. At this longdepicted in the exhibit. run equilibrium, all firms in the industry earn zero economic profit; consequently, new firms have no incentive to enter the market, and existing firms have no incentive to exit the market. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 Firms in Perfectly Competitive Markets SECTION QUIZ 1. The entry of new firms into an industry will likely a. shift the industry supply curve to the right. b. cause the market price to fall. c. reduce the profits of existing firms in the industry. d. do all of the above. 2. In long-run equilibrium under perfect competition, price does not equal which of the following? a. long-run marginal cost b. minimum average total cost c. average fixed cost d. marginal revenue e. average revenue 3. Which of the following is true? W I c. Any economic losses signal resources to leave the industry, leading to supply reduction, higher prices, and L increased revenues. S d. Only at zero economic profits is there no tendency for firms to either enter or exit the industry. e. All of the above are true. O The exit of firms from an unprofitable industry N a. will shift the market supply curve left. , a. Economic profits encourage the entry of new firms, which shift the market supply curve to the right. b. Any positive economic profits signal resources into the industry, driving down prices and revenues to the firm. 4. b. will cause the market price to rise. c. will increase the economic profits of the firms that remain. J A In long-run equilibrium, firms make zero ____________ profits, earning a ____________ rate of return. a. economic; normal M b. economic; zero I c. accounting; normal E d. will do all of the above. 5. d. accounting; zero 5 0 in a perfectly competitive industry? Why does entry eliminate positive economic profits Why do firms exit unprofitable industries? 5 Why does exit eliminate economic losses in a perfectly competitive industry? 1 Why is a situation of zero economic profits a stable long-run equilibrium situation for a perfectly competitive B industry? U 1. Why do firms enter profitable industries? 4. d 5. 3. e 4. 2. c 3. Answers: 1. d 2. 5. a Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 341 342 PART 4 12.6 Households and Market Structure Long-Run Supply What are constant-cost industries? What is productive efficiency? What are increasing-cost industries? What is allocative efficiency? What are decreasing-cost industries? The preceding sections considered the costs for an individual, perfectly competitive firm as it varies output, on the assumption that the prices it pays for inputs (costs) are given. However, when the output of an entire industry changes, the likelihood is greater that changes in costs will occur. How will the changes in the number of firms in an industry affect the input costs of individual firms? In this section, we develop the long-run supply (LRS) curve. As we will see, the shape of the long-run supply curve depends on the extent to which input costs change with the entry or exit of firms in the industry. We will look at three possible types of industries, when considering long-run supply: constant-cost industries, increasing-cost industries, and decreasing-cost industries. constant-cost industry an industry where input prices (and cost curves) do not change as industry output changes W I A Constant-Cost LIndustry S prices of inputs do not change as output is expanded. The In a constant-cost industry, the industry may not use inputs inOsufficient quantities to affect input prices. For example, say the firms in the industry use a lot of unskilled labor, but the industry is small. Therefore, as N output expands, the increase in demand for unskilled labor will not cause the market wage , for unskilled labor to rise. Similarly, suppose a paper clip maker decides to double its output. It is highly unlikely that its demand for steel will have an impact on steel prices, because its demand for the input is so small. J are complete, by necessity each firm operates at the point Once long-run adjustments of lowest long-run average total A cost, because supply shifts with entry and exit, eliminating profits. Therefore, each firm supplies the market with the quantity of output that it can M produce at the lowest possible long-run average total cost. In Exhibit 1, we can seeI the impact of an unexpected increase in market demand. Suppose that recent reports show E that blueberries can lower cholesterol, lower blood pressure, and significantly reduce the risk of all cancers. The increase in market demand for blueberries leads to a price increase from P1 to P2 as the firm increases output from q1 to q2, and blueberry industry output5increases from Q1 to Q2, as seen in Exhibit 1(b). The increase in market demand generates a higher price and positive profits for existing firms in the 0 short run. The existence of economic profits will attract new firms into the industry, causing the short-run supply curve to 5 shift from S1 to S2 and lowering price until excess profits are zero. This shift results in a new 1 equilibrium, point C in Exhibit 1(c). Because the industry is one with constant costs, industry expansion does not alter firms’ cost curves, and the industry long-run supply curveBis horizontal. That is, the long-run equilibrium price is at the same level that prevailed before U demand increased; the only long-run effect of the increase in demand is an increase in industry output, as more firms enter that are just like existing firms [shown in Exhibit 1(c)]. The long-run supply curve is horizontal when the market has free entry and exit, there are a large number of firms with identical costs and input prices are constant. Because these strong assumptions do not generally hold, we will now discuss when the long-run supply curve has a positive or negative slope. Studies have shown that retail trade may fall into the category of a constant-cost industry, because output can be expanded or contracted without a noticeable impact on input prices. The same may be true of the banking industry. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 section 12.6 exhibit 1 343 Firms in Perfectly Competitive Markets Demand Increase in a Constant-Cost Industry a. Initial Equilibrium ATC P1 0 a d1, mr1 Price of Blueberries Price of Blueberries SRMC Supply Demand 0 q1 b Total Profits P1 0 a q1 Q1 Quantity of Blueberries (industry) W b. Short-Run Profits I SRMC L ATC P S d , mr O d , mr P N , 2 2 1 1 Price of Blueberries Price of Blueberries Quantity of Blueberries (firm) P2 A P1 Supply B 2 A 1 D2 D1 0 q2 Q1 Q2 J Quantity of Blueberries Quantity of Blueberries (firm) (industry) A M c. Long-Run Entry and No Economic Profits I SRMC S E P1 0 a, c q1 q2 5 0 5 1 B U Quantity of Blueberries (firm) d2, mr2 d1, mr1 P1 S2 B P2 A C D1 0 Q1 Q2 LRS (Industry)D2 Q3 Quantity of Blueberries (industry) An unexpected increase in market demand for blueberries leads to an increase in the market price in (b). The new market price leads to positive profits for existing firms, which attracts new firms into the industry, shifting market supply from S1 to S2 in (c). This increased short-run industry supply curve intersects D2 at point C. Each firm (of a new, larger number of firms) is again producing at q1 and earning zero economic profits. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. © Cengage Learning 2013 b P2 Price of Blueberries Price of Blueberries 1 ATC 344 PART 4 Households and Market Structure An Increasing-Cost Industry increasing-cost industry In an increasing-cost industry, a more common scenario, the cost curves of individual firms rise as the total output of the industry increases. Increases in input prices (upward shifts in cost curves) occur as larger quantities of factors are employed in the industry. When an industry utilizes a large portion of an input, input prices will rise when the industry uses more of the input. Increasing cost conditions are typical of “extractive” industries, such as agriculture, fishing, mining, and lumbering, which utilize large portions of the total supply of specialized natural resources such as land or mineral deposits. As the output of such an industry expands, the increased demand for the resources raises the prices that must be paid for their use. Because additional resources of giving quality cannot be produced, greater supplies can be obtained (if at all) only by luring them away from other industries, or by using lowerquality (and less-productive, thus higher-cost) resources. Wheat production is a typical example of an increasing-cost industry. As the output of wheat increases, the demand for land suitable for the production of wheat rises, and thus the price paid for the use of land of any given quality increases. If there were a construction Wboom in a fully employed economy, would it be more costly to get additional resources like skilled workers and raw materials? Yes, if this is an increasingI cost industry, the industry can only produce more output if it gets a higher price because Lthe firm’s costs of production rise as output expands. As new section 12.6 Sfirms enter and output expands, the increase in demand for Increasing-Cost Industry exhibit 2 inputs causes the price of inputs to rise—the cost curves of O all construction firms shift upward as the industry expands. S1 NOr consider a downtown building boom where the supply of S2 LRS who are willing to work on tall skyscrapers is very P2 ,workers B inelastic; a very steep supply of labor curve. The high demand for these few workers causes their wages to rise sharply and P3 C Jthe cost of skyscrapers to rise. The industry can produce more A output but only at a higher price, enough to compensate the P1 Afirm for the higher input costs. In an increasing-cost industry, the long-run supply curve is upward sloping. M For example, in Exhibit 2, we see that an unexpected Iincrease in the market demand for wheat will shift the E market demand curve from D1 to D2 . Consequently, price D2 will increase from P1 to P2 in the short run and the industry D1 0 output increases from Q1 to Q2. The typical firm (farm) will Q1 Q2 Q3 5have positive short-run profits and expand output. With the Quantity of Wheat presence of short-run economic profits, new firms will enter 0 The unexpected increase in demand for wheat the industry, shifting the short-run market supply curve to shifts the demand curve from D1 to D2. The 5the right from S to S . The prices of inputs, like farm land, increase in demand leads to higher prices 1 2 from P1 to P2. The short-run economic profits 1fertilizer, seed, farm machinery, and so on, will be bid up by induce other firms to enter the industry. This Bcompeting farmers, causing the firm’s marginal and longcauses the short-run supply curve to shift right, run average cost curves to rise. The cost increases mean that from S1 to S2. As new firms enter and output Uthe market supply curve shifts right less than it would in a expands, the increase in demand for inputs constant-cost industry. This leads to an upward-sloping longcauses the price of inputs to rise, leading to run industry supply curve, as seen in Exhibit 2. higher cost curves for the firm. This means the Another example is provided by the airlines. Growth in supply curve does not shift rightward as much as in the constant-cost industry. The new longthe airline industry results in more congestion of airports run equilibrium is at P3 and Q3. The LRS is and airspace. That is, as the output of the airline industry positively sloped. This means the industry must increases, the firm’s cost increases, ceteris paribus. This situareceive a higher market price to produce more tion of an upward-sloping long-run industry supply curve is output, Q3, because the increased output causes what economists call external diseconomies of scale—factors input prices to rise. that are beyond, the firm’s control (that is, external) raise the © Cengage Learning 2013 Price of Wheat an industry where input prices rise (and cost curves rise) as industry output rises Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 345 Firms in Perfectly Competitive Markets firm’s costs as industry output expands. In contrast, recall the discussion of diseconomies of scale in the last chapter where the costs were internal to the firm—increased costs due to managing a larger firm. A Decreasing-Cost Industry It is also possible that an expansion in the output of an industry can lead to a reduction in input costs and shift the MC and ATC curves downward, and the market price falls because of external economies of scale. We use the term external because the cost decreases are external to the firm; no one firm can gain by its own expansion. That is, the gains occurs when the total industry’s output expands. The new long-run market equilibrium has more output at a lower price—that is, the long-run supply curve for a decreasing-cost industry is downward sloping (not shown). Consider a new mining region, developed in an area remote from railroad facilities back in the days before motor vehicles. So long as the total output of the mines were small, the ore was hauled by wagon, an extremely expensive form of transportation. But when the number of mines increased, and the total output of theW region rose substantially, it became feasible to construct a railroad to serve the area. The railroad lowered transportation costs and reduced the costs of all firms in the industry. AsI a practical matter, decreasing-cost industries are rarely encountered, at least over a large range L of output. However, some industries may operate under decreasing-cost conditions in the short intervals of output expansion when S continued growth makes possible the supply of materials or services at reduced cost. A larger O or financial services, for example. industry might benefit from improved transportation This situation might occur in the computer Nindustry. The firms in the industry may be able to acquire computer chips at a lower price as the industry’s demand for computer chips rises. Why? Perhaps it is because the computer, chip industry can employ cost-saving techniques that become more economical at higher levels of output. That is, the marginal and average costs of the firm fall as input prices fall because of expanded output in the industry. decreasing-cost industry an industry where input prices fall (and cost curves fall) as industry output rises J A M Perfect Competition and Economic Efficiency I In this chapter, we have seen that a firm in a perfectly competitive market produces at the minimum point of the ATC curve in the longErun and charges a price equal to that cost. Because competitive firms are producing using the least-cost method, the minimum value of resources is being used to produce a given level of output. This leads to lower product prices 5 for consumers. In short, productive efficiency requires that firms produce goods and services in the least costly way, where P = Minimum ATC, 0 as seen in Exhibit 3 in section 12.5 on page 340. However, productive efficiency alone does not guarantee that markets are operat5 ing efficiently—society must also produce the goods and services that society wants most. This leads us to what economists call allocative1efficiency. We say that the output that results from equilibrium conditions of market demand and B market supply in perfectly competitive markets achieve an efficient allocation of resources. U demand, we find the competitive equiAt the intersection of market supply and market librium price, P*, and the competitive equilibrium output, Q*. In competitive markets, market supply equals market demand, and P = MC. When P = MC, buyers value the last unit of output by the same amount that it cost sellers to produce it. If buyers value the last unit by more than the marginal cost of production, resources are not being allocated efficiently, as at Q1 in Exhibit 3(a). Think of the demand curve as the marginal benefit curve (D = MB) and the supply curve as the marginal cost curve (S = MC). According to the rule of rational choice, we should pursue an activity as long as the expected marginal benefits are greater than the expected marginal costs. For example, in Exhibit 3(a), if Q1 is produced, then the marginal benefits from producing additional units are greater than the marginal costs. The productive efficiency where a good or service is produced at the lowest possible cost Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 346 PART 4 section 12.6 Households and Market Structure Allocative Efficiency and Perfect Competition exhibit 3 a. Producing Less Than the Competitive Level of Output Lowers Welfare Deadweight Loss —Too Little Output b. Producing More Than the Competitive Level of Output Lowers Welfare Deadweight Loss —Too Much Output S ! MC MC Price Price MB P* MC P* MB D ! MB 0 S ! MC Q1 Q* D ! MB 0 Q* Q2 Quantity W I L S O N , That is, at Q1, resources are not being allocated efficiently, shaded area is deadweight loss. © Cengage Learning 2013 Quantity The demand curve measures the marginal benefits to the consumer and the supply curve measures the marginal cost to the sellers. At P* and Q*, resources are being allocated efficiently—the marginal benefits of these resources are equal to the marginal cost of these resources. If Q1 is produced, then the marginal benefits from producing additional units are greater than the marginal costs. Society gains from expending output up to the point where MB = MC at Q*. If output is expanded beyond Q* (MC > MB) society gains from a reduction in output back to Q*. What is the difference between productive efficiency and allocative efficiency? allocative efficiency where P = MC and production will be allocated to reflect consumer preferences and output should be expanded. We can also produce too much output. For example, if output is expanded beyond Q* J for producing the good is greater than the marginal benefit in Exhibit 3(b), the cost to sellers to consumers. The shaded area Ais deadweight loss. Society would gain from a reduction in output back to Q*. Once the competitive equilibrium is reached, the buyers’ marginal benM efit equals the sellers’ marginal cost. That is, in a competitive market, producers efficiently I machinery, and other inputs) to produce what consumers use their scarce resources (labor, want. In this sense, perfect competition achieves allocative efficiency. E 5 0 If the domino-making industry is a constant-cost industry, one would expect the long-run result 5 of an increase in demand for dominos to include 1 a. a greater number of firms and a higher price. B b. a greater number of firms and the same price. c. the same number of firms and a higher price. U SECTION QUIZ 1. d. the same number of firms and the same price. 2. In an increasing-cost industry, an unexpected increase in demand would lead to what result in the long run? a. higher costs and a higher price b. higher costs and a lower price c. no change in costs or prices d. impossible to determine from the information given (continued) Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 Firms in Perfectly Competitive Markets 347 S E C T I O N Q U I Z (Cont.) 3. Which of the following is true? a. In constant-cost industries, the cost curves of the firm are not affected by changes in the output of the entire industry. b. In an increasing-cost industry, the cost curves of the individual firms rise as total output increases. c. A decreasing-cost industry has a downward-sloping long-run supply curve; firms experience lower cost as industry expands. d. All of the above are true. 4. Which of the following is true? a. Productive efficiency occurs in perfect competition because the firm produces at the minimum of the ATC curve. b. Allocative efficiency occurs when P = MC; production is allocated to reflect consumers’ want. c. Both (a) and (b) are true. d. None of the above is true. 5. In an increasing-cost industry, an increase in industry demand would lead to ____________ number of firms and ____________ firms’ average cost curves in the long run. 1. 2. W a. no change in the; no change in I b. no change in the; an upward shift in L c. an increase in the; no change in S d. an increase in the; an upward shift in the O Noutput expands for a constant-cost industry? What must be true about input costs as industry What must be true about input costs as industry , output expands for an increasing-cost industry? 3. What would be the long-run equilibrium result of an increase in demand in a constant-cost industry? 4. What would be the long-run equilibrium result of an increase in demand in an increasing-cost industry? J A M I E Answers: 1. b 2. a 3. d 4. c 5. d 5 0 Fill in the blanks: 5 1. Perfect competition is a market structure involving a(n) _____________ number of buyers and sellers, 1 a(n) _____________ product, and _____________ B market entry and exit. U 2. Perfectly competitive firms are _____________, who must accept the market price as determined by the forces of demand and supply. Interactive Summary 5. Because of _____________ market entry and exit, perfectly competitive markets generally consist of a(n) _____________ number of small suppliers. 6. In a perfectly competitive industry, each producer provides such a(n) _____________ fraction of the total supply that a change in the amount he or she offers does not have a noticeable effect on the market price. 3. Because perfectly competitive markets have _____________ buyers and sellers, each firm is so _____________ in relation to the industry that its production decisions have no impact on the market. 7. Because perfectly competitive sellers can sell all they want at the market price, their demand curve is _____________ at the market price over the _____________ range of output that they could possibly produce. 4. Because consumers believe that all firms in a perfectly competitive market sell _____________ products, the products of all the firms are perfect substitutes. 8. The objective of a firm is to maximize profits by producing the amount that maximizes the difference between its _____________ and _____________. Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 348 PART 4 Households and Market Structure 9. Total revenue for a perfectly competitive firm equals the _____________ times the _____________. 10. _____________ equals total revenue divided by the number of units of the product sold. 11. _____________ is the additional revenue derived from the sale of one more unit of the good. 12. In perfect competition, we know that _____________ and price are equal. 13. In all types of market environments, firms will maximize profits at that output which maximizes the difference between _____________ and _____________, which is the same output level where _____________ equals _____________. 14. At the level of output chosen by a competitive firm, total cost equals _____________ times quantity, while total revenue equals _____________ times quantity. 15. If total revenue is greater than total costs at its W profit-maximizing output level, a firm is generatI ing _____________. If total revenue is less than L total costs, the firm is generating _____________. If total revenue equals total costs, the firm is earning S _____________. O 16. If a firm cannot generate enough revenues to cover N its _____________ costs, then it will have larger losses if it operates than if it shuts down in the ,short run. 17. The loss a firm would bear if it shuts down would be J equal to _____________. 18. 19. A When price is less than _____________ but more M than _____________, a firm produces in the short run, but at a loss. I The short-run supply curve of an individual comE petitive seller is identical with that portion of the _____________ curve that lies above the minimum of the _____________ curve. 5 0 5 1 B U 20. The short-run market supply curve is the horizontal summation of the individual firms’ supply curves, providing that _____________ are not affected by increased production by existing firms. 21. If perfectly competitive producers are currently making economic profits, the market supply curve will shift to the right over time as more firms _____________ and existing firms _____________. 22. As entry into a profitable industry pushes down the market price, producers will move from a situation where price _____________ average total cost to one where price _____________ average total cost. 23. Only at _____________ is the tendency for firms either to enter or leave the business eliminated. 24. The long-run equilibrium output in perfect competition occurs at the lowest point on the average total cost curve, so the equilibrium condition in the long run in perfect competition is for firms to produce at that output that minimizes the _____________. 25. The shape of the long-run supply curve depends on the extent to which _____________ change with the entry or exit of firms in the industry. 26. In a constant-cost industry, the prices of inputs _____________ as output is expanded. 27. In an increasing-cost industry, the cost curves of the individual firms _____________ as the total output of the industry increases. 28. There is a(n) _____________ efficiency in perfect competition because the firm produces at the minimum of the ATC curve. 29. There is _____________ efficiency in perfect competition because P = MC and production is allocated to reflect consumers’ wants. 30. Once the competitive equilibrium is reached, the buyers’ _____________ equals the sellers’ _____________. Answers: 1. large; homogeneous (standardized); easy 2. price takers 3. many; small 4. identical (homogeneous) 5. easy; large 6. small 7. horizontal; entire 8. total revenues; total costs 9. market price; quantity of units sold 10. Average revenue 11. Marginal revenue 12. marginal revenue 13. total revenue; total costs; marginal revenue; marginal costs 14. average total cost; the market price 15. economic profits; economic losses; zero economic profits 16. variable 17. fixed costs 18. average total costs; average variable costs 19. marginal cost; average variable cost 20. input prices 21. enter the industry; expand 22. exceeds; equals 23. zero economic profits 24. average total cost curve 25. input costs 26. do not change 27. rise 28. productive 29. allocative 30. marginal benefit; marginal cost Key Terms and Concepts total revenue (TR) 328 average revenue (AR) 328 marginal revenue (MR) 328 profit-maximizing level of output 330 short-run supply curve 334 short-run market supply curve 335 constant-cost industry 342 increasing-cost industry 344 decreasing-cost industry 345 productive efficiency 345 allocative efficiency 346 Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. chapter 12 Firms in Perfectly Competitive Markets 349 Section Quiz Answers 12.1 A Perfectly Competitive Market 1. Why do firms in perfectly competitive markets involve homogeneous goods? For there to be a large number of sellers of a particular good, so that no seller can appreciably affect the market price (i.e., sellers are price takers), the goods in question must be the same, or homogeneous. 2. Why does the absence of significant barriers to entry tend to result in a large number of suppliers? With no significant barriers to entry, it is fairly easy for entrepreneurs to become suppliers of a product. W With such easy entry, as long as an industry is profI itable it will attract new suppliers, typically resulting in large numbers of sellers. L S 3. Why does the fact that perfectly competitive firms are small relative to the market make O them price takers? If a perfectly competitive firm sells only a smallN amount relative to the total market supply, even, sharply reducing its output will make virtually no difference in the market quantity supplied; therefore, it will make virtually no difference in the market J price. In this case, a firm is able to sell all it wants at A the market equilibrium price but is unable to appreciably affect that price; therefore, it takes the market M equilibrium price as given—that is, it is a price taker. 12.2 An Individual Price Taker’s Demand Curve I E 1. Why would a perfectly competitive firm 5 not try to raise or lower its price? 0 A perfectly competitive firm is able to sell all it 5 it wants at the market equilibrium price. Therefore, has no incentive to lower prices (sacrificing revenues 1 and therefore profits) in an attempt to increase sales. B Because other firms are willing to sell perfect substitutes for each other’s product (because goodsUare homogeneous) at the market equilibrium price, trying to raise the price would lead to the firm losing all its sales. Therefore, it has no incentive to try to raise its price, either. 2. Why can we represent the demand curve of a perfectly competitive firm as perfectly elastic (horizontal) at the market price? If a perfectly competitive firm can sell all it would like at the market equilibrium price, the demand curve it faces for its output is perfectly elastic (horizontal) at that market equilibrium price. 3. How does an individual perfectly competitive firm’s demand curve change when the market price changes? If a perfectly competitive firm can sell all it would like at the market equilibrium price, it faces a perfectly elastic demand curve at the market equilibrium price. Therefore, anything that changes the market equilibrium price (any of the market demand curve shifters or the market supply curve shifters) will change the price at which each perfectly competitive firm’s demand curve is perfectly elastic (horizontal). 4. If the marginal cost facing every producer of a product shifted upward, would the position of a perfectly competitive firm’s demand curve be likely to change as a result? Why or why not? Yes. If the marginal cost curves facing each producer shifted upward, a decrease (leftward shift) would occur in the industry supply curve. This shift would result in a higher market price that each producer takes as given, which would shift each producer’s horizontal demand curve upward to that new market price. 12.3 Profit Maximization 1. How is total revenue calculated? Total revenue is equal to the price times the quantity sold. However, because the quantity sold at that price must equal the quantity demanded at that price (to sell a product you need a willing buyer), it can also be described as price times quantity demanded at that price. 2. How is average revenue derived from total revenue? Average or per-unit revenue for a given quantity of output is just the total revenue from that quantity of sales divided by the quantity sold. 3. How is marginal revenue derived from total revenue? Marginal revenue is the change in total revenue from the sale of one more unit of output. It can be either positive (total revenue increases with output) or negative (total revenue decreases with output). 4. Why is marginal revenue equal to price for a perfectly competitive firm? If a perfectly competitive seller can sell all it would like at the market equilibrium price, it can sell one more Copyright 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part. Due to electronic rights, some third party content may be suppressed from the eBook and/or eChapter(s). Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it. 350 PART 4 Households and Market Structure unit at that price without having to lower its price on the other units it sells (which would require sacrificing revenues from those sales). Therefore, its marginal revenue from selling one more unit equals the market equilibrium price, and its horizontal demand curve therefore is the same as its horizontal marginal revenue curve. 12.4 Short-Run Profits and Losses 1. How is the profit-maximizing output quantity determined? The profit-maximizing output is the output where marginal revenue equals marginal cost (because profits increase for every unit of output for which marginal revenue exceeds marginal cost). 2. How do we determine total revenue and W total cost for the profit-maximizing output I quantit...
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