ECN 112 Chapter 13 Lecture Notes

13.1 A Firm’s Profit-Maximizing Choices A. Perfect Competition Perfect competition exists when: 1. Many firms sell an identical product to many buyers. 2. There are no restrictions on entry into (or exit from) the market. 3. Established firms have no advantage over new firms. 4. Sellers and buyers are well informed about prices. B. Other Market Types 1. A monopoly is a market for a good or service that has no close substitutes and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms. 2. Monopolistic competition is a market in which a large number of firms compete by making similar but slightly different products. 3. An oligopoly is a market in which a small number of firms compete. C. Price Taker 1. A price taker is a firm that cannot influence the price of the good or service that it produces. The market determines the price, and the firm takes it as given. 2. A perfectly competitive firm faces a perfectly elastic demand for its good or service because there are many substitutes for the firm’s good or service. D. Revenue Concepts 1. In a perfectly competitive market, the equilibrium price and quantity are determined by the intersection of the market supply and demand curves. This is the price that the firm “takes.” 2. A firm’s total revenue = price  quantity. When plotted with total revenue on the vertical axis and quantity on the horizontal axis, a firm’s total revenue curve is upward sloping. 3. Marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. 4. In perfect competition, marginal revenue equals price because the firm can sell any quantity at the market price. E. Profit-Maximizing Output There is one output level that maximizes economic profit, and a perfectly competitive firm chooses this output level. 1. One way to find the profit-maximizing output is to compare total cost with total revenue. Profit reaches a maximum when total revenue exceeds total cost by the greatest amount. At the quantity where total cost equals total revenue, the firm has its break-even point and economic profit equals zero. F. Marginal Analysis and the Supply Decision 1. By comparing marginal cost, which increases as output increases, with marginal revenue, which is constant as output increases, a firm determines its profit-maximizing level of output. 2. If marginal revenue is greater than marginal cost, an extra unit of output sold raises more revenue than it costs to produce. When MR > MC, economic profit increases if output increases. 3. If marginal cost is greater than marginal revenue, an extra unit of output sold costs more to produce than it raises in revenue. When MC > MR, economic profit increases if output decreases. 4. When MC = MR, the firm maximizes economic profit. G. Exit and Temporary Shutdown Decisions. 1. If the price of a good falls, a firm faces three decisions: a. If the firm incurs an economic loss that it believes is permanent, the firm exits the market. b. If the firm incurs an economic loss that it believes is temporary and the price is less than average variable cost, the firm shuts down. c. If the firm incurs an economic loss that it believes is temporary and the price is greater than average variable cost, the firm produces output. H. The Firm’s Short-Run Supply Curve 1. The firm’s short-run supply curve shows how the firm’s profit-maximizing output varies as the price varies. The firm produces output as long as price is above minimum average variable cost (P > minimum AVC). 2. The firm shuts down if price is less than minimum average variable cost (P < minimum AVC). a. The shutdown point is the output and price at which the firm just covers its total variable costs. 3. The firm’s supply curve is divided into two parts: a. At prices that exceed minimum average variable cost, the supply curve is the same as the marginal cost curve above the shutdown point. b. At prices below minimum average variable cost, the firm shuts down and produces nothing. The supply curve runs along the vertical axis. At the shutdown point the firm is indifferent between shutting down and producing. 13.2 Output, Price, and Profit in the Short Run A. Market Supply in the Short Run In the short run, the market supply curve shows the quantity supplied at each price by a fixed number of firms. 1. The market supply curve is divided into three sections: a. At prices below the shutdown point, all firms shut down. The market supply is perfectly inelastic. The market supply curve runs along the vertical axis, and the quantity supplied is zero. b. At a price equal to the shutdown point, firms are indifferent between shutting down and producing. Some produce and some do not. The market supply is perfectly elastic and the market supply curve is horizontal. c. At prices greater than the shutdown point, all firms supply output. The market supply curve is the sum of the quantities supplied by all firms at each price. B. Short-Run Equilibrium in Good Times 1. The price is determined by the intersection of the market supply and demand curves and each perfectly competitive firm takes this price as given. 2. If price is greater than a firm’s average total cost, the firm earns an economic profit. C. Short-Run Equilibrium in Bad Times 1. If price is less than the firm’s average total cost, the firm incurs an economic loss. 13.3 Output, Price, and Profit in the Long Run At the profit-maximizing quantity of output, in the long run price equals average total cost (P = ATC). In the long run, a perfectly competitive firm earns zero economic profit, which means that the firm earns normal profit. A. Entry and Exit New firms enter a market in which the existing firms are making an economic profit, and existing firms exit a market in which they are incurring an economic loss. 1. The Effects of Entry If firms in a market are earning an economic profit, new firms are motivated to enter the market. As new firms enter, market supply increases and the price falls. As the price falls, each firm’s economic profit decreases. Eventually, the price falls so that economic profit disappears, each firm makes a normal profit, the entry process stops, and the market is again in long-run equilibrium. 2. The Effects of Exit If firms are incurring an economic loss, firms are motivated to exit the market. As firms exit, market supply decreases and the market price rises. As the price rises, the economic loss of each remaining firm decreases. Eventually, the price rises so that the economic loss disappears, each remaining firm makes a normal profit, the exit process stops, and the market is again in long-run equilibrium. B. A Permanent Change in Demand A permanent change in demand brings about an adjustment from one long-run equilibrium to another. 1. The market starts in long-run equilibrium (where P = ATC) and firms earn zero economic profit. If demand increases permanently, the market price increases. 2. Because price is greater than average total cost (P > ATC), existing firms earn economic profit and new firms are motivated to enter the market. 3. Entry leads to an increase in the market supply and the price falls. Eventually, enough firms enter the market and the price falls to where P = ATC. Firms earn zero economic profit, so no new firms enter the market and a long-run equilibrium is reached again. 4. The opposite process occurs when there is a permanent decrease in demand. The decrease in demand produces a lower price, leading firms to exit the market because P < minimum AVC. 5. As firms exit, supply decreases and the price increases until all firms earn zero economic profit again. In the long run, there are fewer firms. 6. The price in the new-long run equilibrium might actually be greater than, less than, or equal to the price in the original equilibrium. C. External Economies and Diseconomies 1. The long-run market supply curve shows the relationship between the quantity supplied and the price when the number of firms changes so that each firm earns zero economic profit. 2. The behavior of the long-run equilibrium price depends on factors that are out of the firm’s control: a. External economies are factors beyond the control of an individual firm that lower its costs as the market output increases. The long-run market supply curve slopes downward with external economies and the price falls in the long run as a result of an increase in demand. b. External diseconomies are factors beyond the control of an individual firm that raise the firm’s costs as market output increases. The long-run market supply curve slopes upward with external diseconomies and the price rises in the long run as a result of an increase in demand. c. With no external economies or diseconomies, the long-run market supply curve is horizontal. D. Technological changes allow firms to lower their cost of production, which shifts firm’s cost curves downward. 1. Firms adopting the new technology earn an economic profit. New technology firms enter the market. 2. Firms that do not adopt the new technology incur an economic loss. These firms exit the market. 3. As new-technology firms enter the market and old-technology firms exit the market, the price falls and output increases. The market returns to its long-run equilibrium when all firms make zero economic profit while consumers enjoy lower prices and better products.