econ homework questions for kate

Chapter 12: Perfect Competition

· Firms in perfect competition face the maximum amount of competition because there are many competing firms, each of which produces an identical product.

· Firms in perfect competition maximize their profit by producing where MR = MC.

· Perfect competition leads to an efficient allocation of resources.

I. What is Perfect Competition?

Perfect competition is an industry in which

· Many firms sell identical products to many buyers

· There are no restrictions on entry into the industry

· Established firms have no advantage over existing ones

· Sellers and buyers are well informed about prices

These characteristics of perfect competition arise when the minimum efficient scale for a firm is small relative to the size of the entire market.

If there aren’t really any perfectly competitive markets, what use is studying perfect competition? The perfect competition model serves as a benchmark and its predictions work in a wide range of real markets. Physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the same trip, you need a much fancier model! Economists use the model of perfect competition in a similar way to understand our economic world. Although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition.

· Firms operating in perfect competition seek to maximize economic profit, which is the difference between total revenue (the price of the firm’s output multiplied by the quantity sold) and its total opportunity cost of production.

· Firms in perfect competition are price takers, meaning that a firm that cannot influence the market price and so it sets its own price equal to the market price.

· Because the firm is a price taker, its marginal revenue—which is the change in total revenue that results in a one-unit increase in the quantity sold—is equal to the market price and remains constant as output sold increases. The firm’s demand is perfectly elastic and the firm’s demand curve is a horizontal line at the market price.

II. The Firm’s Output Decision

Marginal Analysis and the Supply Decision

· The firm produces the quantity of output for which the difference between total revenue and total cost is at its maximum because this difference is its economic profit.

· Marginal analysis can be used to determine the profit maximizing quantity. The firm compares the marginal revenue (which remains constant with output) to the marginal cost (which changes with output) of producing different levels of output.

· When MR > MC, then the extra revenue from selling one more unit exceeds the extra cost of producing one more unit, so the firm increases its output to increase its profit.

· When MR < MC, then the extra cost of producing one more unit exceeds the extra revenue from selling one more unit, so the firm decreases its output to increase its profits

· When MR = MC, then the extra cost of producing one more unit equals the extra revenue from selling one more unit, so the firm’s profit is maximized at this level of output.

· In the figure the firm produces 4 units of output because that is the quantity that sets the firm’s marginal cost equal to its marginal revenue, that is, MR = MC. The firm then charges the going market price of $30 for its good.

Temporary Shutdown Decision

· The firm will temporarily shut down in the short run when price falls below the shutdown point, which is the output and price that just allows the firm to cover its total variable cost. The minimum AVC is the lowest price at which the firm will operate because if it operated with a lower price, the firm’s loss would be greater than if it shut down. (The loss when the firm shuts down is equal to its fixed cost.)

· The firm will continue operating in the short run even if it incurs an economic loss as long as the price exceeds the minimum AVC.

Why would a restaurant open on days it knows business will be bad ? Monday is typically the slowest day in the restaurant industry. So why do so many restaurants stay open on Monday? The answer is that even if a restaurant incurs an economic loss on Monday, it still might increase its total profit by remaining open. The point is that as long as the restaurant can cover all its variable costs—the cost of the food, the cost of the servers, and so on—it likely will be able to pay some of its fixed costs using the revenue left over after paying its variable costs. As long as the restaurant can pay some of its fixed costs on Monday, its total profit by staying open exceeds what its total profit would be if it closed. So losing money on Monday might be good business!

Students often have a hard time understanding why operating at an economic loss can be the best action for a firm owner. The key is emphasizing:

· The firm’s short-run decisions are made after some irreversible commitments have generated sunk costs.

· The firm considers only avoidable future costs when making decisions. Unavoidable costs have no impact on the decision (other than to learn from them).

· For the firm to continue to produce output, the firm needs only to receive revenues that exceed any avoidable costs, not necessarily all of the total costs.

Basically, the goal of profit maximization does not guarantee that the firm will earn a positive economic profit in the short run. Sometimes the best the firm can do is to minimize its economic loss.

The Firm’s Supply Curve

· As long as the firm remains open, it produces where MR = MC. So the firm’s supply curve is its MC curve above the minimum AVC. At prices below the minimum AVC, the firm shuts down and supplies zero.

· The figure shows the firm’s supply curve as the heavy dark line.

· At prices less than the minimum average variable cost, which equals P in the figure, the firm shuts down and supplies zero.

· At prices greater than the minimum average variable cost, the firm supplies along its marginal cost curve. Hence the firm’s marginal cost curve is its supply, indicated in the figure by the S = MC curve.

III. Output, Price, and Profit in the Short Run

· The short-run market supply curve shows the quantity supplied by all the firms in the market at each price when each firm’s plant and number of firms remain the same. The quantity supplied in the industry at any price is the summation of all quantities supplied by each firm at that price, so the short-run industry supply curve is the horizontal summation of all the firms’ supply curves.

· Changes in market demand influence the output and the entry or exit decisions made by firms. An increase in market demand shifts the demand curve rightward and raises the market price. Each firm in the industry responds by increasing its quantity supplied.

· The higher price now exceeds each firm’s minimum ATC and the firms in the industry earn an economic profit. The figure illustrates a perfectly competitive firm earning an economic profit. The firm’s economic profit is equal to the area of the darkened rectangle.

· In the short run there are three possible profit outcomes—an economic profit, zero economic profit, and an economic loss.

· If the price exceeds the ATC, the firm earns an economic profit (as illustrated in the figure).

· If the price equals the ATC, the firm “breaks even” by earning zero economic profit. In this case, the firm earns a normal profit. At the profit maximizing level of output, q, the price, P, equals the ATC.

· If the price is less than the ATC, the firm incurs an economic loss.

IV. Output, Price, and Profit in the Long Run

· Economic profit motivates firms to enter the industry, thereby increasing the market supply.

· When the market supply curve shifts rightward, the market price falls. Eventually the price falls to equal the minimum ATC for each firm in the industry and firms have adjusted their plant size so they are producing at the minimum long-run average cost. At this price, firms in the industry no longer make an economic profit and so firms no longer enter the industry. The figure illustrates this long-run equilibrium. In the figure, LRAC is the long-run average cost curve and SRAC is the short-run average cost curve.

· One difference between the old and new market equilibriums is that the number of firms in the industry has risen and total quantity produced in the industry has increased.

· The effects of a decrease in market demand are the opposite of those outlined above.

· In the long run, competitive firms make zero economic profit (price = average total cost) so that their owners make a normal profit.

Profit as a “signal”: When demand for a good increases so that the existing firms in an industry earn an economic profit, the economic profit indicates that consumers are willing to pay a higher price for the good than they were willing to pay before the demand increased. The economic profit for the firms is a signal from the consumers to the owners of firms in other industries that society now values the availability of the good more highly than the availability of goods from those other industries. These self-interested firm owners choose to enter the industry in order to earn an economic profit. Their self-interested decisions promote the social interest by using more resources to produce those goods that are more highly valued by society. The dynamic behavior of a perfectly competitive market characterizes the “invisible hand” coined by Adam Smith.

Why would a firm stay in business if profit is zero? Remember, the profit we’re measuring is economic profit. Zero economic profit doesn’t necessarily mean that the firm isn’t making any money. It is making a normal profit.

V. Changes in Demand and Supply as Technology Advances

· Technological change can cause an increase in demand if it creates new applications for a product or new products. The text considers the impact on the demand for personal computers when the development of the internet leads to new uses for personal computers.

· Technological change can also decrease demand if new ways of doing things or new products become available.

· New, cost-saving technologies typically require new plant and equipment. Consequently it takes time for new technology to spread throughout an industry.

· Firms that adopt the new technology lower their costs and their supply curves shift rightward. The price of the good falls, so that firms using the old technology incur economic losses.

· Old-technology firms either adopt the new technology or else exit the industry. In the long run, all the firms use the new technology and earn zero economic profit.

· Changes in technology brings only temporary economic profit to producers, but the lower prices and better products that technological advances bring are permanent gains for consumers.

Do firms in perfectly competitive markets advertise? Firms in perfectly competitive markets have no incentive to advertise because their product is indistinguishable from the output of rival firms. Industry associations will sometimes advertize to increase demand for the product as a whole. Brainstorming all the ads for agricultural products such as “Pork: the other white meat,” and all the varieties of milk ads can be fun, but the point is that it isn’t a pork producer or a dairy farmer creating the ad, but all of the pork producers or dairy farmers paying dues to an industrial organization that then creates the ads.

VI. Competition and Efficiency

Efficient Use of Resources

· Resource allocation in a market is efficient when society values no other use of the resources more highly. Resource use is efficient when production is such that the marginal social benefit of the good equals the marginal social cost of the good.

Choices, Equilibrium, and Efficiency

· Consumers allocate their budgets to get the most value out of them. Because consumers get the most value out of their budget, a consumer’s individual demand curve for a good is the consumer’s marginal benefit curve for the good. If no one else benefits from the good other than the consumers, then, as shown on the figure, the market demand curve for a good is the marginal social benefit curve.

· Firms maximize their profits in order to get the most value out of their resources. Firms make choices across all possible allocations of their resources. A firm’s supply curve for a good is its marginal cost curve. If all the costs of production of the good are paid by the producers, then, as shown in the figure, the market supply curve for a good is the marginal social cost curve.

· In a competitive equilibrium, the quantity demanded equals the quantity supplied. If there are no externalities, the demand curve is the same as the marginal social benefit curve and the supply curve is the same as the marginal social cost curve, so at the competitive equilibrium, the marginal social benefit equals the marginal social cost. Resource use is efficient. Because resources are used efficiently, at the competitive equilibrium there is no other allocation of resources that will generate greater net benefits to society. The figure shows this outcome, where resource use is efficient at the equilibrium quantity of 3,000 units.