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chapter eleven Firms in Perfectly Competitive Markets Prepared by: Fernando & Yvonn Quijano © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. CHAPTER 11: Firms in Perfectly Competitive Markets Firms in Perfectly Competitive Markets 11 – 1 The Four Market Structures MARKET STRUCTURE CHARACTERISTIC PERFECT COMPETITION MONOPOLISTIC COMPETITION OLIGOPOLY MONOPOLY Number of firms Many Many Few One Type of product Identical Differentiated Unique Ease of entry High High Identical or differentiated Low Examples of industries • Wheat • Apples • Selling DVDs • Restaurants • Manufacturing computers • Manufacturing automobiles • First-class mail delivery • Tap water Entry blocked © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 2 of 35 1 LEARNING OBJECTIVE CHAPTER 11: Firms in Perfectly Competitive Markets Perfectly Competitive Markets Perfectly competitive market A market that meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, (3) no barriers to new firms entering the market. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 3 of 35 Perfectly Competitive Markets CHAPTER 11: Firms in Perfectly Competitive Markets A Perfectly Competitive Firm Cannot Affect the Market Price Price taker A buyer or seller that is unable to affect the market price. 11 - 1 A Perfectly Competitive Firm Faces a Horizontal Demand Curve © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 4 of 35 2 LEARNING OBJECTIVE How a Firm Maximizes Profit in a Perfectly Competitive Market CHAPTER 11: Firms in Perfectly Competitive Markets Profit Total revenue minus total cost. Profit = TR - TC 11 - 2 The Market Demand for Wheat versus the Demand or One Farmer’s Wheat Don’t Confuse the Demand Curve for Farmer Douglas’s Wheat with the Market Demand Curve for Wheat © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 5 of 35 How a Firm Maximizes Profit in a Perfectly Competitive Market CHAPTER 11: Firms in Perfectly Competitive Markets Revenue for a Firm in a Perfectly Competitive Market Average revenue (AR) Total revenue divided by the number of units sold. AR TR Q so, AR TR P Q P Q Q Marginal revenue (MR) Change in total revenue from selling one more unit. Marginal Revenue Change in total revenue TR , or MR Change in quantity Q © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 6 of 35 How a Firm Maximizes Profit in a Perfectly Competitive Market CHAPTER 11: Firms in Perfectly Competitive Markets Revenue for a Firm in a Perfectly Competitive Market 11 – 2 Farmer Douglas’s Revenue from Wheat Farming NUMBER OF BUSHELS (Q) MARKET PRICE (PER BUSHEL) (P) TOTAL REVENUE (TR) AVERAGE REVENUE (AR) MARGINAL REVENUE (MR) 0 1 2 3 4 5 6 7 8 9 10 $4 4 4 4 4 4 4 4 4 4 4 $0 4 8 12 16 20 24 28 32 36 40 $4 4 4 4 4 4 4 4 4 4 $4 4 4 4 4 4 4 4 4 4 © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 7 of 35 How a Firm Maximizes Profit in a Perfectly Competitive Market CHAPTER 11: Firms in Perfectly Competitive Markets Revenue for a Firm in a Perfectly Competitive Market 11 –3 Farmer Douglas’s Profits from Wheat Farming QUANTITY (BUSHELS) (Q) TOTAL REVENUE (TR) TOTAL COSTS (TC) PROFIT (TR-TC) 0 1 2 3 4 5 6 7 8 9 10 $0.00 4.00 8.00 12.00 16.00 20.00 24.00 28.00 32.00 36.00 40.00 $1.00 4.00 6.00 7.50 9.50 12.00 15.00 19.50 25.50 32.50 40.50 -$1.00 0.00 2.00 4.50 6.50 8.00 9.00 8.50 6.50 3.50 -0.50 MARGINAL REVENUE (MR) MARGINAL COST (MC) $4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 4.00 $3.00 2.00 1.50 2.00 2.50 3.00 4.50 6.00 7.00 8.00 © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 8 of 35 How a Firm Maximizes Profit in a Perfectly Competitive Market CHAPTER 11: Firms in Perfectly Competitive Markets Revenue for a Firm in a Perfectly Competitive Market 11 - 3 The Profit-Maximizing Level of Output © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 9 of 35 CHAPTER 11: Firms in Perfectly Competitive Markets 3 LEARNING OBJECTIVE Illustrating Profit or Loss on the Cost Curve Graph Profit = (P x Q) TC ( P Q ) TC Profit Q Q Q Or Profit P ATC, Q Profit = (P ATC)Q © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 10 of 35 Illustrating Profit or Loss on the Cost Curve Graph CHAPTER 11: Firms in Perfectly Competitive Markets Showing a Profit on the Graph 11 - 4 The Area of Maximum Profit © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 11 of 35 Illustrating Profit or Loss on the Cost Curve Graph CHAPTER 11: Firms in Perfectly Competitive Markets Illustrating When a Firm Is Breaking Even or Operating at a Loss P > ATC, which means the firm makes a profit P = ATC, which means the firm breaks even (its total cost equals it total revenue) P < ATC, which means the firm experiences losses 11 - 5 A Firm Breaking Even and Experiencing Losses © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 12 of 35 CHAPTER 11: Firms in Perfectly Competitive Markets 4 LEARNING OBJECTIVE Deciding Whether to Produce or to Shut Down in the Short Run In the short run a firm suffering losses has two choices: Continue to produce Stop production by shutting down temporarily Sunk cost A cost that has already been paid and that cannot be recovered. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 13 of 35 Deciding Whether to Produce or to Shut Down in the Short Run The Supply Curve of the Firm in the Short Run CHAPTER 11: Firms in Perfectly Competitive Markets 11 - 6 The Firm’s Short-Run Supply Curve Shutdown point The minimum point on a firm’s average variable cost curve; if the price falls below this point, the firm shuts down production in the short run. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 14 of 35 “If Everyone Can Do It, You Can’t Make Money At It” – The Entry and Exit of Firms in the Long Run CHAPTER 11: Firms in Perfectly Competitive Markets Economic Profit and the Entry or Exit Decision Economic profit A firm’s revenues minus all its costs, implicit and explicit. Economic loss The situation in which a firm’s total revenue is less than its total cost, including all implicit costs. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 15 of 35 “If Everyone Can Do It, You Can’t Make Money At It” – The Entry and Exit of Firms in the Long Run CHAPTER 11: Firms in Perfectly Competitive Markets Economic Profit and the Entry or Exit Decision 11 – 5 Farmer Appleseed’s Costs per Year EXPLICIT COSTS Water Wages Organic fertilizer Electricity Payment on bank loan $25,000 $35,000 $14,000 $5,000 $6,000 IMPLICIT COSTS Foregone salary Opportunity cost of the $100,000 she has invested in her farm Total Cost $30,000 $10,000 $125,000 © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 16 of 35 “If Everyone Can Do It, You Can’t Make Money At It” – The Entry and Exit of Firms in the Long Run Economic Profit and the Entry or Exit Decision CHAPTER 11: Firms in Perfectly Competitive Markets ECONOMIC PROFIT LEADS TO ENTRY OF NEW FIRMS 11 - 8 The Effect of Entry on Economic Profits © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 17 of 35 “If Everyone Can Do It, You Can’t Make Money At It” – The Entry and Exit of Firms in the Long Run Economic Profit and the Entry or Exit Decision CHAPTER 11: Firms in Perfectly Competitive Markets ECONOMIC LOSSES LEAD TO EXIT OF FIRMS 11 - 9 The Effect of Exit on Economic Losses © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 18 of 35 “If Everyone Can Do It, You Can’t Make Money At It” – The Entry and Exit of Firms in the Long Run CHAPTER 11: Firms in Perfectly Competitive Markets Long-Run Equilibrium in a Perfectly Competitive Market Long-run competitive equilibrium The situation in which the entry and exit of firms have resulted in the typical firm just breaking even. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 19 of 35 “If Everyone Can Do It, You Can’t Make Money At It” – CHAPTER 11: Firms in Perfectly Competitive Markets The Entry and Exit of Firms in the Long Run The Long-Run Supply Curve in a Perfectly Competitive Market Long-run supply curve A curve showing the relationship in the long run between market price and the quantity supplied. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 20 of 35 6 LEARNING OBJECTIVE CHAPTER 11: Firms in Perfectly Competitive Markets Perfect Competition and Efficiency Productive Efficiency Productive efficiency The situation in which a good or service is produced at the lowest possible cost. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 21 of 35 Perfect Competition and Efficiency CHAPTER 11: Firms in Perfectly Competitive Markets Allocative Efficiency Firms will supply all those goods that provide consumers with a marginal benefit at least as great as the marginal cost of producing them: The price of a good represents the marginal benefit consumers receive from consuming the last unit of the good sold. Perfectly competitive firms produce up to the point where the price of the good equals the marginal cost of producing the last unit. Therefore, firms produce up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 22 of 35 Perfect Competition and Efficiency CHAPTER 11: Firms in Perfectly Competitive Markets Allocative Efficiency Allocative efficiency A state of the economy in which production reflects consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 23 of 35 CHAPTER 11: Firms in Perfectly Competitive Markets Allocative efficiency Average revenue (AR) Economic loss Economic profit Long-run supply curve Marginal revenue Perfectly competitive market Price taker Productive efficiency Profit Shutdown point Sunk cost © 2006 Prentice Hall Business Publishing Economics R. Glenn Hubbard, Anthony Patrick O’Brien—1st ed. 24 of 35