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chapter 10 econ Q&A

chapter 10 econ Q&A

Microeconomics

Perfect Competition

Short Run Decisions

Perfect Competition in the Long Run

Should this firm shut down?

PRODUCTION

500 UNITS

PRICE

$4 PER UNIT

AFC = $2

AVC = $3

TVC = $5

Perfect Competition

Short Run Decisions

Perfect Competition

ASSUMPTIONS

There are many sellers and many buyers

Firms produce and sell homogeneous products

Perfect information

No barriers to entry

Firms are price takers

Firm demand is perfectly elastic

P = MR

Profit Maximization Rule

MR = MC

For perfectly elastic firms that maximize profit/minimize cost:

P = MR = MC

P = MC

CONTINUE TO OPERATE Perfectly Competitive Firms SHUT DOWN?

TWO CHOICES

in the short run…

1. CONTINUE

TO

OPERATE

2. SHUT DOWN

Case 1: Continue to Operate or Shut Down?

PRODUCTION

500 UNITS

PRICE

$4 PER UNIT

AFC = $2

AVC = $3

1. If the firm continues to operate…

PRODUCTION

500 UNITS

PRICE

$4 PER UNIT

AFC = $2

AVC = $3

TOTAL REVENUE = $4 * 500 = $2000

TOTAL FIXED COST = $2 * 500 = $1000

TOTAL VARIABLE COST = $3*500 = $1500

TOTAL COST = TFC + TVC = $2500

PROFIT = TR – TC = -$500

2. If the firm shuts downs…

PRODUCTION

500 UNITS

PRICE

$4 PER UNIT

AFC = $2

AVC = $3

TOTAL REVENUE = $4 * 0 = $ZERO

TOTAL FIXED COST = $2 * 500 = $1000

TOTAL VARIABLE COST = $3*0 = $0

TOTAL COST = TFC + TVC = $1000

PROFIT = TR – TC = -$1000

P=$4, Q=500, AFC=$2, AVC=$3

FIRM SHUTS DOWN

TOTAL REVENUE : 0

TOTAL COST : 1000

PROFIT : -1000

FIRM CONTINUES TO OPERATE

TOTAL REVENUE : 2000

TOTAL COST : 2500

PROFIT : -500

So the firm

continues operate, but at a loss.

CASE 2 CONTINUE TO OPERATE OR SHUT DOWN?

PRODUCTION

100 UNITS

PRICE

$7 PER UNIT

AFC = $1

AVC = $3

CONTINUE TO OPERATE OR SHUT DOWN?

PRODUCTION

100 UNITS

PRICE

$7 PER UNIT

AFC = $1

AVC = $3

TOTAL REVENUE = $7 * 100 = $700

TOTAL FIXED COST = $1 * 100 = $100

TOTAL VARIABLE COST = $3*100 = $300

TOTAL COST = TFC + TVC = $400

PROFIT = TR – TC = $300

THIS FIRM IS EARNING A PROFIT

CONTINUE TO OPERATE

Case 3: Continue to Operate or Shut Down?

PRODUCTION

800 UNITS

PRICE

$1 PER UNIT

AFC = $1

AVC = $2

If the firm continues to operate…

PRODUCTION

800 UNITS

PRICE

$1 PER UNIT

AFC = $1

AVC = $2

TOTAL REVENUE = $1 * 800 = $800

TOTAL FIXED COST = $1 * 800 = $800

TOTAL VARIABLE COST = $2*800 = $1600

TOTAL COST = TFC + TVC = $2400

PROFIT = TR – TC = -$1600

If the firm shuts down…

PRODUCTION

800 UNITS

PRICE

$1 PER UNIT

AFC = $1

AVC = $2

TOTAL REVENUE = $1 * 0 = $ ZERO

TOTAL FIXED COST = $1 * 800 = $800

TOTAL VARIABLE COST = $2*800 = $0

TOTAL COST = TFC + TVC = $800

PROFIT = TR – TC = -$800

P=$1, Q=800, AFC=$1, AVC=$2

SHUTS DOWN

TOTAL REVENUE : 0

TOTAL COST : 800

PROFIT : -800

So the firm shuts down

CONTINUES TO OPERATE

TOTAL REVENUE : 800

TOTAL COST : 2400

PROFIT : -1600

Decisions in the Short Run

Relationships with short run costs

CASE 1: AVC < P=$4 < ATC

CONTINUE TO OPERATE

PROFIT = 2000 – 2500 = -500

SHUT DOWN

PROFIT = 0 – 1500 = -1500

CASE 2: P=$7 > ATC

CONTINUE TO OPERATE

PROFIT = 700 – 400 = 300

SHUT DOWN

PROFIT = 0 – 300 = -300

CASE 3: P=$1 < AVC

CONTINUE TO OPERATE

PROFIT = 800 – 2400 = -1600

SHUT DOWN

PROFIT = 0 – 800 = -800

Summary

CASE 1  CONTINUE TO OPERATE

Price is below Average Total Cost and

Price is above Average Variable Cost

CASE 2  CONTINUE TO OPERATE

Price is above Average Total Cost

CASE 3  SHUT DOWN

Price is below Average Variable Cost

So now…why did they close?

Exercise (1 of 2)

A perfectly competitive firm is producing 4900 units per month. The average variable cost is $16, and the total cost is $147,000. If the price is projected to be $20 per unit next month, then should the firm continue to operate or shut down?

Exercise (1 of 2)

P = $20

AVC = $16

ATC = 147000 / 4900 = $30

Continues to Operate:

Loss= $49,000

Shut down:

Loss = $68,600

Microeconomics

Perfect Competition in the Long Run

Why we study market structures

Market Structure

The setting in which a firm operates.

Characteristics of markets determine decisions related to the quantity produced, and the selling price.

TYPES OF MARKET STRUCTURES

Perfect Competition

Monopoly

Monopolistic Competition

Oligopoly

Perfect Competition

ASSUMPTIONS

There are many sellers and many buyers

Each is small enough to have no influence on price

Firms produce and sell homogeneous products

Products are indistinguishable from each other (e.g., corn)

Perfect information

Buyers and sellers have all relevant info: prices, quality, source of supplies

No barriers to entry

Firms are free to enter and exit markets at will

Price Takers

Perfectly competitive firms are price takers; that is, they have no control over the market price, so individual firms face a perfectly elastic demand curve. Furthermore, P=MR…

Profit Maximizers

Profit maximizing firms set MR=MC, so…

P= MR

MR = MC

P=MC

Short Run Decisions, Case 1

P > ATC

Continue to operate

Earn a profit

Short Run Decisions, Case 2

ATC > P > AVC

Continue to operate

Incur a loss

Short Run Decisions, Case 3

P < AVC

Shut down

Incur a loss

Something to think about

Suppose the government imposes a production tax on one perfectly competitive firm in an industry. For each unit the firm produces, it must pay $1 to the government. Will consumers in this market end up paying higher prices because of the tax? Why or why not?

The tax increases the price per unit, and the new equilibrium price is the same as the old equilibrium price.

Buyers pay the full tax, and sellers pay none of the tax.

Types of Economic Efficiency

Resource Allocative Efficiency

Productive Efficiency

Types of Efficiency

Resource Allocative Efficiency

Optimal use of scarce resources

Market price = marginal cost of supply : P = MC

Types of Efficiency

Resource Allocative Efficiency

Optimum use of scarce resources

Market price = marginal cost of supply : P = MC

Productive Efficiency

Minimize resource wastage

Maximum productivity

Unit costs are the lowest possible : min(ATC)

This is not guaranteed in the short run, but is in the long run.

Perfectly Competitive Firm

P = MC

P = SRATC

Economic profit = 0

No incentive for firms to enter

Perfect Competition

Long Run Competitive Equilibrium

Assumptions

Firms are perfectly competitive ( P = MC )

P=MR, MR=MC, P=MC

Economic profit is zero ( P=SRATC )

If P > SRATC, then firms will enter the industry to earn positive economic profits

Firms have no incentive to change plant size ( SRATC = LRATC )

Compared to SRATC > LRATC, where firms have incentive to change plant size in the long run.

Implications

In long-run competitive equilibrium, firms have

no incentive to: Enter or exit industry

…because P=SRATC, and economic profits are zero

no incentive to: Produce more output, or less output

…because P=MC

no incentive to: Change plant size

…because SRATC = LRATC

——————————————————————-

Thus in the long run: P=SRATC=LRATC

Long-Run Competitive Equilibrium

P = MC

the firm has no incentive to move away from the quantity of output at which this occurs, q1

P = SRATC

no incentives for firms to enter or exit the industry (zero economic profit)

SRATC = LRATC

no incentive for the firm to change its plant size

43

Long Run Equilibrium

Industry Adjustment to a Change in Demand

Industry Adjustment to Increased Demand

Increased market demand…

Market equilibrium price rises, and so does Marginal Revenue!

P > SRATC

 Economic Profits

Incentive to produce more.

Incentive for new firms to enter industry.

Increased demand  higher market equilibrium price

P > SRATC  economic profits

 new firms enter industry

 increased market supply

 market equilibrium price falls

…how much does it fall?

Constant Cost Industry

New long run equilibrium price is same as old long run equilibrium price

Increasing Cost Industry

Initially market is in long range competitive equilibrium, then industry adjusts to a change in demand…

Increased demand  higher market equilibrium price

P > SRATC  economic profits

 new firms enter industry

 increased market supply

 market equilibrium price falls

Increasing Cost Industry

New equilibrium price is greater than the old equilibrium price

Increasing Cost Industry

P = MR = MC

P = SRATC = LRATC

New Price is higher

New SRATC, LRATC is too

Finite Resources:

Oil, Gold, Silver

Moving from one LR equilibrium to another

Constant-Cost Industry

New Long Run Price = Old Long Run Price

Agricultural commodities: corn, soybeans

Increasing-Cost Industry

New Long Run Price > Old Long Run Price

Finite natural resources: oil, metals

Decreasing-Cost Industry

New Long Run Price < Old Long Run Price

Long Run Competitive Equilibrium

Market demand increases, raising the equilibrium price.

Demand and Marginal Revenue increase for the firm

P > SRATC  attracts new firms to industry…

New firms enter industry, driving the market price down.

Until P = SRATC = LRATC

New long-run equilibrium price is less than old LR-equilibrium price

Decreasing Cost Industry

P = MR = MC

P = SRATC = LRATC

New Price is lower

New SRATC, LRATC also

Economies of scale allow The industry to produce more at a lower cost.

e.g., microchips, car parts

Moving from one LR equilibrium to another

Constant-Cost Industry

New Long Run Price = Old Long Run Price

Number of firms don’t affect production costs

Agricultural commodities: corn, soybeans

Increasing-Cost Industry

New Long Run Price > Old Long Run Price

Production costs rise as new firms enter the industry

Finite natural resources: oil, metals

Decreasing-Cost Industry

New Long Run Price < Old Long Run Price

Production costs fall as new firms enter industry

Computer chips, car parts

Can Industries Change?

The Case of the Energy Industry:

As oil, gas, and coal production gradually give way to production of energy by solar, wind and tidal power, how will this change production costs for the industry as a whole?

If the industry focuses only on oil, gas, and coal then it will an increasing cost industry, because resources are finite.

Solar, wind, and tidal power are limitless resources…

So…adding solar, wind and tidal power could transform the energy industry into a decreasing-cost industry!

Q: Impact of Discrimination

A firm’s discriminatory behavior can affect its profits in the context of the model of perfect competition

Suppose that under the conditions of long-run competitive equilibrium (zero profits), the owner of a firm chooses not to hire an excellent worker because of that worker’s race, religion or gender; what happens?

A: Impact of Discrimination

A firm’s discriminatory behavior can affect its profits in the context of the model of perfect competition

Suppose that under the conditions of long-run competitive equilibrium (zero profits), the owner of a firm chooses not to hire an excellent worker because of that worker’s race, religion or gender; what happens?

Their costs will rise above those of competitors who hire the best employees without regard to race, religion, etc.

Because they earn zero profit, the act of discrimination will raise total cost and put the firm into taking economic losses

Thank you

Please explore the following

additional graphical examples

on your own

Additional graphical examples of long run competitive equilibrium and how it relates to long run supply (LRS)

Constant-Cost Industry

New long run equilibrium price is equal to the old long run equilibrium price

Long Run Supply Curve

Perfectly Elastic

Increasing-Cost Industry

New long run equilibrium price is greater than the old long run equilibrium price.

Long Run Supply Curve

Upward sloping

Decreasing-Cost Industry

New long run equilibrium price is less than the old long run equilibrium price.

Long Run Supply Curve

Downward sloping

END OF PRESENTATION

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