Transcript Economics for Today 2nd edition Irvin B. Tucker

Chapter 8
Perfect Competition
• Key Concepts
• Summary
• Practice Quiz
• Internet Exercises
©2000 South-Western College Publishing
1
In this chapter, you will
learn to solve these
economic puzzles:
Why
is
the
demand
Why
In the
would
long-run,
a firmcan
stay
curve
horizontal
for
a
alligator
in business
farmswhile
earn an
firm
in
a
perfectly
economic
losing money?
profit?
competitive market?
2
Who was Adam Smith?
The father of modern
economics who wrote
The Wealth of Nations,
published in 1776
3
What did Adam Smith say
about Competitive Forces?
They are like an “invisible
hand” that leads people
who simply pursue their
own interests to serve the
interests of society
4
What is the purpose of
this chapter?
To explain how
competitive markets
determine prices,
output, and profits
5
What is
Market Structure?
A classification system for the
key traits of a market,
including the number of
firms, the similarity of the
products they sell, and the
ease of entry and exit
6
What is
Perfect Competition?
1. many small firms
2. homogeneous product
3. very easy entry and exit
4. price taker
7
What does
Homogeneous mean?
Goods that cannot be
distinguished from one
another; for example,
one potato cannot be
distinguished from
another potato
8
What is a Price Taker?
A seller that has no
control over the price of
the product it sells
9
What determines price?
Supply and demand
10
P
$140
$130
$120
$100
$80
$60
$40
$20
Market Supply and Demand
S
DQ
5 10 15 20 25 30 35 40 45
11
What determines the
individual firm’s
Demand Curve?
A horizontal line at
the market price
12
$140
$130
$120 Individual firm demand
$100
$80
$60
$40
$20
5 10 15 20 25 30 35 40 45
D
13
Why is this horizontal
line the firm’s Demand
Curve?
If the firm charges more
than this price, it will not
sell anything, and it has
no incentive to charge
less than this price
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Why does the firm have
no incentive to charge less
than the market price?
It can sell everything it
brings to market at
the market price
15
What does the Perfectly
Competitive Firm control?
The only thing it
controls is how many
units it produces
16
How many units should
this firm produce?
The number of units
whereby it will maximize
its profits, or at least
minimize its losses
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What are the two methods
to determine how many
units to produce?
• TR and TC
• MR and MC
18
Using the Total Revenue Total Cost method, where
should a firm produce?
Where the distance
between TR and
TC is the greatest
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P
$500
Maximize Profit
TR
TC
$400
$300
$200
$100
Quantity of Output
1
2
3
4
5
Q
20
P
Maximize Profit Output
$150
$100
TR
$50
0
-$50
Quantity of Output
1
2
3
4
5
Q
21
What is
Marginal Revenue?
MR = TR / 1 output
22
What is
Marginal Cost?
MC = TC / 1 output
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Using the Marginal
Revenue and Marginal
Cost method, where
should a firm produce?
MR = MC
24
Why should a firm
continue to produce as
long as MR > MC?
As long as MR is > than
MC, money is being
made on that last unit
25
Why will a firm not
produce that unit
where MR < MC?
At the unit of output where
MR < MC, money is
being lost on that last unit
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Why does P = AR in
Perfect Competition?
Each additional unit sold
is adding the market
price to TR and TR
divided by P = AR
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Price & Cost per unit
$80
$70
$60
$50
$40
$30
$20
$10
MR=MC MC
ATC
P = MR = AR
Profit
AVC
1 2 3 4 5 6 7 8 9
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$70
$60
$50
$40
$30
$20
$10
Price & Cost per unit
P
MR=MC MC
Loss
ATC
AVC
P=MR=AR
1 2 3 4 5 6 7 8 9
Q
29
$70
$60
$50
$40
$30
$20
$10
Price & Cost per unit
P
Short-Run Shutdown
MC
ATC
AVC
Loss
P=MR=AR
MR=MC
1 2 3 4 5 6 7 8 9
Q
30
Firm will shut down
Price (MR) is below
minimum average
variable cost
31
What is the Perfectly
Competitive Firm’s ShortRun Supply Curve?
The firm’s marginal cost
curve above the minimum
point on its average
variable cost curve
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P
$70
$60
$50
$40
$30
$20
$10
Firm’s Short-Run Supply Curve
MR3
MR2
MC ATC
AVC
MR1
1 2 3 4 5 6 7 8 9
Q
33
What is the Industry’s
Supply Curve?
The summation of the
individual firm’s MC
curves that lie above their
minimum AVC points
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P
$130
$120
$100
$80
$60
$40
$20
Industry Equilibrium
S = MC
5 10 15 20 25 30 35 40 45
Q
35
What is a Normal Profit?
The minimum profit
necessary to keep a
firm in operation
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In the long-run, what
happens when Economic
Profits are made?
When firms make more than
a normal profit, firms enter
the industry, as supply
increases, a downward
pressure is put on prices
37
In the long-run,
what happens when
Losses are made?
When firms make less than a
normal profit, firms leave
the industry, as supply
decreases, an upward
pressure is put on prices
38
In the long-run, where
is Equilibrium?
At the market price
that enables firms to
make a normal profit
39
What exists at long-run
perfectly competitive
equilibrium?
P = MR = SRMC =
SRATC = LRAC
40
P
$70
$60
$50
$40
$30
$20
$10
Long-Run Competitive Equilibrium
Equilibrium SRMC
SATC
LRAC
MR
1 2 3 4 5 6 7 8 9
Q
41
P
$130
$120
$100
$80
$60
$40
$20
Industry Equilibrium
S = MC
D
5 10 15 20 25 30 35 40 45
Q
42
What different types
of industries can exist
in the long-run?
• Constant-cost
• Decreasing-cost
• Increasing-cost
43
What is a
Constant-cost Industry?
An industry in which the
expansion of industry
output by the entry of
new firms has no effect
on the firm’s cost curves
44
What does the long-run
supply curve look like in
a Constant-cost industry?
It is perfectly elastic,
which is horizontal
45
Increase in demand sets a
higher equilibrium price
Entry of new firms
increases supply
Initial equilibrium
price is restored
Perfectly elastic long-run
supply curve
46
What is a Decreasingcost Industry?
An industry in which the
expansion of industry
output by the entry of
new firms decreases the
firm’s cost curves
47
What does the long-run
supply curve look like in a
Decreasing-cost industry?
It is downward sloping
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Increase in demand sets a
higher equilibrium price
Entry of new firms
increases supply
Equilibrium price
and ATC decrease
Downward sloping long-run
supply curve
49
What is an Increasingcost Industry?
An industry in which the
expansion of industry
output by the entry of
new firms increases the
firm’s cost curves
50
What does the long-run
supply curve look like in a
Increasing-cost industry?
It is upward sloping
51
Increase in demand sets a
higher equilibrium price
Entry of new firms
increases supply
Equilibrium price
and ATC increase
Upward sloping long-run
supply curve
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Key Concepts
53
Key Concepts
•
•
•
•
What is Perfect Competition?
What is a Price Taker?
What determines price?
What determines the individual firm’s
Demand Curve?
• Why does the firm have no incentive to
charge less than the market price?
• Using the Marginal Revenue and Marginal
Cost method, where should a firm produce?
54
Key Concepts cont.
• Why does MR = P in Perfect Competition?
• What is a Normal Profit?
• In the long-run, what happens when
Economic Profits are made?
• In the long-run, what happens when Losses
are made?
• In the long-run, where is equilibrium?
• What different types of industries can exist in
the long-run?
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Summary
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Market structure consists of
three market characteristics: (1) the
number of sellers, (2) the nature of
the product, (3) the case of entry
into or exit from the market.
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Perfect competition is a market
structure in which an individual firm
cannot affect the price of the product
it produces. Each firm in the industry
is very small relative to the market as
a whole, all the firms sell a
homogeneous product, and firms are
free to enter and exit the industry.
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A price-taker firm in perfect
competition faces a perfectly elastic
demand curve. It can sell all it
wishes at the market-determined
price, but it will sell nothing above
the given market price. This is
because so many competitive firms
are willing to sell at the going
market price.
59
The total revenue-total cost
method is one way the firm
determines the level of output that
maximizes profit. Profit reaches a
maximum when the vertical
difference between the total revenue
and the total cost curves is at a
maximum.
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P
$500
Maximize Profit
TR
TC
$400
$300
$200
$100
Quantity of Output
1
2
3
4
5
Q
61
The marginal revenue equals
marginal cost method is a second
approach to finding where a firm
maximizes profits. Marginal
revenue is the change in total
revenue from a one-unit change in
output. Marginal revenue for a
perfectly competitive firm equals
the market price.
62
The MR = MC rule states that
the firm maximizes profit or
minimizes loss by producing the
output where marginal revenue
equals marginal cost. If the price
(average revenue) is below the
minimum point on the average
variable cost curve, the MR = MC
rule does not apply, and the firm
shuts down to minimize its losses.
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Price & Cost per unit
$80
$70
$60
$50
$40
$30
$20
$10
MR=MC MC
ATC
P = MR = AR
Profit
AVC
1 2 3 4 5 6 7 8 9
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$70
$60
$50
$40
$30
$20
$10
Price & Cost per unit
P
MR=MC MC
Loss
ATC
AVC
P=MR=AR
1 2 3 4 5 6 7 8 9
Q
65
$70
$60
$50
$40
$30
$20
$10
Price & Cost per unit
P
Short-Run Shutdown
MC
ATC
AVC
Loss
P=MR=AR
MR=MC
1 2 3 4 5 6 7 8 9
Q
66
The perfectly competitive firm’s
short-run supply curve is a curve
showing the relationship between the
price of a product and the quantity
supplied in the short run. The individual
firm always produces along its marginal
cost curve above its intersection with the
average variable cost curve. The
perfectly competitive industry’s shortrun supply curve is the horizontal
summation of the short-run supply
curves of all firms in the industry.
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P
$130
$120
$100
$80
$60
$40
$20
Industry Equilibrium
S = MC
5 10 15 20 25 30 35 40 45
Q
68
Long-run perfectly competitive
equilibrium occurs when the firm
earns a normal profit by producing
where price equals minimum longrun average cost equals minimum
short-run average total cost equals
short-run marginal cost.
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P
$70
$60
$50
$40
$30
$20
$10
Long-Run Competitive Equilibrium
Equilibrium SRMC
SATC
LRAC
MR
1 2 3 4 5 6 7 8 9
Q
70
A constant-cost industry is an
industry whose total output can be
expanded without an increase in the
firm’s average total cost. Because
input prices remain constant, the
long-run supply curve in a constantcost industry is perfectly elastic.
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A decreasing-cost industry is an
industry in which lower input prices
result in a downward-sloping longrun supply curve. As industry output
expands, the firm’s average total cost
curve shifts downward, and the longrun equilibrium market price falls.
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An increasing-cost industry is an
industry in which input prices rise as
industry output increases. As a result,
the firm’s average total cost curve
rises, and the long-run supply curve
for an increasing-cost industry is
upward sloping.
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Chapter 8 Quiz
©2000 South-Western College Publishing
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1. A perfectly competitive market is not
characterized by
a. many small firms.
b. a great variety of different products.
c. free entry into and exit from the market.
d. any of the above.
B. Perfect competition is characterized by
goods that cannot be distinguished from
one another.
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2. Which of the following is a characteristic
of perfect competition?
a. Entry barriers.
b. Homogeneous products.
c. Expenditures on advertising.
d. Quality of service.
B. A homogeneous product is one that
cannot be distinguished from the others,
for example, one potato looks just like
another potato.
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3. Which of the following are the same at all
levels of output under perfect competition?
a. Marginal cost and marginal revenue.
b. Price and marginal revenue.
c. Price and marginal cost.
d. All of the above.
B. Price equals marginal revenue because
each unit is sold at the same price;
therefore, every additional unit sold adds
the price to total revenue.
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4. If a perfectly competitive firm sells 100
units of output at a market price of $100 per
unit, its marginal revenue per unit is
a. $1.
b. $100.
c. more than $1, but less than $100.
d. less than $100.
B. Marginal revenue is defined as the addition
to total revenue when selling one unit.
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5. Short-run profit maximization for a
perfectly competitive firm occurs when
the firm’s marginal cost equals
a. average total cost.
b. average variable cost.
c. marginal revenue.
d. all of the above.
C. Profits are maximized or losses are
minimized at the unit of output where MR =
MC. If MR were > than MC, an additional
unit would be produced. If MR were < MC,
that last unit would not be produced.
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6. A perfectly competitive firm sells its output for
$100 per unit, and the minimum average
variable cost is $150 per unit. The firm should
a. increase output.
b. decrease output, but not shut down.
c. maintain its current rate of output.
d. shut down.
D. At this output a firm’s losses exceed its fixed
costs; it would therefore lose more money by
staying open than by closing down.
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Price & Cost per unit
$80
$70
$60
$50
$40
$30
$20
$10
Short-Run Shutdown
MR=MC MC
ATC
AVC
P=MR=AR
1 2 3 4 5 6 7 8 9
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7. A perfectly competitive firm’s supply curve
follows the upward sloping segment of its
marginal cost curve above the
a. average total cost curve.
b. average variable cost curve.
c. average fixed cost curve.
d. average price curve.
B. The supply curve does not extend
below the AVC curve because below
this price the firm would close down;
there would not be a supply curve.
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P
$15
$10
$5
Exhibit 15
Price & Cost per unit
$20
MC
D
C
B
ATC
AVC
A
500
1,000 1,500 2,000
Q
83
8. Assume the price of the firm’s product
in Exhibit 15 is $15 per unit. The firm
will produce
a. 500 units per week.
b. 1,000 units per week.
c. 1,500 units per week.
d. 2,000 units per week.
e. 2,500 units per week.
D. This is the number of units in which
MR = MC.
84
9. The lowest price in Exhibit 15 at which the
firm earns zero economic profit in the
short-run is
a. $5 per unit.
b. $10 per unit.
c. $20 per unit.
d. $30 per unit.
B. This is the minimum point of the ATC
curve at which P = ATC. Exactly a
normal profit is being made, that is,
zero economic profit.
85
10. Assume the price of the firm’s product in
Exhibit 15 is $6 per unit. The firm should
a. continue to operate because it is earning an
economic profit.
b. stay in operation for the time being even
though it is earning an economic loss.
c. shut down temporarily.
d. shut down permanently.
B. At this price, the firm’s losses are less
than its fixed costs; it will therefore lose
less money by staying open than closing.
86
11. Assume the price of the firm’s product
in Exhibit 15 is $10 per unit. The
maximum profit the firm earns is
a. zero.
b. $5,000 per week.
c. $1,500 per week.
d. $10,500 per week.
A. In perfect competition, Price = AR = MR =
the firm’s short-run demand curve. When P
= ATC, the firm’s revenues equal its costs,
so zero economic profits are made. Normal
profit is included as a part of the firm’s cost
data because it is a necessary expense of
operating the business.
87
12. In Exhibit 15, the firm’s total revenue at
a price of $10 per unit pays for
a. a portion of total variable costs.
b. a portion of total fixed costs.
c. none of the total fixed costs.
d. all of the total fixed costs and total
variable cost.
D. At a price of $10, the firm is making an
economic profit - more than enough money
is being made to meet its fixed costs.
88
13. As shown in Exhibit 15, the short-run
supply curve for this firm corresponds to
which segment of its marginal cost curve?
a. A to D and all points above.
b. B to D and all points above.
c. C to D and all points above.
d. B to C only.
B. A supply curve shows how many units
will be produced at various prices. The
firm’s supply curve is its MC curve which
lies above its AVC curve because it will
always produce where MR (AR, P) = MC.
89
14. In long-run equilibrium, the perfectly
competitive firm’s price equals which of
the following?
a. Short-run marginal cost.
b. Minimum short-run average total cost.
c. Marginal revenue.
d. All of the above.
D. Long-run equilibrium is at the price in
which a normal profit is being made.
Normal profit is when P(AR) = ATC in
long-run equilibrium.
90
15. In a constant-cost industry, input prices
remain constant as?
a. the supply of inputs fluctuates.
b. firms encounter diseconomies of scale.
c. workers become more experienced.
d. firms enter and exit the industry.
D. A constant-cost industry is when the
entry or exit of firms has little impact on a
firm’s cost curves.
91
16. Suppose that , in the long run, the price
of feature films rises as the movie
production industry expands. We can
conclude that movie production is a (an)
a. increasing-cost industry.
b. constant-cost industry.
c. decreasing-cost industry.
d. marginal-cost industry.
A. An industry in which the expansion of
industry output by the entry of new firms
increases the firm’s cost curves
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17. Which of the following is true of a
perfectly competitive market?
a. If economic profits are earned, then the
price will fall over time.
b. In long-run equilibrium, P = MR =
SRMC = SRATC = LRAC.
c. A constant-cost industry exists when
the entry of new firms has no effect on
their cost curves.
d. All of the above.
D. All of the above statements are true.
93
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END
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