Perfect Competition: Short Run and Long Run

CHAPTER
9
Perfect Competition: Short Run and Long Run
2001 Prentice Hall Business Publishing
Economics: Principles and Tools, 2/e
OSullivan & Sheffrin
Features of a Perfectly Competitive Market

1. There are many firms.
2. The product is standardized, or
homogeneous.
3. Firms can freely enter or leave the
market in the long run.

4. Each firm takes the market price as
given.
2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e OSullivan & Sheffrin
The Short-run Output Decision
The firms objective is to produce the level of output that will maximize profit.
Economic profit = total revenue minus total economic cost.

Total revenue = price x quantity sold.
The cost structure of the business firm is the same as the one we studied earlier.
Economics: Principles and Tools, 2/e OSullivan & Sheffrin
The Firms Total Cost Structure (Reviewed)

The shape of the total cost curve comes from diminishing returns in the short run.
Output: Rakes per Minute Q 0 1 2 3 4 5 6 7 8 9 10 Fixed Cost FC 36 36 36 36 36 36 36 36 36 36 36
Total Sho Variable Short-run Mar Cost Total Cost C TVC 0 8 12 15 20 27 36 48 65 90 130 STC 36 44 48 51 56 63 72 84 101 126 166
STC TFC STVC

Short-run Short-run Total Fixed = Cost + Total Variable Total Cost Cost
1 1 2 4
The Revenue Structure of the Competitive Business Firm
The perfectly competitive firm is a price-taking firm. This means that the firm takes the price from the market. As long as the market remains in equilibrium, the firm faces only one pricethe equilibrium market price.
Computing the Total Revenue of a Price-taker

C o s t in $
Output: Rakes per Minute Q 0 1 2 3 4 5 6 7 8 9 10
Price ($) P 25 25 25 25 25 25 25 25 25 25 25
Total Revenue ($) TR 0.00 25.00 50.00 75.00 100.00 125.00 150.00 175.00 200.00 225.00 250.00
250 200 150 100 50 0 0 1 2
Total Revenue
10
Output: Rake s pe r minute
Since the perfectly competitive firm faces a constant price, the shape of its total revenue is an upward-sloping line. Total revenue changes only with changes in the quantity sold.
The Totals Approach to Profit Maximization
To maximize profit, a producer finds the largest gap between total revenue and total cost.
Total Revenue ($) TR 0.00 25.00 50.00 75.00 100.00 125.00 150.00 175.00 200.00 225.00 250.00
Short-run Total Cost STC 36 44 48 51 56 63 72 84 101 126 166
P Profit -36 -19 2 24 44 62 78 91 99 99 84
The Marginal Approach
The other way to decide how much output to produce involves the marginal principle.
Marginal PRINCIPLE Increase the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.
Marginal Revenue
The benefit of producing and selling rakes is the revenue the firm collects. If the firm sells one more rake, total revenue increases by $25.
Marginal benefit = marginal revenue = market price
The Marginal Rule for Profit Maximization
A firm maximizes profit in accordance with the marginal principleby setting marginal revenue (or market price) equal to marginal cost.
Marginal Revenue = Price ($) P 25 25 25 25 25 25 25 25 25 25 25
Short-run Marginal Cost SMC 8 4 3 5 7 9 12 17 25 40
Profit -36 -19 2 24 44 62 78 91 99 99 84
Ou Rake Mi
Profit Maximization Using the Marginal Approach
Economic Profit
Profit per unit equals revenue per unit (or price) minus cost per unit (or average total cost).
($25 - $14) = 11
Total economic profit equals: (price average cost) x quantity produced
($25 - $14) x 9 = $99

2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/e OSullivan & Sheffrin
Shut-down Decision
The firm should continue to operate if the benefit of operating (total revenue) exceeds the cost of operating, or total variable cost.
TR = (P x Q) must be greater than STVC = SAVC x Q, therefore,
If P > SAVC, the firm should continue to operate If P < SAVC, the firm should shut down
The Shut-down Decision
The firm suffers a loss, but since price is greater than average variable cost, the firm continues to operate.
When price drops to $9, the firm adjusts output down to 6 rakes per minute to maintain P=SMC. The average variable cost of producing 6 rakes per minute is $6.
The Shut-down Decision
The firms shutdown price is the price at which the firm is indifferent between operating and shutting down.
At $5, P = SAVC. Above this price, the firm is better off continuing to produce at a loss. Below this price, the firm is better off shutting down because it could not recover its operating cost.
Short-run Supply Curve
The firms short-run supply curve shows the relationship between the market price and the quantity supplied by the firm over a period of time during which one inputthe production facility cannot be changed.
Short-run Supply Curve
For any price above the shut-down price, the firm adjusts output along its marginal cost curve as the price level changes.
Below the shut-down price, quantity supplied equals zero.
The short-run supply curve is the firms SMC curve rising above the minimum point on the SAVC curve.
The Market Supply Curve
The short-run market supply curve shows the relationship between the market price and the quantity supplied by all firms in the short run.
A Market in Long-run Equilibrium

A market reaches a long-run equilibrium when three conditions hold:
1. The quantity of the product supplied equals the
quantity demanded
2. Each firm in the market maximizes its profit, given
the market price

3. Each firm in the market earns zero economic profit,
so there is no incentive for other firms to enter the market
In short-run equilibrium, quantity supplied equals quantity demanded and each firm in the market maximizes profit. In addition to the conditions above, in long-run equilibrium the typical firm earns zero economic profit so there is no further incentive for firms to enter the market.
In long-run equilibrium, price equals marginal cost (the profit-maximizing rule), and price equals shortrun average total cost (zero economic profit).
The Long-run Supply Curve for an Increasing-cost Industry
An increasing-cost industry is an industry in which the average cost of production increases as the total output of the industry increases. The average cost increases as the industry grows for two reasons:

Increasing input prices Less productive inputs
Industry Output and Average Production Cost

Number of Firms Industry Output Rakes per Firm
50 100 150
350 700 1,050
7 7 7
Typical Cost for Typical Firm $70 84 96
Average Cost per Rake
$10 12 14
The rake industry is an increasing-cost industry because the average cost of production increases as the total output of the industry increases.
Drawing the Long-run Market Supply Curve

Each point on the long-run supply curve shows the quantity of rakes supplied at a particular price (i.e., at a price of $12, 100 firms produce 700 rakes). The long-run industry supply curve is positivelysloped for an increasing cost OSullivan & Sheffrin
An Increase in Demand and the Incentive to Enter
An increase in market demand puts upward pressure on price. As price increases, there is an opportunity to earn profit in the short run, and the industry attracts new firms.
The Long-run Effects of an Increase in Demand
In the short-run, firms respond to the increase in demand by adjusting output in their existing production facilities, and the price adjusts from $12 to $17.
The Long-run Effects of an Increase in Demand
In the long run, after new firms enter, equilibrium settles at $14. The new price is a higher price than the price before the increase in demand (increasing cost industry).
Long-run Supply Curve for an Constant-cost Industry
In a constant-cost industry, firms continue to buy inputs at the same prices.

The long-run supply curve is horizontal at the constant average cost of production. After the industry expands, the industry settles at the same long-run equilibrium price as before.
Long-run Supply Curve for the Ice Industry
An increase in the demand for ice increases the price of ice to $5 per bag.
In the long-run, the price of ice returns to its original level.

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CHAPTER

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

Features of a Perfectly Competitive Market

market in the long run.

The Short-run Output Decision

Total revenue = price x quantity sold.

2001 Prentice Hall Business Publishing

The Firms Total Cost Structure (Reviewed)

STC TFC STVC

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

The Revenue Structure of the Competitive Business Firm

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

Computing the Total Revenue of a Price-taker

Output: Rakes per Minute Q 0 1 2 3 4 5 6 7 8 9 10

250 200 150 100 50 0 0 1 2

Output: Rake s pe r minute

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

The Totals Approach to Profit Maximization

Output: Rakes per Minute Q 0 1 2 3 4 5 6 7 8 9 10

Short-run Total Cost STC 36 44 48 51 56 63 72 84 101 126 166

P Profit -36 -19 2 24 44 62 78 91 99 99 84

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

The Marginal Approach

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

The Marginal Rule for Profit Maximization

Output: Rakes per Minute Q 0 1 2 3 4 5 6 7 8 9 10

Marginal Revenue = Price ($) P 25 25 25 25 25 25 25 25 25 25 25

Short-run Marginal Cost SMC 8 4 3 5 7 9 12 17 25 40

Profit -36 -19 2 24 44 62 78 91 99 99 84

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

Profit Maximization Using the Marginal Approach

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

Total economic profit equals: (price average cost) x quantity produced

($25 - $14) x 9 = $99

2001 Prentice Hall Business Publishing

Economics: Principles and Tools, 2/e

OSullivan & Sheffrin

The Shut-down Decision

2001 Prentice Hall Business Publishing

OSullivan & Sheffrin