Fourth Edition

Report
R. GLENN
HUBBARD
O’BRIEN
ANTHONY PATRICK
Economics
FOURTH EDITION
CHAPTER
12
Firms in Perfectly Competitive
Markets
Chapter Outline and
Learning Objectives
12.1 Perfectly Competitive Markets
12.2 How a Firm Maximizes Profit in a
Perfectly Competitive Market
12.3 Illustrating Profit or Loss on the
Cost Curve Graph
12.4 Deciding Whether to Produce or to
Shut Down in the Short Run
12.5 “If Everyone Can Do It, You Can’t
Make Money at It”: The Entry and
Exit of Firms in the Long Run
12.6 Perfect Competition and Efficiency
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Perfect Competition in Farmers’ Markets
• With sales of organically grown food increasing at a rate of 20 percent per
year, more farmers have begun participating in farmers’ markets.
• The additional supply of produce, though, has forced down prices and many
farmers have found that the profits they earn from selling in farmers’ markets
is no longer higher than what they earn selling to supermarkets.
• Throughout the economy, entrepreneurs are continually introducing new
products or new ways of selling products, which—when successful—enable
them to earn economic profits in the short run.
• But in the long run, competition among firms forces prices to the level where
they just cover the costs of production.
• AN INSIDE LOOK on page 422 discusses the steady decline in production
and sales of organic food in the United Kingdom after 2008.
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Economics in Your Life
Are You an Entrepreneur?
Were you an entrepreneur during your high school years?
Perhaps you didn’t have your own store, but you may have worked as a
babysitter, or perhaps you mowed lawns for families in your neighborhood.
While you may not think of these jobs as being small businesses, that is exactly
what they are.
How did you decide what price to charge for your services? You may have
wanted to charge $25 per hour to babysit or mow lawns, but you probably
charged much less.
As you read the chapter, think about the competitive situation you faced as a
teenage entrepreneur and try to determine why the prices received by most
people who babysit and mow lawns are so low.
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Firms in perfectly competitive industries are unable to control the prices of the
products they sell and are unable to earn an economic profit in the long run
because:
(1) firms in these industries sell identical products, and
(2) it is easy for new firms to enter these industries.
Studying how perfectly competitive industries operate is the best way to
understand how markets answer the fundamental economic questions
discussed in Chapter 1:
• What goods and services will be produced?
• How will the goods and services be produced?
• Who will receive the goods and services produced?
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Most industries, though, are not perfectly competitive.
In particular, any industry has three key characteristics, which economists use
to classify into four market structures:
1. The number of firms in the industry
2. The similarity of the good or service produced by the firms in the industry
3. The ease with which new firms can enter the industry
Table 12.1 The Four Market Structures
Market Structure
Characteristic
Perfect
Competition
Monopolistic
Competition
Oligopoly
Monopoly
Number of firms
Many
Many
Few
One
Type of product
Identical
Differentiated
Identical or
differentiated
Unique
Ease of entry
High
High
Low
Entry blocked
Examples of
industries
• Growing
wheat
• Growing
apples
• Clothing
stores
• Restaurants
• Manufacturing
computers
• Manufacturing
automobiles
• First-class
mail delivery
• Tap water
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Perfectly Competitive Markets
12.1 LEARNING OBJECTIVE
Explain what a perfectly competitive market is and why a perfect competitor
faces a horizontal demand curve.
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Perfectly competitive market A market that meets the conditions of (1) many
buyers and sellers, (2) all firms selling identical products, and (3) no barriers to
new firms entering the market.
A Perfectly Competitive Firm Cannot Affect the Market Price
Price taker A buyer or seller that is unable to affect the market price.
If any one wheat farmer has the best crop the farmer has ever had, or if any
one wheat farmer stops growing wheat altogether, the market price of wheat
will not be affected because the market supply curve for wheat will not shift by
enough to change the equilibrium price by even 1 cent.
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The Demand Curve for the Output of a Perfectly Competitive Firm
Figure 12.1
A Perfectly Competitive Firm
Faces a Horizontal Demand Curve
A firm in a perfectly competitive
market is selling exactly the same
product as many other firms.
Therefore, it can sell as much as it
wants at the current market price,
but it cannot sell anything at all if it
raises the price by even 1 cent.
As a result, the demand curve for a
perfectly competitive firm’s output
is a horizontal line.
In the figure, whether a wheat farmer
such as Bill Parker sells 6,000 bushels per year
or 15,000 bushels has no effect on the market price of $4.
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Farmer Parker is a price taker because he is selling wheat in a perfectly
competitive market.
With a horizontal demand curve for his wheat, he must accept the market price.
Don’t Let This Happen to You
Don’t Confuse the Demand Curve for Farmer Parker’s Wheat with the Market Demand
Curve for Wheat
The market demand curve for wheat has the normal downward-sloping shape, but the demand curve for
the output of a single wheat farmer and any firm in a perfectly competitive market is a horizontal line.
MyEconLab Your Turn:
Test your understanding by doing related problem 1.6 at the end of this chapter.
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Figure 12.2 The Market Demand for Wheat versus the Demand for One Farmer’s Wheat
In a perfectly competitive market, price is determined by the intersection of market demand
and market supply.
In panel (a), the demand and supply curves for wheat intersect at a price of $4 per bushel.
An individual wheat farmer like Farmer Parker cannot affect the market price for wheat.
Therefore, as panel (b) shows, the demand curve for Farmer Parker’s wheat is a
horizontal line.
To understand this figure, it is important to notice that the scales on the horizontal axes in
the two panels are very different.
In panel (a), the equilibrium quantity of wheat is 2.25 billion bushels,
and in panel (b), Farmer Parker is producing only 15,000 bushels of wheat.
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How a Firm Maximizes Profit in a Perfectly Competitive
Market
12.2 LEARNING OBJECTIVE
Explain how a firm maximizes profit in a perfectly competitive market.
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Profit Total revenue minus total cost.
Profit  TR  TC
Revenue for a Firm in a Perfectly Competitive Market
Average revenue (AR) Total revenue divided by the quantity of the product sold.
For any level of output, a firm’s average revenue is always equal to the market
price. This equality holds because total revenue equals price times quantity:
(TR = P × Q)
and average revenue equals total revenue divided by quantity:
(AR = TR/Q)
So,
AR = TR/Q = (P × Q)/Q = P
Marginal revenue (MR) The change in total revenue from selling one more
unit of a product.
Marginal
revenue

Change in total revenue
Change in quantity
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, or MR 
 TR
Q
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Table 12.2 Farmer Parker’s Revenue from Wheat Farming
Number of
Bushels
(Q)
0
1
2
3
4
5
6
7
8
9
10
Market Price
(per bushel)
(P)
Total
Revenue
(TR)
$4
4
4
4
4
4
4
4
4
4
4
$0
4
8
12
16
20
24
28
32
36
40
Average
Revenue
(AR)
—
$4
4
4
4
4
4
4
4
4
4
Marginal
Revenue
(MR)
—
$4
4
4
4
4
4
4
4
4
4
For a firm in a perfectly competitive market, price is equal to both average
revenue and marginal revenue.
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Determining the Profit-Maximizing Level of Output
Table 12.3 Farmer Parker’s Profits from Wheat Farming
Quantity
(bushels)
(Q)
Total
Revenue
(TR)
Total
Cost
(TC)
0
1
2
3
4
5
6
7
8
9
10
$0.00
4.00
8.00
12.00
16.00
20.00
24.00
28.00
32.00
36.00
40.00
$2.00
5.00
7.00
8.50
10.50
13.00
16.50
21.50
28.50
38.00
50.50
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Profit
(TR−TC)
−$2.00
−1.00
1.00
3.50
5.50
7.00
7.50
6.50
3.50
−2.00
−10.50
Marginal
Revenue
(MR)
Marginal
Cost
(MC)
—
$4.00
4.00
4.00
4.00
4.00
4.00
4.00
4.00
4.00
4.00
—
$3.00
2.00
1.50
2.00
2.50
3.50
5.00
7.00
9.50
12.50
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Figure 12.3a The Profit-Maximizing Level of Output
Farmer Parker maximizes his
profit where the vertical distance
between total revenue and total
cost is the largest.
This happens at an output of 6
bushels.
This is one way of thinking about
how Farmer Parker can determine
the profit-maximizing quantity of
wheat to produce.
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Figure 12.3b The Profit-Maximizing Level of Output
Notice that Farmer Parker’s
marginal revenue (MR) is equal
to a constant $4 per bushel.
Farmer Parker maximizes profits
by producing wheat up to
the point where the marginal
revenue of the last bushel
produced is equal to its
marginal cost, or MR = MC.
In this case, at no level of output
does marginal revenue exactly
equal marginal cost.
The closest Farmer Parker can
come is to produce 6 bushels
of wheat.
He will not want to continue to
produce once marginal cost is
greater than marginal revenue
because that would reduce his profits.
This is another way of thinking about how
Farmer Parker can determine the profit-maximizing quantity of wheat to produce.
The marginal revenue curve for a perfectly competitive firm is the same as its demand curve.
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From the information in Table 12.3 and Figure 12.3, we can draw the following
conclusions:
1. The profit-maximizing level of output is where the difference between total
revenue and total cost is the greatest.
2. The profit-maximizing level of output is also where marginal revenue equals
marginal cost, or MR = MC.
Both of these conclusions are true for any firm, whether or not it is in a perfectly
competitive industry.
We can draw one other conclusion about profit maximization that is true only of
firms in perfectly competitive industries:
For a firm in a perfectly competitive industry, price is equal to marginal revenue,
or P = MR.
So, we can restate the MR = MC condition as P = MC.
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Illustrating Profit or Loss on the Cost Curve Graph
12.3 LEARNING OBJECTIVE
Use graphs to show a firm’s profit or loss.
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We can express profit in terms of average total cost (ATC). Because profit is
equal to total revenue minus total cost (TC) and total revenue is price times
quantity, we can write the following:
Profit  ( P  Q )  TC
If we divide both sides of this equation by Q, we have
Profit

Q
(P  Q)

TC
Q
Q
or
Profit
 P  ATC
Q
because TC/Q equals ATC.
This equation tells us that profit per unit (or average profit) equals price minus
average total cost. Finally, we obtain the equation for the relationship between
total profit and average total cost by multiplying again by Q:
Profit  ( P  ATC )  Q
This equation tells us that a firm’s total profit is equal to the quantity produced
multiplied by the difference between price and average total cost.
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Showing a Profit on the Graph
Figure 12.4
The Area of Maximum Profit
A firm maximizes profit at
the level of output at which
marginal revenue equals
marginal cost.
The difference between
price and average total
cost equals profit per unit
of output.
Total profit equals profit per
unit multiplied by the
number of units produced.
Total profit is represented by
the area of the greenshaded rectangle, which has
a height equal to (P − ATC)
and a width equal to Q.
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Solved Problem 12.3
Determining Profit-Maximizing Price and Quantity
Suppose that Andy sells basketballs in the perfectly competitive basketball market.
The table shows his output per day and his costs:
a. Suppose the current equilibrium price in the basketball market
is $12.50.
To maximize profit, how many basketballs will Andy produce?
What price will he charge?
And how much profit (or loss) will he make?
Draw a graph to illustrate your answer.
Label clearly Andy’s demand, ATC, AVC, MC, and MR curves;
the price he is charging;
the quantity he is producing;
and the area representing his profit (or loss).
b. Suppose the equilibrium price of basketballs falls to $6.00.
Now how many basketballs will Andy produce?
What price will he charge?
And how much profit (or loss) will he make?
Draw a graph to illustrate this situation,
using the instructions in part (a).
Output
per Day
Total
Cost
0
$10.00
1
20.50
2
24.50
3
28.50
4
34.00
5
43.00
6
55.50
7
72.00
8
93.00
9
119.00
Solving the Problem
Step 1: Review the chapter material.
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Solved Problem 12.3
Determining Profit-Maximizing Price and Quantity
Step 2: Calculate Andy’s marginal cost, average total cost, and average variable cost.
Andy will produce the level of output where marginal revenue is equal to marginal cost.
We can calculate costs from the information given in the table to draw the required graph.
Average total cost (ATC) equals total cost (TC) divided by the level of output (Q).
Average variable cost (AVC) equals variable cost (VC) divided by output (Q).
To calculate variable cost, recall that total cost equals variable cost plus fixed cost.
When output equals zero, total cost equals fixed cost. In this case, fixed cost equals $10.00.
Output
per Day
(Q)
Total
Cost
(TC)
Fixed
Cost
(FC)
Variable
Cost
(VC)
Average
Total Cost
(ATC)
Average
Variable
Cost (AVC)
Marginal
Cost
(MC)
0
$10.00
$10.00
$0.00
—
—
—
1
20.50
10.00
10.50
$20.50
$10.50
$10.50
2
24.50
10.00
14.50
12.25
7.25
4.00
3
28.00
10.00
18.00
9.33
6.00
3.50
4
34.00
10.00
24.00
8.50
6.00
6.00
5
43.00
10.00
33.00
8.60
6.60
9.00
6
55.50
10.00
45.50
9.25
7.58
12.50
7
72.00
10.00
62.00
10.29
8.86
16.50
8
93.00
10.00
83.00
11.63
10.38
21.00
9
119.00
10.00
109.00
13.22
12.11
26.00
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Solved Problem 12.3
Determining Profit-Maximizing Price and Quantity
Step 3: Use the information from the table in Step 2 to calculate how many basketballs
Andy will produce, what price he will charge, and how much profit he will earn if the
market price of basketballs is $12.50.
Andy’s marginal revenue is equal to the market price of $12.50.
Marginal revenue equals marginal cost when Andy produces 6 basketballs per day.
So, Andy will produce 6 basketballs per day and charge a price of $12.50 per basketball.
Andy’s profits are equal to his total revenue minus his total costs.
His total revenue equals the 6 basketballs he sells multiplied by the $12.50 price, or $75.00.
So, his profit equals: $75.00 − $55.50 = $19.50.
Step 4: Use the information from the table in Step 2 to illustrate your answer to part (a)
with a graph.
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Solved Problem 12.3
Determining Profit-Maximizing Price and Quantity
Step 5: Calculate how many basketballs Andy will produce, what price he will charge,
and how much profit he will earn when the market price of basketballs is $6.00.
Referring to the table in Step 2, we can see that marginal revenue equals marginal cost
when Andy produces 4 basketballs per day.
He charges the market price of $6.00 per basketball.
His total revenue is only $24.00, while his total costs are $34.00,
so he will have a loss of $10.00.
Step 6: Illustrate your answer to part (b) with a graph.
MyEconLab Your Turn:
For more practice, do related problems 3.3 and 3.4 at the end of this chapter.
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Don’t Let This Happen to You
Remember That Firms Maximize Their Total Profit, Not Their Profit per Unit
Only when the firm has expanded production to Q2 will it have produced every unit for
which marginal revenue is greater than marginal cost.
At that point, it will have maximized profit.
MyEconLab Your Turn:
Test your understanding by doing related problem 3.5 at the end of this chapter.
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Illustrating When a Firm Is Breaking Even or Operating at a Loss
Whether a firm actually makes a profit at the level of output where marginal
revenue equals marginal cost depends on the relationship of price to average
total cost.
There are three possibilities:
1. P > ATC, which means the firm makes a profit
2. P = ATC, which means the firm breaks even (its total cost equals its total
revenue)
3. P < ATC, which means the firm experiences a loss
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Figure 12.5 A Firm Breaking Even and a Firm Experiencing Losses
In panel (a), price equals average total
cost, and the firm breaks even because
its total revenue will be equal to its total
cost.
In this situation, the firm makes zero
economic profit.
In panel (b), price is below average total
cost, and the firm experiences a loss.
The loss is represented by the area of
the red-shaded rectangle, which has a
height equal to (ATC − P) and a width
equal to Q.
Maximizing profit in some cases amounts to minimizing loss.
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Making
the
Losing Money in the Medical Screening Industry
Connection
The owner of California HeartScan would have broken even if the market price
had been $495 per heart scan, but he suffered losses because the actual market
price was only $250.
MyEconLab Your Turn:
Test your understanding by doing related problem 3.7 at the end of this chapter.
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Deciding Whether to Produce or to Shut Down in the
Short Run
12.4 LEARNING OBJECTIVE
Explain why firms may shut down temporarily.
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In the short run, a firm experiencing a loss has two choices:
1. Continue to produce
2. Stop production by shutting down temporarily
Sunk cost A cost that has already been paid and cannot be recovered.
If a farmer has taken out a loan to buy land, the farmer is legally required to
make the monthly loan payment whether he or she grows any wheat that
season or not.
The farmer has to spend those funds and cannot get them back, so the farmer
should treat his or her sunk costs as irrelevant to his or her decision making.
For any firm, whether total revenue is greater or less than variable costs is the
key to deciding whether to shut down.
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Solved Problem 12.4
When to Pull the Plug on a Movie
When Walt Disney released the film Mars Needs Moms directed by Robert Zemeckis in
March 2011, it did very poorly at the box office, earning less than a quarter of its cost to
make. A year before its release, Disney executives were disappointed in its direction and
immediately stopped production on the director’s next film.
They did not, however, stop production on Mars Needs Moms, on which the company had
already spent $100 million with $75 million more needed to reach completion.
In March 2010, at the time the executives became concerned about the quality of the film,
how should Disney have decided whether to finish Mars Needs Moms and release it?
What role should the $100 million Disney executives had already spent on the film have
played in their decision?
Solving the Problem
Step 1: Review the chapter material.
Step 2: Use your knowledge of the role of sunk costs in decisions about whether to
shut down to answer the question.
The $100 million was a sunk cost, irrelevant to Disney’s decision: Whether Disney shut
down the film or finished it and released it to theaters, the company would not be able to
get that $100 million back. Disney should have completed the film if marginal revenue was
expected to be greater than marginal cost, and it should have shut down the film if
marginal cost were expected to be greater than marginal revenue.
MyEconLab Your Turn:
Test your understanding by doing related problems 4.8 and 4.9 at the end of this chapter.
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The Supply Curve of a Firm in the Short Run
A perfectly competitive firm’s marginal cost curve also is its supply curve.
If a firm is experiencing a loss, it will shut down if its total revenue is less than
its variable cost:
Total
revenue
 Variable
cost
or, in symbols:
( P  Q )  VC
If we divide both sides by Q, we have the result that the firm will shut down if:
P  AVC
The firm’s marginal cost curve is its supply curve only for prices at or above
average variable cost.
Shutdown point The minimum point on a firm’s average variable cost curve; if
the price falls below this point, the firm shuts down production in the short run.
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Figure 12.6 The Firm’s Short-Run Supply Curve
The firm will produce at the level
of output at which MR = MC.
Because price equals marginal
revenue for a firm in a perfectly
competitive market, the firm will
produce where P = MC.
For any given price, we can
determine the quantity of output
the firm will supply from the
marginal cost curve.
In other words, the marginal cost
curve is the firm’s supply curve.
The firm will shut down if the price
falls below average variable cost.
The marginal cost curve crosses the average variable cost at the firm’s shutdown point.
This point occurs at output level QSD.
For prices below PMIN, the supply curve is a vertical line along the price axis, which shows
that the firm will supply zero output at those prices.
The red line in the figure is the firm’s short-run supply curve.
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The Market Supply Curve in a Perfectly Competitive Industry
Figure 12.7 Firm Supply and Market Supply
We can derive the market supply curve by adding up the quantity that each firm in the
market is willing to supply at each price.
In panel (a), one wheat farmer is willing to supply 15,000 bushels of wheat at a price of $4
per bushel.
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The Market Supply Curve in a Perfectly Competitive Industry
Figure 12.7 Firm Supply and Market Supply (Continued)
If every wheat farmer supplies the same amount of wheat at this price and if there are
150,000 wheat farmers, the total amount of wheat supplied at a price of $4 will equal
15,000 bushels per farmer × 150,000 farmers = 2.25 billion bushels of wheat.
This is one point on the market supply curve for wheat shown in panel (b).
We can find the other points on the market supply curve by determining how much wheat
each farmer is willing to supply at each price.
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“If Everyone Can Do It, You Can’t Make Money at It”: The
Entry and Exit of Firms in the Long Run
12.5 LEARNING OBJECTIVE
Explain how entry and exit ensure that perfectly competitive firms earn zero
economic profit in the long run.
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Economic Profit and the Entry or Exit Decision
Table 12. 4 Farmer Gillette’s Costs per Year
Explicit Costs
Water
Wages
Fertilizer
Electricity
Payment on bank loan
$10,000
$15,000
$10,000
$5,000
$45,000
Implicit Costs
Forgone salary
Opportunity cost of the $100,000 she has invested in her farm
Total cost
$30,000
$10,000
$125,000
Economic profit A firm’s revenues minus all its costs, implicit and explicit.
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Economic Profit Leads to Entry of New Firms
Figure 12.8 The Effect of Entry on Economic Profits
We assume that Farmer Gillette’s costs are the same as the costs of other carrot farmers.
Initially, she and other farmers selling carrots in farmers’ markets are able to charge $15 per
box and earn an economic profit.
Farmer Gillette’s economic profit is represented by the area of the green box.
Panel (a) shows that as other farmers begin to sell carrots in farmers’ markets, the market
supply curve shifts to the right, from S1 to S2, and the market price drops to $10 per box.
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Economic Profit Leads to Entry of New Firms
Figure 12.8 The Effect of Entry on Economic Profits (Continued)
Panel (b) shows that the falling price causes Farmer Gillette’s demand curve to shift down
from D1 to D2, and she reduces her output from 10,000 boxes to 8,000.
At the new market price of $10 per box, carrot growers are just breaking even:
Their total revenue is equal to their total cost, and their economic profit is zero.
Notice the difference in scale between the graph in panel (a) and the graph in panel (b).
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Economic Losses Lead to Exit of Firms
Figure 12.9a-b The Effect of Exit on Economic Losses
When the price of carrots is $10 per box, Farmer Gillette and other farmers are breaking even.
A total quantity of 310,000 boxes is sold in the market. Farmer Gillette sells 8,000 boxes.
Panel (a) shows a decline in the demand for carrots sold in farmers’ markets from D1 to D2 that reduces
the market price to $7 per box.
Panel (b) shows that the falling price causes Farmer Gillette’s demand curve to shift down from D1 to D2
and her output to fall from 8,000 to 5,000 boxes.
At a market price of $7 per box, farmers have economic losses, represented by the area of the red box.
As a result, some farmers will exit the market, which shifts the market supply curve to the left.
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Figure 12.9c-d The Effect of Exit on Economic Losses
Panel (c) shows that exit continues until the supply curve has shifted from S1 to S2 and the market price
has risen from $7 back to $10.
Panel (d) shows that with the price back at $10, Farmer Gillette will break even.
In the new market equilibrium in panel (c), total sales of carrots in farmers’ markets have fallen from
310,000 to 270,000 boxes.
Economic loss The situation in which a firm’s total revenue is less than its
total cost, including all implicit costs.
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Long-Run Equilibrium in a Perfectly Competitive Market
Long-run competitive equilibrium The situation in which the entry and exit of
firms has resulted in the typical firm breaking even.
The long-run average cost curve shows the lowest cost at which a firm is able
to produce a given quantity of output in the long run.
So, we would expect that in the long run, competition drives the market price to
the minimum point on the typical firm’s long-run average cost curve.
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FIGURE 12.10 The Long-Run Supply Curve in a Perfectly Competitive Industry
Panel (a) shows that an increase in demand for carrots sold in farmers’ markets will lead to a temporary
increase in price from $10 to $15 per box, as the market demand curve shifts to the right, from D1 to D2.
The entry of new firms shifts the market supply curve to the right, from S1 to S2, which will cause the price
to fall back to its long-run level of $10.
Panel (b) shows that a decrease in demand will lead to a temporary decrease in price from $10 to $7 per
box, as the market demand curve shifts to the left, from D1 to D2.
The exit of firms shifts the market supply curve to the left, from S1 to S2, which causes the price to rise
back to its long-run level of $10. The long-run supply curve (SLR) shows the relationship between market
price and the quantity supplied in the long run. In this case, the long-run supply curve is a horizontal line.
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Long-run supply curve A curve that shows the relationship in the long run
between market price and the quantity supplied.
In the long run, a perfectly competitive market will supply whatever amount
of a good consumers demand at a price determined by the minimum point on
the typical firm’s average total cost curve.
Increasing-Cost and Decreasing-Cost Industries
Industries with horizontal long-run supply curves are called constant-cost
industries.
Industries with upward-sloping long-run supply curves are called increasingcost industries.
Industries with downward-sloping long-run supply curves are called decreasingcost industries.
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Making
the
In the Apple iPhone Apps Store, Easy Entry Makes
the Long Run Pretty Short
Connection
When firms earn economic profits
in a market, other firms have a strong economic
incentive to enter that market.
This is exactly what happened with iPhone apps,
first provided for Apple in mid-2008. Proving to be
highly profitable in an instant, more than 25,000
apps were available in the iTunes store within
a year.
The cost of entering this market was very small.
Anyone with the programming skills and the time
to write an app could have it posted in the store.
As a result of this enhanced competition,
the ability to get rich quick with a killer app was
quickly fading.
Economic profits are
rapidly competed away
in the iPhone apps store.
In a competitive market, earning an economic profit in
the long run is extremely difficult, as those so easily entering the market for
iPhone apps soon learned.
MyEconLab Your Turn:
Test your understanding by doing related problem 5.9 at the end of this chapter.
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Perfect Competition and Efficiency
12.6 LEARNING OBJECTIVE
Explain how perfect competition leads to economic efficiency.
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Productive Efficiency
The forces of competition will drive the market price to the minimum average
cost of the typical firm.
Productive efficiency The situation in which a good or service is produced at
the lowest possible cost.
As we have seen, perfect competition results in productive efficiency.
Managers of firms strive to earn an economic profit by reducing costs, but in a
perfectly competitive market, other firms quickly copy ways of reducing costs.
Therefore, in the long run, only the consumer benefits from cost reductions.
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Solved Problem 12.6
How Productive Efficiency Benefits Consumers
Writing in the New York Times on the technology boom of the late 1990s, Michael Lewis
argued, “The sad truth, for investors, seems to be that most of the benefits of new
technologies are passed right through to consumers free of charge.”
a. What do you think Lewis means by the benefits of new technology being “passed right
through to consumers free of charge”?
Use a graph like Figure 12.8 to illustrate your answer.
Solving the Problem
Step 1: Review the chapter material.
Step 2: Use the concepts from this chapter to explain what Lewis means.
By “new technologies,” Lewis means new products—such as smart phones or LED
television sets—or lower-cost ways of producing existing products.
In either case, new technologies will allow firms to earn economic profits for a while, but
these profits will lead new firms to enter the market in the long run.
Step 3: Use a graph like Figure 12.8 to illustrate why the benefits of new
technologies are “passed right through to consumers free of charge.”
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Solved Problem 12.6
How Productive Efficiency Benefits Consumers
Writing in the New York Times on the technology boom of the late 1990s, Michael Lewis
argued, “The sad truth, for investors, seems to be that most of the benefits of new
technologies are passed right through to consumers free of charge.”
LED televisions are being produced at the lowest possible cost, and productive efficiency
is achieved.
Consumers receive the new technology “free of charge” in the sense that they only have
to pay a price equal to the lowest possible cost of production.
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Solved Problem 12.6
How Productive Efficiency Benefits Consumers
Writing in the New York Times on the technology boom of the late 1990s, Michael Lewis
argued, “The sad truth, for investors, seems to be that most of the benefits of new
technologies are passed right through to consumers free of charge.”
b. Explain why this result is a “sad truth” for investors.
Step 4: Answer part (b) by explaining why the result in part (a) is a “sad truth” for
investors.
In the long run, firms only break even on their investment in producing high-technology
goods, implying that investors in these firms are also unlikely to earn an economic profit in
the long run.
The entry of new firms competes away economic profit in the long run, but it benefits
consumers by forcing prices down to the level of average cost.
MyEconLab Your Turn:
For more practice, do related problems 6.5, 6.6, and 6.7 at the end of this chapter.
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Allocative Efficiency
We know firms will supply all those goods that provide consumers with a
marginal benefit at least as great as the marginal cost of producing them
because:
1. The price of a good represents the marginal benefit consumers receive from
consuming the last unit of the good sold.
2. Perfectly competitive firms produce up to the point where the price of the
good equals the marginal cost of producing the last unit.
3. Therefore, firms produce up to the point where the last unit provides a
marginal benefit to consumers equal to the marginal cost of producing it.
Allocative efficiency A state of the economy in which production represents
consumer preferences; in particular, every good or service is produced up to
the point where the last unit provides a marginal benefit to consumers equal to
the marginal cost of producing it.
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Economics in Your Life
Are You an Entrepreneur?
At the beginning of the chapter, we asked you to think about why you can
charge only a relatively low price for performing services such as babysitting or
lawn mowing.
We saw that firms selling products in competitive markets can’t charge prices
higher than those being charged by competing firms, and the markets for
babysitting and lawn mowing are very competitive. In most neighborhoods,
there are many teenagers willing to supply these services.
The price you can charge for babysitting may not be worth your while at age 20
but is enough to cover the opportunity cost of a 14-year-old eager to enter the
market.
So, in your career as a teenage entrepreneur, you may have become familiar
with one of the lessons of this chapter: A firm in a competitive market has no
control over price.
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AN
INSIDE
Organic Farming on the Decline in the United Kingdom
LOOK
Figure 1
Figure 2
The market for organically grown corn.
An individual farmer suffering an
economic loss in the organic corn market.
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