CH.8 TERMS

if P > ATC the firm

makes a profit

In a perfectly competitive market, each firm is a

price taker

(P - ATC) x Q =

profit

profit/Q =

((P x Q) / Q) - (TC / Q) P - ATC

profit per unit of output

(P - ATC)

profit =

(P x Q) - TC

Negative profit =

(P − ATC) × quantity

MONOPOLY

-1 firm -unique product -entry blocked -ex: first-class mail, tap water

DUOPOLY

-2 firms -identical/ differentiated products -low ease of entry -ex: credit cards (Visa/ Mastercard)

OLIGOPOLY

-few firms -identical/differentiated products -low ease of entry -ex: manufacturing computers/ automobiles

characteristics of perfect competition

-many buyers and sellers -homogeneous (standardized) products -no barriers to market entry or exit -no long-run economic profit -no control over price

MONOPOLISTIC COMPETITION

-many firms -differentiated products -high ease of entry -ex: clothing stores, restaurants

PERFECT COMPETITION

-many firms -identical products -high ease of entry -ex: growing wheat, apples

Market structure depends on

-number of firms -nature of product -barriers to entry -control over price

Individual firms get their prices from the market because

-they are so small that they cannot influence the market price -they take the price as given

2 ways to find how much of a product a producer should sell to maximize profit

1) find MR=MC 2) profit=TR-TC

FIVE STEPS TO MAXIMIZING PROFIT

1) find MR=MC 2) find optimal Q* 3) find optimal P* 4) find ATC 5) find profit

Price of *wheat*=

= farmer's demand for *wheat*

When a sports team consistently struggles, one strategy is to replace the coach. But when this happens, the new coach initially has the same players (its primary input). How can a new coach improve the team's record when the players are mostly the same?

A coach, like a manager of a firm, has physical inputs to work with. However, along with physical inputs are ideas, which also represent an important factor of production, because how one uses inputs is as important as the quality of inputs. Therefore, by hiring a new coach, a team can use existing players in a more productive manner, thus potentially improving the team's record.

When a competitive firm is earning economic profits, is it also maximizing profit per unit? Why or why not?

A competitive firm maximizes profit where P = MR = MC. If price is greater than ATC, then the firm is producing more output than that associated with the minimum point on the ATC curve. Maximum profit per unit is at that output where ATC is at a minimum (profit per unit = P − ATC). Beyond that point, ATC is higher and rising, thus profit per unit will be less, but total profit will increase until it is maximized at the output where MR = MC.

LONG RUN

ALL FACTORS ARE VARIABLE. FIRMS ENTER IN RESPONSE TO PROFITS AND EXIT IN RESPONSE TO LOSSES

SHORT RUN

AT LEAST ONE FACTOR OF PRODUCTION (SUCH AS PLANT SIZE) IS FIXED

TC/Q =

ATC

Why do perfectly competitive firms sell their products only at the market price? Why not try to raise prices to make more profit or lower them to garner more sales?

Because a perfectly competitive firm produces a tiny share of overall market output and competes against many similar firms, each firm has no control over the market price. They are pricetakers. Therefore, if one firm chooses to raise its price above the market price, it would likely lose all of its customers, because customers could easily purchase the same product at a lower price elsewhere.

Suppose you master the art of growing herbs in your garden and selling them for profit at the local farmer's market. Your neighbor sees your profitable business and decides to do the same, however with less experience faces a much higher marginal cost curve. How is it possible for both you and your neighbor to sell herbs at the same price?

Because the market price is given, each seller produces herbs until its marginal cost equals the market price (or marginal revenue). Because you have a lower marginal cost curve, you will be able to produce a higher quantity of output than your neighbor at the profit-maximizing equilibrium.

EXAMPLES OF PERFECT COMPETITION

CORN AND WHEAT INDUSTRIES

Describe the reasons why an industry's costs might increase in the long run. Why might they decrease over the long run?

Costs may increase in the long run if expanding the industry bids up resource or input costs. Costs might decline in the long run because of technological advances or if industry growth permits suppliers to gain economies of scale.

Describe the role that easy entry and exit play in competitive markets over the long run.

Easy entry and exit are crucial in the long-run adjustment process in competitive markets. When existing firms are earning economic profits, entry is encouraged, bringing prices down and returning industry profitability to normal. Just the opposite occurs when existing firms are earning losses. Some of the existing firms leave the industry, reducing supply, resulting in higher prices and bringing profits up to normal levels.

A Perfectly Competitive Firm Faces a ______ Demand Curve

Horizontal

In this chapter we suggested that whenever market price fell below average variable costs, the firm would shut down. At that point revenue is not covering its variable costs and the firm is losing more money than if it just shut down and lost fixed costs. Clearly, shutting the firm is more complicated than that. Under what circumstances might the firm continue to operate even though prices are below average variable costs?

Even though continuing to operate when prices are below average variable costs means that the owners of the firm are losing more money than if they shut down, closing a firm (restaurant, department store, beauty parlor, grocery store, and many other firms) often entails additional costs to close up operations. In addition, low prices can be temporary because markets fluctuate. Firms in markets with variable market prices want to remain in the industry over the long run, and this would be difficult if every time prices decline, you close your doors and then reopen when the market is better. People's shopping habits change when one firm closes. For smaller firms, the very act of shutting down in the short run entails psychological costs, because many of their employees are their friends. Shutting a firm is not just the simple act described in the competitive market.

Illustrating When a Firm Is Breaking Even or Operating at a Loss

First, on a graph, find the place where MR (which is the same thing as price which is the same thing as demand) crosses MC. From this point draw a line straight up or down until you hit ATC

PRODUCTIVE EFFICIENCY:

GOODS ARE SUPPLIED AT THE LOWEST POSSIBLE COST.

Why must price cover average variable costs if the firm is to continue operating?

If price is less than average variable costs, then losses will exceed the fixed costs incurred if the firm continues to operate, than if the firm closed its doors. If price cannot cover the costs of the variable factors of production, then the firm should close its doors.

AS MORE STATES LEGALIZE MARIJUANA PRODUCTION, WHAT WILL HAPPEN TO THE MARKET PRICE?

If producers enter a competitive market, prices will fall, assuming that the demand does not significantly rise as a result of the change in law.

Assume a competitive industry is in long-run equilibrium and firms in the industry are earning normal profits. Now assume that production technology improves such that average total cost declines by $5 per unit. Describe the process this industry will go through as it moves to a new longrun equilibrium.

If the ATC curve shifts downward by $5, existing firms will now be making economic profits equal to roughly $5 a unit in the short run. New firms will enter the industry, industry supply will rise, and the new equilibrium will be achieved at a price $5 less than before the technological change.

Why, if competitive firms are earning economic profits in the short run, are they unable to earn them in the long run?

In the same way that honey attracts bears, short-run economic profits attract new firms to the industry in the long run. These new entrants increase market supply, lowering prices and reducing profits to normal.

ALLOCATIVE EFFICIENCY:

MIX OF GOODS AND SERVICES IS JUST WHAT SOCIETY DESIRES.

Profit max is where

MR=MC (or as close as possible without MC exceeding MC)

Why are marginal revenue and price equal for the perfectly competitive firm?

Marginal revenue is equal to the change in total revenue from selling another unit of the product. For competitive firms this is just equal to market price. This is a simple concept for competitive firms, but it becomes more complex for the other market structures, as we will see in the next two chapters.

FIRMS MINIMIZE LOSSES BY SHUT DOWN IF

P < AVC

FIRMS MINIMIZE LOSSES BY PRODUCING IF

P > AVC

Demand=

Price

P*Q - TC=

Profit = TR-TC

Why isn't a short-run supply curve for a perfectly competitive firm equivalent to the entire marginal cost curve?

The marginal cost curve represents the prices that firms must receive in order to be willing to produce. However, only the portion of the marginal cost curve that is above the minimum variable cost is considered part of the short-run supply curve. This is because if prices fall below the minimum variable cost, a firm's best course of action is to shut down, which means it does not supply any output to the market.

LOSS MINIMIZATION

WHEN PRICE < ATC

where does a firm maximizes profit ?

at the level of output at which marginal revenue equals marginal cost

express profit in terms of

average total cost (ATC)

if P = ATC the firm

breaks even (its total cost equals its total revenue)

long-run average total cost (LRATC) varies according to

economies or diseconomies of scale

if P < ATC the firm

experiences a loss

A firm's short-run supply curve is its

marginal cost curve above the minimum point on the average variable cost curve

LONG-RUN INDUSTRY SUPPLY Depends on

on long-run average total cost (LRATC)

A Perfectly Competitive Firm Cannot Affect

the Market Price

The overall market for *wheat* determines

the PRICE of *wheat* (all *wheat* buyers and sellers together)

the intersection of market supply and market demand determine

the equilibrium price of a good

vertical distance between total revenue and total cost is

the largest

a firm's total profit is equal to

the quantity produced multiplied by the difference between price and average total cost

in the long run a perfectly competitive firm earns

zero economic profit

what profit can still be a substantial accounting profit?

zero economic profit (normal profit)

normal profits are equal to

zero economic profit where P = ATC