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Module
26
Graphing Perfect Competition
Module Objectives
Students will learn in this module:
• How to evaluate a perfectly competitive firm’s situation using a graph.
• How to determine a perfectly competitive firm’s profit or loss.
• How a firm decides whether to produce or shut down in the short run.
Module Outline
Opening Example: The opening example for the section is again used to discuss the
idea that high prices for organic foods eventually will lead to an increase in the quantity
of organic foods supplied.
I.Interpreting Perfect Competition Graphs
A.Total profit can be expressed in terms of profit per unit.
a. Profit = TR – TC = (TR/Q – TC/Q) × Q.
b. Equivalently, Profit = (P – ATC) × Q.
B.Profit can be illustrated on the cost curve graph as shown in text Figure 26-1
below.
Profitability and the Market Price
(a) Market Price = $18
Price, cost
of bushel
Minimum
average
total cost
$18
14.40
Break- 14
MC
E
C
even
price
0
MR = P
ATC
Profit
1
2
3
4
Z
5
6
7
Quantity of tomatoes (bushels)
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Graphing Perfect competition
(b) Market Price = $10
Price, cost
of bushel
Minimum
average
total cost
C
Loss
10
0
ATC
Y
$14.67
Break- 14
even
price
MC
MR = P
A
1
2
3
4
5
6
7
Quantity of tomatoes (bushels)
C. Definition: The break-even price of a price-taking firm is the market price at
which it earns zero profits.
D.The rule for determining whether the firm is profitable depends on a comparison of the market price of the good with the firm’s break-even price—its minimum average total cost.
a. Whenever market price exceeds minimum average total cost, the firm is
profitable.
b. Whenever the market price equals minimum average total cost, the firm
breaks even.
c. Whenever market price is less than minimum average total cost, the firm
is unprofitable.
E. The short-run production decision
1. Fixed cost is irrelevant to the firm’s decision regarding whether to produce
or shut down in the short run.
F. The shut-down price
1. Definition: 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.
2. When market price exceeds a firm’s minimum average variable cost, the
price-taking firm produces the quantity of output at which marginal cost
equals price.
3. Definition: 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.The short-run individual supply curve corresponds to the marginal
cost curve at market prices above the shut-down price.
G.Changing fixed cost
1. Fixed cost matters in the long run.
2. In most perfectly competitive industries, the number of producers,
although fixed in the short run, changes in the long run as firms enter or
leave an industry.
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graphing perfect competition
3. In the long run, a firm will exit the industry if price is less than minimum average total cost. If price exceeds minimum average total cost, a
firm will remain in the industry; in addition, other firms will enter.
Teaching Tips
Interpreting Perfect Competition Graphs
Presenting the Material
The cost curve graph is useful for helping students understand when firms make positive versus negative profit. There is sure to be some confusion at first regarding how to
identify the profit-maximizing level of output on the graph and how to identify profit
itself on the graph. Students will need to see a number of examples before they truly feel
comfortable with the graph.
Draw a supply and demand graph to remind students that price is determined in the
market. The perfectly competitive firm takes the market price as given because they are
small relative to the total market and they produce a standard good. Now draw a cost
curve graph to illustrate average total cost and marginal cost. Draw in a market price
that lies above ATC and explain that the firm can produce and sell all they want at this
going market price. Remind them that price is equal to marginal revenue. Identify the
profit-maximizing output.
Students should be able to identify total revenue on the graph because they know total
revenue is equal to price times quantity. Highlight this large box for them. Now ask them
to define how average total cost is measured. From here you can show that total cost is
equal to average total cost times quantity, and you can highlight this box on the graph.
Next you can identify profit on the graph, and explain that price minus average total cost
is the profit per unit sold.
Draw several more cost curve graphs using different prices and identify the profitmaximizing output and the area that represents profit on the graph. Think of these as
different cases. Case 1 has a price greater than ATC and firms will enter the industry.
Case 2 has a price equal to ATC, representing long-run equilibrium. Case 3 has a price
lower than ATC but higher than AVC. Firms will shut down in the long run and exit the
industry. For Case 4 you will need to draw in the average variable cost curve and explain
why the firm will shut down in the short run if price is lower than AVC. Going through the different cases should help students to see that the short-run individual supply curve is the marginal cost curve beginning where MC intersects AVC. The
short-run individual supply curve also has a vertical portion running along the vertical
axis from the origin up to the shut-down price.
Common Student Pitfalls
• Minimizing losses versus maximizing profits. Students may be unclear about
the three separate issues in this module. The first is how firm profitability is determined. The second issue is whether a firm should stay in business or shut down in
the short run, even if facing a loss. The last issue is whether a firm should enter or
exit a specific industry in the long run, when a firm can choose a level of fixed costs.
Students often memorize the MR = MC optimal output rule but do not really
understand its underlying logic. Review the idea that the optimal amount of any
activity is when the marginal benefits are equal to the marginal costs.
Students may wonder why a firm will stay in business at all if price falls below
minimum average cost. Explain that in this case, price greater than AVC produces
revenue that covers all variable costs and some fixed costs, so in the short run the
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firm will have a smaller loss if it produces than if it shuts down. In the long run,
the firm will exit the industry.
Students are often unclear in determining the profitability of a firm from a
cost curve graph. Explain that the graph shows price and marginal cost and profit
per unit. Total profit is shown on the graph as the area of the rectangle where the
width is the optimal quantity and the height is the profit per unit.
Case Studies in the Text
Economics in Action
Prices Are Up . . . But so are Costs—This EIA uses the corn market and ethanol production
as examples of how perfectly competitive markets respond to changes in the market.
Ask students the following questions:
1. How did farmers respond to increases in the price of corn as a result of
the 2005 Energy Policy Act? (They planted corn rather than other crops
like cotton.)
2. In the long run, how did the Energy Policy Act affect individual farmers’
profits? (Both marginal cost and price went up.)
Activities
Match the Graph (5–10 minutes)
Hand out the following graphs and have students match them with the following labels:
(a)
(b)
Price
Price
MC
MC
ATC
MR
$3
ATC
MR
$3
AVC
Quantity
Quantity
(c)
(d)
Price
Price
MC
MC
ATC
AVC
MR
$3
ATC
$3
MR
AVC
Quantity
Quantity
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1.
2.
3.
4.
graphing perfect competition
Shut down (answer: graph D)
Loss (answer: graph B)
Break-even (answer: graph A)
Economic profit (answer: graph C)
Ask a few pairs to report and explain their answers.
Drawing PC Graphs (20 minutes)
In a class period shortly after you have covered the PC story and graphs, have students
practice drawing a graph. Divide the students into three groups—positive profit, 0 profit,
and negative profit. Have each student in each group draw their own PC firm graph representing the situation assigned to their group. Tell them to draw their graph on scratch
paper so they can turn it in to you. You might want to allow them to communicate with
other group members to draw their graphs, since some will not know where to start.
After 5–10 minutes, collect the students’ graphs. Have a volunteer from each group draw
the graph on the board while you look through the students’ graphs. As you go through
the graphs quickly, identify the most common problems students seem to have (for
example, labels, finding MC = MR, location/shape of the ATC curve). Go over and revise
the graphs on the board as needed. Tell students that they need to be able to draw these
graphs (perhaps assign them to draw the three cases as homework). You might also want
to correct the graphs you collected and return them to students, since they might not
be aware of mistakes they are making. You can also add a bonus for a student to add an
AVC to the loss graph on the board, making it a “loss/produce” case.
Perfect Competition Puzzle
Fill in the table for a perfectly competitive firm.
Output
VC
0
1
TC
AVC
AFC
ATC
MC
P
100
—
—
—
—
50
25
20
3
53.3
4
17.5
90
6
30
7
265
8
41.3
9
10
Profit
50
2
5
TR
35
425
Hints: Fixed cost = __________________________________
A perfectly competitive firm’s demand curve is perfectly elastic.
Web Resources
This website provides a “free, multiplayer, online, business strategy game.” http://www.
perfectcompetition.net/.
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