Download Document

Perfect Competition
CHAPTER
8
© 2003 South-Western/Thomson Learning
1
Terminology
An industry consists of all firms that
supply output to a particular market,
interchangeable with market
Many of the firm’s decisions depend on
the structure of the market in which it
operates
Market structure describes the
important features of a market
2
Market Structure
Aspects of market structure
Number of suppliers
• Many or few
Product’s degree of uniformity
• Do firms in the market supply identical products
or are there differences across firms?
The ease of entry into the market
• Can new firms enter easily or are they blocked by
natural or artificial barriers?
Forms of competition among firms
• Do firms compete only through prices or are
advertising and product differences common as
well?
3
Perfectly Competitive Market Structure
Characteristics of perfect competition
Many buyers and sellers  so many that
each buys and sells only a tiny fraction of
the total amount exchanged in the market
Firms sell a standardized or homogeneous
product
Buyers and sellers are fully informed about
the price and availability of all resources
and products
Firms and resources are freely mobile 
over time they can easily enter or leave the
industry
4
Perfect Competition
If these conditions are present in a
market, individual participants have no
control over the price
Price is determined by market supply
and demand  the perfectly
competitive firm is a price taker  it
must “take” or accept, the market price
Once the market establishes the price,
each firm is free to produce whatever
quantity maximizes profit
5
Perfect Competition
The model of perfect competition allows
us to make a number of predictions that
hold up when compared with the real
world
It provides us with an important
benchmark for evaluating the efficiency
of other types of markets
6
Demand Under Perfect Competition
Suppose the market in question is the
world market for wheat and the firm in
question is a wheat firm
Exhibit 1 provides the relationship
between the industry and the firm in
the case of a perfectly competitive
industry
7
Exhibit 1: Market Equilibrium and the
Firm’s Demand Curve in Perfect Competition
The market price of wheat of $5 per bushel is determined in the left panel by the
intersection of the market demand curve and the market supply curve. Once the market
price is established, any farmer can sell all he or she wants at that market price.
(b) Firm’s Demand
Price per bushel
S
$5
Price per bushel
(a) Market Equilibrium
d
$5
D
0
Bushels of
1,200,000 wheat per day
0
5
10
Bushels of
15 wheat per day
8
Demand
Each firm is so small relative to the market
that each has no impact on the market
price  each farmer is a price taker
Because all farmers produce an identical
product, anyone who charges more than
the market price will sell no wheat
No farmer would sell at a lower price
because they can sell all they want at the
higher price
9
Demand
The demand curve facing an individual
farmer is therefore a horizontal line
drawn at the market price
Ironically, two neighboring wheat
farmers in perfect competition are not
really rivals  they both can sell as
much wheat as they want to at the
market price because the amount one
sells has no effect on the market price
or the amount the other can sell
10
Short-Run Profit Maximization
How does the perfectly competitive firm
maximize profit?
The perfectly competitive firm has no
control over price, however, what the
firm does control is the amount
produced – the rate of output  the
question facing the wheat farmer is
How much should I produce to earn the
most profit?
11
Total Revenue Minus Total Cost
The firm maximizes economic profit by
finding the rate of output at which total
revenue exceeds total cost by the
greatest amount
Total revenue is simply output times the
price per unit
Exhibits 2 and 3 provide us with the
needed information
12
Exhibit 2: Short-Run Costs and Revenues
(1)
(2)
(3) = (1)  (2)
(4)
Bushels of Marginal
Wheat
Revenue
Total
Total
per day (Price)
Revenue
Cost
(q)
(p)
(TR = q  p) (TC)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
-$5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
$0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
75
80
$15.00
19.75
23.50
26.50
29.00
31.00
32.50
33.75
35.25
37.25
40.00
43.25
48.00
54.50
64.00
77.50
96.00
(5)
(6) = (4) + (1)
Marginal
Average
Cost
Total Cost
MC=TC/  Q ATC = TC / q
-$4.75
3.75
3.00
2.50
2.00
1.50
1.25
1.50
2.00
2.75
3.25
4.75
6.50
9.50
13.50
18.50
$19.75
11.75
8.83
7.25
6.20
5.42
4.82
4.41
4.14
4.00
3.93
4.00
4.19
4.57
5.17
6.00
(7) = (3) - (4)
Economic
Profit or
Loss = TR - TC
-$15.00
-14.75
-13.50
-11.50
-9.00
-6.00
-2.50
1.25
4.75
7.75
10.00
11.75
12.00
10.50
6.00
-2.50
-16.00
The individual farmer’s
output possibilities
measured in bushels of
wheat per day are
shown in column (1)
Column (2) has the
market price.
Total revenue is in
column (3) = column (1)
 column (2)  P  q
Total cost is shown in
column (4)
Total revenue in column
(3) minus.
Total cost in column (4)
yields the farmer’s
economic profit.
13
Exhibit 3a: Short-Run Profit Maximization
(a) Total Revenue Minus Total Cost
The total cost curve shows
first increasing then
diminishing marginal returns
from the variable resource.
Total cost
Total revenue
(= $5 × q )
$60
Total revenue exceeds total
cost between 7 and 14 bushels
per day  economic profit is
maximized at the rate of
output of 12 bushels of wheat
per day.
Maximum economic
profit = $12
48
Total dollars
At output less than 7 bushels
and greater than 14 bushels,
total cost exceeds total
revenue  economic loss
measured by the vertical
distance between the two
curves.
15
0
5
7
10
12
15
Bushels of wheat per day
14
Marginal Revenue Equals Marginal Cost Approach
Another way to find the profitmaximizing rate of output is to focus on
marginal revenue and marginal cost
Marginal revenue, MR, is the change in
total revenue from selling another unit
of output
Since the firm in perfect competition is
a price taker, marginal revenue from
selling one more unit is the market price
 MR = P
15
Marginal Revenue Equals Marginal Cost Approach
Marginal cost is the change in total cost
resulting from producing another unit of
output
Exhibit 2 provides the information
needed to make this comparison
16
Exhibit 2: Short-Run Costs and Revenues
Marginal
revenue is
presented in
column (2) while
marginal cost is
in column (5).
The firm will
increase
quantity
supplied as long
as each
additional unit
adds more to
total revenue
that to total cost
 as long as
marginal
revenue exceeds
marginal cost.
(1)
(2)
(3) = (1)  (2)
(4)
Bushels of Marginal
Wheat
Revenue
Total
Total
per day (Price)
Revenue
Cost
(q)
(p)
(TR = q  p) (TC)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
-$5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
$0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
75
80
$15.00
19.75
23.50
26.50
29.00
31.00
32.50
33.75
35.25
37.25
40.00
43.25
48.00
54.50
64.00
77.50
96.00
(5)
(6) = (4) + (1)
Marginal
Average
Cost
Total Cost
MC=TC/ Q ATC = TC / q
-$4.75
3.75
3.00
2.50
2.00
1.50
1.25
1.50
2.00
2.75
3.25
4.75
6.50
9.50
13.50
18.50

$19.75
11.75
8.83
7.25
6.20
5.42
4.82
4.41
4.14
4.00
3.93
4.00
4.19
4.57
5.17
6.00
(7) = (3) - (4)
Economic
Profit or
Loss = TR - TC
-$15.00
-14.75
-13.50
-11.50
-9.00
-6.00
-2.50
1.25
4.75
7.75
10.00
11.75
12.00
10.50
6.00
-2.50
-16.00
Marginal revenue exceeds marginal cost for the first 12 bushels of wheat.
The farmer, as a profit-maximizer will limit output to 12 bushels per day.
17
Exhibit 3b: Short-Run Profit Maximization
The marginal cost curve intersects
the marginal revenue curve at
point e where output is 12 bushels
per day.
(b) Marginal Cost Equals Marginal Revenue
Profit appears in the blue
shaded rectangle. The height of
the rectangle, ae, equals the
price of $5 minus the average
cost of $4  per unit profit of
$1 per bushel.
Marginal cost
Average total cost
e
d = Marginal revenue
= average revenue
Profit
a
Dollars per unit
At rates of output less than 12
bushels, marginal revenue
exceeds marginal cost  firm can
increase profit by expanding
output. At higher rates of output,
$5
marginal cost exceeds marginal
revenue  the firm could
4
increase profit by reducing
output.
0
5
10
12
15
Bushels of wheat per day
18
Marginal Revenue Equals Marginal Cost
Approach
Golden rule of profit maximization:
Generally, a firm will expand output as
long as marginal revenue exceeds
marginal cost and will stop expanding
output before marginal cost exceeds
marginal revenue
19
Economic Profit in the Short Run
Because the perfectly competitive firm
can sell any quantity for the same price
per unit, marginal revenue is also
average revenue
Average revenue, AR, equals total revenue
divided by quantity  AR = TR / q
Regardless of the rate of output, the
following equality holds along the firm’s
demand curve
Market price = marginal revenue = average
revenue
20
Minimizing Short-Run Losses
Sometimes the price that the firm is
required to “take” will be so low that no
rate of output will yield an economic
profit
Faced with losses at all rates of output,
the firm has two options
It can continue to produce at a loss, or
Temporarily shut down
It cannot shut down in the short run
because by definition the short run is a
period too short to allow existing firms to
leave or new firms to enter
21
Fixed Cost and Minimizing Losses
The firm has two types of costs in the
short run
Fixed cost
Variable cost
A firm that shuts down in the short run
must still pay its fixed costs
But, by producing, a firm’s revenue may
more than cover variable cost  a firm
will produce if the revenue thus
generated exceeds the variable cost of
production  can cover a least a portion
of its fixed cost
22
Exhibit 4: Minimizing Losses
(1)
(2)
(3) = (1)  (2)
(4)
Bushels of Marginal
Wheat
Revenue
Total
Total
per day (Price)
Revenue
Cost
(q)
(p)
(TR = q  p) (TC)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
-$3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
3
$0
3
6
9
12
15
18
21
24
27
30
33
36
39
42
45
48
$15.00
19.75
23.50
26.50
29.00
31.00
32.50
33.75
35.25
37.25
40.00
43.25
48.00
54.50
64.00
77.50
96.00
(5)
(7)
Average
Marginal
Average
Variable
Cost
Total Cost
Cost
MC=TC/Q ATC = TC /q AVC = TVC / q
-$4.75
3.75
3.00
2.50
2.00
1.50
1.25
1.50
2.00
2.75
3.25
4.75
6.50
9.50
13.50
18.50
(6) = (4) + (1)

$19.75
11.75
8.83
7.25
6.20
5.42
4.82
4.41
4.14
4.00
3.93
4.00
4.19
4.57
5.17
6.00
-$4.75
4.25
3.83
3.50
3.20
2.92
2.68
2.53
2.47
2.50
2.57
2.75
3.04
3.50
4.17
5.06
(8) = (3) - (4)
Economic
Profit or
Loss = TR - TC
-$15.00
-16.75
-17.50
-17.50
-17.00
-16.00
-14.50
-12.75
-11.25
-10.25
-10.00
-10.25
-12.00
-15.50
-22.00
-32.50
-48.00
Marginal revenue exceeds marginal cost for the first 12 bushels of wheat. Because of the lower price,
total revenue is lower at all rates of output and economic profit has disappeared  column (8)
Column (8) indicates that the firm’s loss is minimized at $10 per day when 10 bushels are produced  the net gain of
$5 total cost. Exhibit 5 illustrates this same conclusion graphically.
23
Exhibit 5: Minimizing Short-Run Losses
(a) Total Cost and Total Revenue
Total cost
Total dollars
In panel (a), the total cost
curve remains the same but
the total revenue curve
rotates downward because of
the lower price. Notice that
the total revenue now lies
below the total cost curve at
all output rates. The vertical
distance between the two
curves measures the loss at
each rate of output.
Total revenue
(= $3 × q )
$40
30
Minimum economic
loss = $10
15
0
5
10
15
Bushels of wheat per day
b) Marginal Cost Equals Marginal Revenue
The vertical distance is
minimized at an output rate
of 10 bushels where the loss
is $10 per day.
Dollars per bushel
Marginal cost
Average total cost
Average variable cost
$4.00
Loss
e
3.00
2.50
0
5
10
d = Marginal revenue
= average revenue
15
Bushels of wheat per day
24
Exhibit 5: Minimizing Short-Run Losses
(a) Total Cost and Total Revenue
MR intersects MC at point e,
where the output rate is 10
bushels per day and the price
of $3 exceeds the average
variable cost per bushel of
$2.50. The total economic
loss is shown by the shaded
area.
Total dollars
The firm will produce rather
than shut down if marginal
revenue equals marginal cost
at a rate of output where the
price equals or exceeds
average variable cost.
Total cost
Total revenue
(= $3 × q )
$40
30
Minimum economic
loss = $10
15
0
5
10
15
Bushels of wheat per day
b) Marginal Cost Equals Marginal Revenue
Marginal cost
Dollars per bushel
We get the same result using
marginal analysis as seen in
panel (b).
Average total cost
Average variable cost
$4.00
Loss
e
3.00
2.50
0
5
10
d = Marginal revenue
= average revenue
15
Bushels of wheat per day
25
Shutting Down in the Short Run
As long as the loss that results from
producing is less than the shutdown
loss, the firm will remain open for
business in the short run
However, if the average variable cost of
production exceeds the price of all rates
of output, the firm will shut down
A re-examination of Exhibit 4 indicates
that if the price of wheat were to fall to
$2 per bushel, average variable cost
exceeds $2 at all rates of output
26
Shutting Down in the Short Run
Note that shutting down is not the same
as going out of business
In the short run, even a firm that shuts
down keeps its productive capacity
intact  that when demand increases
enough, the firm will resume operation
If market conditions look grim and are
not expected to increase, the firm may
decide to leave the market  a long run
decision
27
Firm and Industry Short-Run Supply Curves
If the price exceeds average variable
cost, the firm will produce the quantity
where marginal revenue equals
marginal cost
Further, the firm will vary output as the
market price changes
Exhibit 6 illustrates the effects of
various prices on the firm’s output
decision
28
Exhibit 6: Summary of Short-Run Output Decisions
At a price as low as p1, the
firm will shut down rather
than produce at point 1,
because the price is below
average variable cost at all
output rates  the lossminimizing output rate at
a price of p1 is zero as
shown by q1
Average total cost
2
p2
p1
Dollars per unit
At a price of p2, the firm
will be indifferent between
producing q2 and shutting
down because either way
the loss will equal fixed
cost since the price just
equals average variable
cost. Point 2 is called the
shutdown point.
Marginal cost
d2
d1
1
Shutdown
point
0
q
1
q
q
2
5
Quantity per period
29
Exhibit 6: Summary of Short-Run Output Decisions
Marginal cost
If the price is p3, the
firm will produce q3 to
minimize its loss while
at p4, the firm will
produce q4 to earn just
a normal profit  the
break-even point.
Break-even
point
5
p5
4
p4
3
p3
2
If the price rises to p5,
the firm will earn a
short-run economic
profit by producing q5
Dollars per unit
p2
p1
d
Average total cost 5
d
Average variable cost 4
d3
d2
d1
1
Shutdown
point
0
q
q q q q
1
2
Quantity per period
3 4 5
30
Short-Run Firm Supply Curve
As long as the price covers average
variable cost, the firm will supply the
quantity resulting from the intersection
of its upward-sloping marginal cost
curve and its marginal revenue, or
demand curve
Thus, that portion of the firm’s marginal
cost curve that intersects and rises
above the lowest point on its average
variable cost curve becomes the short-
run firm supply curve
31
Exhibit 6: Summary of Short-Run
Output Decisions
The solid portion of the
short-run supply curve
indicates the quantity
the firm is willing and
able to supply in the
short run at each
alternative price.
The short-run supply
curve is the upwardsloping portion of the
marginal cost curve,
beginning at point 2.
Marginal cost
5
p5
4
p4
3
p3
2
p2
p1
Dollars per unit
The quantity supplied
when the price is p2 or
higher is determined by
the intersection of the
firm’s marginal cost curve
and its demand or
marginal revenue curve.
1
q q q q
2
d
Average variable cost 4
d3
d2
d1
1
0
q
d
Average total cost 5
Quantity per period
3 4 5
32
Exhibit 7: Aggregating Individual Supply to Form
Market Supply
Price per unit
(a) Firm A
(b) Firm B
SA
(d) Industry, or market, supply
(c) Firm C
SA+ SB+ SC = S
SC
SB
p'
p'
p'
p'
p
p
p
p
0
10 20
Quantity
per period
0
10 20
Quantity
per period
0
10 20
Quantity
per period
0
30
60
Quantity
per period
The short-run industry supply curve is the horizontal sum of all firms’ short-run supply
curves  horizontal summation of the firm level marginal cost curves
At a price below p, no output is supplied. At a price of p, each of the three firms supplies 10
units, for a market supply of 30 units, and at a price of p', each firm supplies 20 units  the
market supply is 60 units.
33
Exhibit 8: Relationship Between Short-Run
Profit Maximization and Market Equilibriuim
(b) Industry, or market
Price per unit
Dollars per unit
(a) Firm
MC = s
ATC
AVC
$5
4
Profit
d
SMC = S
$5
D
0
5
10 12
Bushels of wheat
per day
0
1,200,000 Bushels of wheat
per day
If we suppose there are 100,000 identical wheat farmers, their individual supply curves are summed
horizontally to yield the market supply curve which is shown in the right panel where the market price
of $5 is determined. At this price, each farmer produces 12 bushels per day, as shown in the left panel,
for a total quantity supplied of 1,200,000 bushels per day  each farmer earns an economic profit of
34
Summary
A perfectly competitive firm selects the
short-run output rate that maximizes
profit or minimizes loss
When confronting a loss, a firm either
produces an output that minimizes that
loss or shuts down temporarily
Given the conditions for perfect
competition, the market will converge
toward the equilibrium price and
quantity
35
Perfect Competition in Long Run
In the short run, the quantity of variable
resources can change, but other
resources, which generally determine
firm size, are fixed
However, in the long run, firms have
time to enter and exit and to adjust
their size  adjust the scale of their
operations  there is no distinction
between fixed and variable cost
because all resources under the firm’s
control are variable
36
Perfect Competition in Long Run
Short-run economic profit will in the
long run encourage new firms to enter
the market and may prompt existing
firms to expand the scale of their
operations
Economic profit will attract resources
from industries where firms earn only
normal profit or suffer losses
37
Perfect Competition in Long Run
The expansion in the number and size of
firms will shift the industry supply curve
rightward in the long run, driving down
the price
New firms will continue to enter a
profitable industry and existing firms
will continue to increase in size as long
as economic profit is greater than zero
38
Perfect Competition in Long Run
Conversely, a short-run loss will, in the
long run, force some firms to leave the
industry or to reduce the scale of
operation
In the long run, departures and
reductions in scale shift market supply
to the left  market price increases
until the remaining firms just earn a
normal profit
Exhibit 9 shows these results
39
Exhibit 9: Long Run Equilibrium for the Firm
and the Industry
(a) Firm
(b) Industry, or market
S
ATC
LRAC
p
e
d
Price per unit
Dollars per unit
MC
p
D
Quantity per period
Q
0
0
q Quantity per period
In the long run, market supply adjusts as firms enter or leave, or change their size. This process
continues until the market supply intersects the market demand at a price that equals the lowest point
on each firm’s long-run average cost curve  at point e with each firm producing q units. At point e,
marginal cost, short-run average total cost and long-run average cost are all equal.
40
Long-Run Adjustment to a Change in Demand
To explore the long-run adjustment
process, let’s consider how a firm and
an industry respond to an change in
market demand
Further, suppose that the costs facing
each individual firm do not depend on
the number of firms in the industry
Exhibits 10 and 11 illustrate the impact
of an increase and a decrease in
demand respectively
41
Exhibit 10: Long-Run Adjustment
to an Increase in Demand
(b) Industry, or Market
(a) Firm
S
p'
d'
ATC
LRAC
Profit
p
d
Price per unit
Dollars per unit
MC
p'
b
a
p
D'
D
0
q
q'
Quantity
per period
0
Qa
Qb
Quantity
per period
Suppose the initial point of equilibrium is given as point a in the right hand panel where the market
clearing price is p and the market quantity is Qa  the individual firm supplies q units and earns a
normal profit.
Now suppose market demand increases as shown by the shift from D to D'  the market price
increases in the short run to p'. Each firm responds to the higher price by expanding output
42
along its short-run supply, or marginal cost curve  the quantity supplied increases to q'
Exhibit 10: Long-Run Adjustment to an Increase in
Demand
(b) Industry, or Market
(a) Firm
S
S'
p'
d'
ATC
LRAC
p
d
Price per unit
Dollars per unit
MC
p'
b
a
c
p
S*
D'
D
0
q
q'
Quantity
per period
0
Qa
Qb
Qc
Quantity
per period
In the long run, economic profit attracts new firms  additional supply to the market shifting out the
market supply curve  market price to fall. Firms continue to enter as long as they earn economic
profit  the market supply eventually shifts out to S', where it intersects D' at point c, returning price
to its initial equilibrium level, p  the demand curve facing the individual firm shifts back down from
d' to d  firms again earning a normal profit. Even though industry output increases from Qa to Qb,
each firm’s output returns to q  new firms provide the additional output
43
Exhibit 11: Long-Run Adjustment to a Decrease in
Demand
(a) Firm
(b) Industry, or Market
S
ATC
LRAC
e
p
d
Loss
p"
d"
Price per unit
Dollars per unit
MC
a
p
p"
f
D
D"
0
q"
q
0
Qg Qf Qa Quantity
Quantity
per period
per period
Again, suppose that the initial long-run equilibrium is shown by point a in the market and point e
for the firm. Now suppose that market demand for this product declines from D to D"  the
market price falls to p"  the demand curve facing each firm drops to d"
Each firm responds in the short run by cutting its output to q", where marginal cost
equals the now-lower marginal revenue. Market output falls to Qf  each firm operates
at a loss as shown by the red shaded area.
44
Exhibit 11: Long-Run Adjustment to a Decrease in
Demand
(a) Firm
(b) Industry, or Market
S"
ATC
LRAC
e
p
d
Loss
p"
d"
Price per unit
Dollars per unit
MC
g
S
a
S*
p
f
p"
D
D"
0
q"
q
Quantity
per period
0
Qg
Qf
Qa
Quantity
per period
The short-run loss, if it continues, will in the long run force some firms out of this business  market
supply will decrease from S to S"  price increases back to p and the new market equilibrium is
shown by point g. Market output has fallen to Qg and the remaining firms are just earning a normal
profit as demand shifts back to d.
45
Long-Run Industry Supply Curve
In Exhibits 10 and 11, we began with an
initial long-run equilibrium point; then,
in response to a shift in demand, we
found two more long-run equilibrium
points
In each case, the price remained the
same in the long run, but industry
output increased in Exhibit 10 and
decreased in Exhibit 11.
46
Long-Run Industry Supply Curve
Connecting these long-run equilibrium
points yields the long-run industry
supply curve, labeled S* in both of these
Exhibits
The long-run industry supply curve
shows the relationship between price
and quantity supplied once firms fully
adjust to any short-term economic
profit or loss resulting from a shift in
demand
47
Constant-Cost Industry
The industry we have studied thus far is
called a constant cost industry because
each firm’s long-run average cost curve
does not shift as industry output
expands
Resource prices and other production
costs remain constant in the long run as
industry output increases or decreases
48
Constant-Cost Industry
In a constant-cost industry, each firm’s
per-unit production costs are
independent of the number of firms in
the industry  the firm’s long-run
average cost curve remains constant in
the long run as firms enter or leave the
industry
The industry uses such a small portion of
the resources available that increasing
industry output does not bid up resource
prices
The long-run supply curve for a
constant-cost industry is horizontal
49
Increasing-Cost Industry
Firms in some industries encounter
higher average costs as industry output
expands in the long run
Firms in these increasing-cost industries
find that expanding output bids up the
prices of some resources or otherwise
increases per-unit production costs 
each firm’s cost curves shift upward
Exhibit 12 illustrates the adjustment
process for an increasing cost industry
50
Exhibit 12: An Increasing-Cost Industry
(a) Firm
(b) Industry, or Market
S
ATC
pa
a
da
Price per unit
Dollars per unit
MC
p
a
a
D
0
q
Quantity
per period
0
Qa
Quantity
per period
The initial position of equilibrium is shown at point a, where the initial market demand and
supply curves are D and S  the market price is pa and the market quantity Qa  the demand
and marginal revenue curve facing each firm is da  the firm produces q, average total cost is at
a minimum  firm earns no economic profit in this long-run equilibrium
51
Exhibit 12: An Increasing-Cost Industry
(a) Firm
(b) Industry, or Market
S
b
pb
pa
db
ATC
da
a
Price per unit
Dollars per unit
MC
pb
b
D'
p
a
a
D
0
q
qb
Quantity
per period
0
Qa
Qb
Quantity
per period
The increase in market demand is shown by the shift from D to D' which intersects the short-run
market supply curve S at point b  short-run equilibrium price pb and market quantity Qb 
each firm’s demand curve shifts from da up to db  b in the left panel where the marginal cost
curve intersects the new demand curve  each firm produces qb  economic profit equal to qb
52
times the difference between the pb and the average total cost at that rate of output
Exhibit 12: An Increasing-Cost Industry
(a) Firm
(b) Industry, or Market
MC'
S
S'
pb
pc
b
ATC'
c
pa
db
ATC
dc
da
a
Price per unit
Dollars per unit
MC
pb
b
pc
c
D'
p
a
a
D
0
q
qb
Quantity
per period
0
Qa
Qb Qc
Quantity
per period
The existence of economic profit attracts new entrants but because this is an increasing-cost industry,
new entrants’ increased demand for resources drives up the costs of production and raises each firm’s
marginal and average cost curves. In the left panel, MC and ATC shift up to MC' and ATC'. The
entry of the new firms also shifts the short-run industry supply curve outward from S to S'  decline
in the market price from b to c.
53
Exhibit 12: An Increasing-Cost Industry
(a) Firm
(b) Industry, or Market
MC'
S
S'
pb
pc
b
ATC'
c
pa
db
ATC
dc
da
a
Price per unit
Dollars per unit
MC
pb
b
S*
pc
c
D'
p
a
a
D
0
q
qb
Quantity
per period
0
Qa
Qb Qc
Quantity
per period
New firms continue to enter the industry until the combination of a higher production cost and a
lower price squeeze economic profit to zero  S'. The market price does not fall back to the
initial equilibrium level because each firm’s average total cost has shifted up with the expansion
of industry output. The new long-run market equilibrium occurs at point c and when points a
and c are connected, we get the upward sloping long-run market supply curve shown as S* 54
Summary
In constant-cost industries, each firm’s
costs depend simply on the scale of its
plant and its rate of output
For firms in increasing-cost industries,
costs depend also on the number of
firms in the market
By bidding up the price of resources, longrun expansion in an increasing-cost industry
increases each firm’s marginal and average
costs
55
Perfect Competition and Efficiency
How does perfect competition stack up
as an efficient allocator of resources?
There are two concepts of efficiency
used to judge market performance
Productive efficiency refers to producing
output at the least possible cost
Allocative efficiency refers to producing the
output that consumers value the most
Perfect competition guarantees both
allocative and productive efficiency in the
long run
56
Productive Efficiency
Productive efficiency occurs when the
firm produces at the minimum point on
its long-run average-cost curve  the
market price equals the minimum
average total cost
The entry and exit of firms and any
adjustment in the scale of each firm
ensure that each firm produces at the
minimum point on its long-run average
cost curve
57
Productive Efficiency
Firms that do not reach minimum longrun average cost curve must, to avoid
continued losses, either adjust their size
or leave the industry
Thus, perfect competition produces
output at the least possible cost per unit
in the long run
58
Allocative Efficiency
Just because production occurs at the
least possible cost does not mean that
the allocation of resources is the most
efficient one possible
The goods being produced may not be
the ones consumers most prefer  they
may be producing the wrong goods
efficiently from the perspective of
minimum costs
59
Allocative Efficiency
Allocative efficiency occurs when firms
produce the output that is most valued
by consumers
How do we know that perfect
competition guarantees allocative
efficiency?
The answer lies with the market supply
and demand curves
60
Allocative Efficiency
The demand curve reflects the marginal
value that consumers attach to each
unit  the market price is the amount
of money that people are willing and
able to pay for the final unit they
consume
We also know that, in both the short run
and the long run, the equilibrium price
in perfect competition equals the
marginal cost of supplying the last unit
sold
61
Allocative Efficiency
Marginal cost measures the opportunity
cost of all resources employed by the
firm to produce the last unit sold  the
supply and demand curves intersect at
the combination of price and quantity at
which the marginal value, or the
marginal benefit that consumers attach
to the final unit purchased, just equals
the opportunity cost of the resources
employed to produce that unit  there
is no way to reallocate resources to
increase the total utility consumers reap
from production
62
What’s So Perfect About Perfect Competition
This should not be taken to mean that market
exchange confers no net benefits to
participants
Market exchange benefits both consumers and
producers
Recall that consumers garner a surplus from market
exchange because the maximum amount they would
be willing to pay for each unit of the good exceeds
the amount they in fact pay
Exhibit 14 depicts a market in short-run equilibrium
63
Exhibit 14: Consumer Surplus and Producer Surplus
Consumer surplus is shown by the
blue shaded area, which is the area
below the demand curve but above
the market clearing price of $10.
Producers also derive a net
benefit, or a surplus, from market
exchange because the amount
they receive for their output
exceeds the minimum amount
they would require to supply that $10
amount in the short run.
Recall that the short-run market
supply curve is the sum of that
5
portion of each firm’s marginal
cost curve at or above the
minimum point on its average
variable cost curve  point m on
0
the market supply curve S.
Dollars per unit
Consumer
surplus
S
e
Producer
surplus
D
m
Quantity per period
100,000 120,000
200,000
64
Exhibit 14: Consumer Surplus and Producer Surplus
Point m implies a price of $5 with each
firm willing to supply 100,000 units. At
prices below $5, quantity supplied is
zero because firms could not cover
variable costs and would shut down.
If the price increases to $6, firms
increase their quantity supplied until
their marginal cost equals $6 
output increases from 100,000 to
$10
120,000, and total revenue increases
from $500,000 to $720,000. Part of
the increased revenue covers the
6
higher marginal cost of production.
5
However, the balance of the
increased revenue is a bonus to
producers, who would have been
willing to supply 100,000 units for
only $5  producer surplus is shown
0
by the red shaded area.
Dollars per unit
Consumer
surplus
S
e
Producer
surplus
D
m
Quantity per period
100,000 120,000
200,000
65
Exhibit 14: Consumer Surplus and Producer Surplus
In the short run, producer surplus is
the total revenue producers are paid
minus their variable cost of production
Dollars per unit
In our example, the market-clearing
price is $10 per unit, and producer
surplus is the red shaded area under
the price but just above the supply
curve.
The combination of consumer
surplus and producer surplus
shows the gains from voluntary
exchange.
Productive and allocative efficiency
in the short run occurs at point e,
which also is the combination of
price and quantity that maximizes
the sum of consumer and producer
surplus.
Consumer
surplus
S
e
10
6
5
Producer
surplus
D
m
Quantity per period
0
100,000 120,000
200,000
66
Producer Surplus
Producer surplus is not the same as
economic profit
Any price that exceeds average variable
cost will result in a short-run producer
surplus, even though that price could
result in a short-run economic loss
The definition of producer surplus
ignores fixed cost, because fixed cost is
irrelevant to the firm’s short-run
production decision
67