Chapter 6 Perfect Competition and the Supply Curve Slides created by Dr. Amy Scott ©2010 Worth Publishers DOING WHAT COMES NATURALLY Demand for organic foods and beverages increased rapidly over the past decade, at an average growth rate of 20% per year resulting in high prices. The supply of organic food, although relatively priceinelastic in the short run, was surely price-elastic in the long run. - existing organic farms increase their capacity - conventional farmers would enter the organic food business In this chapter, we will use our understanding of costs as the basis for an analysis of the supply curve. Chapter Objectives 1. A perfectly competitive market and its characteristics 2. A Price-taking producer and its profitmaximizing quantity of output 3. How to assess profitability and short run performance 4. Why industries behave differently in the short run and the long run 5. The industry supply curve in short run and the long run Perfect Competition and Price-takers A price-taking producer is one whose actions have no effect on the market price of the good it sells. A price-taking consumer is one whose actions have no effect on the market price of the good he or she buys. A perfectly competitive market is a market in which all participants are price-takers. A perfectly competitive industry is an industry in which all producers are price-takers. Two Necessary Conditions for Perfect Competition 1) For an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share. A producer’s market share is the fraction of the total industry output accounted for by that producer’s output. 2) An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent. A good is a standardized product, also known as a commodity, when consumers regard the products of different producers as the same good. For each of the following, is the market perfectly competitive?: There are two producers of aluminum in the world, a good sold in many places. perfectly competitive not perfectly competitive 1. 2. Only a handful of companies produce natural gas from the North Sea. The price of natural gas is determined by global supply and demand, of which North Sea production represents a small share. 1. 2. perfectly competitive not perfectly competitive What’s a Standardized Product? A perfectly competitive industry must produce a standardized product. People must think that these products are the same. Producers often go to great lengths to convince consumers that they have a distinctive, or differentiated, product even when they don’t. So is an industry perfectly competitive if it sells products that are indistinguishable except in name but that consumer’s don’t think are standardized? No. When it comes to defining the nature of competition, the consumer is always right. If consumers believe a product is differentiated, then it is. The Pain of Competition: Pharmaceuticals In pharmaceuticals, the conditions for perfect competition are often met as soon as the patent on a popular drug expires. The field is then open for other companies to sell their own versions of the drug—marketed as “generics” and sold under the medical name of the drug. Generics are standardized products, much like aspirin, and are often sold by many producers. The shift to perfect competition is accompanied by a sharp fall in market price. Free Entry and Exit Free entry and exit into and from an industry is when new producers can easily enter or leave that industry. Free entry and exit ensure: that the number of producers in an industry can adjust to changing market conditions, and, that producers in an industry cannot artificially keep other firms out. Production and Profits 10 Quick Review Total Revenue = Price * Quantity Profit = Total Revenue – Total Cost Using Marginal Analysis to Choose the ProfitMaximizing Quantity of Output Marginal revenue is the change in total revenue generated by an additional unit of output. MR = ∆TR/∆Q The Optimal Output Rule Optimal output rule says that profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to its marginal revenue. MR = MC Profit maximization is also loss minimization Short-Run Costs for Jennifer and Jason’s Farm What if MR and MC Aren’t Exactly Equal? The optimal output rule says to max profit, produce the quantity where MR = MC. But what if there’s no output level at which marginal revenue equals marginal cost? Then produce the largest quantity for which marginal revenue exceeds marginal cost. MR > MC When production involves large numbers, marginal cost, comes in small increments and there is always a level of output at which marginal cost almost exactly equals marginal revenue. Marginal Analysis Leads to ProfitMaximizing Quantity of Output The optimal output rule says profit is max is when MR = MC The marginal revenue curve shows how marginal revenue varies as output varies. Note: when firm is a price taker, MR curve is a flat (horizontal) line which is perfectly elastic The Price-Taking Firm’s Profit-Maximizing Quantity of Output Price, cost of bushel $24 Market price MC Optimal point 20 18 16 E MR = P 12 8 6 0 1 2 3 4 5 6 Profit-maximizing quantity 7 Quantity of tomatoes (bushels) The profitmaximizing point is where MC crosses MR curve (horizontal line at the market price): at an output of 5 bushels of tomatoes (the output quantity at point E). Costs Economic profit: firm’s revenue minus opportunity costs of resources Explicit costs: cost that involve actual outlay of money Implicit costs: do not require an outlay of money; measured by value in dollar terms, of benefits forgone Accounting profit: firm’s revenue minus explicit cost (usually larger than economic profit) When Is Production Profitable? If TR > TC, the firm is profitable. If TR = TC, the firm breaks even. If TR < TC, the firm incurs a loss. Profitability depends on whether market price is more or less than minimum ATC Short-Run Average Costs Costs and Production in the Short Run Price, cost of bushel $30 MC Minimum average total cost 18 Break even price ATC C MR = P 14 0 1 2 3 4 Minimum-cost output At point C (the minimum average total cost), the market price is $14 and output is 4 bushels of tomatoes (the minimumcost output). 5 6 7 Quantity of tomatoes (bushels) This is where MC cuts the ATC curve at its minimum. Minimum average total cost is equal to the firm’s break-even price. Profitability and the Market Price Price, cost of bushel Market Price = $18 Minimum average total cost MC E $18 14.40 14 Break even price 0 MR = P ATC Profit Z C 1 2 3 4 The farm is profitable because price exceeds minimum average total cost, the break-even price, $14. The farm’s optimal output choice is (E) output of 5 bushels. The average total cost of producing bushels is (Z on the ATC curve) $14.40 5 6 7 Quantity of tomatoes (bushels) The vertical distance between E and Z: farm’s per unit profit, $18.00 − $14.40 = $3.60 Total profit:5 × $3.60 = $18.00 Profitability and the Market Price Price, cost of bushel Market Price = $10 Minimum average total cost ATC Y $14.67 14 Break even 10 price 0 MC C Loss MR = P A 1 2 The farm is unprofitable because the price falls below the minimum average total cost, $14. The farm’s optimal output choice is (A) output of 3 bushels. The average total cost of producing bushels is (Y on the ATC curve) $14.67 3 4 5 6 Quantity of tomatoes (bushels) 7 The vertical distance between A and Y: farm’s per unit loss, $14.67 − $10.00 = $4.67 Total profit:3 × $4.67 = approx. $14.00 Profit, Break-Even or Loss The break-even price of a price-taking firm is the market price at which it earns zero profits. Whenever market price exceeds minimum average total cost, the producer is profitable. P > min ATC Profit Whenever the market price equals minimum average total cost, the producer breaks even. P = min ATC Break Even Whenever market price is less than minimum average total cost, the producer is unprofitable. P < min ATC Loss Economic Profit, Again Why would firms enter an industry when they will do little more than break even? Wouldn’t people prefer to go into other businesses that yield a better profit? The answer is that here, as always, when we calculate cost, we mean opportunity cost—the cost that includes the return a business owner could get by using his or her resources elsewhere. And so the profit that we calculate is economic profit; if the market price is above the break-even level, potential business owners can earn more in this industry than they could elsewhere. Profit – another way Profit = TR – TC TR = P*Q TC = ATC*Q Profit = (TR/Q – TC/Q)*Q Or Profit = (P – ATC)*Q The Short-Run Individual Supply Curve Price, cost of bushel Short-run individual supply curve $18 16 14 12 Shut-down 10 price 0 MC The short-run individual supply curve shows how an individual producer’s optimal output quantity depends on the market price, taking fixed cost as given. ATC E AVC C B A 1 2 Minimum average variable cost 3 3.5 4 5 6 Quantity of tomatoes (bushels) 7 A firm will cease production in the short run if the market price falls below the shutdown price, which is equal to minimum average variable cost. Short Run Production Decision Fixed costs are irrelevant because they cannot be changed in the short run. Shut-down price: when price is equal to minimum average variable cost Sunk cost: already been incurred and is nonrecoverable. Not included in production decisions Operate if P > AVC - incur loss in short run Shut down when P < AVC Summary of the Competitive Firm’s Profitability and Production Conditions Prices Are Up… But So Are Costs Congress passed the Energy Policy Act in 2005, mandating to add, by 2012, 7.5 billion gallons of alternative oil—mostly corn-based ethanol—to the American fuel supply with the goal of reducing gasoline consumption. Due to this mandate demand for corn and its price skyrocketed. American farmers like Ronnie Gerick of Texas, responded by increasing the U.S. acreage planted in corn by a total of 15%. Even though the price of corn increased, so did the cost of raw materials needed to grow the corn. Farmers will increase their corn acreage until the marginal cost of producing corn is approximately equal to the market price of corn— which shouldn’t come as a surprise because corn production satisfies all the requirements of a perfectly competitive industry. The firm should shut down immediately when price is ______. 1. 2. 3. between 0 and P1 between P1 and P2 above P2 The firm should operate in the short run (despite sustaining a loss) when the price is _____. 1. 2. 3. between 0 and P1 between P1 and P2 above P2 The firm operates while making a profit at a price _____. 1. 2. 3. between 0 and P1 between P1 and P2 above P2 Industry Supply Curve: Short Run The industry supply curve shows the relationship between the price of a good and the total output of the industry as a whole. SHORT RUN: The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers. There is a short-run market equilibrium when the quantity supplied equals the quantity demanded, taking the number of producers as given. The Long-Run Industry Supply Curve A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur. All have fully adjusted to optimal long run choices. No incentive to enter or exit. The Short-Run Market Equilibrium Price, cost of bushel Short-run industry supply curve, S $26 22 Market price E MKT 18 D 14 Shut-down price The short-run industry supply curve shows how the quantity supplied by an industry depends on the market price given a fixed number of producers. 10 0 200 300 400 500 600 700 Quantity of tomatoes (bushels) There is a short-run market equilibrium when the quantity supplied equals the quantity demanded, taking the number of producers as given. The Long-Run Market Equilibrium (a) Market Price, cost of bushel $18 S 1 E MKT (b) Individual Firm S 2 S 3 Price, cost of bushel $18 E A D MKT 16 MC 16 ATC D B 14.40 C MKT D 14 0 500 750 1,000 Quantity of tomatoes (bushels) Breakeven price 14 0 C 3 Y Z 4 Quantity 4.5 5of tomatoes 6 (bushels) A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur. Effect of Increase in Demand in Short Run and Long Run Price, cost (a) Existing Firm Response to Increase in Demand An increase in demand raises price and profit. $18 14 0 Price (b) Short-Run and Long-Run Market Response to Increase in Demand Long-run industry supply S curve,LRS S 1 2 MC Y ATC X MKT The LRS shows how the quantity supplied responds to the price once producers have had time to enter or exit the industry. Price, cost Higher industry output from new entrants drive price and profit back down. Y Y MKT X Quantity (a) Existing Firm Response to New Entrants 0 QXQY ATC Z D Z MKT 2 D 1 QZ Quantity MC 0 Quantity Increase in output from new entrants D↑ P↑ non-zero profits entry S↑ P↓ back to zero profit (on LRS curve) Short-Run vs. Long-Run Industry Supply Curves Price LRS may slope upward, but it is always flatter—more elastic— than the short-run industry supply curve. Short-run industry supply curve, S Long-run industry supply curve, LRS The long-run industry supply curve is always flatter – more elastic than the short-run industry supply curve. Quantity This is because of entry and exit: a higher price attracts new entrants in the long run, resulting in a rise in industry output and lower price; a fall in price induces existing producer to exit in the long run, generating a fall in industry output and a rise in price. Conclusions: Cost of Production and Efficiency in Long Run 1. 2. 3. In a perfectly competitive industry in equilibrium, marginal cost is the same for all firms. In a perfectly competitive industry with free entry and exit, each firm will have zero economic profits in long-run equilibrium Long-run market equilibrium of a perfectly competitive industry is efficient: no mutually beneficial transactions go unexploited. A Crushing Reversal Starting in the mid-1990s, Americans began drinking a lot more wine. Part of this increase in demand may have reflected a booming economy, but the surge in wine consumption continued even after the economy stumbled in 2001. At first, the increase in wine demand led to sharply higher prices; between 1993 and 2000, the price of red wine rose approximately 50%, and California grape growers earned high profits. As a result, there was a rapid expansion of the industry. Between 1994 and 2002, production of red wine grapes almost doubled. The result was predictable: the price of grapes fell as the supply curve shifted out. As demand growth slowed in 2002, prices plunged by 17%. The effect was to end the California wine industry’s expansion. Given the following costs for Alicia’s Apple Pies, a perfectly competitive firm, find the profit-maximizing or lossminimizing output for each price… If the price of a pie is $3, how many pies should be produced in the short-run? 1. 2. 3. 4. 1 2 3 4 4 4.28 If the price of a pie is $3 and Alicia decides to produce 3 pies, what is her short-run profit or loss? 1. 2. 3. 4. $0 $4.74 loss $1.75 loss $2.25 profit 4 4.28 If the price of a pie is $6, how many pies should be produced in the short-run? 1. 2. 3. 4. 3 4 5 6 4 4.28 If the price of a pie is $6 and Alicia produces 5 pies, how much is her short-run profit or loss? 1. 2. 3. 4. 0 $4.70 $7.80 $21.00 4 4.28 Which of the following events will induce firms to enter an industry? Which will induce firms to exit? 1a) A technological advance lowers the fixed cost of production of every firm in the industry. 1. enter 2. exit 3. no change 4. entry and exit 1b) The wages paid to workers in the industry go up. 1. 2. 3. 4. enter exit no change entry and exit Which of the following events will induce firms to enter an industry? Which will induce firms to exit? 1c) A permanent change in consumer tastes increases demand for the good. 1. enter 2. exit 3. no change 4. entry and exit 1d) The price of a key input rises due to a shortage of that input. 1. 2. 3. 4. enter exit no change entry and exit Given the following costs for Alicia’s Apple Pies, a perfectly competitive firm, find the long-run equilibrium price and quantity… How many pies will Alicia produce in the long run? 1. 2. 3. 4. 0 3 4 5 4 4.28 What price will Alicia charge in the long run? 1. 2. 3. 4. 0 $3.38 $4.28 $5 4 4.28 Summary 1. 2. 1 of 4 In a perfectly competitive market all producers are price-taking producers and all consumers are price-taking consumers—no one’s actions can influence the market price. There are two necessary conditions for a perfectly competitive industry: there are many producers, none of whom have a large market share, and the industry produces a standardized product or commodity— goods that consumers regard as equivalent. A third condition is often satisfied as well: free entry and exit into and from the industry. Summary 3. 4. 2 of 4 A producer chooses output according to the optimal output rule: produce where marginal revenue equals marginal cost. For a price-taking firm, marginal revenue is equal to price and its marginal revenue curve is a horizontal line at the market price. A firm is profitable if total revenue exceeds total cost or, equivalently, if the market price exceeds its breakeven price—minimum average total cost. If market price exceeds the break-even price, the firm is profitable; if it is less, the firm is unprofitable; if it is equal, the firm breaks even. When profitable, the firm’s per-unit profit is P − ATC; when unprofitable, its per-unit loss is ATC − P. Summary 5. 6. 3 of 4 Fixed cost is irrelevant to the firm’s optimal short-run production decision. When the market price is equal to or exceeds the shut-down price, the firm produces where MR = MC. When the market price falls below the shut-down price, the firm ceases production in the short run. This generates the firm’s short-run individual supply curve. Fixed cost matters over time. If the market price is below minimum average total cost for an extended period of time, firms will exit the industry in the long run. If above, existing firms are profitable and new firms will enter the industry in the long run. Summary 7. 8. 4 of 4 The short-run industry supply curve is the industry supply curve given that the number of firms is fixed. The short-run market equilibrium is given by the intersection of the short-run industry supply curve and the demand curve. The long-run industry supply curve is the industry supply curve given sufficient time for entry into and exit from the industry. In the long-run market equilibrium—given by the intersection of the long-run industry supply curve and the demand curve—no producer has an incentive to enter or exit. The long-run industry supply curve is often horizontal.