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chapter eight Firms in Perfectly Competitive Markets Prepared by: Fernando & Yvonn Quijano © 2007 Prentice Hall Business Publishing Essentials of Economics R. Glenn Hubbard, Anthony Patrick O’Brien Perfect Competition in the Market for Organic Apples 1 The process of competition is at the heart of the market system and is the focus of this chapter. LEARNING OBJECTIVES CHAPTER 8: Firms in Perfectly Competitive Markets After studying this chapter, you should be able to: 2 3 4 5 6 Define a perfectly competitive market, and explain why a perfect competitor faces a horizontal demand curve. Explain how a perfect competitor decides how much to produce. Use graphs to show a firm’s profit or loss. Explain why firms may shut down temporarily. Explain how entry and exit ensure that firms earn zero economic profit in the long run. Explain how perfect competition leads to economic efficiency. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 2 of 35 CHAPTER 8: Firms in Perfectly Competitive Markets Firms in Perfectly Competitive Markets 8–1 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 © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 3 of 35 1 LEARNING OBJECTIVE CHAPTER 8: 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. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 4 of 35 Perfectly Competitive Markets CHAPTER 8: 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. 8-1 A Perfectly Competitive Firm Faces a Horizontal Demand Curve © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 5 of 35 2 LEARNING OBJECTIVE How a Firm Maximizes Profit in a Perfectly Competitive Market CHAPTER 8: Firms in Perfectly Competitive Markets Profit Total revenue minus total cost. Profit = TR - TC 8-2 The Market Demand for Wheat versus the Demand or One Farmer’s Wheat Don’t Confuse the Demand Curve for Farmer Whaples’s Wheat with the Market Demand Curve for Wheat © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 6 of 35 How a Firm Maximizes Profit in a Perfectly Competitive Market CHAPTER 8: 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 © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 7 of 35 How a Firm Maximizes Profit in a Perfectly Competitive Market CHAPTER 8: Firms in Perfectly Competitive Markets Revenue for a Firm in a Perfectly Competitive Market 8–2 Farmer Whaples’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 © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 8 of 35 How a Firm Maximizes Profit in a Perfectly Competitive Market CHAPTER 8: Firms in Perfectly Competitive Markets Revenue for a Firm in a Perfectly Competitive Market 8 –3 Farmer Whaples’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 © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 9 of 35 How a Firm Maximizes Profit in a Perfectly Competitive Market CHAPTER 8: Firms in Perfectly Competitive Markets Revenue for a Firm in a Perfectly Competitive Market 8-3 The Profit-Maximizing Level of Output © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 10 of 35 CHAPTER 8: 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 © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 11 of 35 Illustrating Profit or Loss on the Cost Curve Graph CHAPTER 8: Firms in Perfectly Competitive Markets Showing a Profit on the Graph 8-4 The Area of Maximum Profit © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 12 of 35 8-1 3 LEARNING OBJECTIVE CHAPTER 8: Firms in Perfectly Competitive Markets Determining Profit-Maximizing Price and Quantity OUTPUT PER DAY TOTAL COST MARGINAL COST 0 1 2 3 4 5 6 7 8 9 $1.00 1.50 1.75 2.25 3.00 4.00 5.25 6.75 8.50 10.50 $0.50 0.25 0.50 0.75 1.00 1.25 1.50 1.75 2.00 © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 13 of 35 Illustrating Profit or Loss on the Cost Curve Graph CHAPTER 8: 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 8-5 A Firm Breaking Even and Experiencing Losses © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 14 of 35 CHAPTER 8: Firms in Perfectly Competitive Markets Illustrating Profit or Loss on the Cost Curve Graph Remember that Firms Maximize Total Profit, Not Profit per Unit © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 15 of 35 8-1 CHAPTER 8: Firms in Perfectly Competitive Markets Losing Money in the Medical Screening Industry Providing preventive medical scans turned out not to be a profitable business. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 16 of 35 CHAPTER 8: 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. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 17 of 35 8-2 CHAPTER 8: Firms in Perfectly Competitive Markets When to Close a Laundry Keeping a business open even when suffering losses can sometimes be the best decision in the short run. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 18 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 8: Firms in Perfectly Competitive Markets 8-6 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. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 19 of 35 5 LEARNING OBJECTIVE “If Everyone Can Do It, You Can’t Make Money At It” – The Entry and Exit of Firms in the Long Run CHAPTER 8: Firms in Perfectly Competitive Markets Economic Profit and the Entry or Exit Decision 8-7 Firm Supply and Market Supply © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 20 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 8: 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. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 21 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 8: Firms in Perfectly Competitive Markets ECONOMIC PROFIT LEADS TO ENTRY OF NEW FIRMS 8-8 The Effect of Entry on Economic Profits © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 22 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 8: Firms in Perfectly Competitive Markets ECONOMIC LOSSES LEAD TO EXIT OF FIRMS 8-9 The Effect of Exit on Economic Losses © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 23 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 8: Firms in Perfectly Competitive Markets ECONOMIC LOSSES LEAD TO EXIT OF FIRMS 8-9 The Effect of Exit on Economic Losses (cont’d.) © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 24 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 8: 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. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 25 of 35 CHAPTER 8: Firms in Perfectly Competitive Markets “If Everyone Can Do It, You Can’t Make Money At It” – 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. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 26 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 8: Firms in Perfectly Competitive Markets The Long-Run Supply Curve in a Perfectly Competitive Market 8 -10 The Long-Run Supply Curve in a Perfectly Competitive Industry © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 27 of 35 6 LEARNING OBJECTIVE CHAPTER 8: 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. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 28 of 35 8-2 6 LEARNING OBJECTIVE CHAPTER 8: Firms in Perfectly Competitive Markets How Productive Efficiency Benefits Consumers © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 29 of 35 Perfect Competition and Efficiency CHAPTER 8: 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. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 30 of 35 Perfect Competition and Efficiency CHAPTER 8: 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. © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 31 of 35 CHAPTER 8: Firms in Perfectly Competitive Markets Organic Food Trend Chips Out a Niche in Snack Food Isle © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 32 of 35 CHAPTER 8: 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 © 2007 Prentice Hall Business Publishing; Essentials of Economics, R. Glenn Hubbard, Anthony Patrick O’Brien 33 of 35