Competitive firms cannot individually affect market price because

12c h a p t e r t w e l v e CHICAGO BOARD OF TRADE

Firms in Perfectly Competitive Markets 12.1 A Perfectly Competitive Market

12.2 An Individual Price Taker’s Demand Curve

12.3 Profit Maximization

12.4 Short-Run Profits and Losses

12.5 Long-Run Equilibrium

12.6 Long-Run Supply

At the Chicago Board of Trade (CBOT), prices are set by thousands of buyers interacting with thousands of sellers. The goods in question are standardized (e.g., grade A winter wheat) and information is readily available. Every buyer and seller in the market knows the price, the quantity, and the quality of the wheat available. Transaction costs are negligible. For example, if a news story breaks on an infestation in the cotton crop, the price of cotton will rise immedi- ately. CBOT price information is used to determine the value of some commodities throughout the world.

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T O N E Y , A D R I A N N A 5 5 2 1 B U

A firm must answer two critical questions: What price should we charge for the goods and services we sell, and how much should we produce? The answers to these two questions will depend on the market structure. The behavior of firms will depend on the number of firms in the market, the ease with which firms can enter and exit the market, and the ability of firms to differentiate their products from those of other firms. There is no typical industry. An industry might include one firm that dominates the market, or it might consist of thousands of smaller firms that each pro- duce a small fraction of the market supply. Between these two end points are many other industries. However, because we cannot examine each industry individually, we break them into four main categories: perfect competition, monopoly, monopolistic competition, and oligopoly. In a perfectly competitive market, the market price is the critical piece of information that a firm needs to know. A firm in a perfectly competitive market can sell all it wants at the market price. A firm in a perfectly competitive market is said to be a price taker, because it cannot appreciably affect the market price for its output or the market price for its inputs. For example, suppose a Washington apple grower decides that he wants to get out of the family business and go to work for Microsoft. Because he may be one of 50,000 apple growers in the United States, his decision will not appreciably change the price of the apples, the production of apples, or the price of inputs.

A Perfectly Competitive Market This chapter examines perfect competition, a market structure characterized by (1) many buyers and sellers, (2) identical (homogeneous) products, and (3) easy market entry and exit. Let’s examine these characteristics in greater detail.

Many Buyers and Sellers In a perfectly competitive market, there are many buyers and sellers, perhaps thousands or conceivably millions. Because each firm is so small in relation to the industry, its production decisions have no impact on the market—each regards price as something over which it has no control. For this reason, perfectly competitive firms are called price takers: They must take the price given by the market because their influence on price is insignificant. If the price of wheat in the wheat market is $5 a bushel, then individual wheat farmers will receive $5 a bushel for their wheat. Similarly, no single buyer of wheat can influence the price of wheat, because each buyer purchases only a small amount of wheat. We will see how this relation- ship works in more detail in Section 12.2.

Identical (Homogeneous) Products Consumers believe that all firms in perfectly competitive markets sell identical (or homo- geneous) products. For example, in the wheat market, we are assuming it is not possible to determine any significant and consistent qualitative differences in the wheat produced by different farmers. Wheat produced by Farmer Jones looks, feels, smells, and tastes like that

What are the characteristics of a firm in a perfectly competitive market?

What is a price taker?

A Perfectly Competitive Market 12.1

Why do they call firms in a perfectly competitive market price takers?

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T O N E Y , A D R I A N N A 5 5 2 1 B U

produced by Farmer Smith. In short, a bushel of wheat is a bushel of wheat. The products of all the firms are considered to be perfect substitutes.

Easy Entry and Exit Product markets characterized by perfect competition have no sig- nificant barriers to entry or exit. Therefore it is fairly easy for entre- preneurs to become suppliers of the product or, if they are already producers, to stop supplying the product. “Fairly easy” does not mean that any person on the street can instantly enter the business but rather that the financial, legal, educational, and other barriers to entering the business are modest, enabling large numbers of people to overcome the barriers and enter the business, if they so desire, in any given period. If buyers can easily switch from one seller to another and sellers can easily enter or exit the industry, then they have met the perfectly competitive condition of easy entry and exit. Because of this easy market entry, perfectly competitive markets generally consist of a large number of small suppliers.

A perfectly competitive market is approximated most closely in highly organized mar- kets for securities and agricultural commodities, such as the New York Stock Exchange or the Chicago Board of Trade. Wheat, corn, soybeans, cotton, and many other agricultural products are sold in perfectly competitive markets. Although all the criteria for a perfectly competitive market are rarely met, a number of markets come close to satisfying them. Even when all the assumptions don’t hold, it is important to note that studying the model of perfect competition is useful because many markets resemble perfect competition—that is, markets in which firms face highly elastic (flat) demand curves and relatively easy entry and exit. The model also gives us a standard of comparison. In other words, we can make comparisons with the perfectly competitive model to help us evaluate what is going on in the real world.

Can the owner of this orchard charge a noticeably higher price for apples of similar quality to those sold at the orchard down the road? What if she charges a lower price for apples of similar quality? How many apples can she sell at the market price?

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S E C T I O N Q U I Z

1. Perfectly competitive markets tend to have a ____ number of sellers and a(n) ____ entry.

a. large; easy

b. large; difficult

c. small; easy

d. small; difficult

2. In perfectly competitive markets, products are ____ and sellers are ____.

a. homogeneous; price takers

b. homogeneous; price searchers

c. substantially different; price takers

d. substantially different; price searchers.

3. Perfectly competitive markets have ____ sellers, each of which produces a ____ share of industry output.

a. few; substantial

b. few; small

c. many; substantial

d. many; small

(continued)

What are the three characteristics of a perfectly competitive market?

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T O N E Y , A D R I A N N A 5 5 2 1 B U

S E C T I O N Q U I Z (Cont.)

4. Which of the following is false about perfect competition?

a. Perfectly competitive firms sell homogeneous products.

b. A perfectly competitive industry allows easy entry and exit.

c. A perfectly competitive firm must take the market price as given.

d. A perfectly competitive firm produces a substantial fraction of the industry output.

e. All of the above are true.

5. An individual, perfectly competitive firm

a. may increase its price without losing sales.

b. is a price maker.

c. has no perceptible influence on the market price.

d. sells a product that is differentiated from those of its competitors.

1. Why do firms in perfectly competitive markets involve homogeneous goods?

2. Why does the absence of significant barriers to entry tend to result in a large number of suppliers?

3. Why does the fact that perfectly competitive firms are small relative to the market make them price takers?

Answers: 1. a 2. a 3. d 4. d 5. c

An Individual Firm’s Demand Curve In perfectly competitive markets, buyers and sellers must accept the price that the market determines, so they are said to be price takers. The market price and output are determined by the intersection of the market supply and demand curves, as seen in Exhibit 1(b). As we stated earlier, perfectly competitive markets have many buyers and sellers and the goods offered for sale are essentially identical. Consequently, no buyer or seller can influence the market price. They take the market price as given.

For example, no single consumer of wheat can influence the market price of wheat because each buyer purchases such a small percentage of the total amount sold in the wheat market. Likewise, each wheat farmer sells relatively small amounts of almost identical wheat, so the farmer has little control over wheat prices.

Individual wheat farmers know that they cannot dispose of their wheat at any figure high- er than the current market price; if they attempt to charge a higher price, potential buyers will simply make their purchases from other wheat farmers. Further, the farmers certainly would not knowingly charge a lower price, because they could sell all they want at the market price.

Likewise, in a perfectly competitive market, individual sellers can change their outputs, and it will not alter the market price. The large number of sellers who are selling identical products

Why won’t individual price takers raise or lower their prices?

Can individual price takers sell all they want at the market price?

Will the position of individual price takers’ demand curves change when market price changes?

An Individual Price Taker’s Demand Curve

12.2

Can an individual wheat farmer influence the market price of wheat? Can an individual consumer of wheat influence the market price of wheat?

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T O N E Y , A D R I A N N A 5 5 2 1 B U

make this situation possible. Each producer provides such a small fraction of the total supply that a change in the amount he offers does not have a noticeable effect on market equilibrium price. In a perfectly competitive market, then, an individual firm can sell as much as it wishes to place on the market at the prevailing price; the demand, as seen by the seller, is perfectly elastic.

It is easy to construct the demand curve for an individual seller in a perfectly competitive market. Remember, she won’t charge more than the market price because no one will buy it, and she won’t charge less because she can sell all she wants at the market price. Thus, the farmer’s demand curve is horizontal over the entire range of output that she could possibly produce. If the prevailing market price of the product is $5, the farmer’s demand curve will be represented graphically by a horizontal line at the market price of $5, as shown in Exhibit 1(a).

In short, both consumers and producers are price takers in the perfectly competitive market. Consumers, for the most part, are price takers. Consumers cannot generally affect the the prices they pay. However, in a number of market situations the producer can affect the market price and we will study those in the following chapters.

A Change in Market Price and the Firm’s Demand Curve To say that under perfect competition producers regard price as a given is not to say that price is constant. The position of the firm’s demand curve varies with every change in the market price. In Exhibit 2, we see that when the market price for wheat increases, say as a result of an increase in market demand, the price-taking firm will receive a higher price for all its output. Or when the market price decreases, say as a result of a decrease in market demand, the price-taking firm will receive a lower price for all its output.

In effect, sellers are provided with current information about market demand and supply conditions as a result of price changes. It is an essential aspect of the perfectly competitive model that sellers respond to the signals provided by such price movements, so they must alter their behavior over time in the light of actual experience, revising their production deci- sions to reflect changes in market price. In this respect, the perfectly competitive model is straightforward; it does not assume any knowledge on the part of individual buyers and sell- ers about market demand and supply—they only have to know the price of the good they sell.

section 12.2 exhibit 1 Market and Individual Firm Demand Curves in a Perfectly Competitive Market

a. Individual Firm Demand Curve b. Market Supply and Demand Curve P

ri ce

100 200

d

Quantity of Wheat (bushels)

0

$5

Firm's Demand Curve

Firm is a price taker —must take market price

150 D

S

Quantity of Wheat (millions of bushels)

0

$5

Market price and output determined

here.

At the market price for wheat, $5, the individual farmer can sell all the wheat he wishes. Because each pro- ducer provides only a small fraction of industry output, any additional output will have an insignificant impact on market price. The firm’s demand curve is perfectly elastic at the market price.

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Why is the perfectly competitive firm’s demand curve perfectly elastic?

What happens to the perfectly competitive firm’s demand curve if there is an increase in the market price?

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T O N E Y , A D R I A N N A 5 5 2 1 B U

section 12.2 exhibit 2 Market Prices and the Position of a Firm’s Demand Curve

Quantity (market)

0

$5

$6

Q1 Q2

D2

S

D1

d1

d2

P ri

ce

Quantity (firm)

0

$5

$6

The position of the firm’s demand curve will vary with every change in the market price.

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S E C T I O N Q U I Z

1. Which of the following is false?

a. A perfectly competitive firm cannot sell at any price higher than the current market price and would not knowingly charge a lower price, because it could sell all it wants at the market price.

b. In a perfectly competitive market, individual sellers can change their output without altering the market price.

c. In a perfectly competitive industry, the firm’s demand curve is downward sloping.

d. The perfectly competitive model does not assume any knowledge on the part of individual buyers and sellers about market demand and supply—they only have to know the price of the good they sell.

2. When market demand shifts ____________, a perfectly competitive firm’s demand curve shifts ____________.

a. rightward; upward

b. rightward; downward

c. leftward; upward

d. leftward; downward

e. Both (a) and (d) are correct.

3. When will a perfectly competitive firm’s demand curve shift?

a. never

b. when the market demand curve shifts

c. when new producers enter the industry in large numbers

d. when either (b) or (c) occurs

4. In a market with perfectly competitive firms, the market demand curve is ____________ and the demand curve facing each individual firm is ____________.

a. upward sloping; horizontal

b. downward sloping; horizontal

c. horizontal; downward sloping

d. horizontal; upward sloping

e. horizontal; horizontal

(continued)

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T O N E Y , A D R I A N N A 5 5 2 1 B U

S E C T I O N Q U I Z (Cont.)

1. Why would a perfectly competitive firm not try to raise or lower its price?

2. Why can we represent the demand curve of a perfectly competitive firm as perfectly elastic (horizontal) at the market price?

3. How does an individual perfectly competitive firm’s demand curve change when the market price changes?

4. If the marginal cost facing every producer of a product shifted upward, would the position of a perfectly competitive firm’s demand curve be likely to change as a result? Why or why not?

Answers: 1. c 2. e 3. c 4. b

What is total revenue?

What is average revenue?

What is marginal revenue?

Why does the firm maximize profits where marginal revenue equals marginal cost?

Profit Maximization

Revenues in a Perfectly Competitive Market The objective of the firm is to maximize profits. To maximize profits, the firm wants to pro- duce the amount that maximizes the difference between its total revenues and total costs. In this section, we will examine the different ways to look at revenue in a perfectly competitive market: total revenue, average revenue, and marginal revenue.

Total Revenue Total revenue (TR) is the revenue that the firm receives from the sale of its products. Total revenue from a product equals the price of the good (P) times the quantity (q) of units sold (TR = P × q). For example, if a farmer sells 10 bushels of wheat a day for $5 a bushel, his total revenue is $50 ($5 × 10 bushels). (Note: We will use the lowercase letter q to denote the single firm’s output and reserve the uppercase letter Q for the output of the entire mar- ket. For example, q would be used to represent the output of one lettuce grower, while Q would be used to represent the output of all lettuce growers in the lettuce market.)

Average Revenue and Marginal Revenue Average revenue (AR) equals total revenue divided by the number of units of the product sold (TR ÷ q, or [P × q] ÷ q). For example, if the farmer sells 10 bushels at $5 a bushel, total revenue is $50 and average revenue is $5 per bushel ($50 ÷ 10 bushels). Thus, in per- fect competition, average revenue is equal to the price of the good.

Marginal revenue (MR) is the additional revenue derived from the production of one more unit of the good. In other words, marginal revenue represents the increase in total revenue that results from the sale of one more unit (MR = ∆TR ÷ ∆q). In a perfectly com- petitive market, because additional units of output can be sold without reducing the price of the product, marginal revenue is constant at all outputs and equal to average revenue. For

total revenue (TR) the product price times the quantity sold

average revenue (AR) total revenue divided by the number of units sold

marginal revenue (MR) the increase in total revenue resulting from a one-unit increase in sales

12.3

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T O N E Y , A D R I A N N A 5 5 2 1 B U

example, if the price of wheat per bushel is $5, the marginal revenue is $5. Because total revenue is equal to price multiplied by quantity (TR = P × q), as we add one additional unit of output, total revenue will always increase by the amount of the product price, $5. Marginal revenue facing a perfectly competitive firm is equal to the price of the good.

In perfect competition, then, we know that marginal revenue, average revenue, and price are all equal: P = MR = AR. These relationships are clearly illustrated in the calculations presented in Exhibit 1.

How Do Firms Maximize Profits? Now that we have discussed the firm’s cost curves (in Chapter 11) and its revenues, we are ready to see how a firm maximizes its profits. A firm’s profits equal its total revenues minus its total costs. However, at what output level must a firm produce and sell to maximize profits? In all types of mar- ket environments, the firm will maximize its profits at the output that maximizes the difference between total revenue and total cost, which is at the same output level at which marginal revenue equals marginal cost.

Equating Marginal Revenue and Marginal Cost The importance of equating marginal revenue and marginal cost is seen in Exhibit 2. As output expands beyond zero up to q*, the marginal revenue derived from each unit of the expanded output exceeds the marginal cost of that unit of output, so the expansion of output creates additional prof- its. This addition to profit is shown as the leftmost shaded section in Exhibit 2. As long as marginal revenue exceeds marginal cost, profits continue to grow. For example, if the firm decides to produce q1, the firm sacrifices potential profits, because the marginal revenue from producing more output is greater than the marginal cost. Only at q*, where MR = MC, is the output level just right—not too large, not too small. Further expansion of output beyond q* will lead to losses on the additional output (i.e., decrease the firm’s overall profits), because MC > MR. For example, if the firm produces q2, the firm incurs losses on the output produced

section 12.3 exhibit 1 Revenues for a Perfectly Competitive Firm

Quantity (q)

Price (P)

Total Revenue (TR = P × q)

Average Revenue (AR = TR/q)

Marginal Revenue

(MR = ∆TR/∆q)

1 $5 $ 5 $5 $5

5

5

5

2 5 10 5

3 5 15 5

4 5 20 5

5 5 25 5

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section 12.3 exhibit 2

Finding the Profit-Maximizing Level of Output

P ri

ce

Lost profit q 2 � q*

Lost profit q 1 � q*

MC

q 1 q* q 2

P � MR

Quantity of Wheat (bushels per year)

0

$5

A firm maximizes profits by producing the quantity where MR � MC at q*.

At any output below q*—at q1, for example—the marginal revenue (MR) from expanding output exceeds the added costs (MC) of that output, so additional profits can be made by expanding output. Beyond q*—at q2, for example— marginal costs exceed marginal revenue, so output expansion is unprofitable and output should be reduced. The profit-maximizing level of output is at q*, where the profit-maximizing output rule is followed—the firm should produce the level of output where MR = MC.

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How does a perfectly competitive firm decide how much to produce and at what price?

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T O N E Y , A D R I A N N A 5 5 2 1 B U

beyond q*; the firm should reduce its output. Only at output q*, where MR = MC, can we find the profit-maximizing level of output.

Be careful not to make the mistake of focusing on profit per unit rather than total profit. That is, you might think that at q1, if MR is much greater than MC, the firm should not pro- duce more because the profit per unit is high at this point. However, that would be a mistake because a firm can add to its total profits as long as MR > MC—that is, all the way to q*.

The Marginal Approach We can use the data from the table in Exhibit 3 to find Farmer Jones’s profit-maximizing position. Columns 5 and 6 show the marginal revenue and marginal cost, respectively. The first bushel of wheat that Farmer Jones produces has a marginal revenue of $5 and a marginal cost of $2; so producing that bushel of wheat increases profits by $3 ($5 − $2). The second bushel of wheat pro- duced has a marginal revenue of $5 and a marginal cost of $3; so producing that bushel of wheat increases profits by $2 ($5 − $3). Farmer Jones wants to produce those units and more. That is, as long as marginal revenue exceeds marginal cost, producing and selling those units add more to revenues than to costs; in other words, they add to profits. However, once he expands produc- tion beyond four units of output, Farmer Jones’s costs are less than his marginal revenues, and his profits begin to fall. Clearly, Farmer Jones should not produce beyond four bushels of wheat.

Let’s take another look at profit maximization, using the table in Exhibit 3. Comparing columns 2 and 3—the calculations of total revenue and total cost, respectively—we see that Farmer Jones maximizes his profits at output levels of three or four bushels, where he will make profits of $4. In column 4—profit—you can see that there is no higher level of profit at any of the other output levels. Producing five bushels would reduce profits by $1, because marginal revenue, $5, is less than the marginal cost, $6. Consequently, Farmer Jones would not produce this level of output. If MR > MC, Farmer Jones should increase production; if MR < MC, Farmer Jones should decrease production.

In the next section we will use the profit-maximizing output rule to see what happens when changes in the market cause the price to fall below average total cost and even below average variable costs. We will introduce the three-step method to determine whether the firm is making an economic profit, minimizing its losses, or should be temporarily shut down.

profit-maximizing level of output a firm should always produce at the output where MR = MC

section 12.3 exhibit 3 Cost and Revenue Calculations for a Perfectly Competitive Firm

Quantity (1)

Total Revenue

(2)

Total Cost (3)

Profit (TR – TC)

(4)

Marginal Revenue ΔTR/Δq)

(5)

Marginal Cost (ΔTC/Δq)

(6)

Change in Profit (MR – MC)

(7)

0 $ 0 $ 2 $–2 $5

5

5

5

5

$2

3

4

5

6

$3

2

1

0

–1

1 5 4 1

2 10 7 3

3 15 11 4

4 20 16 4

5 25 22 3

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S E C T I O N Q U I Z

1. The marginal revenue of a perfectly competitive firm

a. decreases as output increases.

b. increases as output increases.

c. is constant as output increases and is equal to price.

d. increases as output increases and is equal to price.

(continued)

Should we focus on profit per unit or total profit?

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.

T O N E Y , A D R I A N N A 5 5 2 1 B U

S E C T I O N Q U I Z (Cont.)

2. A perfectly competitive firm seeking to maximize its profits would want to maximize the difference between

a. its marginal revenue and its marginal cost.

b. its average revenue and its average cost.

c. its total revenue and its total cost.

d. its price and its marginal cost.

e. either (a) or (d).

3. If a perfectly competitive firm’s marginal revenue exceeded its marginal cost,

a. it would cut its price in order to sell more output and increase its profits.

b. it would expand its output but not cut its price in order to increase its profits.

c. it would raise its price and expand its output to increase its profits.

d. none of the above would be true.

4. Which of the following is true?

a. Total revenue is price times the quantity sold.

b. Average revenue is total revenue divided by the quantity sold.

c. Marginal revenue is the change in total revenue from the sale of an additional unit of output.

d. In a competitive industry, the price of the good equals both the average revenue and the marginal revenue.

e. All of the above are true.

1. How is total revenue calculated?

2. How is average revenue derived from total revenue?

3. How is marginal revenue derived from total revenue?

4. Why is marginal revenue equal to price for a perfectly competitive firm?

Answers: 1. c 2. c 3. b 4. e

In the previous section, we discussed how to determine the profit-maximizing output level for a perfectly competitive firm. How do we know whether a firm is actually making eco- nomic profits or losses?

The Three-Step Method What Is the Three-Step Method? Determining whether a firm is generating economic profits, economic losses, or zero eco- nomic profits at the profit-maximizing level of output, q*, can be done in three easy steps. First, we will walk through these steps, and then we will apply the method to three situations for a hypothetical firm in the short run in Exhibit 1.

How do we determine whether a firm is generating an economic profit?

How do we determine whether a firm is experiencing an economic loss?

How do we determine whether a firm is making zero economic profits?

Why doesn’t a firm produce when price is below average variable cost?

Short-Run Profits and Losses 12.4

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T O N E Y , A D R I A N N A 5 5 2 1 B U

1. Find where marginal revenue equals marginal cost and proceed straight down to the horizontal quantity axis to find q*, the profit-maximizing output level.

2. At q*, go straight up to the demand curve and then to the left to find the market price, P*. Once you have identified P* and q*, you can find total revenue at the profit- maximizing output level, because TR = P × q.

3. The last step is to find the total cost. Again, go straight up from q* to the average total cost (ATC) curve and then left to the vertical axis to compute the average total cost per unit. If we multiply average total cost by the output level, we can find the total cost (TC = ATC × q).

If total revenue is greater than total cost at q*, the firm is generating economic profits. If total revenue is less than total cost at q*, the firm is generating economic losses. If total revenue is equal to total cost at q*, there are zero economic profits (or a normal rate of return).

Alternatively, to find total economic profits, we can take the product price at P* and subtract the average total cost at q*. This will give us per-unit profit. If we multiply this by output, we will arrive at total economic profit (P* – ATC) × q* = Total economic profit.

Remember, the cost curves include implicit and explicit costs—that is, we are covering the opportunity costs of our resources. Therefore, even with zero economic profits, no tears should be shed, because the firm is covering both its implicit and explicit costs. Because firms are also covering their implicit costs, or what they could be producing with these resources in another endeavor, economists sometimes call this zero economic profit a normal rate of return. That is, the owners are doing as well as they could elsewhere, in that they are getting the normal rate of return on the resources they invested in the firm.

The Three-Step Method in Action Exhibit 1 shows three different short-run equilibrium positions; in each case, the firm is producing at a level where marginal revenue equals marginal cost. Each of these alternatives shows that the firm is maximizing profits or minimizing losses in the short run.

Assume that three alternative prices—$6, $5, and $4—are available for a firm with given costs. In Exhibit 1(a), the firm receives $6 per unit at an equilibrium level of output (MR = MC) of 120 units. Total revenue (P × q*) is $6 × 120, or $720. The average total cost at 120 units of output is $5, and the total cost (ATC × q*) is $600. Following the three-step method, we can calculate that this firm is earning a total economic profit of $120. Or we can calculate total economic profit by using the following equation: (P* – ATC) × q* = ($6 – $5) × 120 = $120.

section 12.4 exhibit 1 Short-Run Profits, Losses, and Zero Economic Profits

a. Economic Profit b. Economic Loss c. Zero Economic Profits

Profit-Maximizing Output

0 q* � 100

P � MR P * � ATC

� $4.90

MC

ATC

Loss-Minimizing Output

0 q* � 80

Total Loss P � MR

ATC � $5

P*� 4

MC ATC

Profit-Maximizing Output

0 q* � 120

Total Profit

P � MR

Price Price Price

P* � $6

ATC � 5

MC

ATC

P � ATC at q* Zero Economic Profit

P � ATC at q* Economic Profit

P � ATC at q* Economic Loss

Quantity Quantity Quantity

In (a), the firm is earning short-run economic profits of $120. In (b), the firm is suffering losses of $80. In (c), the firm is making zero economic profits, with the price just equal to the average total cost in the short run.

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Why do economists sometimes call a zero economic profit a normal rate of return?

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T O N E Y , A D R I A N N A 5 5 2 1 B U

In Exhibit 1(b), the market price has fallen to $4 per unit. At the equilibrium level of output, the firm is now producing 80 units of output at an average total cost of $5 per unit. The total revenue is now $320 ($4 × 80), and the total cost is $400 ($5 × 80). We can see that the firm is now incurring a total economic loss of $80. Or we can calculate total eco- nomic profit by using the following equation: (P* – ATC) × q* = ($4 – $5) × 80 = –$80.

In Exhibit 1(c), the firm is earning zero economic profits, or a normal rate of return. The market price is $4.90, and the average total cost is $4.90 per unit for 100 units of output. In this case, economic profits are zero, because total revenue, $490, minus total cost, $490, is equal to zero. This firm is just covering all its costs, both implicit and explicit. Or we can calculate total economic profit by using the following equation: (P* – ATC) × q* = $4.90 – $4.90 × 100 = $0.

Evaluating Economic Losses in the Short Run A firm generating an economic loss faces a tough choice: Should it continue to produce or should it shut down its operation? To make this decision, we need to add another variable to our discussion of economic profits and losses: average variable cost. Variable costs are costs that vary with output—for example, wages, raw material, transportation, and electricity. If a firm cannot generate enough revenues to cover its variable costs, it will have larger losses if it oper- ates than if it shuts down (when losses are equal to fixed costs). That is, the firm will shut down if its total revenue (p × q) is less than its variable costs (VC). If we divide p × q by q, we get p, and if we divide VC by q we get AVC, so if p < AVC, a profit-maximizing firm will shut down. Thus, a firm will not produce at all unless the price is greater than its average variable cost.

Operating at a Loss At price levels greater than or equal to the average variable cost, a firm may continue to operate in the short run even if its average total cost—variable and fixed costs—is not com- pletely covered. That is, the firm may continue to operate even though it is experiencing an economic loss. Why? Because fixed costs continue whether the firm produces or not; it is better to earn enough to cover a portion of fixed costs than to earn nothing at all.

For example, a restaurant may decide to stay open for lunch even with few customers if its revenues can cover variable costs. Many of a restaurant’s costs are fixed—rent, insurance, kitchen appliances, pots, pans, tableware, and so on. These are sunk costs in the short run, so shutting down for lunch would not reduce these costs.

The restaurant’s lunch decision hinges on whether or not the revenue from the few lunchtime customers can cover the variable costs like staff and extra food. If the restaurant owner cannot cover the variable costs at lunchtime, she shuts it down for lunch.

Similarly, a grocery store may stay open all night even if it anticipates only a few customers. To the person on the street, this may look unprofitable. However, the relevant question to the store owner is not whether all the costs can be covered, but whether the additional sales from staying open all night cover the variable costs of electricity, staff, and extra food. Many businesses that are “failing” may continue to operate because they can cover their variable costs and at least part of their fixed costs, like rent.

In Exhibit 2, price is less than average total cost but more than average variable cost. In this case, the firm

section 12.4 exhibit 2

Short-Run Losses: Price Above AVC but Below ATC

Quantity (firm)

0

P ri

ce

q

P

MC ATC AVC

Shutdown Point

P �AVC Firm should not shut down.

P � MR

In this case, the firm operates in the short run but incurs a loss because P < ATC. nevertheless, P > AVC, and revenues cover variable costs and partially defray fixed costs. This firm will leave the industry in the long run unless prices are expected to rise in the near future; but in the short run, it continues to operate at a loss as long as P > AVC, the shutdown point.

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Why doesn’t a firm just shut down whenever it is making economic losses?

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T O N E Y , A D R I A N N A 5 5 2 1 B U

produces in the short run, but at a loss. To shut down would make this firm worse off, because it can cover at least some of its fixed costs with the excess of revenue over its variable costs.

The Decision to Shut Down Exhibit 3 illustrates a situation in which the price a firm is able to obtain for its product is below its average variable cost at all ranges of output. In this case, the firm is unable to cover even its variable costs in the short run. Because the firm is losing even more than the fixed costs it would lose if it shut down, it is more logical for the firm to cease operations. Hence, if P < AVC, the firm can cut its losses by shutting down.

The Short-Run Supply Curve As we have just seen, at all prices above the minimum AVC, a firm produces in the short run even if average total cost (ATC) is not completely covered; at all prices below the minimum AVC, the firm shuts down. The firm produces

above the minimum AVC even if it is incurring economic losses because it can still earn enough in total revenues to cover all its average variable cost and a portion of its fixed costs, which is better than not producing and earning nothing at all.

In graphical terms, the short-run supply curve of an individual competitive seller is identical to the portion of the MC curve that lies above the minimum of the AVC curve. As a cost relation, this curve shows the marginal cost of producing any given output; as a supply curve, it shows the equilibrium output that the firm will supply at various prices in the short run. The thick line in Exhibit 4 is the firm’s supply curve—the portion of MC above its intersection with AVC. The declining portion of the MC curve has no

short-run supply curve the portion of the MC curve above the AVC curve

section 12.4 exhibit 3

Short-Run Losses: Price Below AVC

Quantity 0

P ri

ce

P

MC ATC AVC

P � MR Shutdown Point

P �AVC Firm should shut down.

Because its average variable cost exceeds price at all levels of output, this firm would cut its losses by discontinuing production.

section 12.4 exhibit 4

The Firm’s Short-Run Supply Curve

Quantity

0

P ri

ce

Short-Run Supply MC

AVC

PMIN

qShutdown

ATC

Firms shut down if P � AVC.

If price is less than average variable cost, the firm’s losses would be smaller if it shut down and stopped producing. That is, if P < AVC, the firm is better off producing zero output. Hence, the firm’s short-run supply curve is the marginal cost curve above average variable cost.

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Why might a restaurant stay open at lunch even though there are only a few customers?

Is the shutdown rule (P < AVC) related to a perfectly competitive firm’s supply curve?

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T O N E Y , A D R I A N N A 5 5 2 1 B U

significance for supply, because if the price falls below the average variable cost, the firm is better off shutting down—producing no output. The shutdown point is at the minimum point on the aver- age variable cost curve where the output level is qShut Down. Beyond the point of lowest AVC, the marginal costs of successively larger amounts of output are progressively greater, so the firm will supply larger and larger amounts only at higher prices.

Deriving the Short-Run Market Supply Curve The short-run market supply curve is the summation of all the indi- vidual firms’ supply curves (that is, the portion of the firms’ MC above AVC) in the market. Because the short run is too brief for new firms to enter the market, the market supply curve is the summation of existing firms. For example, in Exhibit 5, at P1, each of the 1,000 identical firms in the industry produces 500 bushels of wheat per day at point a, in Exhibit 5(a); and the quantity supplied in the market is 500,000 bushels of wheat, point A, in Exhibit 5(b). We can again sum horizontally at P2; the quantity supplied for each of the 1,000 identical firms is 800 bushels of wheat per day at point b in Exhibit 5(a), so the quantity supplied for the industry is 800,000 bushels of wheat per day, point B in Exhibit 5(b). Continuing this process gives us the market supply curve for the wheat market. In a market of 1,000 identical wheat farmers, the market supply curve is 1,000 times the quantity supplied by each firm, as long as the price is above AVC.

short-run market supply curve the horizontal summation of the individual firms’ supply curves in the market

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Because the demand for summer camps will be lower during the off-season, it is likely that revenues may be too low for the camp to cover its variable costs, and the owner will choose to shut down. Remember, the owner will still have to pay the fixed costs: property tax, insurance, the costs associated with the building and land. However, if the camp is not in operation during the off-season, the owner will at least not have to pay the variable costs: salaries for the camp staff, food, and electricity.

section 12.4 exhibit 5 Deriving the Short-Run Market Supply Curve

a. Individual Firm Supply Curve for Wheat b. Market Supply Curve for Wheat

Quantity of Wheat (bushels per day)

0 500 800

b

a

B

A

P2

P1

Individual Firm

Supply (MC )

Quantity of Wheat (bushels per day)

0 500,000 800,000

P2

P1

P AVCP AVC

Market Supply

Pr ic

e pe

r B us

he l

Pr ic

e pe

r B us

he l

A

B

The short-run supply curve is the horizontal summation of the individual firms’ supply curves (each firm’s marginal cost curve above AVC), shown in (a). In a market of 1,000 identical wheat farmers, the market supply curve is 1,000 times the quantity supplied by each firm, shown in (b).

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T O N E Y , A D R I A N N A 5 5 2 1 B U

Reviewing the Short-Run Output Decisionwhat you’ve learned Exhibit 6 shows the firm’s short-run output at these various market prices: P1, P2, P3, and P4.

At the market price of P1, the firm would not cover its average variable cost—the firm would pro- duce zero output, because the firm’s losses would be smaller if it shut down and stopped producing. At the market price of P2, the firm would produce at the loss-minimizing output of q2 units. It would oper- ate rather than shut down, because it could cover all its average variable costs and some of its fixed costs. At the market price of P3, the firm would produce q3 units of output and make zero economic profit (a normal rate of return). At the market price of P4, the firm would produce q4 units of output and be making short-run economic profits.

Evaluating Short-Run Economic Losseswhat you’ve learned

Q Lei-ann is one of many florists in a medium- size urban area. That is, we assume that she works in a market similar to a perfectly competitive market and operates, of course, in the short run. Lei-ann’s cost and revenue information is shown in Exhibit 7. Based on this information, what should Lei-ann do in the short run, and why?

A Fixed costs are unavoidable unless the firm goes out of business. Lei-ann really has two deci- sions in the short run—either to operate or to shut down temporarily. In Exhibit 7, we see that Lei-ann makes $2,000 a day in total revenue, but her daily costs (fixed and variable) are $2,500. She has to pay her workers, pay for fresh flowers, and pay for the fuel used by her drivers in picking up and deliver- ing flowers. She must also pay the electricity bill to heat her shop and keep her refrigerators going to protect her flowers. That is, every day, poor Lei-ann is losing $500; but she still might want to operate the shop despite the loss. Why? Lei-ann’s average variable cost (comprising flowers, transportation, fuel, daily wage earners, and so on) amounts to

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If Lei-ann cannot cover her fixed costs, will she continue to operate?

$1,500 a day; her fixed costs (insurance, property taxes, rent for the building, and refrigerator pay- ments) are $1,000 a day. now, if Lei-ann does not operate, she will save on her variable cost—$1,500 a day—but she will be out the $2,000 a day she makes in revenue from selling her flowers. Thus, every day she operates, she is better off than if she had not operated at all. That is, if the firm can cover the average variable cost, it is better off operating than

section 12.4 exhibit 6 The Short-Run Output Decision

0

P ri

ce

Shutdown Point

P1

q2q3q4

P2

P3

P4 d4, mr4 d3, mr3 d2, mr2 d1, mr1

MC

ATC

AVC

Quantity

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(continued)

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T O N E Y , A D R I A N N A 5 5 2 1 B U

Evaluating Short-Run Economic Losses (Cont.)

what you’ve learned

not operating. But suppose Lei-ann’s VC were $2,100 a day. Then Lei-ann should not operate, because every day she does, she is $100 worse off than if she shut down altogether. In short, a firm will shut down if TR < VC or (P × q) < VC. If we divide both sides by q, the firm will shut down if P < AVC or (P × q)/q < VC/q.

Why does Lei-ann even bother operating if she is making a loss? Perhaps the economy is in a reces- sion and the demand for flowers is temporarily down, but Lei-ann thinks things will pick up again in the next few months. If Lei-ann is right and demand

picks up, her prices and marginal revenue will rise, and she may have a chance to make short-run eco- nomic profits.

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S E C T I O N Q U I Z

1. If a perfectly competitive firm’s marginal revenue exceeded its marginal cost,

a. it would cut its price in order to sell more output and increase its profits.

b. it would expand its output but not cut its price in order to increase its profits.

c. it is currently earning economic profits.

d. both (a) and (c) are true.

e. both (b) and (c) are true.

2. A perfectly competitive firm maximizes its profit at an output in which

a. total revenue exceeds total cost by the greatest dollar amount.

b. marginal cost equals the price.

c. marginal cost equals marginal revenue.

d. all of the above are true.

3. In perfect competition, at a firm’s short-run profit-maximizing (or loss minimizing) output,

a. its marginal revenue equals zero.

b. its price could be greater or less than average cost.

c. its marginal revenue will be falling.

d. both (b) and (c) will be true.

4. The minimum price at which a firm would produce in the short run is the point at which

a. price equals the minimum point on its marginal cost curve.

b. price equals the minimum point on its average variable cost curve.

c. price equals the minimum point on its average total cost curve.

d. price equals the minimum point on its average fixed cost curve.

(continued)

section 12.4 exhibit 7

Lei-ann’s Daily Revenue and Cost Schedule

Total Revenue $2,000

Total Costs 2,500

Variable Costs 1,500

Fixed Costs 1,000

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T O N E Y , A D R I A N N A 5 5 2 1 B U

S E C T I O N Q U I Z (Cont.)

5. A profit-maximizing perfectly competitive firm would never knowingly operate at an output level at which

a. it would lose more than its total fixed costs.

b. it was not earning a positive economic profit.

c. it was not earning a zero economic profit.

d. it was not earning an accounting profit.

6. If a perfectly competitive firm finds that price is greater than AVC but less than ATC at the quantity where its marginal cost equals the market price,

a. the firm will produce in the short run but may eventually go out of business.

b. the firm will produce in the short run, and new entrants will tend to enter the industry over time.

c. the firm will immediately shut down.

d. the firm will be earning economic profits.

e. both b and d are true.

7. The short-run supply curve of a perfectly competitive firm is

a. its MC curve.

b. its MC curve above the minimum point of AVC.

c. its MC curve above the minimum point of ATC.

d. none of the above.

1. How is the profit-maximizing output quantity determined?

2. How do we determine total revenue and total cost for the profit-maximizing output quantity?

3. If a profit-maximizing, perfectly competitive firm is earning a profit because total revenue exceeds total cost, why must the market price exceed average total cost?

4. If a profit-maximizing, perfectly competitive firm is earning a loss because total revenue is less than total cost, why must the market price be less than average total cost?

5. If a profit-maximizing, perfectly competitive firm is earning zero economic profits because total revenue equals total cost, why must the market price be equal to the average total cost for that level of output?

6. Why would a profit-maximizing, perfectly competitive firm shut down rather than operate if price was less than its average variable cost?

7. Why would a profit-maximizing, perfectly competitive firm continue to operate for a period of time if price was greater than average variable cost but less than average total cost?

Answers: 1. b 2. d 3. b 4. b 5. a 6. a 7. b

When an industry is earning profits, will it encourage the entry of new firms?

Why do perfectly competitive firms make zero economic profits in the long run?

Long-Run Equilibrium

Economic Profits and Losses Disappear in the Long Run If farmers are able to make economic profits producing wheat, what will their response be in the long run? Farmers will increase the resources that they devote to the lucrative business of producing wheat. Suppose Farmer Jones is making an economic profit (he is

12.5

Do economic profits and losses provide incentives for perfectly competitive firms to enter or exit?

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T O N E Y , A D R I A N N A 5 5 2 1 B U

earning an above-normal rate of return) producing wheat. To make even more profits, he may take land out of producing other crops and plant more wheat. Other farmers or people who are holding land for speculative purposes may also decide to plant wheat on their land.

As word gets out that wheat production is proving profitable, it will cause a supply response—the market supply curve will shift to the right as more firms enter the industry and existing firms expand, as shown in Exhibit 1(b). With this shift, the quantity of wheat supplied at any given price is greater than before. It may take a year or even longer, of course, for the complete supply response to take place, simply because it takes some time for infor- mation on profit opportunities to spread and still more time to plant, grow, and harvest the wheat. Note that the effect of increasing supply, other things being equal, is a reduction in the equilibrium price of wheat.

Suppose that, as a result of the supply response, the price of wheat falls from P1 to P2. The impact of the change in the market price of wheat, over which Farmer Jones has absolutely no control, is simple. If his costs don’t change, he moves from making a profit (P1 > ATC) to zero economic profits (P2 = ATC), as shown in Exhibit 1(a). In long-run equilibrium, perfectly competitive firms make zero economic profits. Remember, a zero economic profit means that the firm actually earns a normal return on the use of its capital. Zero economic profit is an equilibrium or stable situation because any positive economic (above-normal) profit signals resources into the industry, beating down prices and therefore revenues to the firm.

Any economic losses signal resources to leave the industry, caus- ing supply reductions that lead to increased prices and higher firm revenues for the remaining firms. For example, in Exhibit 2 we see a firm that continues to operate despite its losses—ATC is greater than P1 at q1. With losses, however, some firms will exit the industry, caus- ing the market supply curve to shift from S1 to S2 and driving up the market price to P2. This price increase reduces the losses for the firms remaining in the industry, until the losses are completely eliminated at P2. The remaining firms will maximize profits by producing at q2

section 12.5 exhibit 1 Profits Disappear with Entry

a. Individual Firm b. Market

Quantity

0

P ri

ce

Q1 Q2

P1

P2

S1

D

S2

Quantity

0 q2 q1

d1, mr1

d2, mr2

P1

P2

P ri

ce

MC

ATC

ATC

Economic Profits P1 > ATC at q1

As the industry-determined price of wheat falls in (b), Farmer Jones’s marginal revenue curve shifts down- ward from mr1 to mr2 in (a). A new profit-maximizing (MC = MR) point is reached at q2. When the price is P1, Farmer Jones is making a profit, because P1 > ATC. When the market supply increases, causing the market price to fall to P2, Farmer Jones’s profits disappear, because P2 = ATC.

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In the late 1990s, when organic food was in its infancy, an organic apple grower could sell apples at a much higher price than regular apples. A price that covered more than its cost of production—an economic profit. Today, there are many more organic farmers, increas- ing market supply and decreasing the market price and moving firms toward zero economic profits— normal rate of return.

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Editorial review has deemed that any suppressed content does not materially affect the overall learning experience. Cengage Learning reserves the right to remove additional content at any time if subsequent rights restrictions require it.