Chapter 9 Supply Under Perfect Competition Introduction to Economics (Combined Version) 5th Edition

Chapter 9Supply Under

Perfect Competition

Introduction to Economics (Combined Version) 5th Edition

Market Structure Market structure is the characteristics of the market

environment; such as the nature of the product, number and size of competitors, and conditions of entry and exit, that shape the ways in which a firm interacts with its customers and competitors.

Market structure matters because it helps determine the constraints a firm faces in making decisions related to pricing and profit maximization.


Perfect Competition

Many small firms Each has small market share Product is homogeneous Entry is unrestricted Equal access to information Example: Some kinds of

farming


Monopoly One firm 100% market share Unique product Restricted entry Possible restrictions on

information Example: Post office

monopoly on first-class mail


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Oligopoly

A few firms At least some have large

market shares Homogeneous or

differentiated products Entry may be restricted Possible restrictions on

information Example: Airlines


Monopolistic Competition Many firms Each has small market

share Product differentiated by

quality, location, style, etc.

Unrestricted entry Possible restrictions on

information Example: Hotels in a

resort community


Demand for a Perfect Competitor The perfectly competitive firm is a price taker It is so small relative to the market as a whole that its decisions

do not significantly affect the market price, so the demand curve it faces is perfectly elastic.


Profit Maximization for Perfect Competitor Assume a perfectly competitive

firm and a market price P=50 The maximum profit will be

earned at a quantity Q* where P = MC and MC is increasingAt a lower Q, P>MC so

revenue from one more unit will exceed the cost of that unit

At a higher Q, P<MC so revenue from one more unit will be less than the cost of that unit


Profit Maximization vs. Loss Minimization

If P>ATC where P=MC, then the firm will earn a positive profit at that point (point a)

If ATC>P>AVC where P=MC, then “profit maximization” will really mean loss minimization, for example, point b


Profit Maximization vs. Loss Minimization At point b, price is enough to

pay variable costs in full. After variable costs are paid,

there is enough revenue left to pay part, but not all of fixed costs.

If market conditions are expected to return to profitability in the future, short-run losses are minimized by operating at point b


Example: Housing Construction During a downturn in the

housing market, a building contractor may continue to operate even though prices for contractor services are low.

Revenue is enough to cover variable costs (workers’ wages) with enough left over to pay part, but not all, of fixed costs (tools and heavy equipment).

When the housing market recovers, prices will rise and profits will return.


Short-Run Shutdown Suppose that the firm is

expected to be profitable in the long run but, in the short run, P<AVC

The firm should consider shutting down in the short-run to minimize operating losses

Possible exceptions: Continue operating to avoid losing

your regular customers Continue operating to retain

loyalty of key employees


Example: Seasonal Resorts Some ski resorts do not have

enough demand to even cover their variable costs of operation in the summer.

They shut down in the summer to minimize losses.

Other mountain resorts have enough demand from hikers and sightseers to remain open all year.

Exercise: Draw diagrams to illustrate each possibility.


MC Curve and the Supply Curve As the price increases, the

profit-maximizing quantity will increase

The positively-sloped segment of the marginal cost curve above minimum average variable cost can be considered the firm’s supply curve

Points where price intersects the negatively-sloped segment of the MC curve are not part of the supply curve


Industry Supply Curve A short-run industry supply curve can be obtained by summing

the supply curves of individual firms. Here this method is shown for the first three firms in an industry. The supply curves of additional firms would be added in the same way.


Long-Run EquilibriumLong-run equilibrium in a

perfectly competitive industry requires that the firm

1. have no short-run incentive to change the level of its output

2. have no long-run incentive to change the size of the plant used to produce its output

3. have no long-run incentive to enter or leave the industry

This requires that price, short-run marginal cost, short-run average total cost, and long-run average cost all have the same value in equilibrium


Entry in Perfect Competition An increase in demand temporarily increases price. With positive

economic profit, new firms will enter. Supply shifts to right and price returns to AVC.


Exit from Perfect Competition A decrease in demand temporarily lowers price. With negative

economic profit (assuming no sunk costs), some firms leave the market. As they do, supply shifts to left and price returns to AVC


Industry Supply with Rising Input Prices This pair of diagrams show what happens if industry expansion causes input

prices to rise. As output expands, rising input prices push up the firm’s marginal cost curve from MC1 to MC2, and its average total cost from ATC1 to ATC2. The result is a new long-run equilibrium price that is higher than the initial price. The long-run industry supply curve thus has a positive slope.


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Chapter 9 Supply Under Perfect Competition Introduction to Economics (Combined Version) 5th Edition