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Outline
I. Competition A. A market is perfectly competitive when: 1. 2. 3. 4. 5. 1. 2. Many firms are selling an identical product. Many buyers demand that product. Entry into the industry is not restricted. Firms already in the industry have no advantage over potential new entrants. Firms and buyers are completely informed about each firms price for the product. The minimum efficient scale of a single producer is small relative to the demand for the good o r service. Each firm is perceived to produce a good or service that has no unique characteristics, so consumers do not care from whom they buy.

B. Perfect competition arises when:

C. Each firm in a perfectly competitive market is a price taker, that is, a firm that cannot affect the price of its product. 1. Price-taking behavior occurs when a single firm produces a tiny fraction of the markets total output and buyers are informed about competitors prices.

D. Although market demand is not perfectly elastic, demand for a price-taking firms product is perfectly elastic. E. The firms total economic profit equals its total revenue minus its total opportunity cost. Its goal is to maximize its economic profit. 1. 2. 3. Part of the opportunity cost is the normal profit, the return the firms entrepreneur can obtain in the best alternative business. Total revenue is the number of units sold times the price per unit, P Q . Marginal revenue, MR, is the change in total revenue brought about by a oneunit increase in the quantity sold. For a perfectly competitive firm, marginal revenue equals the market price of the product, or MR = P. Average revenue is total revenue per unit sold, that is, total revenue divided by quantity. Thus, average revenue equals the price of the product, P. In the short run, the number of firms in the industry and the sizes of their plants are fixed. A firms short-run decisions are: a) 2. Whether to shut down temporarily. b) If the firm decides to produce, how much to produce. In the long run, firms can enter or exit the industry and change the scale of their operations. A firms long-run decisions are: a) Whether to change plant size. b) Whether to remain in the industry. G. Because the firm cannot affect the price of its product, to maximize its economic profit the company adjusts the level of its production.

4. F.

In both the short and long run, a perfectly competitive firm faces two decisions. 1.

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1. 2.

The level of production at which total revenue minus total opportunity cost is largest is the profit-maximizing level. The break-even point is the amount of output at which total revenue equals total cost.

H. Marginal analysis can be used to determine the profit-maximizing amount of production. Profit is maximized by producing the level of output at which marginal revenue equals marginal cost, that is, by producing so that MR = MC. 1. 2. I. If the marginal revenue from an additional unit of output exceeds its marginal cost, or MR > MC, producing the unit is profitable. If the marginal revenue from an additional unit of output is less than its marginal cost, or MR < MC, producing the unit is not profitable.

The shutdown point is the level of output and price at which the firm just covers its total variable cost. 1. If the price of the product is less than the minimu m average variable cost, or P < AVC, the firm will shut down because this action minimizes the firms loss. In this case, the firms economic loss equals its total fixed cost.

J.

A perfectly competitive firms short-run supply curve shows how a firms profitmaximizing output varies as the price changes, other things remaining constant. 1. As long as P > AVC, the business produces the level of output at which the price equals marginal cost. For this range of prices the firms supply curve is its MC curve. If P < AVC, it shuts down, so for this range of prices the firms supply curve runs along the vertical axis.

2.

K. The short-run industry supply curve shows how the industrys quantity supplied varies as the price varies. It is the horizontal sum of the supply curves of the firms in the industry. II. Output, Price, and Profit in Perfect Competition A. The short-run equilibrium market price and quantity are determined by the intersection of the short-run industry supply curve and demand curve. 1. In the short run, the number of firms and the sizes of their plants are fixed. B. At short-run equilibrium, an individual firm may be making an economic profit, earning a normal profit, or incurring an economic loss. Whether it earns an economic profit, a normal profit, or incurs an economic loss, depends on a comparison of the price and average total cost. 1. If the price of the product is more than the profitmaximizing average total cost, or P > ATC , the firm earns an economic profit. If the price of the product equals the profit-maximizing average total cost, or P = ATC , the firm earns a normal

2.

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profit. This situation is illustrated in Figure 12.1. 3. If the price of the product is less than the profit-maximizing average total cost, or P < ATC , the firm incurs an economic loss. a. To verify these results, take the case of P > ATC . Multiplying both sides by quantity, gives (P)(q ) > (ATC )(q ). Now, (P)(q ) = TR, where TR is total revenue, and (ATC )(q ) = (TC q)( q) = TC , where TC is total cost. Thus, the inequality P > ATC implies that TR > TC , which means that the firm earns an economic profit. The other two assertions may be confirmed similarly.

C. As time passes, long-run adjustment in the form of entry (new firms joining the industry), or exit (firms leaving the industry) may occur. Economic profits motivate entry and economic losses trigger exit. In the long run, firms also can adjust their plant size. 1. As firms enter or exit an industry, the industry supply curve shifts. a) If firms in an industry are making an economic profit, new ones enter. As a result, the industry supply curve shifts rightward, the price of the product falls, the total quantity sold increases, and the economic profits of the existing ones decline.

b) If firms in an industry are incurring an economic loss, some exit the industry. As a result, the industry supply curve shifts leftward, the price of the product rises, the quantity sold decreases, and the economic losses of the remaining firms shrink. D. Firms change their plant sizes whenever doing so is profitable. If the price of the product exceeds the minimum long-run average cost (P > LRAC ), firms expand their plants. E. Long-run equilibrium occurs in a competitive industry when: 1. 2. Economic profits are zero so that entry and exit cease. Long-run average cost is at its minimum so that no firm has an incentive to change the size of its plant.

III. Changing Tastes and Advancing Technology A. The impact of a permanent decrease in demand can be determined by looking at the effect in the market as a whole and at the effect on individual firms. 1. 2. 3. 4. 5. In the short run, the price falls and market quantity decreases according to the intersection of the short-run industry supply curve and the new demand curve. The lower price causes the typical firm in the market to suffer an economic loss, as the price falls below average total cost. In response to losses, firms exit the industry, which shifts the short-run industry supply curve leftward. As the industry supply curve shifts leftward, the market price rises and the market quantity decreases even more. The long-run equilibrium occurs when the price rises sufficiently so that firms do not incur economic losses (they earn normal profits), and hence firms stop leaving the industry.

B. The impact of a permanent increase in demand is the reverse of the effect from a permanent decrease in demand.

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C. The ultimate change in the equilibrium price from a permanent increase or decrease in demand depends on the presence or absence of external diseconomies and external economies, which shape the long-run supply curve. 1. The long-run industry supply curve shows how the quantity supplied by an industry changes when the price varies after all possible adjustments to the change in price have been made. In the absence of external diseconomies or external economies, the long-run supply curve is perfectly elastic, so a permanent increase or decrease in demand has no long-run effect on the price. External diseconomies are factors beyond the control of an individual firm that raise its costs as industry output increases. The existence of external diseconomies causes the long-run supply curve to slope upward. A permanent increase in demand results in the long-run equilibrium price being higher than the initial price. External economies are factors beyond the control of an individual firm that lower its costs as industry output rises. In this case the long-run supply curve slopes downward, and a permanent increase in demand ultimately results in an equilibrium price lower than it was before the increase in demand.

2.

3.

4.

D. Technological advances result in lower costs. The effect of technological advances can be examined by distinguishing between the consequences for the entire market and for individual firms: 1. 2. Technological advances result in lower costs for firms that adopt the new technology, and initially they earn an economic profit. The presence of an economic profit causes other new technology firms to enter the industry. The industry supply curve shifts rightward, causing a fall in price and an increase in total industry output. Eventually the price falls enough that an economic profit no longer can be reaped. At this point, firms stop entering the industry. Only companies using the new technology continue to operate. The equilibrium price is lower than it was before the technological innovation, and the industry output is higher.

3.

V. Competition and Efficiency A. Resources are used efficiently when no one can be made better off without making someone else worse off. Resource use is efficient when the marginal benefit equals the marginal cost. Efficient use of resources can be described using consumers and firms decisions and the concept of equilibrium. 1. A households demand curves show the quantity demanded when the household has made the best use possible of its budgets. Consumers get the most value out of their resources at all points on the household demand curve, which is also their marginal benefit curve. Competitive firms produce the quantity that maximizes profit. The supply curves are derived from the profit maximizing quantities at each price. Firms get the most value out of their resources when a firm operates on its supply curve, which is also its marginal benefit curve. In competitive equilibrium, the quantity demanded equals the quantity supplied, so the marginal benefit equals the marginal cost. All gains from trade have been realized. Gains from trade are the sum of consumer surplus plus producer surplus.

2.

3.

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B. In the absence of external costs or benefits, perfect competition is efficient. a) External benefits are those reaped by someone other than the buyer of a good. In the absence of external benefits, the market demand curve measures marginal benefit, so points on the market demand curve are consumer efficient.

b) External costs are those imposed on someone other than the producer of a good. In the absence of external costs, if the industry is on its supply curve (so that all firms are on their supply curves), producer efficiency is achieved. C. External costs and benefits or the presence of monopoly can prevent the attainment of efficiency.