Download Chapter 10 THE FIRM AND THE INDUSTRY UNDER PERFECT COMPETITION

Some Midterm Stats
● Average score: 77 out of 100
● 6 (six) maximum scores
● Problems 3 and 4 were most challenging on
average
● See the Answer Key published
● Go to recitation to get your MT1 back
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Last Lecture Clean-up:
Tax Policy Analysis
Tax Policy Analysis
● Last time we considered the model of
supply and demand
● It can be used to demonstrate the effects of
taxation on both consumers and producers
● Today we will consider an example of how
to measure the tax burden
● Assume a market for cigarettes
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Tax Policy Analysis
● We assume demand is: P(Q) = 140 – 2Q
● And supply is: P(Q) = 20 + Q
♦ We call these inverse demand and inverse
supply since usually think of quantity as
function of price
● What is the equilibrium?
● What are CS, PS, TS?
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Tax Policy Analysis
● Eqm: S = D, or 140 – 2Q = 20 + Q
● Solving for Q gives Q = 40, then P = 60
● CS = (140 – 60) * 40 * ½ = 1600
● PS = (60 – 20) * 40 * ½ = 800
● So TS = 1600 + 1600 = 2400
● Illustration:
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FIGURE
1 Supply and Demand
for Cigarettes
P
140
S
E
60
20
40
D
Q
0
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2006 Southwestern/Thomson
Learning
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Tax Policy Analysis
● Suppose government wants to introduce a
tax that induces people not to smoke
● Usually taxes are levied on producers –
easier to collect
● So assume there is a tax of 12 per pack
♦ If uncomfortable with such high prices, think
of other currency rather than dollars
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Tax Policy Analysis
● Costs of producers stay the same
● So they translate tax into price one-for-one
♦ Had supply P(Q) = 20 + Q
♦ Now have P(Q) = (20 + Q) + 12 = 32 + Q
● New eqm: S = D, or 140 – 2Q = 32 + Q
● Solving for Q gives Q = 36, then P = 68
● What changes in the picture?
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2 Supply and Demand
for Cigarettes, After Tax
FIGURE
P
140
S’
S
E’
68
E
60
32
20
36
40
D
Q
0
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2006 Southwestern/Thomson
Learning
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reserved.
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Tax Policy Analysis
● We compute new CS and PS:
● CS = ½ * (140 – 68) * 36 = 1296
● PS = ½ * (68 – 32) * 36 = 648
● Now CS + PS ≠ TS, also have tax revenue
of government
● Where is it on the picture?
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FIGURE
6 Demand Curve for Milk
P
140
Consumer tax burden
S’
S
E’
68
E
60
56
32
Producer tax burden
36 40
20
D
Q
0
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2006 Southwestern/Thomson
Learning
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reserved.
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Learning.
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Tax Policy Analysis
● Notice that both consumers and producers
pay tax, what are the burdens?
● Total tax collected = 12 * 36 = 432
♦ Consumers pay = (68 – 60) * 36 = 288
♦ Producers pay = (60 – 56) * 36 = 144
● Had CS = 1296, PS = 648
● TS now is CS + PS + Tax Revenue
= 1296 + 648 + 432 = 2376
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Tax Policy Analysis
● Before had TS = 2400
● Now have TS = 2376
● Difference is DWL of taxation
● Can compute it to check ourselves:
♦ DWL = (68 – 56 ) * (40 – 36) * ½ = 24
♦ Note that 2400 – 2376 = 24, which confirms
our calculations are correct
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FIGURE
6 Demand Curve for Milk
P
140
Consumer tax burden
S’
S
E’
68
E
60
56
Dead Weight Loss
32
Producer tax burden
36 40
20
D
Q
0
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2006 Southwestern/Thomson
Learning
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reserved.
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Learning.
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Tax Policy Analysis: Results
● By introducing taxes, government creates
inefficiency (positive DWL)
● So for efficient outcomes it is best not to
have any taxes at all
♦ But this is rarely possible in practice
● Some current research in economics tries to
design taxes that minimize inefficiency
♦ That’s what our professor got Nobel Prize for!
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The Firm and the Industry
Under Perfect Competition
Contents
● Perfect Competition Defined
● The Competitive Firm
● The Competitive Industry
● Perfect Competition and Economic
Efficiency
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Perfect Competition Defined
● Four Principal Market Types
♦ Perfect competition
♦ Monopolistic competition
♦ Oligopoly
♦ Pure monopoly
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Perfect Competition Defined
● Perfect competition
♦ Many small firms and customers
♦ Homogeneous product
♦ Free entry and exit
♦ Well-informed producers and consumers
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The Competitive Firm
● Perfect competition
♦ Firm is a price taker.
♦ Price is set in the market.
♦ Firm is too small to affect the market.
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The Competitive Firm
● The Firm’s Demand Curve under Perfect
Competition
♦ Horizontal
♦ Can sell as much as it wants at the market
price.
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1: Demand Curve for a
Firm under Perfect Competition
FIGURE
Price per Bushel
in Chicago
D
A
B
C
Industry
supply
curve
E
$3
$3
S
Industry
demand
curve
Jasmine’s demand
curve
S
D
0
1
2
3
4
0
100 200 300 400
Truckloads of Corn
Sold by Farmer Jasmine
per Year
Total Sales in Chicago
in Thousands of Truckloads
per Year
(a)
(b)
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The Competitive Firm
● Short-Run Equilibrium for the Perfectly
Competitive Firm
♦ Marginal revenue = price
♦ Profit-maximizing level of output we derived
before:
MR = MC
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1: Revenues, Costs, and
Profits of a Competitive Firm
TABLE
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The Competitive Firm
● D = MR = AR = P at all levels of output
♦ Since P isEquilibrium
constant, AR = TR / Q =
Short-Run
=P*Q/Q=P
♦ MR = TR(Q+1) – TR(Q) = P (Q+1) – P Q = P
● D = MR = AR = P = MC
at the equilibrium level of output
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Computing Profit:
An Equivalent Approach
● For single firm, D = AR = MR = P
● Short-Run
Recall thatEquilibrium
ATC(Q) = TC(Q) / Q
● Also recall that Profit = TR − TC
♦ Since TC(Q) = ATC(Q) * Q
♦ And since TR = P * Q
● Can write Profit = (P – ATC) * Q
● Will use this one a lot
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2: Short-Run Equilibrium
of the Perfectly Competitive Firm
Revenue and Cost per Bushel
FIGURE
MC
AC
B
$3.00
2.25
D = MR = AR
A
1.50
0
50,000
Bushels of Corn per Year
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Short-Run Profit: Graphic
Representation
● The MC = P condition does not show if the
firm is making a profit or incurring a loss.
● Compare price (average revenue) with
average cost to calculate profit or loss per
unit.
● The profit-maximizing output may lead to a
loss, but if so it is the minimum possible
loss.
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3: S-R Equilibrium of
Competitive Firm w/Lower Price
MC
per Bushel
Revenue and Cost
FIGURE
AC
A
$2.25
1.50
0
B
D = MR = P
30,000
Bushels of Corn per Year
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Shutdown and Break-Even
Analysis
● Rule 1: The firm will make a profit if total
revenue (TR) > total cost (TC)
● Should not plan to shut down in either the
short run or the long run.
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Shutdown and Breakeven
Analysis
● Rule 2: Even if TR < TC, the firm should
continue to operate in the short run as long
as TR > TVC.
● If TR > TVC, the firm can at least pay some
of its fixed costs.
● The firm should close in the long run if TR
< TC.
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2:
The Shutdown Decision
TABLE
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Shutdown and Breakeven
Analysis
● The competitive firm will produce nothing
unless price lies above the minimum point
on the AVC curve.
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FIGURE
4: Shutdown Analysis
MC
Price
P3
P2
B
A
AC AVC
P3
P2
P1
P1
0
Quantity Supplied
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The Competitive Firm’s Short-run
Supply Curve
● Horizontal  individual supply curves 
market supply curve
● Since assume firms are identical – just
replicate the individual supplies as many
times as there are firms in the industry
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5: Derivation of the
Industry Supply Curve
FIGURE
e
$3.00
c
2.25
s
S
Price per Bushel
Price per Bushel
s
E
$3.00
C
2.25
S
45 50
45 50
Quantity Supplied in
Thousands of Bushels
Quantity Supplied in
Millions of Bushels
(a)
(b)
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The Competitive Industry
● The Competitive Industry’s Short-Run
Supply Curve
♦ A competitive industry has a stable equilibrium
at the output where supply equals demand.
♦ The competitive industry (unlike the
competitive firm) faces a downward sloping
demand curve.
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6: Supply-Demand Eqm.
of a Competitive Industry
FIGURE
S
Price per Bushel
D
$3.75
E
3.00
C
2.25
A
D
S
0
45 50
72
Quantity of Corn in
Millions of Bushels
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The Competitive Industry
● Industry Equilibrium in the Short Run
♦ Economic costs include opportunity costs, so
zero economic profit means that firms are
earning the normal, economy-wide rate of
profit.
♦ Freedom of entry and exit guarantee this result
in the long run under perfect competition.
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The Competitive Industry
● Industry and Firm Equilibrium in the Long
Run
♦ In the long run, firms enter or exit the industry
in response to profits or losses.
♦ This shifts the supply curve and the price until
profits are zero.
♦ In long-run, competitive equilibrium,
P = MC = AC.
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7: A Shift in the Industry
Supply Curve
FIGURE
Price per Bushel
(1,000 firms)
S0
D
E
(1,600 firms)
S1
F
$3.00
A
2.25
S0
D
S1
50
72 80
Quantity of Corn in
Millions of Bushels
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8: The Competitive Firm
and the Competitive Industry
FIGURE
Firm
Industry
MC
(1,000 firms)
S0
e
$3.00
2.25
a
D0
D1
b
40 45 50
Quantity of Corn in
Thousands of Bushels
(a)
Price per Bushel
Price per Bushel
AC
D
E
$3.00
(1,600 firms)
S1
A
2.25
S0
D
S1
50
72
Quantity of Corn in
Millions of Bushels
(b)
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9: L-R Equilibrium of the
Competitive Firm and Industry
FIGURE
Firm
Industry
AC
m
$1.87
D2
Price per Bushel
Price per Bushel
MC
D
(2,075 firms)
S2
M
$1.87
S2
83
40
Quantity of Corn in
Thousands of Bushels
(a)
D
Quantity of Corn in
Millions of Bushels
(b)
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Perfect Competition and
Economic Efficiency
● In the long run, competitive firms are driven
to produce at the minimum point of their
average cost curves.
● In this case, output is produced at the lowest
possible cost to society.
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3: Avg. Cost for the Firm
and Total Cost for the Industry
TABLE
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?
Which is Better to Cut
Pollution: Carrot or Stick?
● The analysis of perfect competition can be
used to show that, if firms are offered a
subsidy to reduce their polluting emissions,
the industry is likely to increase its
emissions, because of free entry.
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11: Taxes vs. Subsidies
as Incentives to Cut Pollution
FIGURE
T
Price, Average Cost
D
X
B
E
A
S
T
D
X
S
0
Qb
Qe
Qa
Output
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