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Learning Objectives
By the end of this chapter, you will be able to:
• List the assumptions of perfect competition.
• Diagram the relationship between a firm and the total market. Calculate profits, given quantity, mar- ginal revenue, marginal cost, average cost, and price. Identify the profit-maximizing level of output.
• Define the shutdown point in terms of price and average variable costs or total fixed costs and losses.
• Describe the long-run supply curve for a constant cost industry, an increasing cost industry, an increasing cost industry, and a decreasing cost industry.
• Identify the long-run equilibrium for the firm and the industry under perfect competition.
• Explain how economic rent might exist in perfect competition, even in long-run equilibrium.
Perfect Competition
9
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Section 9.1 Characteristics of Perfect Competition CHAPTER 9
Introduction
Consider this. . . Some firms, like convenience stores and grocery chains, are open 24 hours a day. Others close at 6:00 or 7:00 P.M. Some bars and restaurants open at 11:00 A.M. to cater to a lunch crowd, while others don’t open until 4:00 P.M. for the happy hour crowd. Some resorts are open year-round, while others close for business during the off-peak season.
How can you explain this distinctly different behavior across firms that are in the same industry? Any firm that makes production decisions will relate potential, or forecasted, revenues to costs in order to determine output levels. However, the forecasted revenues will depend on the market conditions faced by the firm. After studying the material in this chapter you will be able to explain why firms in the same industry make different choices, whether they choose to close at 7:00 P.M., close for the winter, or close permanently.
This chapter and the next two look at four different models, referred to as market struc- tures. The model discussed in this chapter is perfect competition. Perfect competition is the market structure in which there are many sellers and buyers, firms produce a homo- geneous product, and there is free entry into and exit out of the industry. It is important to keep in mind that this is a theoretical model. Real data does not exist, and the model does not precisely describe reality. The model is useful, however, because it provides a point of reference. It allows the development of tools of analysis that indicate what determines price and quantity when conditions are close to those of perfect competition. The perfectly competitive market is the abstract ideal to which we will compare other market structures.
9.1 Characteristics of Perfect Competition
There are six basic assumptions for the model of perfect competition. In developing the theory, we assume that all firms in the market in which the product is sold pos-sess these six characteristics. The first assumption is that there is a large number of sellers (producers) in the market. A large number means there are so many sellers of the product that no single seller’s decisions can affect price. For example, no single wheat farmer can influence the price of wheat. A farmer could sell the entire crop or none of the crop. The farmer’s decision wouldn’t affect the price of wheat in any per- ceptible manner because the market for wheat is so large relative to any single producer.
The second assumption is that there is a large number of buyers (consumers) in the market. A large number means that no one buyer can affect the price in any perceptible way. That is, no single purchaser has any market power.
The third assumption is that perfectly competitive firms produce a homoge- neous product. Homogeneous means that the product of one firm is no different from that of other firms in the industry. Since this is the case, purchasers have no preference for one producer over another. If you are a miller and want to
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Section 9.1 Characteristics of Perfect Competition CHAPTER 9
purchase wheat, you don’t care if it was produced by Farmer Jones or Farmer Smith—a bushel of No. 1 winter wheat is a bushel of No. 1 winter wheat!
The fourth assumption, a very important assumption, is that there is free entry into and free exit out of the market. This means that if one firm wishes to go into business or if another firm wishes to cease production, either can do so with- out any kind of constraint. This assumption is crucial in distinguishing perfect competition from monopoly, which we will examine in the next chapter.
The fifth assumption is that there is perfect knowledge. The sixth assumption is that workers and other resources can easily move in and out of the industry. These last two assumptions are even more unrealistic than the others because infor- mation is costly to acquire and resources are usually costly to move. The effect of these two assumptions is that when economic profits exist, firms will find out about these profits and enter the industry. Even though these assumptions are unrealistic, the resulting model is valuable because it shows what adjust- ments would take place in an ideal setting.
If these six assumptions are met, a market will be perfectly competitive. These assump- tions create a model market in which no firm or individual has the power to exert control over the market. This means that neither buyer nor seller has any influence over price.
The six assumptions were first stated more than two centuries ago by Adam Smith in a general outline of the perfectly competitive model in his book, An Inquiry Into the Nature and Causes of the Wealth of Nations (1776). In the nineteenth century, the model of perfect competition was the main way of looking at how firms and markets determined price and output levels. The study of other market structures arose later.
Economics in Action: What Criteria Is Necessary for Perfect Competition? Looking at the airline industry, the Khan Academy lists the criteria for perfection competition. Follow the link to the Khan Academy (http://www.khanacademy.org), and then do a search for the video "Perfect Competition" to learn more about how this criteria applies to any market.
Large Numbers on the Buyers’ Side
This chapter concentrates on developing a theory of firms in perfect competition, or com- petition on the sellers’ side of the market. Keep in mind, however, that we also assume large numbers of buyers—so many that no single firm possesses market power.
Concentrating on the firm should not obscure the importance of competition on the buy- ers’ side of the market. In order for markets to be competitive, there must be enough buy- ers that none can affect the market price by withholding purchases. Note also that perfect competition and free markets are not necessarily the same. A free market means a market that is free of government regulation—thus a perfectly competitive market could also be a free market, but the reverse is typically not the case.
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Section 9.2 Competitive Adjustment in the Short Run CHAPTER 9
Check Point: Perfect Competition Assumptions
• Many sellers • Many buyers • Homogenous product • Free entry to/exit from the market • Perfect knowledge • Resources move freely
9.2 Competitive Adjustment in the Short Run
Since the perfectly competitive firm is small relative to the market and its product is the same as that of other firms, this firm views itself as having no influence on market price. If the perfectly competitive firm wants to sell any of its output, it must sell at the market price. A firm in perfect competition is referred to as a price taker because it has no influence on price. It can sell any amount at the market-clearing price. The firm takes that price as its selling price. If it sets a higher price, none of its output will be sold because buyers will be able to purchase an identical product at the lower market price elsewhere. On the other hand, it makes no sense to sell below the market price because the firm can sell all it produces at that market price.
The market demand and supply curves and the firm’s resultant demand curve are shown in Figure 9.1. (The graphs in this chapter are based on models first developed by nineteenth-century British economist Alfred Marshall.) Market demand (D) and supply (S) curves are such that the market equilibrium price is P
1 . If the market is in equilib-
rium, the perfectly competitive firm can sell as much of its product as it wishes at price P
1 . From the firm’s viewpoint, the demand curve is perfectly elastic at price P
1 .
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Section 9.2 Competitive Adjustment in the Short Run CHAPTER 9
Figure 9.1: Elastic demand at market equilibrium
In perfect competition, a firm’s demand curve is perfectly elastic at the market equilibrium price.
The demand schedule a firm faces is also its average revenue schedule. If, for example, the price consumers pay in the market is $15, the average revenue a seller receives per unit sold is also $15. As price changes along a market demand curve, the average revenue that sellers receive will also change. Total revenue of a firm is the price times the quantity sold (TR 5 P 3 Q). Average revenue (AR) is total revenue divided by the quantity sold. It is the revenue per unit sold, or the price of the product. A demand curve is an average revenue curve. With perfect competition, price does not vary with output. Thus, AR 5 (P 3 Q)/Q 5 P is a constant. The firm’s perfectly elastic demand curve in Figure 9.1 is also a perfectly elastic average revenue curve.
The Level of Output
Recall that a profit-maximizing firm always produces that quantity for which marginal revenue is equal to marginal cost. Thus, we need to determine what the competitive firm’s marginal revenue curve looks like. Marginal revenue for the nth unit is the change in total revenue from selling one more unit:
MR n 5 TR
n 3 TR
n21
0 Quantity/ Time Period
Quantity/ Time Period
Price
0
Price (a) Firm (b) Market
P1 P1
x 1 x 2 x 3 x 4
D
S
D = P = AR = MR
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Section 9.2 Competitive Adjustment in the Short Run CHAPTER 9
In Figure 9.1, the change in total revenue if sales increase from x 1 to x
2 (where x
2 is one unit
more than x 1 ) is P
1 (x
2 2 x
1 ). If sales increase from x
2 to x
3 the change in total revenue is P
1
(x 3 2 x
2 ). In other words, in the case of a perfectly elastic demand curve, such as the firm’s
demand curve in Figure 9.1, D 5 P 5 AR 5 MR. The marginal revenue curve associated with a perfectly elastic demand curve is the same as the demand curve. The demand curve is always the average revenue curve for any market structure. The demand curve is equal to the marginal revenue curve only in perfect competition. Remember the relationship between average and marginal values—if the average value doesn’t change, the marginal value must be the same as the average.
Using marginal cost and marginal revenue, we now can determine how a perfectly com- petitive firm will adjust its output to changed prices in the short run. The demand curves for the market and a representative firm are depicted in Figure 9.2. A representative firm is a typical firm in perfect competition, one of the many similar firms in this market. In Fig- ure 9.2, the representative firm’s marginal cost curve is also shown. This firm maximizes profit by producing quantity x
1 when the price per unit is P
1 because at that output level,
MR 1 5 MC. Now assume the market demand increases to D
2 . The market price rises to P
2 .
The firm’s demand curve, average revenue curve, and marginal revenue curve change to D
2 5 AR
2 5 MR
2 . The firm responds by increasing its output level to x
2 , where MR
2 5 MC.
Figure 9.2: Profit maximization
An increase in market demand causes the equilibrium price to rise. The demand curve the firm faces adjusts by the amount of the increase in price, and the firm increases its output to equate MC and MR. The adjustment process is such that the firm’s marginal cost curve is its short-run curve.
0 Quantity/ Time Period
Quantity/ Time Period
Price, Cost
0
Price (a) Firm (b) Market
P1 P1
x 1 x 2
MC S
P2 P2 2 2 2D = AR = MR
1 1 1D = AR = MR
D1 D2
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Section 9.2 Competitive Adjustment in the Short Run CHAPTER 9
Economics in Action: Plotting Profits and Perfect Competition Free Econ Help uses graphs to explain perfect competition (where marginal cost equals marginal rev- enue) and how one can identify profit maximization. Follow the link to see at http://www.youtube .com/watch?v5eh1cc6P-eeI.
The Supply Curve
Changes in market price cause the firm to increase or decrease production along its mar- ginal cost curve until MR 5 MC. The profit maximizing price–output combinations gener- ate a supply curve, which, as we have just seen, is also the marginal cost curve. In Figure 9.2, the firm’s short-run marginal cost curve is the same as its short-run supply curve. A short-run supply curve is a supply curve for the period in which the size of the plant can- not be varied (the short run). In perfect competition, the short-run marginal cost curve is the short-run supply curve. As the market price rose, the firm in Figure 9.2 increased its output. The quantity which will be produced at each price is identified by the marginal cost curve. Of course, no firm that seeks to maximize profit would choose to produce out- put at any price; there is a price below which the firm would lose money if it continued to participate. As we shall see, we can identify the point on the marginal cost curve at which the firm should cease production. The marginal cost curve (above the so-called shutdown point) is also the supply curve for a competitive firm.
We can now look at the relationship between the firm’s supply (marginal cost) curve and the market supply curve. The firm’s supply curve represents its output response to increased market prices. Just as an industry is made up of all the firms that produce and sell homogenous goods, the short-run supply curve of an industry is the sum of supply curves for all firms in the industry. If we were to add the output (horizontally) across the short-run supply curves for all firms, we would construct the short-run market (or indus- try) supply curve. The market supply curve is simply the aggregate of all the firms’ sup- ply curves. The short-run market supply curve, then, is the aggregate of the portions of all firms’ marginal cost curves that lie above their average variable cost curves. In the long run, more firms can enter an industry as a response to economic profits. The market sup- ply curve will shift to the right because it is made up of more individual supply curves. On the other hand, as firms leave an industry due to losses, the market supply curve will shift to the left, representing a decrease in supply. This decrease is due to the fact that there are fewer individual supply curves to be summed.
Profits and Losses
We have just seen how a representative firm adjusts in the short run to changes in market demand. We don’t yet know whether the firm has a profit or a loss, or how large this profit or loss is. To find out, we need to add the average cost curve to the graph. Also, in order to decide if the firm should continue to produce if losses are encountered, we need to add the average variable cost curve.
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Section 9.2 Competitive Adjustment in the Short Run CHAPTER 9
In Figure 9.3, the firm is maximizing profit by producing output x 1 at price P
1 , where
P 5 MR 5 MC. The average cost of producing x 1 is measured by distance x
1 C in
Figure 9.3. The total cost of producing x 1 is represented by the area of the rectangle
0P 1 Cx
1 . Total revenue in Figure 9.3 is also the area of 0P
1 Cx
1 , so TR 5 TC. This firm is
therefore making zero economic profit, although it is meeting its opportunity costs. Remember that total cost includes normal profit, which is the return on capital and enter- prise necessary to keep firms in an industry.
The point at which the firm is making only a normal rate of return, or zero economic profit, is the breakeven point. If there is zero economic profit then P 5 AC and so AC 5 P 5 MR 5 MC. The breakeven point occurs at the intersection of the average cost (AC) curve and the marginal cost (MC) curve. If price rises above the breakeven point, the firm will make an economic profit; if the price falls below breakeven, the result will be a negative economic profit.
Figure 9.3: Firm earning zero economic profit
The average cost (AC) curve is used to determine if a firm is making an economic profit. If average revenue (price) is equal to average cost, the firm is making zero economic profit.
0
Price, Cost
Quantity/Time Period
P1
x1
D=AR=MR
MC AC
C
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Section 9.2 Competitive Adjustment in the Short Run CHAPTER 9
If the firm’s average cost (AC) curve is the one drawn in Figure 9.4, the average cost of producing x
1 is the distance x
1 A. Total revenue (TR) is still P
1 3 x
1 , or the area of 0P
1 Bx
1
Total cost is now the area of 0CAx 1 . Since TR . TC, there is an economic profit equal to the
area of CP 1 BA in Figure 9.4. On the other hand, if the firm’s average cost curve is the one
drawn in Figure 9.5, the average cost of producing x 1 is the distance x
1 A. Total revenue is
the area of 0P 1 Bx
1 and total cost is the area of 0CAx
1 . In this case, TC . TR, so economic
losses are being incurred. The economic loss is equal to the area of P 1 CAB in Figure 9.5.
Figure 9.4: Firm earning an economic profit
If the firm’s average revenue is greater than its average cost at the level of output being produced, the firm is making an economic profit.
0
Price, Cost
Quantity/Time Period
P1
C
x1
D=AR=MR
MC
AC
B
A
Profit
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Section 9.3 The Shutdown Decision CHAPTER 9
Figure 9.5: Firm suffering a loss
If the firm’s average cost is greater than its average revenue at the level of output being produced, the firm is incurring a loss.
Should the firm of Figure 9.5 continue to produce, and, if so, for how long? It is suffering a loss, which means the productive resources employed by this firm could earn more in some other use. Revenues are less than opportunity costs. But keep in mind that this dia- gram shows the short run, which means that some input is fixed. This fixed input means that there are fixed costs that cannot be eliminated. Fixed costs must be paid in the short run even if production ceases. Because variable costs are the only ones under the firm’s control in the short run, we need to include the average variable cost (AVC) curve to deter- mine the conditions under which the firm should cease production.
9.3 The Shutdown Decision
The short-run cost curves of a firm are depicted with several equilibrium points in Figure 9.6. At a price of P1, which represents a marginal revenue of MR1, the firm maximizes profits by producing x 1 . At P
1 , the firm is making an economic profit
because total revenue (area of 0P 1 Ax
1 ) is greater than total cost (area of 0C
1 Dx
1 ). At price P
2
5 MR 2 , the firm would produce x
2 and make zero economic profit because total revenue
0
Price, Cost
Quantity/Time Period
P1
C
x1
D=AR=MR
MC AC
A
B
Loss
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Section 9.3 The Shutdown Decision CHAPTER 9
(area of 0P 2 Bx
2 ) is equal to total cost (area of 0C
2 Bx
2 ). Notice that this Point B lies at the
intersection of the average cost and marginal cost curves. This, then, is the breakeven point, and the firm makes zero economic profit.
Figure 9.6: The shutdown point
If a firm’s average revenue is greater than its average variable cost, the firm will be able to cover total variable costs and make a payment toward total fixed costs. If price falls below average variable costs, the firm will lose less money if it shuts down than if it continues to produce. The shutdown point in this case is Point S at a price of P
3 .
Examine carefully what happens when price falls to P 3 and marginal revenue falls to MR
3 .
The profit-maximizing or loss-minimizing output is now x 3 . At output level x
3 , economic
losses are incurred because total revenue is the area of 0P 3 Sx
3 , and total cost is the area of
0C 3 Ex
3 . Economic losses are thus represented by the rectangle P
3 C
3 ES. The firm needs to
answer this question: Should it produce and incur this loss or should it cease production? Remember, if production is halted, fixed costs must still be paid. In Figure 9.6, if the mar- ket price is P
3 , the firm is earning a total revenue equal to the area of 0P
3 Sx
3 , and its total
variable costs (TVC 5 AVC 3 Q) are 0P 3 Sx
3 . At this price–output combination, marginal
revenue is equal to average variable cost. In other words, the firm is covering (exactly) its total variable costs and losing an amount equal to its total fixed costs. It must pay the fixed costs even if it shuts down, so at price P
3 the firm is indifferent about shutting down
or continuing to produce. If the price falls below P 3 , the firm should shut down in order
0
Price, Cost
Output/Time Periodx1x4 x2
MR 1
MC
G
H
F
E
S
B
A
D
AC AVC
MR 2C 2 P2,
C 4
C 3 C 1
P3
P4
x3
MR 3
MR 4
P1
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Section 9.3 The Shutdown Decision CHAPTER 9
to minimize losses. By shutting down, it will lose only total fixed costs, instead of losing total fixed costs plus some portion of variable costs (as it will if it continues to produce). The minimum or low point on the AVC curve where it intersects the MC curve (Point S in Figure 9.6) is called the shutdown point because if price falls below that point, the firm loses less by ceasing production.
Consider price P 4 (or MR
4 ) in Figure 9.6. The MR 5 MC rule tells the firm that at P
4 it
should produce output level x 4 . However, at x
4 the firm is losing P
4 C
4 GF (0P
4 Fx
4 2 0C
4 Gx
4 ).
Total revenue of 0P 4 Fx
4 does not cover the total variable costs of producing x
4 , which are
x 4 H times x
4 . In other words, the firm is losing more than its total fixed costs. It is making
variable cost outlays that it wouldn’t have to make if it stopped production entirely. The firm would be better off to shut down and only incur its fixed costs.
Because the firm shuts down, we need to modify the earlier statement that the firm’s mar- ginal cost curve represents its short-run supply curve. That statement is not completely correct. A firm’s short-run supply curve is represented by its marginal cost curve only above the shutdown point (Point S in Figure 9.6). Below the shutdown point, the firm will produce no output, so only the part of the marginal cost curve above the minimum point on the average variable cost curve is the firm’s supply curve.
The model has just told us that in the short run, the firm will shut down when price falls below average variable cost. It says nothing about the real-world timing of such a shut- down. The decision to shut down is more difficult in reality than in theory. It depends on many factors, including time and anticipated changes. A few examples may illustrate such problems.
First, imagine yourself the owner of a sporting goods store in a ski area or a beach resort. Shutdown may be a seasonal decision. If revenues fall below average variable costs (clerks’ wages, electricity, and so on) in the off-season, you may close up, bearing only your fixed costs (such as rent on the store) until crowds return and your revenues increase. In this case, shutdown does not mean you are moving your investments in plant and equipment into other businesses. It simply means that you lose money in certain seasons and you lose less money if you shut down. You fully intend to reopen for business when the snow flies or the temperature sends people to the beaches. Past experience helps you to determine when to shut down and when to reopen.
Second, imagine yourself the owner–manager of a steel mill. The price of steel has fallen below your average variable costs of production. In the short run, you shut down (if laws and union contracts allow you to do so—a union contract might change labor from a vari- able to a fixed resource). The short run is too short a time period for you to vary your plant size (which is one way of saying that you can’t move your fixed resources in this time period). If, however, you are convinced that this low price is permanent, you will begin to liquidate. You will sell equipment and attempt to sell your buildings and other fixed assets. As you do this, you are moving to the long run.
The short-run output decisions and profit determination for a perfectly competitive firm can be illustrated with a simple example. Table 9.1 presents some production cost data for a firm. Assuming that different market prices are the result of different market equilib- rium situations, it is possible to determine the firm’s response to different prices. In Table 9.2, six different market prices corresponding to different market conditions are assumed.
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Section 9.3 The Shutdown Decision CHAPTER 9
When the market price is $61, the demand and marginal revenue curves the firm faces are perfectly elastic at $61. The firm produces 10 units (where MR 5 MC 5 $61) and earns an economic profit of $120. This situation corresponds to the graph in Figure 9.4. At a market price of $46, the firm maximizes profit where MR 5 MC 5 $46, which is at an output of 7 units. Since TR 5 TC at 7 units, there is zero economic profit. This situation corresponds to Figure 9.3. When market price falls to $41, the firm reacts by decreasing its output to 6 units (where MR 5 MC 5 $41). At 6 units of output, it incurs a loss of $30. This economic loss corresponds to that shown in Figure 9.5.
Table 9.1: Production costs for a firm Output Average variable
cost (AVC) Average cost (AC) Marginal cost (MC) Total cost (TC)
1 $40 $100 $40 $100
2 38 68 36 136
3 36 56 32 168
4 35 50 32 200
5 35 47 35 235
6 36 46 41 276
7 37�⁄₇ 46 46 322
8 39 46½ 50 372
9 41 47⅔ 57 429
10 43 49 61 490
Table 9.2: Production decisions at various market prices Market price (MR) Firm’s output Total revenue (TR) Total cost (TC) Firm’s profit
$61 10 $610 $490 $120
50 8 400 372 28
46 7 322 322 0
41 6 246 276 -30
35 5 175 235 -60
32 4 128 200 -72
The firm will continue to produce in the short run unless price falls below $35 because the minimum value of average variable costs (minimum point on the AVC curve) is at $35. To see why, look at how the firm responds when market price falls to $32. At $32, the firm produces 4 units. However, it loses $72 (TR 5 4 3 $32 5 $128, TC 5 4 3 $50 5 $200, and $128 2 $200 5 2$72). If it shuts down, the firm loses only $60 in total fixed costs. The total variable cost (TVC) would have been $140 if production had taken place (TVC 5 4 3 $35 5 $140 and TFC 5 $200 2 $140 5 $60). So the firm loses less if it ceases production. At any price less than $35, the firm will shut down.
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Section 9.3 The Shutdown Decision CHAPTER 9
Global Outlook: The Organization of Markets in Developing Countries In many countries, markets are not as well developed as they are in the United States. In these countries, many nonmarket institutions have strong holds that affect production, distribution, and consumption. The laws of supply and demand still hold, but customs, systems of land tenure, village and family organization, religious practices, and corruption all have an impact on the functioning of markets.
Cultural differences affect the emergence of entrepreneurs and the profit motive. In poor countries, entrepreneurs may lack the help of markets to bring together materials, labor, and capital. If indi- viduals are discouraged from being risk takers, their reaction may be to say “no” to new business opportunities. These kinds of cultural obstacles make economic development more difficult in many developing countries, because development requires a strong entrepreneurial class. Also, if the rul- ing structure of a society does not encourage entrepreneurial development but supports the stability of a traditional society, this influence slows economic growth.
Another difference between the markets of developing and industrialized countries is that retail markets are often less organized and the products are less standardized. As a consequence, neither buyers nor sellers are price takers. Instead, much time and effort is expended in negotiating prices, which is time that does not go into producing goods and services.
Almost all developing countries are really two societies in the same country—one modern, urban, and market-oriented, and the other made up of rural workers who are largely employed in agricul- ture, have little access to education, and whose economic activity largely does not pass through the market. This coexistence is called dualism. (continued)
Check Point: What Short-Run Cost Curves Tell Us
• The minimum point on the average cost curve is the least-cost combination. • The minimum point on the average variable cost curve is the shutdown point. • The part of the marginal cost curve above the average variable cost curve is the perfectly
competitive firm’s supply curve. • Profit or loss is measured as average revenue (price) times quantity minus average cost times
quantity.
iStockphoto/Thinkstock
Markets in some countries are not as developed as markets in other countries. Almost all developing countries are really two societies in the same country—one modern and market- oriented and the other rural and less economically active.
iStockphoto/Thinkstock
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Section 9.4 The Long Run: Constant, Increasing, or Decreasing Costs CHAPTER 9
Global Outlook: The Organization of Markets in Developing Countries (continued) Cities in developing countries contain many poor people, but also have modern transportation and plumbing, manufacturing and service jobs, culture, a concentration of educated people, and a mod- ern market economy. Birth rates are lower and women are more likely to have access to educa- tion and market opportunities. Rural areas, in contrast, tend to maintain traditional lifestyles with centuries-old farming methods, early marriage with many children, and much home production with few market transactions. Most citizens in rural areas live in poverty or near poverty, generating little saving and investment.
China is one example of a nation with a dualistic economic structure. Following the opening of trade barriers and booming economic growth reaching a high of 14% per year in 1992 and still upwards of 7.6% in 2012, China is poised to offer its citizens a far greater standard of living (Trading Economics, n.d.). However, that greater standard of living has not reached many regions of China, where access to running water and basic health care is still very much a problem.
Dualism can be a major handicap to development. The urban population in a dual economy is often too small to provide a market for manufacturing and services or to generate enough saving and investment in human and physical capital. It is easy for people in developed countries to take mar- kets and entrepreneurs for granted and overlook the role they play in creating and sustaining a high standard of living.
9.4 The Long Run: Constant, Increasing, or Decreasing Costs
The process of determining price and output, when firms have time to alter their fixed inputs and when new firms can enter the industry, is illustrated in Figure 9.7. The D 1 and S
1 curves are the equilibrium demand and supply curves for the
industry. The industry is in long-run equilibrium when no economic forces are working to cause it to expand or contract (or to cause the price to change). In part (a) of the figure, the firm is making zero economic profit at price P
1 and output x
1 . Let’s assume this firm
is representative of 1,000 identical firms. Thus, the market supply curve (S 1 ) in part (b) is
the summation of 1,000 MC curves (above the AVC curves). Since these firms are making zero economic profits at P
1 , the industry is in equilibrium with an industry output of Q
1
(with each firm producing x 1 ). Now suppose there is an increase in market demand to D
2 ,
brought about by an increase in consumers’ real income, and assume that the good under consideration is a normal good. When market demand shifts to D
2 , market price rises to
P 2 . The demand curve for the firm rises to D
2 and is perfectly elastic at price P
2 .
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Section 9.4 The Long Run: Constant, Increasing, or Decreasing Costs CHAPTER 9
Figure 9.7: Long-run adjustment to an increase in market demand
An increase in market demand will cause the price to rise. The demand curve the representative firm faces will shift upward. Economic profit will result, and new firms will enter the industry in response to this profit. As new firms enter, the market supply curve shifts to the right, causing price to fall to the point at which the representative firm is again earning zero economic profit.
The firm’s initial (short-run) response is to increase its output to x 2 because MR
2 5 MC at
output level x 2 . Thus, the increase in market demand from Q
1 to Q
2 is met by an increase
in output by each of the 1,000 firms, from x 1 to x
2 . Note, however, that each firm will then
make an economic profit equal to the shaded area in Figure 9.7(a). Economic profit, you recall, means that productive resources are earning more than their opportunity cost. This profit means that the industry is out of equilibrium. Other firms are going to attempt to get some of this profit. The existence of profit is the signal for new firms to enter this industry.
Since free entry and perfect knowledge are assumed to be characteristics of perfect com- petition, entrepreneurs will be aware of this profit and will enter the industry. As firms enter the industry, the market supply curve will shift because it now is the summation of the 1,000 original MC curves plus the MC curves of the new entrant firms. In fact, firms will keep entering the industry until equilibrium (zero economic profit) is restored. This is illustrated in Figure 9.7. If all firms have the same costs (that is, all firms are exactly like the representative firm) and if nothing happens to change these costs, equilibrium will be restored when the price has been reduced to P
1 , the original equilibrium price. If the
new equilibrium price is P 1 and industry output is Q
3 , each firm is producing x
1 units. The
0 Quantity/ Time Period
Quantity/ Time Period
Price, Cost
0
Price (a) Firm (b) Market
P1 P1
x 1 x 2 Q 1 Q 2 Q 3
MC
AC
A B Slr
D1 1 1D =AR =MR
P2 P2 D2 2 2D =AR =MR
D1
D2
S 1
S 2
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Section 9.4 The Long Run: Constant, Increasing, or Decreasing Costs CHAPTER 9
summation of the firms’ output (1,000 plus the number of new firms times x 1 ) is equal to
the industry output (Q 3 ). Connecting the market equilibrium points, Points A and B in
Figure 9.7(b), gives the industry’s long-run supply curve, Slr. This curve represents what firms will supply after all adjustments have taken place.
Just as profits are the signal for firms to enter an industry, losses are the signal for firms to exit an industry. Entrepreneurs move their productive resources to other uses, seeking to earn their opportunity cost elsewhere. With perfect knowledge, entrepreneurs will know where they can earn at least normal profit. As firms leave the industry, the short-run mar- ket supply curve will shift to the left because it is now derived by adding up the short-run supply curves of fewer firms. Firms will leave the industry until the remaining firms have zero economic profits or losses and equilibrium is restored.
Constant Cost Industries
The adjustments traced in Figure 9.7 assumed that input prices, and thus costs, were unaf- fected by the quantity of output the industry produced. As firms entered the industry (Figure 9.7) or exited the industry, the price of the productive resources did not change. As a result, the average and marginal cost curves did not change. When cost curves do not change as an industry expands or contracts, the industry is referred to as a constant cost industry. A constant cost industry is an industry in which expansion of output does not cause average costs to rise in the long run. In a constant cost industry, as more steel, labor, electricity, and other inputs are purchased, the price of those inputs does not increase. Constant costs are most likely to occur when the industry’s purchase of inputs is small relative to the market supply of those inputs. If the industry’s use of inputs is small rela- tive to a very elastic market supply, increased demand for those inputs will not increase their prices (very much). For example, consider the personal computer industry. If prof- its exist and firms enter, these firms will demand more inputs. They will demand more plastic, more labor, and more microchips. If all the computer-producing firms use a small fraction of the total supply of these inputs, the increase in demand will not cause the price of plastic, labor, and microchips to rise.
Figure 9.7 represents long-run expansions in constant cost industries. The short-run response to a contraction in demand is a decrease in price. An expansion in demand pro- duces a short-run increase in price. The market adjustment, however, will return price to its original level, with fewer firms in the case of the contraction or more firms in the case of the expansion. The long-run supply curve in a constant cost industry is perfectly elastic, even though the short- run supply curve has a positive slope.
Increasing Cost Industries
Sometimes an expansion in industry output will cause costs to increase in the long run. In this case, as an industry expands output and demands more inputs, the increased demand causes prices of inputs to rise. For example, an increase in demand for chicken causes new firms to enter the packing industry and to demand more chicken coops, chicken pluckers, land, and packaging. If the increased demand causes the price of chicken coops, chicken pluckers, land, or packaging to rise, the average production costs of the representative firm will increase as a result of the increased demand for chicken. Also, less productive
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Section 9.4 The Long Run: Constant, Increasing, or Decreasing Costs CHAPTER 9
inputs and firms may be drawn into the industry. These conditions describe an increasing cost industry. An increasing cost industry is an industry in which expansion of output causes average costs to rise in the long run.
Figure 9.8 illustrates the long-run adjustment process in an increasing cost industry. The industry is originally in equilibrium at price P
1 and output level Q
1 . Each firm is produc-
ing x 1 units of output. Market demand increases to D
2 . As a result, market price rises to P
2 .
The firm’s demand is now represented by D 2 5 AR
2 5 MR
2 . The firm’s short-run response
is to increase output to x 2 , where MC
1 5 MR
2 . The industry’s output is now at Q
2 . At this
increased output, two things will happen. First, new firms will enter the industry because of the economic profits that now exist. Second, costs will rise as a result of the increased demand for inputs. This rise in cost is represented by the upward shift in the marginal and average cost curves to MC
2 and AC
2 in Figure 9.8(a).
Figure 9.8: Long-run adjustment to increasing demand in an increasing cost industry
When demand increases in an increasing cost industry, the firms that enter the industry bid up the prices of the productive resources for all firms in the industry. As a result, price does not return to the old equilibrium. Instead, a new equilibrium with the representative firm earning zero economic profit is established at a price above the old equilibrium price.
0 Quantity/ Time Period
Quantity/ Time Period
Price, Cost
0
Price (a) Firm (b) Market
P1
MC 1
MC 2 AC1AC2
P3 P1
P3
x 1 x 2 Q 1 Q 2Q 3
A BD1 1 1D =AR =MR D3 3 3D =AR =MR
P2 P2 D2 2 2D =AR =MR
D1
D2
S 1
S 2
Slr
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Section 9.4 The Long Run: Constant, Increasing, or Decreasing Costs CHAPTER 9
Check Point: What Equilibrium in Perfect Competition Means
• P 5 MC Production is at the level consumers indicate (through the market) they want. It is commonly called allocative efficiency.
• P 5 AC Firms are earning normal profits. There is no movement into or out of the industry. • AC 5 MC Firms are using a least-cost method of production.
The upward shift of the marginal and average cost curves is based on the assumption that all costs increase at the same rate. In most cases, this would not be true, since the prices of some inputs (the scarcer ones) would rise faster. However, the example is clearer if we assume that all input prices rise proportionally, and this assumption does not seriously affect the analysis. Firms, as purchasers of inputs, are likely to have much influence in some input markets and little influence in others. In the chicken-packing example, as the demand for chicken increases and firms enter the industry, there may be no effect on the price of land but a large effect on the price of machines used to pluck chickens. This kind of cost increase is most likely when specific, rather than general, inputs are used in the production process. It is also possible that the new firms attracted to an industry will be less efficient at producing the good in question. In this case, the representative firm will have higher costs, indicating less efficient production.
The net result of an increased number of firms and increased costs is a rightward shift in the short-run market supply curve. The supply curve shifts to the right because it is the sum of the supply curves of more firms. However, it will not shift as far to the right as it did in the constant cost industry because costs have risen for every firm. The new short-run market supply curve will be S
2 in Figure 9.8(b). Equilibrium is reached at price
P 3 , where firms are no longer making profits. Industry output is now Q
3 , and each firm is
producing x 1 units, where MR
3 5 MC
2 .
As before, the long-run market supply curve connects the industry’s equilibrium points on all of the short-run supply curves. Connecting Points A and B in Figure 9.8(b) produces a long-run supply curve (Slr) with a positive slope, indicating an increasing cost industry.
Decreasing Cost Industries
To complete the analysis, consider a decreasing cost industry. A decreasing cost industry is an industry in which an expansion of output causes average costs to fall in the long run. In a decreasing cost industry, as more firms enter the industry causing the demand for inputs to increase, input prices fall. Falling input prices imply that there are econo- mies of scale in an industry that is supplying an input to the decreasing cost industry. For example, as more electricity is demanded, more efficient generators are built and the price of this input falls.
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Section 9.5 Competitive Equilibrium: What’s So Great About Perfect Competition? CHAPTER 9
9.5 Competitive Equilibrium: What’s So Great About Perfect Competition?
The nature of perfect competition is such that the firm and industry are driven to equilibrium at zero economic profit. This equilibrium is the appeal of perfect com-petition as a standard against which to judge other market structures. Economists view this equilibrium as an ideal, or a social optimum. In equilibrium, resources are opti- mally allocated among competing uses. Figure 9.9 shows a perfectly competitive firm in equilibrium. At equilibrium, price (P) is equal to average cost (AC) and also is equal to marginal cost (MC).
Figure 9.9: The equilibrium condition for a perfectly competitive firm
In short-run equilibrium with perfect competition, allocative efficiency is met. This means that the resources of the firm are being allocated as consumers wish.
First, consider P 5 MC. This means that allocative efficiency is being achieved and that the resources of the firm are being allocated exactly as consumers wish. It means that firms are expanding production exactly to the level desired by society. If P were greater than MC, it would mean that not enough resources were going into the production of the good in question. Consumers would be willing to pay a higher price (P) than it costs to produce another unit of the good (MC). If P were less than MC, too many resources would be devoted to the production of the good. Consumers would not be willing to pay as much as it costs to produce another unit of the good. In other words, where P 5 MC, the socially optimal (or correct) amount of resources is being devoted to producing the good.
0
Price, Cost
Quantity/Time Period
P
x1
D=AR=MR
MC AC
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Section 9.5 Competitive Equilibrium: What’s So Great About Perfect Competition? CHAPTER 9
Second, consider P 5 AC. This means that firms are earning only normal profits. There is no incentive for firms to enter or leave the industry. It is important to note the role of profits in the perfectly competitive model. Economic profits serve as the signal for firms to move in or out of an industry. When profits exist, entrepreneurs rush in to attempt to capture them. The industry is forced to a new equilibrium. When losses are present, entre- preneurs leave to seek higher returns elsewhere. Equilibrium is attained because of the profit-seeking nature of firms. In equilibrium, there is efficiency. It is not because of some altruistic behavior on the part of entrepreneurs that firms are efficient. Entrepreneurs are assumed to be profit maximizers motivated by individual self-interest, and their response to changing profits brings about efficiency. In the competitive model, self-interest and the quest for profits produce the efficiency that benefits consumers. The firm is striving not for efficiency but for profits. When economic profits have served their signaling function, they disappear.
Third, consider MC 5 AC. This means that average cost (AC) is at a minimum. The vari- able resources are being combined as efficiently as possible.
In long-run equilibrium, as in Figure 9.10, the short-run average cost (AC) curve will be tangent with the long-run average cost (LRAQ) curve at their respective minimum points. Also, short-run marginal cost, as well as long-run marginal cost, equals marginal revenue. In fact, P 5 AR 5 AC 5 MC 5 LRAC 5 LRMC. This means several things:
Figure 9.10: Long-run equilibrium with perfect competition
In long-run equilibrium with perfect competition, average cost is equal to long-run average cost. This means that all firms are at the optimal size and are also combining variable resources efficiently. This is the ideal of efficiency to which other market structures are compared.
0
Price, Cost
Quantity/Time Periodxe
D=AR=MR
MC LRMC LRAC
AC
Pe
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Section 9.5 Competitive Equilibrium: What’s So Great About Perfect Competition? CHAPTER 9
Policy Focus: Floods, Subsidies, and the Farm Problem Agriculture has become a complex industry and farmers face numerous problems. The market for farm products can be characterized as a competitive market. Many programs that are well-intended add to the problems of competitive, productive farmers. Some of the programs aimed at aiding farmers hit hard by drought in 2012 are a case in point.
If the prices for farm products are “too low,” mean- ing that farmers are suffering economic losses, the competitive solution is for some farms to exit the industry. That is what has been happening since 1900 in the United States. As farm production falls, prices will rise to the point where existing farmers receive normal profits and remain in business.
Let’s consider the impact of a well-intended emer- gency program that was in place in 2012 to help farmers recover from production and physical losses due to natural disasters. Even though the droughts of 2012 did not cause destruction in Minnesota, it was a bad year for growing soy and Minnesota was the third largest producer of soy in the coun- try (American Soybean Association, 2012, p. 15). Luckily, the government had a program called EM Loans that was triggered by an event like a drought that allowed farmers to borrow up to 100% of the actual production or physical losses less any other disaster-related compensation. The farmers could get a 3.75% loan in order to get them through this difficult time. One of the conditions for the 3.75% loan was that the farmer be unable to get adequate credit elsewhere (United States Department of Agriculture, n.d).
Consider now the case of Roddy, a successful, energetic soy farmer. He has a efficient, well-run oper- ation and has been making profit for many years. He had carefully managed his water resources and worked hard to get his soy planted at the right time to avoid the worst of the drought. (continued)
1. The firm has no further opportunities to improve or to enhance profitability. 2. Any larger or smaller plant size or production levels would be non-optimal and
result in economic losses. 3. Only the least-cost, most efficient firms will survive in a perfect competition.
The model of perfect competition is not meant to be a precise description of reality. Nor is it, in every case, the ideal state that society should be striving to reach. In certain indus- tries, it may be too costly to bring about the necessary conditions for perfect competition. For example, in most markets, buyers are not perfectly informed about all prices from all sellers. In that case, society can accept less than the ideal. The model of perfect competi- tion is a theoretical tool for an economist. The economist can compare the real-world situ- ation to the hypothetical world of perfect competition to determine what would be the case if perfect competition existed. In this sense, perfect competition is a benchmark, or yardstick, by which economists can measure the performance of other market structures.
iStockphoto/Thinkstock
Agriculture is a complex industry. Government policy makers need to understand that competition requires relatively free entry and exit. Sometimes a farmer’s best option is to exit the industry.
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Section 9.6 Economic Rent in Perfect Competition CHAPTER 9
9.6 Economic Rent in Perfect Competition
According to the model of perfect competition, in industries in which free entry exists, profits will be driven to normal rates of return. Yet we all know of indi-viduals who have become rich in industries that are very competitive and that have relatively free entry. How can this happen without totally invalidating this model? To explain how returns in excess of normal profits can exist in the long run, even under perfect competition, we must introduce some new concepts.
Economic Rent
Rent is a familiar term. You pay rent on your apartment. But economists have a special (and very different) meaning for this term. Economic rent is a payment to a productive resource in excess of the opportunity cost of that productive resource. Let’s say, for exam- ple, you are trained as a teacher and could earn $50,000 per year in that profession. How- ever, you also have beautiful teeth and can do toothpaste commercials, for which you earn $70,000 per year. Economists would say that $20,000 of your income is economic rent because it is the amount by which your earnings exceed your opportunity cost. They would predict that you would do the commercials for $50,001 per year since you would then be earning more than your opportunity cost.
Economic rent, then, is more general than economic profit. Since economic profit is defined as revenue in excess of all the implicit costs (including normal profit) and explicit costs of production, economic profit is rent to entrepreneurs. Entrepreneurs will earn only normal profits in perfect competition because new entry will drive out higher rates of return. It is possible that economic rents to other productive resources will exist. Thus, we need to relate the concept of economic rent to the model of perfect competition.
Policy Focus: Floods, Subsidies, and the Farm Problem (continued) He is in pretty good shape and stands to make at least a normal profit this year. The best thing for his long-term economic interest would be for some of the marginal farmers in his market area to go out of business, decreasing supply. Roddy has no trouble going to the bank and getting a loan to finance his soy farm. He will get a farm loan and pay market rates of interest, about 5% in 2012. Yet he is going to have to compete with the marginal farmer down the road who can’t get a farm loan. That marginal farmer will be able to get a 3.75% government loan. Now Roddy has to compete with a neighbor that has a lower cost of capital. A policy designed to help an unfortunate individual has disadvantaged an individual who worked hard and was successful.
One of the hardest things for governmental policy makers to understand is that competition requires relatively free entry and exit. If the price of farm products is insufficient to permit normal profit, the only solution is for some farmers and some farm production to exit the industry. But politicians want to help people, and many of those that are hurt by the governmental policy don’t even know why they were hurt.
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Section 9.6 Economic Rent in Perfect Competition CHAPTER 9
Representative Firms and Economic Rents
The theory of perfect competition uses a representative firm that is one of many firms with cost structures that are identical. This assumption is not always realistic. Consider agri- culture as an example. Some farmland is far superior to other farmland. It is more fertile, gets more rainfall, or is located where the weather is warmer. The quality of the land will affect the farmer’s costs of production. Economic rent will always be earned on the better land, and entry of new firms will not eliminate such rent. In other competitive industries, location, family connections, or talent will make firms’ cost structures different, creating economic rents.
Differential Rent Theory
Economic rent does not weaken the theory of perfect competition. In 1817, classical econo- mist David Ricardo reconciled the existence of economic rents with perfect competition by developing differential rent theory. He was interested in explaining the fact that fertile farmland earned a higher rent than poor farmland.
Consider, for example, the cost and revenue functions of two farms, shown in panels (a) and (b) of Figure 9.11. The market is represented in panel (c).
Figure 9.11: Differential rents in perfect competition
Farms A and B both face perfectly elastic demand curves at price P, determined in the market for their product, panel (c). Because its land is more fertile, farm B has lower average costs and earns a profit shown by the shaded area in panel (b). That profit will be converted to economic rent as competition for the fertile land bids up its price.
0
P P
C
P
Quantity/ Time Period
Quantity/ Time Period
Price, Cost
(a) Farm A (b) Farm B
0
Price, Cost
0
S
D
Q
Price, CostMC A
AC A
MC B
AC B
xA xB
(c) Market
Quantity/ Time Period
D=AR=MR D=AR=MR
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Summary CHAPTER 9
Supply and demand are such that market price for the farms’ product is P. Farm A is earn- ing zero economic profit (P 5 AC
A ). Farm B has economic rent equal to the shaded area.
This economic rent comes from the fact that the land used to produce the farm product is much more fertile for farm B. As a result, the costs of production are lower.
Other farmers would be willing to pay the owner of the land owned by farm B a higher price for being able to farm that land. This higher price becomes a cost of production to farm B because economic rent for the more fertile land will rise as farmers seek to either purchase or lease this land. Even if the owner of the land is also the farmer, economic rent is still an opportunity cost of production because the owner could lease the land to other farmers.
The result of differential rent to productive resources is because rents rise on more pro- ductive inputs. This rise equalizes the average cost of production among firms in perfect competition. In other words, the economic rent for farm B is a result of a superior produc- tive resource, more fertile land. The user of the input (it could be the owner of the farm or someone else) will receive this rent. When the rent is paid, AC
B will, in fact, rise, as the
shaded area for farm B is really an economic cost. We would expect the cost curves in Fig- ure 9.11 (a) and (b) to equalize.
The point is that competitive firms may appear to earn economic profits (more than a normal rate of return), but these returns are often economic rents to unique inputs, not economic profits. In many cases, the firm’s entrepreneur is the owner of the inputs. As a result, the rent looks like an economic profit. In fact, many times the entrepreneur has special skills that form the basis for the firm. The return to these skills is an economic rent to the productive resource enterprise. It is not an economic profit. The concept of eco- nomic rent is an important one and will be discussed in more detail in several upcoming chapters.
Summary
Consider again. . . The question we began with is now easy to answer. Firms shut down in the short run when average revenue does not cover average variable costs. For many firms, the timing of the revenue flow determines hours of operation. One restaurant may open at 11:00 A.M. when one across the street opens at 5:00 P.M. A resort with very slow off-peak business may incur losses if it remained open during the off-season. For the firm that is closed, the fixed cost is less than would be incurred if the firm were open for business.
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Key Terms CHAPTER 9
average revenue (AR) Total revenue divided by the quantity sold, or the rev- enue per unit sold (the price).
breakeven point The point at which the firm is making only a normal rate of return.
constant cost industry An industry in which expansion of output does not cause average costs to rise in the long run.
decreasing cost industry An industry in which expansion of output causes average costs to fall in the long run.
economic rent A payment to a productive resource in excess of its opportunity cost.
increasing cost industry An industry in which expansion of output causes average costs to rise in the long run.
market power The ability of buyers or sellers to affect price.
perfect competition The market structure in which there are many sellers and buy- ers, firms produce a homogeneous prod- uct, and there is free entry into and exit out of the industry.
Key Points
1. Perfect competition is characterized by large numbers of buyers and sellers, homogeneous products, ease of entry into and exit out of the industry, perfect knowledge, and mobility of resources. Profits are the force that drives the per- fectly competitive model to efficiency. The firm is seeking not efficiency, but prof- its. This search for profits produces the efficiency that characterizes the model of perfect competition. Large numbers of buyers in a perfectly competitive market ensure that no single buyer can influence price.
2. A firm in a perfectly competitive market faces a perfectly elastic demand curve at the price determined by equilibrium in the market. The firm’s short-run supply curve is the same as its short-run marginal cost curve.
3. Since the firm will shut down when price falls below average variable cost, the actual short-run supply curve is the marginal cost (MC) curve above the mini- mum point on the average variable cost (AVC) curve. This point of intersection is known as the shutdown point.
4. Long-run adjustments to changes in market demand are dependent on the cost characteristics for the industry. Since entry is easy, additional firms will enter an industry as long as economic profits are present. Thus, economic profits, brought about by an increase in demand, will lead to new entry. An industry can be char- acterized by constant, increasing, or decreasing costs. The slope of the long-run market supply curve will depend upon which of these cost situations prevails.
5. At perfectly competitive equilibrium, P 5 AC 5 MC 5 MR 5 LRAC 5 LRMC. This condition describes the ideal allocative efficiency of perfect competition, to which other market structures are compared. From a society’s perspective, noth- ing can be done to improve the allocation of scarce resources.
6. Economic rent is a payment (return) to a productive resource over the opportu- nity cost of that input. Competitive firms may appear to be earning long-run eco- nomic profits, but these returns are actually economic rents to specific productive resources in the firms.
Key Terms
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Critical Thinking and Discussion Questions CHAPTER 9
price taker A seller (or buyer) in perfect competition that has no influence on price and can sell (or buy) any amount at the market-clearing price.
representative firm A typical firm in per- fect competition, one of the many identical firms in the market.
short-run supply curve The supply curve for the period in which the size of the plant cannot be varied (in perfect competition, the same as the short-run marginal cost curve).
shutdown point The minimum point on the average variable cost (AVC) curve, or the level of output at which a firm mini- mizes its losses by ceasing operation.
Critical Thinking and Discussion Questions
1. What are the characteristics that describe a perfectly competitive market? Why is it important to have a large number of buyers and sellers?
2. What does it mean for a firm to be a price taker? How does this limit the ability of a firm in perfect competition to generate large profits?
3. Why might a firm continue to produce in the short run even if it was incurring a loss? Would this occur in the long run? Why or why not?
4. What does it mean to say that in perfectly competitive equilibrium, P 5 MC 5 MR 5 LRAC?
5. Explain how the long-run market supply curve will be determined by short-run supply adjustments in an increasing cost industry.
6. Assume that the market for soy is perfectly competitive. If the market price is $5.50 per unit, what would happen if an individual farmer tried to sell at a price of $6.00? What would happen if the farmer set the price at $5.25?
7. Assume a firm in a perfectly competitive market can produce at a quantity where marginal revenue is less than average variable cost, but greater than average fixed cost. Should the firm shut down? Why or why not?
8. Assume a firm in a perfectly competitive market can produce at a quantity where marginal revenue is less than average variable cost and average fixed cost. Should the firm shut down? If so, what would determine whether they shut down temporarily or permanently?
9. Consider some markets that possess two or more characteristics of a perfectly competitive market. What types of products are they? How closely do they resemble the theoretical extreme of a perfectly competitive market?
10. One characteristic of a perfectly competitive market is free entry and exit. Why is this important? What would happen if there was not free entry into the market? What if there was not free exit from the market?
11. “If the price of wheat doesn’t rise, farmers will lose money and the long-run price will be even higher.” Analyze this statement.
12. What would happen to the price, output level, and profit for a firm in a perfectly competitive industry if the price of capital decreased? Distinguish between short- run and long-run impacts.
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Critical Thinking and Discussion Questions CHAPTER 9
13. Why do some ski resorts in Lake Tahoe, California, stay open all year, and others are only open during certain months of the year?
14. If there were a series of mergers among firms in a perfectly competitive market, would there be an impact on the market price? Why or why not?
15. Farmers in the Midwest occasionally share expensive machinery during harvest seasons. Why would competing firms choose to do this? What other motivation might they have?
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