1

The Competitive Firm in the Long Run

2

Remember that the long run is that period of time in which all inputs to the production process can be changed. Before, in a section on production and cost we saw that the basic cost structure could be summarized in the following graph. (Note, since all costs are variable the AC curve is really an AVC curve, we just call it the AC curve.)

ACMC

$

Q

firm

3

The firm is still a price taker and P = D =MR = AR for the firm. The firm makes the output level where MR = MC, as long as the P>AC. The amount of the profit is calculated as (P – AC)times Q*, and the P and the AC are measured at the Q* level.

ACMC

$

Q

firmQ*

P

Profit rectangle

4

Here, where MR = MC, the P = AC so profit would be zero. Remember that zero profit means that accounting profit is greater than zero if there are some opportunity costs that are not explicit. Since at this price the firm breaks even we say the price here is the break-even price. So when MR = MC if P = AC, the price is called the break-even price.

ACMC

$

Q

firmQ*

P

Note when MC = AC, AC is at its lowest. Now at break-even point, P = MC and P = AC, so MC = AC.

5

Here, where MR = MC, the P < AC so profit would be negative. Firms would be better off exiting the industry.

ACMC

$

Q

firmQ*

P

The loss

6

The MC curve above the AC curve is the supply curve for the firm in the long run. If the price line comes through at any point in this area the firm will have positive profit and the quantity supplied will correspond with the amount on the MC curve. If the price is any lower the firm will exit and make nothing.

ACMC

$

Q

firmQ*

7

Let’s look at an example next.

Quantity TC MC AC P Q TR TC Profit

1 10 2 10

2 15 5 7.5

3 21 6 7

4 28 7 7

5 37 9 7.40

6 48 11 8Here is an example of Floyd’s Barbershop. Floyd operates in a competitive environment. If he didn’t have a barbershop he would make 8 bucks at a gas station. This cost has been factored into his TC. So, really at Q=0 TC=8 at the barbershop. MC = change in TC divided by change in Q, while AC = TC/Q.

8

Quantity TC MC AC P Q TR TC Profit 1 10 2 10 2 1 2 15 5 7.5 3 21 6 7 4 28 7 7 5 37 9 7.40 6 48 11 8

Here I have added a 2 under the P column and a 1 under the Q column. The P and Q column is the supply curve. The supply curve for a firm is the MC above the AC curve. But to draw the MC curve we will follow the rule that firms produce where P (=MR)=MC. Since the MC at Q = 1 is 2 the MC = 2 = P on the supply curve. What is the P if Q=2? Can you fill in the rest of these two columns? (sure you can!)

9

Quantity TC MC AC P Q TR TC Profit 1 10 2 10 2 1 2 2 15 5 7.5 5 2 3 21 6 7 6 3 4 28 7 7 7 4 5 37 9 7.40 9 5 6 48 11 8 11 6

Here I added the TR for the Q=1 by taking the P times Q. Can you fill in the rest of table? (SURE you can, because, dang it, you are good enough!)

10

Quantity TC MC AC P Q TR TC Profit 1 10 2 10 2 1 2 10 -8 2 15 5 7.5 5 2 10 15 -5 3 21 6 7 6 3 18 21 -3 4 28 7 7 7 4 28 28 0 5 37 9 7.40 9 5 45 37 8 6 48 11 8 11 6 66 48 18

Here I copied the TC and found profit as TR minus TC.

What have we done here? I HAVE NO IDEA!

No, really we looked at the graph on the next page.

11

So, in the graph, when P = 2, MR = MC at Q=1 and profit is less than zero. Firm really wouldn’t make this amount though, it would quit. So this part of the MC curve is not the supply curve. Only the part above AC is the supply curve Each row in the table can be put into this graph.

ACMC

$

Q

firm1

2

10

P

Profit=-8

12

Profits and lossesIn a competitive industry it is felt the existence of profits at the firm level will attract more firms into the industry.

This will increase supply and lower price in the market.

With a lower price firm level profit falls.

The existence of losses at the firm level will make some firms leave the market.

This will decrease supply and raise market price.

The entry and exit of firms will stop when profit is zero. At that point P = MC = AC and AC is at a minimum .