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C H A P T E R 9 Perfect Competition: Short Run and Long Run Prepared by: Fernando Quijano and Yvonn Quijano © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e O’Sullivan/Sheffrin Perfectly Competitive Market A perfectly competitive market is a market with four features: • There are many firms. • The product is standardized or homogeneous. • Firms can freely enter or leave the market in the long run. • Each firm takes the market price as given. © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e The Short-Run Output Decision The firm’s objective is to maximize its profit, equal to revenue minus cost. • Total revenue is the money the firm gets by selling its product; equal to the price times the quantity sold. • Economic profit equals total revenue minus total economic cost. © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e Total Approach • Choose the quantity of output that generates the largest vertical difference between the total revenue curve and total cost curve. © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e Marginal Approach • choose the quantity at which marginal revenue equals marginal cost © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e The Shut-Down Decision • The firm should continue to operate if the benefit of operating (total revenue) exceeds the cost of operating, or total variable cost • Remember: Variable costs are… • When the fixed costs are very high, it is sometimes better to continue operating at a slight loss, rather then shut-down completely and have to pay the fixed costs in full • Why don’t we continue operating when profit sinks below the variable costs? © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e The Shut-down Decision © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e Short-Run Supply Curves • The firm’s short-run supply curve shows the relationship between the price of a product and the quantity of output supplied by a firm in the short run. • The firm’s short-run supply curve is the part of the firm’s short-run marginal cost curve above the shut-down price. © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e The Short-Run Supply Curve of the Firm • short-run supply curve shows the relationship between the price of a product and the quantity of output supplied (in the short run) • = the part of the firm’s short-run marginal cost curve above the shutdown price. © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e Short-Run Market Supply Curve © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e A Market in Long-Run Equilibrium • A market reaches a long-run equilibrium when three conditions hold: 1. The quantity of the product supplied equals the quantity demanded 2. Each firm in the market maximizes its profit, given the market price 3. Each firm in the market earns zero economic profit, so there is no incentive for other firms to enter the market • In addition to the conditions above, in long-run equilibrium the typical firm earns zero economic profit so there is no further incentive for firms to enter the market. © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e A Market in Long-run Equilibrium • In long-run equilibrium, price equals marginal cost (the profit-maximizing rule), and price equals shortrun average total cost (zero economic profit). © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e Production Costs and the Size of the Industry in the Long Run Industry Output and Average Production Cost Number of Firms Industry Output Rakes per Firm Typical Cost for Typical Firm Average Cost per Rake 50 350 7 $70 $10 100 700 7 84 12 150 1,050 7 96 14 • The rake industry is an increasing-cost industry because the average cost of production increases as the total output of the industry increases. © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e The Long-Run Supply Curve for an Increasing-Cost Industry • An increasing-cost industry is an industry in which the average cost of production increases as the total output of the industry increases. The long-run supply curve is positively sloped. • The average cost increases as the industry grows for two reasons: • Increasing input prices • Less productive inputs © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e Drawing the Long-run Market Supply Curve • Each point on the long-run supply curve shows the quantity of rakes supplied at a particular price (i.e., at a price of $12, 100 firms produce 700 rakes). • The long-run industry supply curve is positively sloped for an increasing cost industry. • As price increases, supply increases © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e Market Equilibrium Revisited • An increase in demand increases the market price to $17, causing the typical firm to produce 8 rakes instead of 7. Price exceeds the short-run average total cost, so economic profit is positive. Firms will enter the market. © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e The Long-Run Effects of an Increase in Demand • In the short-run, firms respond to the increase in demand by adjusting output in their existing production facilities, and the price adjusts from $12 to $17. © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e The Long-Run Effects of an Increase in Demand • In the long run, after new firms enter, equilibrium settles at $14. • The new price is a higher price than the price before the increase in demand (increasing cost industry). © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e Long-Run Supply for a Constant-Cost Industry • In a constant-cost industry, firms continue to buy inputs at the same prices. • The long-run supply curve is horizontal at the constant average cost of production. • After the industry expands, the industry settles at the same long-run equilibrium price as before. © 2003 Prentice Hall Business Publishing Economics: Principles and Tools, 3/e