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Learning Objectives Discuss 3 characteristics of perfectly competitive markets Explain why the demand curve facing a perfectly competitive firm is perfectly elastic and serves as the firm’s marginal revenue curve Find short‐run profit‐maximizing output, derive firm and industry supply curves, and identify producer surplus Explain characteristics of long‐run competitive equilibrium for a firm, derive long‐run industry supply, and identify economic rent and producer surplus Find the profit‐maximizing level of a variable input Employ empirically estimated values of market price, average variable cost, and marginal cost to calculate 11-1 profit‐maximizing output and profit Perfect Competition Firms are price-takers ~ Each produces only a very small portion of total market or industry output All firms produce a homogeneous product Entry into & exit from the market is unrestricted 11-2 Market Structures Markets differ according to: ~ the number of firms in the market, ~ the ease with which firms may enter and leave the market, and ~ the ability of firms in a market to differentiate their products from those of their rivals. 11-3 Properties of Monopoly, Oligopoly, Monopolistic Competition, and Competition 11-4 Zero Long-Run Profit with Free Entry One implication of the shutdown rule is that the firm is willing to operate in the long run even if it is making zero profit. But how can this be? Because opportunity cost includes the value of the next best investment, at a zero long-run economic profit, the firm is earning the normal business profit that the firm could earn by investing elsewhere in the economy. 11-5 Demand for a Competitive Price-Taker Demand curve is horizontal at price determined by intersection of market demand & supply ~ Perfectly elastic Marginal revenue equals price ~ Demand curve is also marginal revenue curve (D = MR) Can sell all they want at the market price ~ Each additional unit of sales adds to total revenue an amount equal to price 11-6 Zero Long-Run Profit When Entry Is Limited Figure 9.1 • Rent - a payment to the owner of an input beyond the minimum necessary for the factor to be supplied. Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-7 The Need to Maximize Profit • In a competitive market with identical firms and free entry, if most firms are profit maximizing, profits are driven to zero at the long-run equilibrium. • Any firm that did not maximize profit would lose money. Thus, to survive in a competitive market, a firm must maximize its profit. Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-8 Measuring Consumer Welfare Using a Demand Curve • Consumer welfare from a good is the benefit a consumer gets from consuming that good minus what the consumer paid to buy the good. • The demand curve reflects a consumer’s marginal willingness to pay: – the maximum amount a consumer will spend for an extra unit – the marginal value the consumer places on the last unit of output Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-9 Figure 9.2 Consumer Surplus Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-10 Application: Willingness to Pay and Consumer Surplus on eBay Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-11 Consumer Surplus • Consumer surplus (CS) - the monetary difference between what a consumer is willing to pay for the quantity of the good purchased and what the good actually costs. Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-12 Consumer Surplus (cont.) • An individual’s consumer surplus is the area under the demand curve and above the market price up to the quantity the consumer buys. • Market consumer surplus is the area under the market demand curve above the market price up to the quantity consumers buy. Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-13 Effect of a Price Change on Consumer Surplus • If the supply curve shifts upward or a government imposes a new sales tax, the equilibrium price rises, reducing consumer surplus. Copyright ©2015 Pearson Education, Inc. All rights reserved. 9-14 Consumer Surplus and Elasticity Suppose that two linear demand curves go through the initial equilibrium, e1. One demand curve is less elastic than the other at e1. For which demand curve will a price increase cause the larger consumer surplus loss? 11-15 11-16 Demand for a Competitive Price-Taking Firm (Figure 11.2) Price (dollars) Price (dollars) S P0 P0 D = MR D 0 Q0 Quantity Panel A – Market 0 Quantity Panel B – Demand curve facing a price-taker 11-17 Profit-Maximization in the Short Run In the short run, managers must make two decisions: 1. Produce or shut down? ~ If shut down, produce no output and hires no variable inputs ~ If shut down, firm loses amount equal to TFC 2. If produce, what is the optimal output level? ~ If firm does produce, then how much? ~ Produce amount that maximizes economic profit Profit = π = TR - TC 11-18 Profit-Maximization in the Short Run In the short run, the firm incurs costs that are: ~ Unavoidable and must be paid even if output is zero ~ Variable costs that are avoidable if the firm chooses to shut down In making the decision to produce or shut down, the firm considers only the (avoidable) variable costs & ignores fixed costs 11-19 Profit Margin (or Average Profit) Level of output that maximizes total profit occurs at a higher level than the output that maximizes profit margin (& average profit) ~ Managers should ignore profit margin (average profit) when making optimal decisions ( P ATC )Q Average profit Q Q P ATC Profit margin 11-20 Short-Run Output Decision Firm will produce output where P = SMC as long as: ~ Total revenue ≥ total avoidable cost or total variable cost (TR TVC) Equivalently, the firm should produce if P AVC 11-21 Short-Run Output Decision The firm will shut down if: ~ Total revenue cannot cover total avoidable cost (TR < TVC) or, equivalently, P AVC ~ Produce zero output ~ Lose only total fixed costs ~ Shutdown price is minimum AVC 11-22 Fixed, Sunk,& Average Costs Fixed, sunk, & average costs are irrelevant in the production decision ~ Fixed costs have no effect on marginal cost or minimum average variable cost—thus optimal level of output is unaffected ~ Sunk costs are forever unrecoverable and cannot affect current or future decisions ~ Only marginal costs, not average costs, matter for the optimal level of output 11-23 Profit Maximization: P = $36 (Figure 11.3) 11-24 Profit Maximization: P = $36 (Figure 11.3) 11-25 Profit Maximization: P = $36 (Figure 11.4) Break-even point Panel A: Total revenue & total cost Break-even point Panel B: Profit curve when P = $36 11-26 Short-Run Loss Minimization: P = $10.50 (Figure 11.5) Profit = $3,150 Total cost = $17- $5,100 x 300 = -$1,950 = $5,100 Total revenue = $10.50 x 300 = $3,150 11-27 Summary of Short-Run Output Decision AVC tells whether to produce ~ Shut down if price falls below minimum AVC SMC tells how much to produce ~ If P minimum AVC, produce output at which P = SMC ATC tells how much profit/loss if produce π = (P – ATC)Q 11-28 Short-Run Supply Curves For an individual price-taking firm ~ Portion of firm’s marginal cost curve above minimum AVC ~ For prices below minimum AVC, quantity supplied is zero For a competitive industry ~ Horizontal sum of supply curves of all individual firms; always upward sloping ~ Supply prices give marginal costs of production for every firm 11-29 Short-Run Producer Surplus Short-run producer surplus is the amount by which TR exceeds TVC ~ The area above the short-run supply curve that is below market price over the range of output supplied ~ Exceeds economic profit by the amount of TFC 11-30 Computing Short-Run Producer Surplus (Figure 11.6) Producer surplus TR TVC $9 110 $5.55 110 $990 $610 $380 Or, equivalently, Producer surplus = Area of trapezoid edba in Figure 11.6 = Height Average base 80 110 ($9 $5) 2 $380 $380 multiplied by 100 firms ($380 100) $38, 000 11-31 Short-Run Firm & Industry Supply (Figure 11.6) 11-32 Long-Run Profit-Maximizing Equilibrium (Figure 11.7) Profit = ($17 - $12) x 240 = $1,200 11-33 Long-Run Competitive Equilibrium All firms are in profit-maximizing equilibrium (P = LMC) Occurs because of entry/exit of firms in/out of industry ~ Market adjusts so P = LMC = LAC 11-34 Long-Run Competitive Equilibrium (Figure 11.8) 11-35 Long-Run Industry Supply Long-run industry supply curve can be flat (perfectly elastic) or upward sloping ~ Depends on whether constant cost industry or increasing cost industry Economic profit is zero for all points on the long-run industry supply curve for both types of industries 11-36 Long-Run Industry Supply Constant cost industry ~ As industry output expands, input prices remain constant, & minimum LAC is unchanged ~ P = minimum LAC, so curve is horizontal (perfectly elastic) Increasing cost industry ~ As industry output expands, input prices rise, & minimum LAC rises ~ Long-run supply price rises & curve is upward sloping 11-37 Long-Run Industry Supply for a Constant Cost Industry (Figure 11.9) 11-38 Long-Run Industry Supply for an Increasing Cost Industry (Figure 11.10) Firm’s output 11-39 Economic Rent Payment to the owner of a scarce, superior resource in excess of the resource’s opportunity cost In long-run competitive equilibrium firms that employ such resources earn zero economic profit ~ Potential economic profit is paid to the resource as economic rent ~ In increasing cost industries, all long-run producer surplus is paid to resource suppliers as economic rent 11-40 Economic Rent in Long-Run Competitive Equilibrium (Figure 11.11) 11-41 Producer Welfare Producer surplus (PS) - the difference between the amount for which a good sells and the minimum amount necessary for the seller to be willing to produce the good. 11-42 Measuring Producer Surplus Using a Supply Curve The total producer surplus is the area above the supply curve and below the market price up to the quantity actually produced. PS = R − VC. Thus, the difference between producer surplus and profit is fixed cost, F. 11-43 Producer Surplus 11-44 If the estimated supply curve for roses is linear, how much producer surplus is lost when the price of roses falls from 30¢ to 21¢ per stem (so that the quantity sold falls from 1.25 billion to 1.16 billion rose stems per year)? 11-45 11-46 Competition Maximizes Welfare One commonly used measure of the welfare of society, W, is the sum of consumer surplus plus producer surplus: W = CS + PS. 11-47 Deadweight Loss (DWL) Deadweight loss (DWL) - the net reduction in welfare from a loss of surplus by one group that is not offset by a gain to another group from an action that alters a market equilibrium. The deadweight loss results because consumers value extra output by more than the marginal cost of producing it. 11-48 Why Reducing Output from the Competitive Level Lowers Welfare 11-49 Why Producing More than the Competitive Output Lowers Welfare Increasing output beyond the competitive level also decreases welfare because the cost of producing this extra output exceeds the value consumers place on it. The reason that competition maximizes welfare is that price equals marginal cost at the competitive equilibrium. Market failure - inefficient production or consumption, often because a price exceeds marginal cost. 11-50 Show that increasing output beyond the competitive level decreases welfare because the cost of producing this extra output exceeds the value consumers place on it. 11-51 Answer 11-52 Policies That Shift Supply and Demand Curves Welfare tools are helpful in predicting the impact of government policies and other events that alter a competitive equilibrium. 11-53 Policies That Shift Supply and Demand Curves (cont.) All government actions affect a competitive equilibrium in one of two ways. 1. by shifting the supply or demand curve 2. by creating a wedge or gap between price and marginal cost so that they are not equal, even though they were in the original competitive equilibrium 11-54 Policies That Shift Supply and Demand Curves (cont.) The two most common types of government policies that shift the supply curve are: ~ limits on the number of firms in a market ~ quotas or other limits on the amount of output that firms may produce 11-55 Profit-Maximizing Input Usage Profit-maximizing level of input usage produces exactly that level of output that maximizes profit 11-56 Restricting the Number of Firms Governments, other organizations, and social pressures limit the number of firms in at least three ways: ~ explicitly in some markets, such as the one for taxi service ~ barring some members of society from owning firms or performing certain jobs or services ~ by raising the cost of entry 11-57 Restricting the Number of Firms (cont.) A limit on the number of firms causes a shift of the supply curve to the left, which raises the equilibrium price and reduces the equilibrium quantity. ~ Consumers are harmed since they don’t buy as much as they would at lower prices. ~ Firms that are in the market when the limits are first imposed benefit from higher profits. 11-58 Restricting the Number of Firms: Example Regulation of taxicabs Countries throughout the world limit the number of taxicabs. To operate a cab in these cities legally, you must possess a city-issued permit, which may be a piece of paper or a medallion. 11-59 Effect of a Restriction on the Number of Cabs 11-60 Profit-Maximizing Input Usage Marginal revenue product (MRP) ~ MRP of an additional unit of a variable input is the additional revenue from hiring one more unit of the input TR MRP P MP L If choose to produce: ~ If the MRP of an additional unit of input is greater than the price of input, that unit should be hired ~ Employ amount of input where MRP = input price 11-61 Profit-Maximizing Input Usage Average revenue product (ARP) ~ Average revenue per worker TR ARP P AP L Shut down in short run if ARP < MRP ~ When ARP < MRP, TR < TVC 11-62 Profit-Maximizing Labor Usage (Figure 11.12) 11-63 Implementing the Profit-Maximizing Output Decision Step 1: Forecast product price ~ Use statistical techniques from Chapter 7 Step 2: Estimate AVC & SMC ~ AVC = a + bQ + cQ2 ~ SMC = a + 2bQ + 3cQ2 11-64 Implementing the Profit-Maximizing Output Decision Step 3: Check shutdown rule ~ If P AVCmin then produce ~ If P < AVCmin then shut down ~ To find AVCmin substitute Qmin into AVC equation Qmin b 2c AVC min a bQmin cQ 2 min 11-65 Implementing the Profit-Maximizing Output Decision Step 4: If P AVCmin, find output where P = SMC ~ Set forecasted price equal to estimated marginal cost & solve for Q* P = a + 2bQ* + 3cQ*2 11-66 Implementing the Profit-Maximizing Output Decision Step 5: Compute profit or loss ~ Profit = TR – TC = P x Q* - AVC x Q* - TFC = (P – AVC)Q* - TFC ~ If P < AVCmin, firm shuts down & profit is -TFC 11-67 Profit & Loss at Beau Apparel (Figure 11.13) 11-68 Profit & Loss at Beau Apparel (Figure 11.13) 11-69 Summary Perfect competitors are price-takers, produce homogenous output, and have no barriers to entry The demand curve for a perfectly competitive firm is perfectly elastic (or horizontal) at the market determined equilibrium price, and marginal revenue equals price Managers make two decisions in the short run: (1) produce or shut down, and (2) if produce, how much to produce ~ When positive profit is possible, profit is maximized at the output where P = SMC ~ When market price falls below minimum AVC the firm shuts down and produces nothing, losing only TFC 11-70 Summary In long-run competitive equilibrium, all firms are in profit-maximizing equilibrium (P = LMC) ~ No incentive for firms to enter or exit the industry because economic profit is zero (P = LAC) Choosing either output or input usage leads to the same optimal output decision and profit level Five steps to find the profit-maximizing rate of production and the level of profit for a competitive firm: 1) Forecast the price of the product 2) Estimate average variable cost and marginal cost 3) Check the shutdown rule 4) If P ≥ min AVC find the output level where P = SMC 5) Compute profit or loss 11-71