McTaggart Micro Ch10

Objectives After studying this chapter, you will be able to: Define perfect competition Explain how firms make their supply decisions and why they sometimes shut down temporarily and lay off workers Explain how price and output are determined and why firms enter and leave an industry Predict the effects of a change in demand and of a technological advance Explain why perfect competition is efficient Rivalry in Personal Computers The personal computer business is a highly competitive business made of such firms as Apple, Dell, Gateway etc competing with hundreds of smaller firms. How do firms operate when they face the fiercest competition from other firms. What determines their production decisions? Why do firms enter or leave the industry? These and other questions about competitive markets will be answered in this chapter What is Perfect Competition? Perfect competition is an industry in which: Many firms sell identical products to many buyers. There are no restrictions to entry into the industry. Existing firms have no advantages over new ones. Sellers and buyers are well informed about prices. What is Perfect Competition? How Perfect Competition Arises Perfect competition arises when two conditions are present: A firm’s minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level. When each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy from. What is Perfect Competition? Price Takers In perfect competition, each firm is a price taker. A price taker is a firm that cannot influence the market price of a good or service. Each firm produces a tiny fraction of the total output and buyers are well informed about the prices of other firms. The firm faces a perfectly elastic demand for its output What is Perfect Competition? Economic Profit and Revenue The goal of each firm is to maximise economic profit, which equals total revenue minus total cost. Total cost is the opportunity cost of production, which includes normal profit. A firm’s total revenue equals price times quantity sold A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. Demand, Price, and Revenue in Perfect Competition Quantity Price Marginal sold (P) Total revenue (Q) (dollars revenue (T-shirts per TR = P ? Q (dollars per additional per day) T-shirts) (dollars) T-shirts) 7 25 200 8 25 225 9 25 250 Demand, Price, and Revenue in Perfect Competition The Firm’s Decisions in Perfect Competition A perfectly competitive firm faces two constraints: A market constraint summarised by the market price and the firm’s revenue curves. A technology constraint summarised by the firm’s product curves and cost curves. The Firm’s Decisions in Perfect Competition Short-Run Decisions The perfectly competitive firm makes two decisions in the short run: Whether to produce or to temporarily shut down What quantity to produce The Firm’s Decisions in Perfect Competition Long-Run Decisions A firm’s long-run decisions are: Whether to increase or decrease its plant size Whether to remain in, enter, or leave an industry The Firm’s Decisions in Perfect Competition Profit-Maximising Output A perfectly competitive firm chooses the output that maximises its economic profit. One way to find the profit maximising output is to look at the firm’s the total revenue and total cost curves. Revenue and Cost Economic Profit and Loss The Firm’s Decisions in Perfect Competition Marginal Analysis The firm can use marginal analysis to determine the profit-maximising output. Profit is maximised by producing the output at which marginal revenue, MR, equals marginal cost, MC. Profit-Maximizing Output The Firm’s Decisions in Perfect Competition Profits and Losses in the Short-run Maximum profit is not always a positive economic profit. To determine whether a firm is earning an economic profit or incurring an economic loss, we compare the firm’s average total cost, ATC, at the profit maximising output with the market price. Three Possible Profit Outcomes in the Short-Run Three Possible Profit Outcomes in the Short-Run Three Possible Profit Outcomes in the Short-Run The Firm’s Decisions in Perfect Competition Temporary Plant Shutdown If price is less than the minimum average variable cost, the firm shuts down temporarily and incurs a loss equal to total fixed cost. This loss is the largest that the firm must bear. If the firm were to produce just 1 unit of output at price below average variable cost, it would incur an additional (and avoidable) loss. The Firm’s Decisions in Perfect Competition The Firm’s Short-run Supply Curve A perfectly competitive firm’s short-run supply curve shows how the firm’s profit-maximising output varies as the market price varies, other things remaining the same. Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve. But there is a price below which the firm produces nothing and shuts down temporarily. The Firm’s Decisions in Perfect Competition The shutdown point is the output and price at which the firm just covers its total variable cost. This point is where average variable cost is at its minimum. It is also the point at which the marginal cost curve crosses the average variable cost curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily. It incurs a loss equal to total fixed cost from either action. The Firm’s Decisions in Perfect Competition If the price exceeds minimum average variable cost, the firm produces the quantity at which marginal cost equals price. Price exceeds average variable cost, and the firm covers all its variable cost and at least part of its fixed cost. A Firm’s Shutdown Point and Supply Curve A Firm’s Supply Curve The Firm’s Decisions in Perfect Competition Short-run Industry Supply Curve The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant. The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price. Industry Supply Curve Output, Price, and Profit in Perfect Competition Short-Run Equilibrium Short-run industry supply and industry demand determine the market price and output. A short-run equilibrium occurs at the intersection of the demand and supply curves. Short-run Equilibrium Output, Price, and Profit in Perfect Competition A Change in Demand An increase in demand brings a rightward shift of the industry demand curve: the price rises and the quantity increases. A decrease in demand brings a leftward shift of the industry demand curve: the price falls and the quantity decreases. Short-Run Equilibrium Output, Price, and Profit in Perfect Competition Long-Run Adjustments In short-run equilibrium, a firm may earn an economic profit, earn normal profit, or incur an economic loss and which of these states exists determines the further decisions the firm makes in the long run. In the long run, the firm may: Enter or exit an industry Change its plant size Output, Price, and Profit in Perfect Competition Entry and Exit New firms enter an industry in which existing firms earn an economic profit. Firms exit an industry in which they incur an economic loss. Entry and exit of new firms shifts the industry supply curve. Entry and Exit Output, Price, and Profit in Perfect Competition Changes in Plant Size Firms change their plant size whenever doing so is profitable. If average total cost exceeds the minimum long-run average cost, firms change their plant size to lower costs and increase profits. Figure 10.9 on the next slide shows the effects of changes in plant size. Plant Size and Long-Run Equilibrium Output, Price, and Profit in Perfect Competition Long-Run Equilibrium Long-run equilibrium occurs in a competitive industry when: Economic profit is zero, so firms neither enter nor exit the industry. Long-run average cost is at its minimum, so firms don’t change their plant size. Changing Tastes and Advancing Technology A Permanent Change in Demand A decrease in demand shifts the demand curve leftward. The price falls and the quantity decreases. Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward. Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward. A Decrease in Demand Changing Tastes and Advancing Technology Increase in Demand An increase in demand shifts the demand curve rightward. The price rises and the quantity increases. Economic profit induces entry, which increases short-run supply and shifts the short-run industry supply curve rightward. As industry supply increases, the price falls and the market quantity continues to increase. Changing Tastes and Advancing Technology External Economics and Diseconomies The change in the long-run equilibrium price following a permanent change in demand depends on external economies and external diseconomies. External economies are factors beyond the control of an individual firm that lower the firm’s costs as the industry output increases. External diseconomies are factors beyond the control of a firm that raise the firm’s costs as industry output increases. Changing Tastes and Advancing Technology A long-run industry supply curve shows how the quantity supplied by an industry varies as the market price varies, after all the possible adjustments have been made, including changes in plant size and changes in the number of firms in the industry Long-Run Changes in Price and Quantity Changing Tastes and Advancing Technology Technological Change New technologies are constantly discovered that lower costs. A new technology enables firms to produce at a lower average cost and lower marginal cost—firms’ cost curves shift downward. Firms that adopt the new technology earn an economic profit. Competition and Efficiency Efficient Use of Resources Resource use is efficient when we produce the goods and services that people value most highly If someone can become better off without anyone else becoming worse off, resources are not being used efficiently. In other words, resource use is efficient when marginal benefit equals marginal cost. Competition and Efficiency Choices, Equilibrium, and Efficiency We can describe an efficient use of resources in terms of the choices of consumers and firms coordinated in market equilibrium. Consumers allocate their resources to get the most value possible out of them Consumers get the most value possible out of their resources at all points along their demand curves, which are also their marginal benefit curves. Competition and Efficiency In competitive equilibrium, the quantity demanded equals the quantity supplied. This means that the consumer’s marginal benefit equals the producer’s marginal cost. The gains from trade — consumer surplus plus producer surplus — are maximised. Efficiency of Competition Chapter 10: Perfect Competition 25 25 Replace Figure 10.1 Table Quantity (thousands of T-shirts per day) Quantity (T-shirts per day) Quantity (T-shirts per day) Price (dollars per T-shirt) Price (dollars per T-shirt) Total revenue (dollar per day) 0 9 0 9 0 10 20 25 50 225 S D TR A T-shirt market Sam’s demand, average revenue, and marginal revenue Sam’s total revenue 25 50 AR= MR Demand for Sam’s T-shirts Figure 10.1 Total Revenue, Total Cost, and Economic Profit Quantity Total Total Economic (Q) revenue cost profit (T-shirts (TR) (TC) (TR – TC) per day) (dollars) (dollars) (dollars) 0 0 22 -22 1 25 45 -20 2 50 66 -16 3 75 85 -10 4 100 100 0 5 125 114 11 6 150 126 24 7 105 141 34 8 175 160 40 9 225 183 42 10 250 210 40 11 275 245 30 12 300 300 0 13 325 360 -35 Replace Fig 10.2 Table Economic loss Economic profit = TR - TC Economic loss Quantity (T-shirts per day) Total revenue & total cost (dollars per day) 0 4 9 12 300 183 225 TR TC 100 Figure 10.2(a) Profit maximising quantity Profit/ loss Economic profit Economic loss Economic profit and loss Quantity (T-shirts per day) 4 9 12 -20 0 -40 42 20 Profit/loss (dollars per day) Figure 10.2(b) Profit-Maximising Output Marginal Marginal revenue cost Quantity Total (MR) Total (MC) Economic (Q) revenue (dollars per cost (dollars per profit (T-shirts (TR) additional (TC) additional (TR – TC) per day) (dollars) T-shirt) (dollars T-shirt) (dollars) 7 175 141 34 8 200 160 40 9 225 183 42 10 250 210 40 11 275 245 30 25 25 25 25 19 23 27 35 Replace Figure 10.3 table MC MR Profit- maximization point Loss from an extra 10th T-shirt Profit from an extra 10th T-shirt 0 Quantity (T-shirts per day) 8 9 10 Marginal revenue & marginal cost (dollars per T-shirt) 10 20 30 25 Figure 10.3 AR = MR MC Break-even point Normal profit 0 Quantity (T-shirts per day) Price (dollars per T-shirt) 8 15.00 20.00 25.00 30.00 ATC 10 Figure 10.4(a) Economic Profit 0 MR Economic profit Quantity ( T-shirts per day) Price (dollars per T-shirt) MC 9 15.00 20.00 25.00 30.00 ATC 10 Figure 10.4(b) Economic loss MR MC ATC Economic loss 0 Quantity ( T-shirts per day) Price (dollars per T-shirt) 17.00 7 15.00 20.00 25.00 30.00 10 Figure 10.4(c) MR0 MR2 MR1 MC AVC T Shutdown point 0 Quantity (T-shirts per day) 7 9 10 17 25 31 Marginal revenue & marginal cost (dollars per T-shirt) Figure 10.5(a) S T 0 Quantity (T-shirts per day) 60 70 80 Marginal revenue & marginal cost (dollars per T-shirt) 17 25 31 Figure 10.5(b) Quantity (thousands of T-shirts per day) 7 8 9 10 Price (dollars per T-shirt) 17 25 31 0 A B 20 S1 C D Figure 10.6 D1 Quantity (thousands of T-shirts per day) 7 8 9 10 Price (dollars per T-shirt) 17 25 31 0 A B 20 S1 C D Figure 10.7(a) D3 D2 S D1 Increase in demand: price rises and firms increase production 0 Quantity (thousands of T-shirts per day) 6 7 8 9 10 Price (dollars per T-shirt) 17 25 31 20 Decrease in demand: price falls and firms decrease production Figure 10.4(b) S0 S2 D1 S1 Entry increases supply Exit decreases supply 0 Quantity (thousands of T-shirts per day) 7 8 9 10 Price (dollars per T-shirt) 17 23 31 20 Figure 10.8 SRAC0 MC0 SRAC1 MR0 MR1 LRAC Long-run competitive equilibrium M Quantity (T-shirts per day) Price (dollars per T-shirt) 25 20 6 8 Short-run profit maximizing point MC1 Figure 10.9 P0 MR0 ATC MC MR1 P1 D1 D0 S0 Quantity Price 0 Quantity Price and Cost P0 Industry Firm P1 q0 q1 Q0 Q1 S1 Q2 Figure 10.10 LSC LSB LSA Constant-cost industry Increasing-cost industry Decreasing-cost industry Quantity Price P0 Q0 D1 Ps S0 Quantity Price P0 Q0 D0 D1 Ps S0 Quantity Price P0 Q0 D0 D1 Ps S0 S1 Qs Qs Qs Q1 P2 Q2 S3 S2 P3 Q3 D0 Figure 10.11 Producer surplus Consumer surplus Quantity Price S D=MSB q* P* 0 MC 0 Quantity Price and cost q* P* MR Long-run Competitive equilibrium SRAC LRAC Efficient allocation A Single Firm A Market END CHAPTER 10 Objectives After studying this chapter, you will be able to: Define perfect competition Explain how firms make their supply decisions and why they sometimes shut down temporarily and lay off workers Explain how price and output are determined and why firms enter and leave an industry Predict the effects of a change in demand and of a technological advance Explain why perfect competition is efficient Rivalry in Personal Computers The personal computer business is a highly competitive business made of such firms as Apple, Dell, Gateway etc competing with hundreds of smaller firms. How do firms operate when they face the fiercest competition from other firms. What determines their production decisions? Why do firms enter or leave the industry? These and other questions about competitive markets will be answered in this chapter What is Perfect Competition? Perfect competition is an industry in which: Many firms sell identical products to many buyers. There are no restrictions to entry into the industry. Existing firms have no advantages over new ones. Sellers and buyers are well informed about prices. What is Perfect Competition? How Perfect Competition Arises Perfect competition arises when two conditions are present: A firm’s minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level. When each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy from. What is Perfect Competition? Price Takers In perfect competition, each firm is a price taker. A price taker is a firm that cannot influence the market price of a good or service. Each firm produces a tiny fraction of the total output and buyers are well informed about the prices of other firms. The firm faces a perfectly elastic demand for its output What is Perfect Competition? Economic Profit and Revenue The goal of each firm is to maximise economic profit, which equals total revenue minus total cost. Total cost is the opportunity cost of production, which includes normal profit. A firm’s total revenue equals price times quantity sold A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. Demand, Price, and Revenue in Perfect Competition Quantity Price Marginal sold (P) Total revenue (Q) (dollars revenue (T-shirts per TR = P ? Q (dollars per additional per day) T-shirts) (dollars) T-shirts) 7 25 200 8 25 225 9 25 250 Demand, Price, and Revenue in Perfect Competition The Firm’s Decisions in Perfect Competition A perfectly competitive firm faces two constraints: A market constraint summarised by the market price and the firm’s revenue curves. A technology constraint summarised by the firm’s product curves and cost curves. The Firm’s Decisions in Perfect Competition Short-Run Decisions The perfectly competitive firm makes two decisions in the short run: Whether to produce or to temporarily shut down What quantity to produce The Firm’s Decisions in Perfect Competition Long-Run Decisions A firm’s long-run decisions are: Whether to increase or decrease its plant size Whether to remain in, enter, or leave an industry The Firm’s Decisions in Perfect Competition Profit-Maximising Output A perfectly competitive firm chooses the output that maximises its economic profit. One way to find the profit maximising output is to look at the firm’s the total revenue and total cost curves. Revenue and Cost Economic Profit and Loss The Firm’s Decisions in Perfect Competition Marginal Analysis The firm can use marginal analysis to determine the profit-maximising output. Profit is maximised by producing the output at which marginal revenue, MR, equals marginal cost, MC. Profit-Maximizing Output The Firm’s Decisions in Perfect Competition Profits and Losses in the Short-run Maximum profit is not always a positive economic profit. To determine whether a firm is earning an economic profit or incurring an economic loss, we compare the firm’s average total cost, ATC, at the profit maximising output with the market price. Three Possible Profit Outcomes in the Short-Run Three Possible Profit Outcomes in the Short-Run Three Possible Profit Outcomes in the Short-Run The Firm’s Decisions in Perfect Competition Temporary Plant Shutdown If price is less than the minimum average variable cost, the firm shuts down temporarily and incurs a loss equal to total fixed cost. This loss is the largest that the firm must bear. If the firm were to produce just 1 unit of output at price below average variable cost, it would incur an additional (and avoidable) loss. The Firm’s Decisions in Perfect Competition The Firm’s Short-run Supply Curve A perfectly competitive firm’s short-run supply curve shows how the firm’s profit-maximising output varies as the market price varies, other things remaining the same. Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve. But there is a price below which the firm produces nothing and shuts down temporarily. The Firm’s Decisions in Perfect Competition The shutdown point is the output and price at which the firm just covers its total variable cost. This point is where average variable cost is at its minimum. It is also the point at which the marginal cost curve crosses the average variable cost curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily. It incurs a loss equal to total fixed cost from either action. The Firm’s Decisions in Perfect Competition If the price exceeds minimum average variable cost, the firm produces the quantity at which marginal cost equals price. Price exceeds average variable cost, and the firm covers all its variable cost and at least part of its fixed cost. A Firm’s Shutdown Point and Supply Curve A Firm’s Supply Curve The Firm’s Decisions in Perfect Competition Short-run Industry Supply Curve The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant. The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price. Industry Supply Curve Output, Price, and Profit in Perfect Competition Short-Run Equilibrium Short-run industry supply and industry demand determine the market price and output. A short-run equilibrium occurs at the intersection of the demand and supply curves. Short-run Equilibrium Output, Price, and Profit in Perfect Competition A Change in Demand An increase in demand brings a rightward shift of the industry demand curve: the price rises and the quantity increases. A decrease in demand brings a leftward shift of the industry demand curve: the price falls and the quantity decreases. Short-Run Equilibrium Output, Price, and Profit in Perfect Competition Long-Run Adjustments In short-run equilibrium, a firm may earn an economic profit, earn normal profit, or incur an economic loss and which of these states exists determines the further decisions the firm makes in the long run. In the long run, the firm may: Enter or exit an industry Change its plant size Output, Price, and Profit in Perfect Competition Entry and Exit New firms enter an industry in which existing firms earn an economic profit. Firms exit an industry in which they incur an economic loss. Entry and exit of new firms shifts the industry supply curve. Entry and Exit Output, Price, and Profit in Perfect Competition Changes in Plant Size Firms change their plant size whenever doing so is profitable. If average total cost exceeds the minimum long-run average cost, firms change their plant size to lower costs and increase profits. Figure 10.9 on the next slide shows the effects of changes in plant size. Plant Size and Long-Run Equilibrium Output, Price, and Profit in Perfect Competition Long-Run Equilibrium Long-run equilibrium occurs in a competitive industry when: Economic profit is zero, so firms neither enter nor exit the industry. Long-run average cost is at its minimum, so firms don’t change their plant size. Changing Tastes and Advancing Technology A Permanent Change in Demand A decrease in demand shifts the demand curve leftward. The price falls and the quantity decreases. Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward. Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward. A Decrease in Demand Changing Tastes and Advancing Technology Increase in Demand An increase in demand shifts the demand curve rightward. The price rises and the quantity increases. Economic profit induces entry, which increases short-run supply and shifts the short-run industry supply curve rightward. As industry supply increases, the price falls and the market quantity continues to increase. Changing Tastes and Advancing Technology External Economics and Diseconomies The change in the long-run equilibrium price following a permanent change in demand depends on external economies and external diseconomies. External economies are factors beyond the control of an individual firm that lower the firm’s costs as the industry output increases. External diseconomies are factors beyond the control of a firm that raise the firm’s costs as industry output increases. Changing Tastes and Advancing Technology A long-run industry supply curve shows how the quantity supplied by an industry varies as the market price varies, after all the possible adjustments have been made, including changes in plant size and changes in the number of firms in the industry Long-Run Changes in Price and Quantity Changing Tastes and Advancing Technology Technological Change New technologies are constantly discovered that lower costs. A new technology enables firms to produce at a lower average cost and lower marginal cost—firms’ cost curves shift downward. Firms that adopt the new technology earn an economic profit. Competition and Efficiency Efficient Use of Resources Resource use is efficient when we produce the goods and services that people value most highly If someone can become better off without anyone else becoming worse off, resources are not being used efficiently. In other words, resource use is efficient when marginal benefit equals marginal cost. Competition and Efficiency Choices, Equilibrium, and Efficiency We can describe an efficient use of resources in terms of the choices of consumers and firms coordinated in market equilibrium. Consumers allocate their resources to get the most value possible out of them Consumers get the most value possible out of their resources at all points along their demand curves, which are also their marginal benefit curves. Competition and Efficiency In competitive equilibrium, the quantity demanded equals the quantity supplied. This means that the consumer’s marginal benefit equals the producer’s marginal cost. The gains from trade — consumer surplus plus producer surplus — are maximised. Efficiency of Competition Objectives After studying this chapter, you will be able to: Define perfect competition Explain how firms make their supply decisions and why they sometimes shut down temporarily and lay off workers Explain how price and output are determined and why firms enter and leave an industry Predict the effects of a change in demand and of a technological advance Explain why perfect competition is efficient Rivalry in Personal Computers The personal computer business is a highly competitive business made of such firms as Apple, Dell, Gateway etc competing with hundreds of smaller firms. How do firms operate when they face the fiercest competition from other firms. What determines their production decisions? Why do firms enter or leave the industry? These and other questions about competitive markets will be answered in this chapter What is Perfect Competition? Perfect competition is an industry in which: Many firms sell identical products to many buyers. There are no restrictions to entry into the industry. Existing firms have no advantages over new ones. Sellers and buyers are well informed about prices. What is Perfect Competition? How Perfect Competition Arises Perfect competition arises when two conditions are present: A firm’s minimum efficient scale is the smallest quantity of output at which long-run average cost reaches its lowest level. When each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm they buy from. What is Perfect Competition? Price Takers In perfect competition, each firm is a price taker. A price taker is a firm that cannot influence the market price of a good or service. Each firm produces a tiny fraction of the total output and buyers are well informed about the prices of other firms. The firm faces a perfectly elastic demand for its output What is Perfect Competition? Economic Profit and Revenue The goal of each firm is to maximise economic profit, which equals total revenue minus total cost. Total cost is the opportunity cost of production, which includes normal profit. A firm’s total revenue equals price times quantity sold A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. Demand, Price, and Revenue in Perfect Competition Demand, Price, and Revenue in Perfect Competition The Firm’s Decisions in Perfect Competition A perfectly competitive firm faces two constraints: A market constraint summarised by the market price and the firm’s revenue curves. A technology constraint summarised by the firm’s product curves and cost curves. The Firm’s Decisions in Perfect Competition Short-Run Decisions The perfectly competitive firm makes two decisions in the short run: Whether to produce or to temporarily shut down What quantity to produce The Firm’s Decisions in Perfect Competition Long-Run Decisions A firm’s long-run decisions are: Whether to increase or decrease its plant size Whether to remain in, enter, or leave an industry The Firm’s Decisions in Perfect Competition Profit-Maximising Output A perfectly competitive firm chooses the output that maximises its economic profit. One way to find the profit maximising output is to look at the firm’s the total revenue and total cost curves. Revenue and Cost Economic Profit and Loss The Firm’s Decisions in Perfect Competition Marginal Analysis The firm can use marginal analysis to determine the profit-maximising output. Profit is maximised by producing the output at which marginal revenue, MR, equals marginal cost, MC. Profit-Maximizing Output The Firm’s Decisions in Perfect Competition Profits and Losses in the Short-run Maximum profit is not always a positive economic profit. To determine whether a firm is earning an economic profit or incurring an economic loss, we compare the firm’s average total cost, ATC, at the profit maximising output with the market price. Three Possible Profit Outcomes in the Short-Run Three Possible Profit Outcomes in the Short-Run Three Possible Profit Outcomes in the Short-Run The Firm’s Decisions in Perfect Competition Temporary Plant Shutdown If price is less than the minimum average variable cost, the firm shuts down temporarily and incurs a loss equal to total fixed cost. This loss is the largest that the firm must bear. If the firm were to produce just 1 unit of output at price below average variable cost, it would incur an additional (and avoidable) loss. The Firm’s Decisions in Perfect Competition The Firm’s Short-run Supply Curve A perfectly competitive firm’s short-run supply curve shows how the firm’s profit-maximising output varies as the market price varies, other things remaining the same. Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve. But there is a price below which the firm produces nothing and shuts down temporarily. The Firm’s Decisions in Perfect Competition The shutdown point is the output and price at which the firm just covers its total variable cost. This point is where average variable cost is at its minimum. It is also the point at which the marginal cost curve crosses the average variable cost curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily. It incurs a loss equal to total fixed cost from either action. The Firm’s Decisions in Perfect Competition If the price exceeds minimum average variable cost, the firm produces the quantity at which marginal cost equals price. Price exceeds average variable cost, and the firm covers all its variable cost and at least part of its fixed cost. A Firm’s Shutdown Point and Supply Curve A Firm’s Supply Curve The Firm’s Decisions in Perfect Competition Short-run Industry Supply Curve The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant. The quantity supplied by the industry at any given price is the sum of the quantities supplied by all the firms in the industry at that price. Industry Supply Curve Output, Price, and Profit in Perfect Competition Short-Run Equilibrium Short-run industry supply and industry demand determine the market price and output. A short-run equilibrium occurs at the intersection of the demand and supply curves. Short-run Equilibrium Output, Price, and Profit in Perfect Competition A Change in Demand An increase in demand brings a rightward shift of the industry demand curve: the price rises and the quantity increases. A decrease in demand brings a leftward shift of the industry demand curve: the price falls and the quantity decreases. Short-Run Equilibrium Output, Price, and Profit in Perfect Competition Long-Run Adjustments In short-run equilibrium, a firm may earn an economic profit, earn normal profit, or incur an economic loss and which of these states exists determines the further decisions the firm makes in the long run. In the long run, the firm may: Enter or exit an industry Change its plant size Output, Price, and Profit in Perfect Competition Entry and Exit New firms enter an industry in which existing firms earn an economic profit. Firms exit an industry in which they incur an economic loss. Entry and exit of new firms shifts the industry supply curve. Entry and Exit Output, Price, and Profit in Perfect Competition Changes in Plant Size Firms change their plant size whenever doing so is profitable. If average total cost exceeds the minimum long-run average cost, firms change their plant size to lower costs and increase profits. Figure 10.9 on the next slide shows the effects of changes in plant size. Plant Size and Long-Run Equilibrium Output, Price, and Profit in Perfect Competition Long-Run Equilibrium Long-run equilibrium occurs in a competitive industry when: Economic profit is zero, so firms neither enter nor exit the industry. Long-run average cost is at its minimum, so firms don’t change their plant size. Changing Tastes and Advancing Technology A Permanent Change in Demand A decrease in demand shifts the demand curve leftward. The price falls and the quantity decreases. Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward. Economic losses induce exit, which decreases short-run supply and shifts the short-run industry supply curve leftward. A Decrease in Demand Changing Tastes and Advancing Technology Increase in Demand An increase in demand shifts the demand curve rightward. The price rises and the quantity increases. Economic profit induces entry, which increases short-run supply and shifts the short-run industry supply curve rightward. As industry supply increases, the price falls and the market quantity continues to increase. Changing Tastes and Advancing Technology External Economics and Diseconomies The change in the long-run equilibrium price following a permanent change in demand depends on external economies and external diseconomies. External economies are factors beyond the control of an individual firm that lower the firm’s costs as the industry output increases. External diseconomies are factors beyond the control of a firm that raise the firm’s costs as industry output increases. Changing Tastes and Advancing Technology A long-run industry supply curve shows how the quantity supplied by an industry varies as the market price varies, after all the possible adjustments have been made, including changes in plant size and changes in the number of firms in the industry Long-Run Changes in Price and Quantity Changing Tastes and Advancing Technology Technological Change New technologies are constantly discovered that lower costs. A new technology enables firms to produce at a lower average cost and lower marginal cost—firms’ cost curves shift downward. Firms that adopt the new technology earn an economic profit. Competition and Efficiency Efficient Use of Resources Resource use is efficient when we produce the goods and services that people value most highly If someone can become better off without anyone else becoming worse off, resources are not being used efficiently. In other words, resource use is efficient when marginal benefit equals marginal cost. Competition and Efficiency Choices, Equilibrium, and Efficiency We can describe an efficient use of resources in terms of the choices of consumers and firms coordinated in market equilibrium. Consumers allocate their resources to get the most value possible out of them Consumers get the most value possible out of their resources at all points along their demand curves, which are also their marginal benefit curves. Competition and Efficiency In competitive equilibrium, the quantity demanded equals the quantity supplied. This means that the consumer’s marginal benefit equals the producer’s marginal cost. The gains from trade — consumer surplus plus producer surplus — are maximised. Efficiency of Competition Table 10.1 Total Revenue, Total Cost, and Economic Profit Table 10.2 Profit-Maximising Output Table 10.3