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“THE MARKET IS THE WORST SYSTEM OF ECONOMIC AND SOCIAL DEVELOPMENT – EXCEPT FOR ALL THE OTHERS THAT HAVE BEEN TRIED FROM TIME TO TIME.”
Sir Winston Churchill2
MES: SMALLEST PLANT WITH LOWEST ATC IN THE LONG RUNMES: The smallest plant that prevents the firm from being “priced out” of the industry by firms with lower costs.
Only firms with plants with the lowest cost will survive in the long run.
3
500,000
SRATC1
SRATC2
SRATC3
SRATC4SRATC5
SRATC6
SRATC7
LRATC
MES
Total Market Demand = 3,000,000150,000
# of surviving Firms = 3,000,000/500,000 = 6 firms each selling 500,000# of surviving Firms = 3,000,000/150,000 = 20 firms each one sells 150,000
10,000
# of surviving Firms = 3,000,000/10,000 = 300 firms each sells 10,000
The smaller the size of the
MES, the larger the number of firms that can successfully compete and survive in the
industry
The smaller the size of the
MES, the more competitive the
industry is.
The larger the size of the
MES, the more concentrated
the industry is.
Perfect Competition Arises WhenThe minimum efficient scale is small relative to Market demand.
©2001C
laudiaG
arcia-Szekely
5
In a Perfectly Competitive Industry
There are many firms: no single firm can affect the price
Firms are price takers. There are many buyers: no single
buyer can affect the price Buyers are price takers.
All firms sell identical products. Established firms have no advantages
over new firms.
6
Price is Determined by the Market
7
S
D
Q
PAll firms
Sell at thisprice
Each firm produces only a tiny fraction(q) of this total Q
Sum of all firms’ output
Total Market Demand
Perfectly competitive firms are price takers
Each firm produces only small portion of the total supply
Buyers know all prices from all firms in the market
8
A firm wouldn’t increase price above market price
Because
Lose all its customers to the competition
A firm would not decrease its price
Because
It can sell all it wants at market price
d
Demand as perceived by each firm is perfectly elastic at the market price
Perfectly Competitive Firms are Price Takers
9
S
D
Q
P d
q1
P
Given the price determined by the market
PC firms decide how many units to produce at the
market price.
q2 q3
Which output level is
best?
Total Revenues
Total Revenues =
10
Price x Quantity Sold
TR
quantity
TR
q TRPrice
5 30 150
5 10 50
5 20 100
10
50
20
100
30
150
TRPrice
$7
$7
70
140
210
70
140
210
TR’
As the price increases, TR line becomes steeper
$7
11
dP = $5
1 2 3 4 5 6
Quantity purchased
Price
Quantity purchased
TRTR
1 2 3 4 5 6
5
10
15
20
25
305
5
5
5
5
MRMR = $5
1 2 3 4 5 6Q
MR
In PC markets:
MR = Price
Total Revenue /Total Cost view
12
Total Revenues
Total Costs
TR,TC
Output
Revenues (TR)- Total Costs (TC)
Profit or Loss = Profit
Total Revenues
Total Costs
Loss
Firms want to maximize Profits
Total
Rev
enue
sTot
al C
osts
Total
Rev
enue
s
Total
Cos
ts
TR,TC
-Total Costs (TC)
=Profit (Loss)
Total Revenues
All these output levels generate
losses.
LossesAll these output levels generate
Profits.
Profits
All these output levels
generate Losses.
14
Total
Rev
enue
sTot
al C
osts
Total
Rev
enue
s
Total
Cos
ts
TR,TC
Firm must produce more than q0 to
offset these losses
Firm chooses the output level that
maximizes profits
Profit
The largest distance between
TR and TCoccurs when TR and TC have the same slope.
TR
TC
q0
Losse
s
Total Profits are Maximized when MR = MC
15
Total
Rev
enue
s
Total
Cos
ts
TR,TC
Slope of TC = Slope
of TRMC = MR
Profit Maximizing Output Level q*
Choose output where MC= MR to maximize profit
TRTC
Slope = MC
Slope = MR
MC = MR: Maximize Profit
MAX Profit
q*
Price determines Profit/Loss
Total
Rev
enue
sTot
al C
osts
Total
Rev
enue
sTotal
Cos
ts
TR,TC
Output
Losse
s
Profits
If Price Decreases
Slope of TR line decreases
If the price continues to drop, there will be NO output level that generate a profit, only loss.
For all these output levels the firm makes a profit: chooses the output with the largest profit.
ProfitsProfitsProfitsProfitProfit
Choosing q where MR = MC Maximize profit or Minimize Loss
TR
TC
Slope = MC
Slope = MR
Loss
Loss
Loss
Loss
q*
MC = MR TR = TC Loss = zero
Choose q where MC = MR to Minimize Loss
TR less than TC: Economic Losses
At q*, the slope of TC (MC) = Slope of TR (MR) But the firm does not make a profit
TR
TC
Slope = MC
Slope = MR
q*
Smallest Loss
Loss
LossLoss
Loss
Choose q where MC = MR to Minimize Loss
Marginal Revenue (MR): Additional revenue from selling one more unit.
20
MR
Q
MR = Price = $5In PC markets, the
additional Revenue the firm gets from selling one more
unit is the price per unit
In PC markets, the additional Revenue the firm gets from selling one more
unit is the price per unit
5
PROFIT PER UNIT = MR-MCPROFIT PER UNIT = PRICE - MC
21
MR, MC
Q
MR= Price = $5
MC = Cost per unit
Negative: Loss
Positive: Profit
Number of Units (Q) Profit Per Unit = MR – MCTotal Profit
= Sum of Per unit profit.
1234567891011
Fill in the values in the table using the information in the next slide
Price - MC
P = $5 MR=$5
MC9
8
6
3
21 2
3
8
11
7
4
4 111 2 3 5 6 7 8 9 10 12 13 14
Loss = $5 - $9 = -4Loss = $5 - $8 = -3
Loss = $5 - $6 = -1Loss = $5 - $5 = 0
Profit = $5 - $3 = +2Profit = $5 - $2 = +3
Profit = $5 - $1 = +4Profit = $5 - $2 = +3
Profit = $5 - $3 = +2
5 5Profit = $5 - $5 = 0
Profit = $5 - $4 = +1
Loss = $5 - $7 = -2
Loss = $5 - $8 = -3
Loss = $5 - $11 = -6
P = 5 MR
MC
9
8
6
32 1 2
3
8
11
7
4
4 11
If The firm produces more than 11 units, profits will shrink as losses start to accumulate…
-2
-3
-6
1 2 3 5 6 7 8 9 10 12 13 14
Profit maximizing output level
-4
-3
-1
+2+3 +4 +3 +2 +1
Number of Units (Q) Profit Per Unit = Price – MCTotal Profit is sum of
per unit profit
1 5 - 9= - 4 -4
2 5 - 8 = - 3 -7
3 5 - 6 = - 1 -8
4 5 - 5 = 0 -8
5 5 – 3 = +2 -6
6 5 – 2 = +3 -3
7 5 – 1 = + 4 +18 5 – 2 = +3 +4
9 5 – 3 =+2 +6
10 5 – 4 = +1 +7
11 5 – 5 = 0 +712 5 - 7 = -2 +5
13 5 - 8 = -3 +2
14 5 - 11 = -6 -4
Max per unit
profit at q = 7
Max TOTAL profit at q=
11
Always choose output at the maximum TOTAL profit
Never choose output at the maximum PER UNIT profit
26
Per unit view
Total view
Profit maximizing output level
Total
Rev
enue
sTot
al C
osts
Total
Rev
enue
s
Total
Cos
tsTR,TC
Output
Losse
s
Profit
s
1 2 313
5 67
8
9
10411
12 14
11
27
Total
Rev
enue
sTotal
Cos
tsTR,TC
Slope of TC = Slope
of TRMR = MC
The output level where the Total Profit is largestIs the same as the output level where per unit profit is zero
TRTC
CHOOSING THE OUTPUT LEVEL THAT MAXIMIZES PROFIT
Choose q* at the point where MC = MRSince MR = PriceChoose q* where MC = Price
28
ATC less than Price: Economic Profit
30
© 2001 Claudia Garcia-Szekely
MC
AVC
ATC
P=MR
ATCAVC
q*
Profit Max Output level
VC
FC
TC
AVC x Q = VC
AFC x Q = FCATC x Q = TC
PTR
P x Q = TRTR – TC = Profit
ATC = Price: Zero Economic Profit
MC
AVC
ATC
P = MRP
q* Profit Max Output level
AVC
VC
ATC = P
TC = TR No loss or profit
TC TR = TC
MC
AVC
ATC
P = MRP
q* Profit Max Output level
AVC
VC
ATC
TC larger than TR
TC
ATC larger than Price: Loss
LOSS
TR
SHUT DOWN
Firm continues to pay all the fixed costs in order to KEEP the plant.Produces zero units.Variable Cost= ZERO Total Cost = Fixed CostTotal Revenue = ZEROLoss = TR (0) – TC (FC) = FC.
33
If by producing q*, the firm generates a loss larger than the FC, the firm should
shut down to minimize the loss
MC
AVC
ATC
P = MRP
q* Profit Max Output level
AVCVC
ATC
FCLOSS < FC
TR
Loss if the firm produces q* is smaller than the FC Loss if the firm produces q* is smaller than the FC ATC larger than
P P larger than AVC
ATC larger than P P larger than
AVC
Revenues cover all VC and some of
FC
Revenues cover all VC and some of
FC
MC
P=MR
ATC
AVC
q*
Profit Max Output
PRevenues are NOT enough to
pay for ALL the VCRevenues are NOT enough to
pay for ALL the VC
Loss if the firm produces q* is larger than the FCLoss if the firm produces q* is larger than the FC
VC
TCTC FC
TR
Loss = + some of the
Loss
P less than ATC P less than AVCP less than ATC P less than AVC
MC
P=MR
ATC
AVC
q*
Profit Max Output level
=P
Loss if the firm produces q* is equal
to FC
Loss if the firm produces q* is equal
to FC
VC
TCTC FC
TR
Loss =
Revenues are enough to cover only
the VC
Revenues are enough to cover only
the VC
P less than ATC P =AVC
P less than ATC P =AVC
Loss
TR
TC
q*
VC
Firm should produce at a loss
Loss less than FC
FC
TC larger than TR TR larger than VCTC larger than TR TR larger than VC
TR
TC
q*
VCFirm should shut down
Loss greater than FCFC
TC larger than TR TR less than VC
TC larger than TR TR less than VC
41
P0
P1
P2
P3
P4
q0 q1
q2
q3 q4
P Qs short run
P0q0
P1 q1
P2 q2
P3q3
P4 q4
MR
MRMRMR
Choose output where: MC = MR = Price
As long as Price > AVC
Choose output where: MC = MR = Price
As long as Price > AVC
MC
MR
If Price < AVC
The firm should shut down
If Price < AVC
The firm should shut down
42
Minimum AVC is the shutdown point.
The firm minimizes its losses by producing zero units.
Shut Down
P
Shutdown PriceShutdown Price
AVC
If Price < AVC
Producing at MC=MR will generate losses greater than fixed costs. The firm should shut down
If Price < AVC
Producing at MC=MR will generate losses greater than fixed costs. The firm should shut down
The Short Run Supply Curve
Shut Down
MCMC Above AVC = Supply in the short run To determine the
quantity supplied in the short run choose
q where:
Price = MC.
= Shut down point = minimum
AVC
If price < shut down price then
the quantity supplied = 0
Produce at
MR=MC
AVC
2
46
8
14
5060
70
80 100
P
Typical Firm’s
qs short run
10,000Firms Market Supply
2
4
6
8
14
MR
MRMRMR80
1M
800,000
700,00070
60 or 0
0600,000
Or 0
0
P =
Shutdown Price100
In the Long Run firms EXIT the industry if they are incurring losses
EXIT
P
EXIT Price = Min ATC
MC = Supply in the long run
If price > exit price choose q where
Price = MC.
If price > exit price choose q where
Price = MC.
If price < exit price quantity supplied = 0.
If price < exit price quantity supplied = 0.
P
q
If price = ATC Firm is indifferent
ATC
46
Long-Run Adjustment
If firms in an industry are earning economic profits, firms will enter and the industry expands.
If firms in an industry are earning economic losses, firms will exit and the industry contracts.
If firms in an industry are earning normal profits, expect no further entry or exit.
Firms enter attracted by profits: Supply shifts right
P0MR0
ATC
MC
Profit
D
S0
S1
P1 MR1
q0q1
Zero Profit
Price drops
Firms will enter until profits are zero
Firms will enter until price = Min ATC
q0
q0
Firms exit due to Loss: Supply shifts left
P0 MR0
ATC
MC
Loss
D
S0
S1
P1
MR1
q0 q1
Zero Loss / Profit
Firms will exit until Losses/profits are zero
Firms will exit until price = Min ATC
An industry is not in equilibrium if:
Firms have an incentive to change their output level
Firms have an incentive to enter or exit the industry.
Firms have an incentive to expand or contract the plant size
51
Firms have an incentive to change their output level if:
1. They are not maximizing profits.
Firm should produce more Firm should produce less
MR > MCMC
MR
q0
MR < MCMC
q1
52
Firms have an incentive to change their plant if:
2. They are not minimizing LRATC.
Firm should Expand to Plant 5 Firm should Contract to Plant 5
LRATC
Min
ATC
sratc5
sratc1
q0 q1
LRATC
sratc5
sratc1
q0
Min
ATC
q1
Firms have an incentive to enter or exit an industry if
New Firms will ENTER the industry
Some Firms will EXIT the industry
ATC
Economic Profits
MC
MRProfit
q0
Economic Losses
MC
ATC
Loss
q0
MR
Conditions for Equilibrium In the Long Run
1. Firms must be maximizing Profits
MR = MC
2. Firms must be Minimizing Long Run Costs
SRATC = LRATC
3. Firms must be earning Zero Economic Profit
(No entry, No exit)
P = ATC
MR = MC MC
MR
q0
LRATCSRATC
ATCMC
P
Long Run Equilibrium Condition
MR = MC = Price = SRATC = LRATC
Max Profit Zero Economic Profit/Loss
Min Cost
No change in Output No entry/exit No change in plant size
Competition forces firms to be efficient
P0MR0
ATC
MC
D
S0
S1
P1 MR1
q1
Price drops
Firms will produce at the lowest ATC
Firms will enter until price = Min ATC
No Excess Capacity
When firms expand Supply shifts right
MC
SRATC1
SRATC2
SRATC3
LRACP0
D
S0
S1
P1
Price drops
Firms will expand until they minimize the LRATC
Firms produce with the lowest
cost plant