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ECO 2220, Principles of Microeconomics - Section 1C

Class Presentation for

March 22, & 24, 2016

Chapter #24

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Econ 2220

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Charles E. Merril

1885 – 1956

In 1915 he and Edmond C. Lynch (1885 – 1938) created Merril Lynch Investing

If the planters carry politics into the fields they will find it bad business.

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ECO 2220, Principles of Microeconomics - Section 1C

Looking Forward:

March 17, 2016 – Test #2

Chapters # 20, 21, 22, & 23

March 22, 2016 – Journal #7 due.
March 24, 2016 - Project Paper Outline Due.
March 29, 2016 – Journal #8 due.
April 5, 2016 – Journal #9 due.
April 7, 2016 – Test #2

Chapters # 24, 25, 26, & 27

Prepared By Brock Williams

Chapter 24
Perfect Competition

In the award-winning 2004 movie Sideways, the main character raved about pinot noir wine. This review increased the demand for pinot noir wine grown in the Willamette Valley in Oregon.

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Learning Objectives

Distinguish between four market structures

Explain the short-run output rule and the break-even price

Explain the shut-down rule

Explain why the short-run supply curve is positively sloped

Explain why the long-run industry supply curve may be positively sloped

Describe the short-run and long-run effects of changes in demand for an increasing-cost industry

Describe the short-run and long-run effects of changes in demand for a constant-cost industry

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perfectly competitive market

A market with many sellers and

buyers of a homogeneous product

and no barriers to entry.

price taker

A buyer or seller that takes the market price as given.

Perfect Competition

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Here are the five features of a perfectly competitive market:

1 There are many sellers.

2 There are many buyers.

3 The product is homogeneous.

4 There are no barriers to market entry.

5 Both buyers and sellers are price takers.

Perfect Competition

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Perfect Competition and the Affordable Care Act

Perfect Competition	Affordable Care Act
There are many sellers.	Open to all private health insurance providers (HIP) in America
There are many buyers.	All citizens who do not have health insurance (employers or other means) must join exchanges
The product is homogeneous.	Act establishes minimum standards for policies for all customers
There are no barriers to market entry.	Large barriers for market entry – economies of scale
Both buyers and sellers are price takers.	Act helps to establish market prices for participating HIP’s

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24.1 PREVIEW OF THE FOUR
MARKET STRUCTURES

Perfect Competition: There are many sellers & buyers; homogeneous product; no barriers to entry; price takers are buyers & sellers.

Monopoly: A single firm serves the entire market. A monopoly occurs when the barriers to market entry are very large.

Monopolistic competition: There are no barriers to entering the market, so there are many firms, and each firm sells a slightly different product.

Oligopoly: The market consist of just a few firms because economies of scale or government policies limit the number of firms.

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 FIGURE 24.1

Monopoly versus Perfect Competition

In Panel A, the demand curve facing a monopolist is the market demand curve.

In Panel B, a perfectly competitive firm takes the market price as given, so the firm-specific demand curve is horizontal. The firm can sell all it wants at the market price, but would sell nothing if it charged a higher price.

24.1 PREVIEW OF THE FOUR
MARKET STRUCTURES (cont.)

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24.1 PREVIEW OF THE FOUR
MARKET STRUCTURES (cont.)

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The Total Approach: Computing Total Revenue and Total Cost

24.2 THE FIRM’S SHORT-RUN OUTPUT DECISION

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The Total Approach: Computing Total Revenue and Total Cost

► FIGURE 24.2

Using the Total Approach to Choose an Output Level

Economic profit is shown by the vertical distance between the total-revenue curve and the total-cost curve.

To maximize profit, the firm chooses the quantity of output that generates the largest vertical difference between the two curves.

24.2 THE FIRM’S SHORT-RUN OUTPUT DECISION (cont.)

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24.2 THE FIRM’S SHORT-RUN OUTPUT DECISION

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The Marginal Approach

marginal revenue

The change in total revenue from

selling one more unit of output.

marginal revenue = price

To maximize profit, produce the quantity where price = marginal cost

M A R G I N A L P R I N C I P L E

Increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost.

24.2 THE FIRM’S SHORT-RUN OUTPUT DECISION (cont.)

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The Marginal Approach

 FIGURE 24.3

The Marginal Approach to Picking an Output Level

A perfectly competitive firm takes the market price as given, so the marginal benefit, or marginal revenue, equals the price.

Using the marginal principle, the typical firm will maximize profit at point a, where the $12 market price equals the marginal cost.

Economic profit equals the difference between the price and the average cost ($4.125 = $12 – $7.875) times the quantity produced (eight shirts per minute), or $33 per minute.

24.2 THE FIRM’S SHORT-RUN OUTPUT DECISION (cont.)

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24.2 THE FIRM’S SHORT-RUN OUTPUT DECISION

Profit

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Economic Profit and the Break-Even Price

economic profit = (price − average cost) × quantity produced

break-even price

The price at which economic profit is

zero; price equals average total cost.

24.2 THE FIRM’S SHORT-RUN OUTPUT DECISION (cont.)

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THE BREAK-EVEN PRICE FOR SWITCHGRASS, A FEEDSTOCK FOR BIOFUEL

APPLYING THE CONCEPTS #2: What is the break-even price?

To illustrate the notions of break-even price, let’s look at these prices for the typical farmer.

Comparing switchgrass to alfalfa:

The implicit rent on land to grow alfalfa $120 per acre.
If the switchgrass yield is 3 tons per acre, the opportunity cost is $40 per ton.
If the explicit cost of a ton of switchgrass is $36
The breakeven price is $76 = $36 + $40
To get some farmers to grow switchgrass instead of alfalfa the price must be at least $56 per ton and to get the most fertile land switched the price must be $95 per ton, or $76 on average.

A P P L I C A T I O N

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24.3 THE FIRM’S SHUT-DOWN DECISION

Two approaches:

Revenue;
Price

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Total Revenue, Variable Cost, and the Shut-Down Decision

operate if total revenue > variable cost

shut down if total revenue < variable cost

24.3 THE FIRM’S SHUT-DOWN DECISION

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Total Revenue, Variable Cost, and the Shut-Down Decision

► FIGURE 24.4

The Shut-Down Decision and the Shut-Down Price

When the price is $4, marginal revenue equals marginal cost at four shirts (point a).

At this quantity, average cost is $7.50, so the firm loses $3.50 on each shirt, for a total loss of $14.

Total revenue is $16 and the variable cost is only $13, so the firm is better off operating at a loss rather than shutting down and losing its fixed cost of $17.

The shutdown price, shown by the minimum point of the AVC curve, is $3.00.

24.3 THE FIRM’S SHUT-DOWN DECISION (cont.)

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24.3 THE FIRM’S SHUT-DOWN DECISION (cont.)

operate if total revenue > variable cost

shut down if total revenue < variable cost

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The Shut-Down Price

operate if price > average variable cost

shut down if price < average variable cost

shut-down price

The price at which the firm is

indifferent between operating and

shutting down; equal to the minimum

average variable cost.

24.3 THE FIRM’S SHUT-DOWN DECISION (cont.)

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Fixed Costs and Sunk Costs

sunk cost

A cost that a firm has already paid – or -

committed to pay, so it cannot be

recovered.

24.3 THE FIRM’S SHUT-DOWN DECISION (cont.)

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STRADDLING THE ZINK COST CURVE

APPLYING THE CONCEPTS #3: What is the shut down price?

Zinc is a vital input to the production of steel. Because the cost of mining zinc varies from one mine to another, the shutdown price varies too. The world price of zinc decreased from roughly $2,300 per ton in 2010-2011 to $1,900 in early 2012.

The lower price was below the shutdown prices of Alcoa’s mines in Italy and Spain: at a price of $1,900, the total revenue from the mines was less than the variable cost of operating the mines.

The shutdown of Alcoa’s mines decreased mining output by 531,000 tons. Although mines with lower production costs continued mining at a price of $1,900, many mines have shutdown prices in the range $1,500 to $1,900, and will shut down if the price continues to drop.

A P P L I C A T I O N

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The Firm’s Short-Run Supply Curve

short-run supply curve

A curve showing the relationship

between the market price of a

product and the quantity of output

supplied by a firm in the short run.

24.4 SHORT-RUN SUPPLY CURVES

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The Firm’s Short-Run Supply Curve

 FIGURE 24.5

Short-Run Supply Curves

24.4 SHORT-RUN SUPPLY CURVES (cont.)

In Panel A, the firm’s short-run supply curve is the part of the marginal-cost curve above the shut-down price.

In Panel B, there are 100 firms in the market, so the market supply at a given price is 100 times the quantity supplied by the typical firm. At a price of $7, each firm supplies 6 shirts per minute (point b), so the market supply is 600 shirts per minute (point f)

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The Short-Run Market Supply Curve

short-run market supply curve

A curve showing the relationship

between market price and the

quantity supplied in the short run.

24.4 SHORT-RUN SUPPLY CURVES (cont.)

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Market Equilibrium

 FIGURE 24.6

Market Equilibrium

In Panel A, the market demand curve intersects the short-run market supply curve at a price of $7.

In Panel B, given the market price of $7, the typical firm satisfies the marginal principle at point b, producing six shirts per minute. The $7 price equals the average cost at the equilibrium quantity, so economic profit is zero, and no other firms will enter the market.

24.4 SHORT-RUN SUPPLY CURVES (cont.)

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long-run market supply curve

A curve showing the relationship

between the market price and

quantity supplied in the long run.

increasing-cost industry

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.

24.5 THE LONG-RUN SUPPLY CURVE FOR AN INCREASING-COST INDUSTRY

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Production Cost and Industry Size

24.5 THE LONG-RUN SUPPLY CURVE FOR AN INCREASING-COST INDUSTRY (cont.)

[page 532 – 534]

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Drawing the Long-Run Market Supply Curve

 FIGURE 24.7

Long-Run Market Supply Curve

The long-run market supply curve shows the relationship between the price and quantity supplied in the long run, when firms can enter or leave the industry.

At each point on the supply curve, the market price equals the long-run average cost of production. Because this is an increasing-cost industry, the long-run market supply curve is positively sloped.

24.5 THE LONG-RUN SUPPLY CURVE FOR AN INCREASING-COST INDUSTRY (cont.)

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The Short-Run Response to an Increase in Demand

 FIGURE 24.8

Short-Run Effects of an Increase in Demand

An increase in demand for shirts increases the market price to $12, causing the typical firm to produce eight shirts instead of six.

Price exceeds the average total cost at the eight-shirt quantity, so economic profit is positive. Firms will enter the profitable market.

24.6 SHORT-RUN AND LONG-RUN EFFECTS
OF CHANGES IN DEMAND

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The Long-Run Response to an Increase in Demand

 FIGURE 24.9

Short-Run and Long-Run Effects of an Increase in Demand

The short-run supply curve is steeper than the long-run supply curve because of diminishing returns in the short run.

In the short run, an increase in demand increases the price from $7 (point a) to $12 (point b).

In the long run, firms can enter the industry and build more production facilities, so the price eventually drops to $10 (point c).

The large upward jump in price after the increase in demand is followed by a downward slide to the new long-run equilibrium price.

24.6 SHORT-RUN AND LONG-RUN EFFECTS
OF CHANGES IN DEMAND (cont.)

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constant-cost industry

An industry in which the average cost

of production is constant; the long-run supply curve is horizontal.

24.7 LONG-RUN SUPPLY FOR A
CONSTANT-COST INDUSTRY

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Long-Run Supply Curve for a Constant-Cost Industry

 FIGURE 24.10

Long-Run Supply Curve for a Constant-Cost Industry

In a constant-cost industry, input prices do not change as the industry grows.

Therefore, the average production cost is constant and the long-run supply curve is horizontal.

For the candle industry, the cost per candle is constant at $0.05, so the supply curve is horizontal at $0.05 per candle.

24.7 LONG-RUN SUPPLY FOR A
CONSTANT-COST INDUSTRY (cont.)

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Hurricane Andrew and the Price of Ice

► FIGURE 24.11

Hurricane Andrew and the Price of Ice

A hurricane increases the demand for ice, shifting the demand curve to the right.

In the short run, the supply curve is relatively steep, so the price rises by a large amount—from $1 to $5.

In the long run, firms enter the industry, pulling the price back down.

Because ice production is a constant-cost industry, the supply is horizontal, and the large upward jump in price is followed by a downward slide back to the original price.

24.7 LONG-RUN SUPPLY FOR A
CONSTANT-COST INDUSTRY (cont.)

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break-even price

constant-cost industry

firm-specific demand curve

increasing-cost industry

long-run market supply curve

marginal revenue

perfectly competitive market

price taker

short-run market supply curve

short-run supply curve

shut-down price

sunk cost

K E Y T E R M S

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Econ 2220