Unlike a perfectly competitive firm for a monopolistically competitive firm

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?

chapter 12 Firms in Perfectly Competitive Markets 325

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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

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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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

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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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

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