Chapter 9 Perfect Competition In the award-winning 2004 movie Sideways, the main character raved about pinot noir wine. This review increased the demand for pinot noir wine grown in the Willamette Valley in Oregon. O'Sullivan | Sheffrin Perez Prepared By Brock WilliamsLearning Objectives 1. Distinguish between four market structures 2. Explain the short-run output rule and the break- even price 3. Explain the shut-down rule 4. Explain why the short-run supply curve is positively sloped 5. Explain why the long-run industry supply curve may be positively sloped 6. Describe the short-run and long-run effects of changes in demand for an increasing-cost industry 7. Describe the short-run and long-run effects of changes in demand for a constant-cost industryPerfect Competition * perfectly competitive market Me A market with many sellers and buyers of a homogeneous product and no barriers to entry. * price taker > f A buyer or seller that takes the market price as given.Perfect Competition “ Cu _ Moa .— Oliga ol —Monop. “P cont. 9 p J Here are the five features of a perfectly competitive market: There are many sellers. There are many buyers. * ~ The product is homogeneous. There are no barriers to market entry. uerwn a Both buyers and sellers are price takers.9.1 PREVIEW OF THE FOUR MARKET STRUCTURES = + firm-specific demand curve xe A curve showing the relationship between the price charged by a specific firm and the quantity the firm can sell.9.1 PREVIEW OF THE FOUR MARKET STRUCTURES (cont.) @ FIGURE 9.1 Monopoly versus Perfect Competition In Panel A, the demand curve facing a monopolist is the market demand curve. In Panel B, a perfectly competitive firm takes the market price as given, so the firm-specific demand curve is horizontal. The firm can sell all it wants at the market price, but would sell nothing if it charged a higher price. Monopolist’s demand z 5 g 2p----- 3 Demand facing perfectly 2 & : 3 ie competitive firm 30 2 Z z = 0 70 Number of subscribers (1,000) Quantity of T-shirts: (A) Firm-Specific Demand (B) Firm-Specifie Demand Curve (Curve of Monopolist of Perfectly Competitive Firm9.1 PREVIEW OF THE FOUR MARKET STRUCTURES (cont.) @ TABLE 9.1 Characteristics of the Four Market Structures . Characteristic Number offers Type of product Fim-spectic demand curve Entry conditions Examples Menopolistic Competition | Oligopoly Many Diteentated Demand is elastic but not Perfect elastic No barrios Toothbrushes, music stores, groceries Few Homogeneous or sierentiaton Demand isiess elastic than ‘demand facng monopoisticlly ccompettive fm Lage barriers rom economies Cf scale ar government policies ‘A travel, automobiles, beverages, cgaretes, mobile Phone service Monopoly One Unique Firm faces market demand curve Large barriers from economies of scale or government paises Local phone service, patented rugs= APPLICATION €C 1 WIRELESS WOMEN IN PAKISTAN APPLYING THE CONCEPTS #1: How do entry costs affect the number of firms in a market? In Pakistan, phone service is now provided by thousands of “wireless. women,” entrepreneurs who invest $310 in wireless phone equipment (transceiver, battery, charger), a signboard, a calculator, and a stopwatch. * They sell phone service to their neighbors, charging by the minute and second. * Onaverage, their net income is about $2 per day, about three times the average per capita income in Pakistan. The market for phone service has the features of a perfectly competitive market, with easy entry, a standardized good, and a large enough number of suppliers that each takes the market price as given. In contrast, to enter the phone business in the United States, your initial investment would be millions, or perhaps billions, of dollars, so the market for phone service is not perfectly competitive.9.2 THE FIRM’S SHORT-RUN OUTPUT DECISION The Total Approach: Computing Total Revenue and Total Cost @ TABLE 9.2 Deciding How Much to Produce When the Price Is $12 1 2 3 4 5 6 7 8 Output: Fixed Variable —Total Total —Profit= Marginal Marginal Shirts per Cost(FC) Cost Cost(TC) | Revenue TR-TC Revenue= Cost Minute (Q) (vc) (TR) Price (mc) 0 $17 $0 $17 $0 $17 1 7 5 22 12 =10 $12 $5 2 7 6 23 24 1 12 1 3 17 9 26 36 10 12 3 4 7 13 30 48 18 12 4 5 kf 18 35 60 25 12 5 6 7 25 42 72 30 12 7 7 iy) M4 51 84 33 12 9 8 17 48 63 96 33 12 12 9 7 62 79 108. 29 12 16 10 7 83 100 120 20 12 29.2 THE FIRM’S SHORT-RUN OUTPUT DECISION (cont.) The Total Approach: Computing Total Revenue and Total Cost ‘Total revenue (FR) » FIGURE 9.2 Using the Total Approach ‘Total cost (TC) to Choose an Output Level Bae Economic profitis shown by the vertical distance between the totalrevenue curve and the total-cost curve. To maximize profit, the firm chooses the quantity of ‘output that generates the largest vertical difference between the two curves. ” Total revenue oF total cost si Shirts per minute9.2 THE FIRM’S SHORT-RUN OUTPUT DECISION (cont.) The Marginal Approach MARGINAL PRINCIPLE Increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost. * marginal revenue The change in total revenue from selling one more unit of output. marginal revenue = price To maximize profit, produce the quantity where price = marginal cost9.2 THE FIRM’S SHORT-RUN OUTPUT DECISION (cont.) The Marginal Approach @ FIGURE 9.3 The Marginal Approach to Picking an Output Level A perfectly competitive firm Kk takes the market price as given, so the marginal benefit, 7 ‘or marginal revenue, equals the price. Marginal cost (MC) Using the marginal principle, Pesreliek revere Prk? the typical firm will maximize profit at point a, where the $12 market price equals the marginal cost. Average total cost (ATC) 2875 Average variable cost (AVC) Revenue or cost Economic profit equals the difference between the price and the average cost ($4.125 = $12 - $7.875) times the quantity produced (eight shirts per minute), or $33 per ' ' ' 0 6 a) Shists per minute minute.9.2 THE FIRM’S SHORT-RUN OUTPUT DECISION (cont.) Economic Profit and the Break-Even Price = economic profit = (price - average cost) x quantity produced * break-even price The price at which economic profit is zero; price equals average total cost.APPLICATION € J THE BREAK-EVEN PRICE FOR SWITCHGRASS, A FEEDSTOCK FOR BIOFUEL APPLYING THE CONCEPTS #2: Whatis the break-even price? To illustrate the notions of break-even price, let's look at these prices for the typical farmer. Comparing switchgrass to alfalfa: + The implicit rent on land to grow alfalfa $120 per acre. If the switchgrass yieldis 3 tons per acre, the opportunity cost is $40 per ton. If the explicit cost of a ton of switchgrass is $36 The breakeven price is $76 = $36 + $40 + To get some farmers to grow switchgrass instead of alfalfa the price must be at least $56 per ton and to get the most fertile land switched the price must be $95 per ton, or $76 on average.9.3 THE FIRM’S SHUT-DOWN DECISION @ TABLE 9.3 Deciding How Much to Produce When the Price Is $4 1 2 3 4 5 6 7 a Qutput: Fixed Variable TotalGost._ Total = Profit= Marginal. ~—- Marginal Shirts per Gost (FC) Gost(¥c) (TC) Revenue TR-TC Revenue= Cost Minute (2) (TR) Price (mc) ° si7 $0 $17 $0 -si7 1 7 5 22 4 -18 $4 $5 2 17 6 23. 8 15 4 4 3 7 a 26 12 -14 4 3 4 7 13 30 16 14 4 4 5 7 18 35 20 -15 4 5 6 7 25 42, 24 =18 4 i, Total Revenue, Variable Cost, and the Shut-Down Decision operate if total revenue > variable cost shut down if total revenue < variable cost9.3 THE FIRM’S SHUT-DOWN DECISION (cont.) Total Revenue, Variable Cost, and the Shut-Down Decision » FIGURE 9.4 The Shut-Down Decision and the Shut-Down Price Average total cost (ATC) Marginal cost (MC) $7.50) When the price is $4, marginal revenue equals marginal cost at four shirts (point a). Loss = $14 when price = $4 Average variable cost (AVC) Atthis quantity, average cost is $7.50, so the firm loses $3.50 on each shirt, for a total loss Marginal of $14. = revenue = Price Price per shirt Total revenue is $16 and the variable costis ‘only $13, so the firm is better off operating at a loss rather than shutting down and losing its fixed cost of $17. t i 1 ' t 6 The shutdown price, shown by the minimum, Ces ts : point of the AVC curve, is $3.00. juantity of shits per minute9.3 THE FIRM’S SHUT-DOWN DECISION (cont.) The Shut-Down Price = operate if price > average variable cost shut down if price < average variable cost + shut-down price The price at which the firm is indifferent between operating and shutting down; equal to the minimum average variable cost.9.3 THE FIRM’S SHUT-DOWN DECISION (cont.) Fixed Costs and Sunk Costs * sunk cost A cost that a firm has already paid or committed to pay, so it cannot be recovered.APPLICATION C 4 STRADDLING THE ZINK COST CURVE APPLYING THE CONCEPTS #3: What is the shutdown price? = * Zinc is a vital input to the production of steel. Because the cost of mining zinc varies from one mine to another, the shutdown price varies too. The world price of zinc decreased from roughly $2,300 per ton in 2010-2011 to $1,900 in early 2012. The lower price was below the shutdown prices of Alcoa's mines in Italy and Spain: at a price of $1,900, the total revenue from the mines was less than the variable cost of operating the mines. The shutdown of Alcoa's mines decreased mining output by 531,000 tons. Although mines with lower production costs continued mining at a price of $1,900, many mines have shutdown prices in the range $1,500 to $1,900, and will shut down if the price continues to drop.9.4 SHORT-RUN SUPPLY CURVES “~The Firm’s Short-Run Supply Curve +» short-run supply curve Acurve showing the relationship between the market price of a product and the quantity of output supplied by a firm in the short run.9.4 SHORT-RUN SUPPLY CURVES (cont.) The Firm's Short-Run Supply Curve @ FIGURE 9.5 Short-Run Supply Curves In Panel A, the firm's short-run supply curve is the part of the margina-cost curve above the shut-down price. In Panel B, thereare eM sscrase 100 firms in the market, so the market supply ata given price is 100 times the quantity supplied by the typical firm. At a price of $7, each firm supplies 6 shirts per 2 minute (point b), so the market supply is 600 shirts per minute (point Price per shirt Price per shirt 0 3 68 10 0 300600 800 _1,000 Shirts per minute Shins per minute (4) Firm’s Supply Curve (B) Industry Supply Curve9.4 SHORT-RUN SUPPLY CURVES (cont.) The Short-Run Market Supply Curve * short-run market supply curve Acurve showing the relationship between market price and the quantity supplied in the short run.Price per shirt 9.4 SHORT-RUN SUPPLY CURVES (cont.) Market Equilibrium @ FIGURE 9.6 Market Equilibrium In Panel A, the market demand curve intersects the short-run market supply curve at a price of $7. In Panel B, given the market price of $7, the typical firm satisfies the marginal principle at point b, producing six shirts per minute. The $7 price equals the average cost at the equilibrium quantity, so economic profits zero, and no other firms will enter the market. Short-run market supply MC ATC sif------- Marginal revenue = Price Cast or revenue Market demand 0 600 0 6 Shirts per minute Shirts per minute (A) Market (B) Individual= APPLICATION ( 4 THE SHORT RUN SUPPLY CURVE FOR CARGO APPLYING THE CONCEPTS #4: Why is theshort-run supply curve positively sloped? Consider the supply of shipping services. The law of supply suggests that as the price of shipping increases, the quantity of shipping services will increase. The figure below shows the supply curve for shipping services. At a relatively low freight rate of $2 per ton, only the most efficient ships operate, and they economize on fuel by traveling at a slow speed. As a resut, the annual quantity of shipping services is relatively low (70 units per year). At an intermediate freight price of $3 per ton, more ships are engaged: less efficient ships join the fleet. In addition, all the ships travel at a greater speed, using more fuel in the process. The combination of more ships and faster travel increases the quantity of shipping services provided (85 units per year). At ahigh freight rate of $7 per ton, all the ships operate and run at full speed, and the quantity of shipping services is 96 units per year.= 9.5 THE FOR AN LONG-RUN SUPPLY CURVE INCREASING-COST INDUSTRY long-run market supply curve Accurve showing the relationship between the market price and quantity supplied in the long run. increasing-cost industry An industry in which the average cost of production increases as the total output of the industry increases; the long-run supply curve is Positively sloped.= 9.5 THE LONG-RUN SUPPLY CURVE FOR AN INCREASING-COST INDUSTRY (cont.) The average cost of production increases as the total output increases, for two reasons: + Increasing input price. As an industry grows, it competes with other industries for limited amounts of various inputs, and this competition drives up the prices of these inputs. + Less productive inputs. A small industry will use only the most productive inputs, but as the industry grows, firms may be forced to use less productive inputs.9.5 THE LONG-RUN SUPPLY CURVE FOR AN INCREASING-COST INDUSTRY (cont.) ~ Production Cost and Industry Size @ TABLE 9.4 Industry Output and Average Production Cost Total Cost for Average Cost Number of Firms Industry Output Shirts per Firm Typical Firm per Shirt 4100 600 6 $42 $7 200 1,200 6 60 10 300 1,800 6 78 139.5 THE LONG-RUN SUPPLY CURVE FOR AN INCREASING-COST INDUSTRY (cont.) = Drawing the Long-Run Market Supply Curve @ FIGURE 9.7 Long-Run Market Supply Curve Long-run supply curve The long-run market supply curve shows the relationship between the price and quantity supplied in the long run, when firms can enter or leave the industry. Price per shirt At each pointon the supply curve, the market price equals the long-run average cost of production. Because this is an increasing-cost industry, the long-run market supply curve is positively sloped. Shirts per minute9.5 THE LONG-RUN SUPPLY CURVE FOR AN INCREASING-COST INDUSTRY (cont.) Examples of Increasing-Cost Industries: Sugar and Apartments + The sugar industry is an example of an increasing-cost industry. As the price increases, sugar production becomes profitable in areas where production costs are higher, and as these areas enter the world market, the quantity of sugar supplied increases. The market for apartments is another example of an increasing-cost industry with a positively sloped supply curve. Most communities use zoning laws to restrict the amount of land available for apartments. As the industry expands by building more apartments, firms compete fiercely for the small amount of land zoned for apartments. Housing firms bid up the price of land, increasing the cost of producing apartments. Producers can cover these higher production costs only by charging higher rents to tenants. In other words, the supply curve for apartments is positively sloped because land prices increase with the total output of the industry, pulling up average cost and necessitating a higher price for firms to make zero economic profit.APPLICATION € J CHINESE COFFEE GROWERS OBEY THE LAW OF SUPPLY APPLYING THE CONCEPTS #5: How do producers respond to an increase in price? Purer is a city in southern China that is famous for its tea, but is now getting a reputation for its coffee. Between 2009 and 2012, the world price of coffee beans nearly doubled. Farmers in Puer responded to the higher price by doubling the acreage of coffee, and cleared forested hillsides to grow more beans. Atthe relatively high world price, a hectare of coffee earns a family about $10,000 per year, which is three times the earnings from growing tea and five times the earnings from growing rice. The farmers’ response illustrates the law of supply: an increase in price increases the quantity supplied.9.6 SHORT-RUN AND LONG-RUN EFFECTS OF CHANGES IN DEMAND The Short-Run Response to an Increase in Demand @ FIGURE 9.8 Short-Run Effects of an Increase in Demand An increase in demand for shirts increases the market price to $12, causing the typical firm to Produce eight shirts instead of six. Price exceeds the average total cost at the eight-shirt quantity, so economic profit is positive. Firms will enter the profitable market. i Shoccm mare smply 8 é sx ‘I E | ices Now don 1 EN ta dean v oo 9 Shits pr mint Shs per ite (A) Market (B) Individual Firm9.6 SHORT-RUN AND LONG-RUN EFFECTS OF CHANGES IN DEMAND (cont.) The Long-Run Response to an Increase in Demand @ FIGURE 9.9 Short-Run and Long-Run Effects. of an Increase in Demand Short-ran supply The shortrun supply curveis steeper than the long-run supply curve because Long-run supply curve of diminishing retums in the short run. $3) In the short run, an increase in demand increases the price from $7 (point a) to $12 (point b). 10 Price per shin In the long run, firms can enter the industry and build more production facilities, so the price eventually drops to. $10 (point ). Initial demand The large upward jump in price after the i : increase in demand is followed by a 0 0 800 7200 downward slide to the new long-run equilibrium price. Shirts per minute= APPLICATION 3 THE UPWARD JUMP AND DOWNWARD SLIDE OF WINE. PRICES. APPLYING THE CONCEPTS #6: Whatis thetime path of market prices after an increase in demand? As we saw in the chapter opener, the on-screen rave review of pinot noir wine increased the demand for pinot noir wine grown in the Willamette Valley in Oregon. As a result, the price of wine soared, and for some brands the price tripled. In the short run, the supply of wine is inflexible, and eager consumers competed for the limited stock, causing prices to soar. For some brands, the price tripled. Producers responded to higher prices by expanding the vineyard acreage devoted to the pinot grape. A few years later, the new acreage came on line, increasing the quantity of wine produced. Eager growers competed for consumers by cutting prices, in many cases back to pre-Sideways prices. As welll see in this chapter, when an increase in demand meets an inflexible short-run supply, prices rise in the short run. Eventually suppliers catch up with demand, and prices fall.9.7 LONG-RUN SUPPLY FORA CONSTANT-COST INDUSTRY * constant-cost industry An industry in which the average cost of production is constant; the long-run supply curve is horizontal.9.7 LONG-RUN SUPPLY FORA CONSTANT-COST INDUSTRY (cont.) Long-Run Supply Curve for a Constant-Cost Industry @ FIGURE 9.10 Long-Run Supply Curve fora Constant-Cost Industry In a constant-cost industry, input prices do not change as the industry grows. Therefore, the average production cost is constant and the long-run supply curve is horizontal. For the candle industry, the cost per candle is constant at $0.05, so the supply curve is horizontal at $0.05 per candle. ‘Long-run supply g a Price per candle 6000 Candles per day9.7 LONG-RUN SUPPLY FORA CONSTANT-COST INDUSTRY (cont.) Hurricane Andrew and the Price of Ice » FIGURE 9.11 Hurricane Andrew and the Price of Ice ‘Short-run supply A hurricane increases the demand for ice, shifting the demand curve to the right. Initial demand In the short run, the supply curve is relatively steep, so the price rises by a large amount—trom $1 to $5. Demand after hurricane Price of ice per bag In the long run, firms enter the industry, Long-run supply pulling the price back down. . Because ice production is a constant- Cost industry, the supply is horizontal, and the large upward jump in price is followed by a downward slide back to the original price. o 10) 15 25 Thousands of bags of ice per dayAPPLICATION C 7 ECONOMIC DETECTIVE AND THE CASE OF MARGARINEPRICES APPLYING THE CONCEPTS #7: How does a permanent decreasein demand affect the equilibrium price in a constant-cost industry? Between 2000 and 2009, concerns about the health effects of trans-fatty acids decreased the demand for margarine. Although total consumption in the U.S. decreased by roughly half, the price of margarine in 2009 was roughly the same, in real terms, as the price in 2000. Why didn’t the decrease in demand decrease the equilibrium price? The margarine industry is an example of a constant-cost industry. As the total output of the industry changes, the prices of the key inputs to the production of margarine don't change, so the unit cost of production is unaffected by changes in total output.KEY TERMS break-even price constant-cost industry firm-specific demand curve increasing-cost industry long-run market supply curve marginal revenue perfectly competitive market price taker short-run market supply curve short-run supply curve shut-down price sunk cost