Perfect Competition: Short Run and Long Run

Prepared by: Jamal Husein
C H A P T E R
5
2005 Prentice Hall Business Publishing Survey of Economics, 2/e OSullivan & Sheffrin
Perfect Competition:
Short Run and
Long Run
2
Perfectly Competitive Market
1. There are many firms.
2. The product is standardized, or
homogeneous.
3. Firms can freely enter or leave the
market in the long run.
4. Each firm takes the market price as
given.
A perfectly Competitive market is
characterized by:
3
The Short-run Output Decision
The firms objective is to produce the
level of output that will maximize
profit.
Economic profit = total revenue (TR)
minus total economic cost (TC).
Total revenue = price quantity sold.
The cost structure of the business firm
is the same as the one we studied
earlier.
4
The Firms TC Structure (Revisited)
The shape of the total cost curve
comes from diminishing returns
in the short run.
STC TFC STVC
Short-run
Total Cost
=
Total Fixed
Cost
+
Short-run
Total Variable
Cost
Cost
Marginal
Short-run
Total Cost
Short-run
Cost
Variable
Total
Cost
Fixed
Minute
Rakes per
Output:
SMC STC TVC FC Q
- 36 0 36 0
8 44 8 36 1
4 48 12 36 2
3 51 15 36 3
5 56 20 36 4
7 63 27 36 5
9 72 36 36 6
12 84 48 36 7
17 101 65 36 8
25 126 90 36 9
40 166 130 36 10
5
The Revenue Structure of the
Competitive Business Firm
The perfectly competitive firm is
a price-taking firm. This means
that the firm takes the price
from the market.
As long as the market remains
in equilibrium, the firm faces
only one pricethe equilibrium
market price.
6
Computing the Total Revenue of a
Price-taker
Since the perfectly competitive firm
faces a constant price, the shape of its
total revenue is an upward-sloping
line. Total revenue changes only with
changes in the quantity sold.
($)
Revenue
Total
Price ($)
Minute
Rakes per
Output:
TR P Q
0.00 25 0
25.00 25 1
50.00 25 2
75.00 25 3
100.00 25 4
125.00 25 5
150.00 25 6
175.00 25 7
200.00 25 8
225.00 25 9
250.00 25 10
0
50
100
150
200
250
C
o
s
t

i
n

$
0 1 2 3 4 5 6 7 8 9 10
Output: Rakes per minute
Total Revenue
7
The Totals Approach to Profit Maximization
To maximize profit, a
producer finds the
largest gap between total
revenue and total cost. ($)
Price
Profit
Total Cost
Short-run
($)
Revenue
Total
Minute
Rakes per
Output:
P STC TR Q
25 -36 36 0.00 0
25 -19 44 25.00 1
25 2 48 50.00 2
25 24 51 75.00 3
25 44 56 100.00 4
25 62 63 125.00 5
25 78 72 150.00 6
25 91 84 175.00 7
25 99 101 200.00 8
25 99 126 225.00 9
25 84 166 250.00 10
8
The Marginal Approach
The other way to decide how much
output to produce involves the
marginal principle.
Marginal PRINCIPLE
Increase the level of an activity if its marginal
benefit exceeds its marginal cost, but reduce the
level if the marginal cost exceeds the marginal
benefit. If possible, pick the level at which the
marginal benefit equals the marginal cost.
9
Marginal Revenue
The benefit of producing and
selling rakes is the revenue the
firm collects. If the firm sells
one more rake, total revenue
increases by $25.
Marginal benefit = marginal
revenue = market price
10
A firm maximizes
profit in accordance
with the marginal
principleby
setting marginal
revenue (or market
price) equal to
marginal cost.
Minute
Rakes per
Output:
Profit Cost
Marginal
Short-run
Price ($)
Revenue =
Marginal
Minute
Rakes per
Output:
Q SMC P Q
0 -36 - 25 0
1 -19 8 25 1
2 2 4 25 2
3 24 3 25 3
4 44 5 25 4
5 62 7 25 5
6 78 9 25 6
7 91 12 25 7
8 99 17 25 8
9 99 25 25 9
10 84 40 25 10
The Marginal Rule for Profit Maximization
11
Profit Maximization Using the
Marginal Approach
12
Economic Profit
Profit per unit
equals revenue per
unit (or price)
minus cost per unit
(or average total
cost).

($25 - $14) = 11
Total economic profit equals:
(price average cost) quantity produced

($25 - $14) x 9 = $99
13
Shut-down Decision
The firm should continue to operate if
the benefit of operating (total revenue)
exceeds the cost of operating, or total
variable cost.
TR = (P Q) must be greater than STVC
= SAVC Q, therefore,
I f P > SAVC, the firm should
continue to operate
I f P < SAVC, the firm should
shut down
14
The Shut-down Decision
When price drops to
$9, the firm adjusts
output down to 6
rakes per minute to
maintain P=SMC.
The firm suffers a loss, but since price is
greater than AVC, the firm continues to
operate.
The average
variable cost of
producing 6 rakes
per minute is $6.
15
The Shut-down Decision
The firms shut-
down price is the
price at which the
firm is indifferent
between operating
and shutting down.
At $5, P = SAVC. Above this price, the firm is
better off continuing to produce at a loss. Below
this price, the firm is better off shutting down
because it could not recover its operating cost.
16
Short-run Supply Curve
The firms short-run supply
curve shows the relationship
between the market price and
the quantity supplied by the
firm over a period of time
during which one inputthe
production facilitycannot
be changed.
17
The Firms SR Supply Curve
For any price above
the shut-down price,
the firm adjusts
output along its
marginal cost curve
as the price level
changes.
The short-run supply curve is the firms SMC
curve rising above the minimum point on the
SAVC curve.
Below the shut-down
price, quantity
supplied equals zero.
18
The Market Supply Curve
The short-run market supply curve shows the
relationship between the market price and the
quantity supplied by all firms in the short run.
19
A Market in Long-run Equilibrium
1. The quantity of the product supplied equals
the quantity demanded
2. Each firm in the market maximizes its profit,
given the market price
3. Each firm in the market earns zero economic
profit, so there is no incentive for other firms
to enter the market
A market reaches a long-run equilibrium when
three conditions hold:
20
In short-run equilibrium, quantity
supplied equals quantity demanded
and each firm in the market
maximizes profit.
In addition to the conditions above,
in long-run equilibrium the typical
firm earns zero economic profit so
there is no further incentive for
firms to enter the market.
21
In long-run equilibrium, price = marginal cost (the
profit-maximizing rule), and price = short-run
average total cost (zero economic profit).
22
The LR Supply Curve for an
Increasing-cost Industry
An increasing-cost industry is an
industry in which the average cost
of production increases as the total
output of the industry increases.
The average cost increases as the
industry grows for two reasons:
Increasing input prices
Less productive inputs
23
Industry Output and Average
Production Cost
Number of
Firms
I ndustry
Output
Rakes per
Firm
Typical
Cost for
Typical
Firm
Average
Cost per
Rake
50 350 7 $70 $10
100 700 7 84 12
150 1,050 7 96 14
The rake industry is an increasing-cost industry
because the average cost of production increases
as the total output of the industry increases.
24
Drawing the Long-run Market Supply
Curve
Each point on the
long-run supply curve
shows the quantity of
rakes supplied at a
particular price (i.e.,
at a price of $12, 100
firms produce 700
rakes).
The long-run
industry supply curve
is positively-sloped
for an increasing cost
industry.
25
SR Increase in Demand and the
Incentive to Enter
An increase in market demand puts upward
pressure on price. As price increases, there is an
opportunity to earn profit in the short run, and the
industry attracts new firms.
26
The Long-run Effects of an Increase in
Demand
In the short-run,
firms respond to
the increase in
demand by
adjusting output in
their existing
production
facilities, and the
price adjusts from
$12 to $17.
27
The Long-run Effects of an Increase in
Demand
In the long run,
after new firms
enter, equilibrium
settles at $14.
The new price is a
higher price than
the price before the
increase in demand
(increasing cost
industry).
28
Long-run Supply Curve for an
Constant-cost Industry
In a constant-cost industry, firms
continue to buy inputs at the same
prices.
The long-run supply curve is
horizontal at the constant average cost
of production.
After the industry expands, the
industry settles at the same long-run
equilibrium price as before.
29
Long-run Supply Curve for the Ice
Industry
In the long-run,
the price of ice
returns to its
original level.
An increase in
the demand for
ice increases the
price of ice to $5
per bag.

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Prepared by: Jamal Husein

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