“A business absolutely devoted to service will have only one worry about profits. They will be embarrassingly large.” H

1. 11 Perfect Competition CHAPTER “A business absolutely devoted to service will have only one worry about profits. They will be embarrassingly large.” Henry Ford

2. C H A P T E R C H E C K L I S T • When you have completed your study of this chapter, you will be able to • 1Explain a perfectly competitive firm’s profit-maximizing choices and derive its supply curve. • 2 Explain how output, price, and profit are determined in the short run. 3 Explain how output, price, and profit are determined in the long run and explain why perfect competition is efficient.

3. MARKET TYPES • The four market types are • Perfect competition • Monopoly • Monopolistic competition • Oligopoly

4. MARKET TYPES • Perfect Competition - Characteristics • Many, many, many, many sellers, none so large that they can influence price. • Homogeneous product (buyers don’t care who they by from). • No barriers to entry or exit (easy to get in and out of market). • Long run economic profit = zero. (only earning normal profit) • Firms are price takers (no market power, so market sets same price for all firms).

5. 11.1 A FIRM’S PROFIT-MAXIMIZING CHOICES • Revenue Concepts • In perfect competition, market demand and market supply determine price. • A firm’s total revenue equals the market price multiplied by the quantity sold. • A firm’s marginal revenue(MR) = change in total revenue (TR) that results from a one-unit increase in the quantity sold. • MR = Price

6. 11.1 A FIRM’S PROFIT-MAXIMIZING CHOICES • Profit-Maximizing Output • As output increases, total revenue (TR) increases. • But total cost (TC) also increases. • Because of diminishing marginal returns, TC eventually increases faster than TR. • There is one output level (Q) that maximizes economic profit (profit max), and a perfectly competitive firm chooses this output level.

7. 11.1 A FIRM’S PROFIT-MAXIMIZING CHOICES • One way (the hard way) to find the profit-maximizing output is to use a firm’s total revenue and total cost curves. • Profit is maximized at output level where TR exceeds TC by the largest amount.

8. 11.1 A FIRM’S PROFIT-MAXIMIZING CHOICES Total revenue increases as the quantity increases —shown by the TR curve. Total cost increases as the quantity increases—shown by the TC curve. As the quantity increases, economic profit (TR– TC) increases, reaches a maximum, and then decreases.

9. 11.1 A FIRM’S PROFIT-MAXIMIZING CHOICES At low output levels, the firm incurs an economic loss. When total revenue exceeds total cost, the firm earns an economic profit. Profit is maximized when the gap between total revenue and total cost is the largest, at 10 cans per day.

10. 11.1 A FIRM’S PROFIT-MAXIMIZING CHOICES • Marginal Analysis and the Output Decision • Marginal analysis (the simple way to find profit max) compares marginal revenue, MR, with marginal cost, MC. • As output (Q) increases, MR is constant but MC increases. • (NOTE: Maximizing profit = minimizing losses)

11. 11.1 A FIRM’S PROFIT-MAXIMIZING CHOICES • If MR > MC: • The additional revenue from selling one more unit > the additional cost incurred to produce it. • Should increase output to increase economic profit. • If MR < MC: • The additional revenue from selling one more unit < the additional cost incurred to produce it. • Should decrease output to increase economic profit. • If MR = MC: PROFIT MAX • The additional revenue from selling one more unit = the additional cost incurred to produce it. • Economic profit would decrease if output increases or decreases, so economic profit is maximized where MR=MC. • SHOW PROFIT MAX GRAPHS

12. 11.1 A FIRM’S PROFIT-MAXIMIZING CHOICES • Temporary Shutdown Decisions • If a firm is incurring an economic loss that it believes is temporary, it will remain in the market, and it might produce some output or temporarily shut down.

13. 11.1 A FIRM’S PROFIT-MAXIMIZING CHOICES • Firms won’t produce unless they can cover some of their fixed costs (have to be paid whether they produce or not) • If P is above AVC, they are covering the variable costs of producing something, and some of fixed. • If P is below AVC, they are not covering all of variable costs, so they are better off not producing anything. • The firm’s shutdown point is where P=min AVC. • SHUTDOWN GRAPHS

14. 11.1 A FIRM’S PROFIT-MAXIMIZING CHOICES • The Firm’s Short-Run Supply Curve • A perfectly competitive firm’s short-run supply curve shows how the firm’s profit-maximizing output varies as the price varies, other things remaining the same. • Since a firm shuts down when P falls below AVC, the firm supply curve is the portion of the MC curve that lies above AVC. • SHOW FIRM SUPPLY CURVE

15. 11.2 OUTPUT, PRICE, PROFIT IN THE SHORT RUN • Market Supply in the Short Run • The market supply curve in the short run shows the quantity supplied at each price by a fixed number of firms. • The quantity supplied at a given price is the sum of the quantities supplied by all firms at that price.

16. 11.2 OUTPUT, PRICE, PROFIT IN THE SHORT RUN • Short-Run Equilibrium in Normal Times • Because PC firms are price takers, market demand and market supply determine the market price and quantity bought and sold.

17. 11.2 OUTPUT, PRICE, PROFIT IN THE SHORT RUN • Short-Run Equilibrium in Normal Times • NOTE: Profit per unit = P – ATC • Profit = (P – ATC) x Q • So, if P > ATC, firm earns positive economic profit. • if P < ATC, firm earns negative economic profit (loss) • if P = ATC, firm earns zero economic profit

18. 11.2 OUTPUT, PRICE, PROFIT IN THE SHORT RUN • Short-Run Equilibrium • Economic profit can be positive or negative in the short run. • If firms are earning economic profits, other firms will jump into market to earn higher than normal profits (no barriers to entry to prevent it). • New firms will increase supply, shift curve right, and lower price. • Economic profits will disappear.

19. 11.2 OUTPUT, PRICE, PROFIT IN THE SHORT RUN • Short-Run Equilibrium • Economic profit can be positive or negative in the short run. • If firms are earning economic losses, some firms will jump OUT of market (no barriers to exit to prevent it). • Fewer firms will decrease supply, shift curve left, and increase price. • Economic losses will shrink, firms earn zero economic profit in LR.

20. 11.3 OUTPUT, PRICE, PROFIT IN THE LONG RUN • Is Perfect Competition Efficient? • Resources are used efficiently when it is not possible to get more of one good without giving up something that is valued more highly. • To achieve this outcome, MB=MC. That is what perfect competition achieves. • Surplus is maximized at point where MC=MR (see discussion in Ch 6)