Chapter 7

©2010 Worth Publishers

Perfect Competition

1. A perfectly competitive market and its characteristics

2. A Price-taking producer and its profit-maximizing quantity of output

3. How to assess profitability

Chapter Objectives

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.

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

6

Quick Review

Total Revenue = Price * Quantity

Profit = Total Revenue – Total Cost

Using Marginal Analysis to Choose the Profit-Maximizing 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 = MCProfit maximization is also loss

minimization

Short-Run Costs for Jennifer and Jason’s Farm

Marginal Analysis Leads to Profit-Maximizing 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

The profit-maximizing 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).76543210

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Price, cost of bushel

Quantity of tomatoes (bushels)

MC

MR = PE

Profit-maximizing quantity

Optimal point

Market price

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

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MC

ATC

MR = PC

Break even price

Minimum-cost output

Price, cost of bushel

Quantity of tomatoes (bushels)

Minimum average total cost

At point C (the minimum average total cost), the market price is $14 and output is 4 bushels of tomatoes (the minimum-cost output).

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

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

The vertical distance between E and Z:farm’s per unit profit, $18.00 − $14.40 = $3.60Total profit:5 × $3.60 = $18.00

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MC

Profit ATCMR= P

C Z

E

Market Price = $18

1414.40

$18

Price, cost of bushel

Quantity of tomatoes (bushels)

Minimum average total cost

Break even price

Profitability and the Market Price

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

The vertical distance between A and Y:farm’s per unit loss, $14.67 − $10.00 = $4.67Total profit:3 × $4.67 = approx. $14.00

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Loss

ATC

MR = PC

A

Y

Market Price = $10

14

10

$14.67

Price, cost of bushel

Quantity of tomatoes (bushels)

Minimum average total cost

Break even price

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 ProfitWhenever 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

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.

Economic Profit, Again

Profit – another way

Profit = TR – TC TR = P*Q TC = ATC*Q

Profit = (TR/Q – TC/Q)*QOr

Profit = (P – ATC)*Q

The Short-Run Individual Supply Curve

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.

A firm will cease production in the short run if the market price falls below the shut-down price, which is equal to minimum average variable cost.

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MC

ATC

AVCC

B

A

E

Minimum average variable cost

Short-run individual supply curve

Shut-down price

Price, cost of bushel

Quantity of tomatoes (bushels)

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 non-recoverable. 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