Econ 101 Ch. 12 Notes - Principles of Microeconomics PDF

Preview

Summary

Ch. 12 Notes...

Description

Ch. 12: Perfect Competition and the Supply Curve: Perfect competition: Defining perfect competition: ○ Price taking: a producer is a price-taker when their individual actions cannot affect the market ■ When there is perfect competition, every producer is a price-taker ○ Price taking consumer: a consumer is a price taker when their individual actions don’t affect the market ○ In a perfectly competitive market, all producers and consumers are price takers ○ Perfectly competitive industry: an industry in which all producers are price takers Two necessary conditions for perfect competition: 1. For an industry to be competitive, it must contain many producers, none of whom have a large market share a. Market share: the fraction of the total industry output accounted for by producers’ output 2. For an industry to be competitive, the industry output must be a standardized product a. Standardized product (commodity): when consumers regard the products of different producers as the same good Free entry and exit: ● It is easy for new firms to enter the market and old firms to leave ● Ensures that the number of producers in a market can react to changing market conditions ● Not strictly necessary for a free market but often present Production and profits: TR (total revenue) = market price (P) x quantity (Q) TR = P x Q Using marginal analysis to choose the profit-maximizing quantity of output: ● Marginal revenue = change in total revenue generated by one additional unit of output = change in total revenue / change in quantity of output ● Optimal output role: profit is maximized by producing the quantity at which the marginal revenue of the last unit produced is equal to the marginal cost ○ MR = MC at the optimal quantity of output ○ Aka: when the amount generated by producing one additional unit is equal to the cost added by producing one additional unit, that is the optimal quantity of output ● Price-taking firm’s optimal output rule: says that a price-taking firm’s output rule: a pricetaking firm’s profit is maximized by producing the quantity of output at which the market price is equal to the marginal cost of the last unit produced ○ P = MC at the firm’s optimal quantity of output

○ ○

○ ○

In the case of a price-taking firm, marginal revenue is equal to the market price A price-taking firm cannot alter the market price by producing more or less, so the additional revenue a firm gets by producing one more unit (MR) is always the market price Marginal revenue curve: shows how marginal revenue varies as output varies The individual firm faces a horizontal, perfectly elastic demand curve for its output (a demand curve that is equivalent to its marginal cost curve)

When is production profitable? ● Decision of whether or not to produce depends on the economic profit ● Economic profit: the measure of profit based on the opportunity cost of resources used in the business (implicit and explicit cost) ● Accounting profit: calculated only using explicit costs ● Given the firm’s cost curves, whether or not it is profitable depends on the market prices of the product (specifically, whether or not the market price is more or less than the farm’s average total cost ● Where average total cost is minimized is the minimum cost output ● Profit = total revenue - total cost ( P = TR -TC) ● If the firm produces a quantity at which TR > TC, the firm is profitable ● If the firm produces a quantity at which TR = TC, the firm breaks even ● If the firm produces a quantity at which TR < TC, the firm incurs a loss ● TR / Q = market price ● TC / Q = average total cost ● If the firm produces a quantity at which P > ATC, the firm is profitable ● If the firm produces a quantity at which P = ATC, the firm breaks even ● If the firm produces a quantity at which P < ATC, the firm incurs a loss ● Profit = TR - TC = (TR/Q - TC/Q) x Q Or ● Profit = (P - ATC) x Q ● Break-even price: the market price at which it earns zero profit ● Whenever the market price exceeds minimum average total cost, the producer is profitable (i.e., the market price is higher than the break-even price) ● Whenever the market price equals the minimum average total cost, the producer breaks even ● Whenever the market price is less than minimum average total cost, the producer is unprofitable The short-run production decision: ● In the short run, sometimes the firm should produce even if price falls below minimum average total cost ○ Why? Because total cost includes fixed cost- the cost that does not depend on the amount of output produced and can can only be altered in the long run ○ In the short run, the fixed cost must be paid, whether or not a firm produces ■ For example, if Noelle rents a refrigerated truck for a year, she has to pay

rent on the truck whether or not she produces any trees Since it cannot be changed in the short run, her fixed cost is irrelevant to her decision about whether to produce or shut down in the short run What happens when the market price is below minimum average variable cost? ○ When this happens, the price that the firm receives per unit is not covering its variable cost per unit ○ A firm in this position should cease production immediately, because there is no level of output at which the firm’s total revenue covers its variable costs- the costs it can avoid by not operating ○ It will still incur a fixed cost in the short run, but it will no longer incur any variable cost ○ This means that the minimum average variable cost is equal to the shutdown price (the shutdown price is that price at which the firm ceases short-term production) What happens when the market price is greater than or equal to the minimum average variable costs? ○ When this happens, the firm should produce in the short run ○ The firm maximizes profit and minimizes loss by choosing the output quantity at which the marginal cost is equal to the market price What if the market price is between the break-even price and shutdown price? ○ Even if a firm isn’t covering its total cost per unit, it is covering some of its fixed cost per unit ■ It is covering the variable cost per unit and some but not all of the fixed cost per unit ○ In this case, the firm may continue producing because it is covering the variable cost and part of the fixed cost so shutting down would generate even greater losses ○ In this case, the fixed costs are kind of like sunk costs What happens if market price is exactly equal to the minimum average variable cost (shutdown price) ○ The firm is indifferent about producing 0 vs. a # of units Short-run individual supply curve: shows how an individual producer’s profit-maximizing output quantity depends on the market price, taking fixed cost as given ○ As long as the market price is equal to or above the shutdown price, the producer will produce the quantity of output at which marginal cost is equal to or above the shutdown price ■ This means that at market prices equal to or above the shutdown price, the firm’s short-run supply curve corresponds to its marginal cost curve ■

●

●

●

●

●

Changing fixed cost: ● Fixed cost cannot be altered in the short run, but in the long run, firms can acquire or sell machinery, buildings, etc ○ In the long run, fixed costs can be eliminated by selling stuff and thus exiting the industry

● ●

○ This would make fixed costs $0 In the long run, businesses will exit an industry if their fixed cost is consistently less than their breakeven price (minimum average total cost) In the long run, a price excess of the break-even price will attract new producers into an industry ○ This has a bearing on the short-term industry supply curve vs. the long-term industry supply curve

Summing up: the perfectly competitive firm’s profitability and production conditions (Remember, ATC is the average cost per unit produced; ATC = TC / Q) Profitability condition (minimum ATC = break-even price)

result

price > minimum average total cost (price a good can be sold at is greater than the average cost of producing one unit of that good, so the firm makes money)

Firm profitable; entry into industry in the long run

price = minimum average total cost (price a good can be sold at is equal to the average cost of producing one unit of that good, so the firm isn’t making or losing money)

Firm breaks even, no entry into or exit from the industry in the long run

price < minimum average total cost (price that a good can be sold at is less than the average cost of producing one unit of that good, so the firm is losing money)

Firm unprofitable; exit from the industry in the long run

(Remember, average variable cost is the variable costs of output divided by the quantity produced; AVC = VC / Q) Production condition (minimum AVC = shutdown price)

result

price > minimum average variable cost (the price that a good can be sold at is greater than the break-even price)

The firm produces in the short run. If P < minimum average total cost (break-even price), the firm covers variable cost and some but not all of fixed cost. If P > minimum ATC, the firm covers all variable cost AND all fixed cost

price = minimum average variable cost (price that a good can be sold at is equal to the breakeven price)

The firm is indifferent to production in the short run; they are just covering their variable costs

price < minimum average variable cost (price that a good can be sold at is less than the breakeven price)

Firm shuts down in the short run; does not cover variable cost.

The industry supply curves:

●

Industry supply curve: shows the relationship between the price of a good and the total output of the industry as a whole

Short-run industry supply curve: shows how the quantity supplied by an industry depends on the market price (given a fixed number of producers because in the short run, no one can enter or exit the market of an industry) ● Short-run market equilibrium: the quantity supplied equals the quantity demanded, taking the number of producers as given and unchangeable in the short run ○ In the long run, producers can exit and enter, so the curve will look different for long-run market equilibrium Long-run industry supply curve: ● Shows how the quantity supplied responds to the price once producers have had time to exit the industry ○ What happens when new producers enter the industry? ■ The quantity supplied at any given price will increase ■ The short-term industry supply curve will shift to the right ■ ^ this will alter the market equilibrium and lower the market price ■ Existing firms will lower their output produced, but the total industry output will increase because of the larger number of firms in the industry ○ Long-run market equilibrium: where the quantity supplied equals the quantity demanded given that sufficient time has elapsed for entry and exit into and out of the market ■ In this situation, all existing and potential producers have fully adjusted to their optimal long-term choices; thus, no producers have any incentive to enter or exit the industry ● In the long run, industry supply curve is often perfectly elastic (given time to enter and exit, producers will supply any quantity that producers demand at a specific price ○ Perfectly elastic supply curves are a good assumption for many industries ● Constant costs across the industry: each firm, no matter how long it has been in the industry, faces the same cost structure (meaning they have the same cost curves) ●

When long-run industry supply curve is HORIZONTAL: ○ Perfectly elastic supply of inputs ○ Industry will supply any quantity that consumers demand at a specific price ○ Cost structure is the same for new and old producers (constant costs across the industry) ○ Ex: bakery (flour is elastically available because it is not limited)

●

When long-run industry supply curve slopes UPWARD: ○ Usually this is because producers must use some input that is in limited supply (inelastically supplied), and, as the industry expands, the price of that input is driven up because demand for it is increasing

○

○

This means that later (newer) entrants into the industry will face a higher cost structure than earlier (older) entrants ■ Ex: beachfront property (there is a limited supply of beachfront property) Increasing costs across the industry

●

When long-run industry supply curve slopes DOWNWARD: ○ Happens when the industry faces increasing returns to scale ○ Average costs fall as output rises ○ When increasing returns to scale apply at the level of an individual firm, the industry usually ends up dominated by a small number of firms (oligopoly) or a single firm (a monopoly)

●

In some cases, the advantage of large scale for an entire industry accrue to all firms in that industry (i.e., having a lot of firms in an industry mean lower costs everyone in the industry) ○ Ex: solar energy; the costs of solar panels tend to fall as the industry grows because that growth leads to improved knowledge, a large pool of workers with skills related to solar panels, etc. Whether the long-term industry supply curve is horizontal, upward-sloping, or downward sloping, the long-run price elasticity of supply is ALWAYS HIGHER than the short-run price elasticity of supply ○ This is because of entry and exit (a high price caused by an increase in demand attracts new producers, resulting in a rise in industry output and an eventual fall in price; a low price caused by a decrease in demand means that firms will exit the industry, meaning that the industry output will fall and there will be an eventual increase in price) Sequences of events that often occur: ○ A decrease in demand initially leads to a large price increase, but prices return to their initial level once new firms have entered the industry ○ Or, a fall in demand reduces prices in the short run but then they return to their initial level as producers exit the industry

●

●

The cost of production and efficiency in long-run equilibrium: 1. In a perfectly competitive industry that is in equilibrium, the value of the marginal cost is the same for all firms (because all firms produce the quantity of output at which marginal cost equals market price, and as price-takers, they all face the same market price) 2. In a perfectly competitive industry with free entry and exit, each firm will have zero economic profit in long-term equilibrium (each firm produces the quantity of output that minimizes its average total cost) a. This means that the cost of production is minimized in a perfectly competitive industry 3. The long-run market equilibrium of a perfectly competitive industry is efficient, meaning that no mutually benefitted transactions go unexploited

Vocab and chapter summary: 1. In a perfectly competitive market, all producers are price-takers and all consumers are price takers, meaning that no individual consumer or producer can influence the market price 2. There are three conditions necessary for a perfectly competitive industry: a. Many producers, none of whom have a market share b. The industry produces a standardized product/commodity (a good that consumers regard as equivalent) c. Free entry and exit into and from the industry 3. A producer chooses output level from the optimal output rule: choose the quantity at which marginal revenue equals marginal cost a. For a price-taking firm, marginal revenue is equal to price b. For a price-taking firm, the marginal revenue curve will be a horizontal line at the market price c. A price-taking firm will choose output based on the price-taking firm’s optimal output rule: produce the quantity at which price equals marginal cost d. A firm that produces the optimal quantity may not be profitable 4. A firm is profitable if total revenue exceeds total cost a. i.e., if the market price exceeds the breakeven price (minimum average total cost) b. If the market price is less than the breakeven price (minimum average total cost), the firm is unprofitable c. If the market price is equal to the breakeven price (minimum average total cost), the firm will break even 5. Fixed cost is irrelevant to the firm’s optimal short-run production decision, which depends on its shutdown price (minimum average variable cost) and the market price 6. If the market price is equal to or exceeds the shutdown price, the firm produces the output quantity where marginal price equals the market price a. When the market price is below the shutdown price, the firm stops production in the short-run b. This generates the firm’s short-run individual supply curve 7. If the market price is below the minimum average total cost (breakeven price) for an extended period of time, firms will exit the industry in the long run. 8. If the market price is above the minimum average total cost (breakeven price), firms are profitable and new firms will enter the industry in the long run 9. The long-run industry supply curve is the industry supply curve given sufficient time for entry into and exit from the industry 10. The short-run industry supply curve is the industry supply curve given that the number of firms is fixed 11. The short-run market equilibrium is given by the intersection of the short-run industry supply curve and the demand curve 12. The long-run industry supply curve is the industry supply curve given sufficient time for entry into and exit from the industry

13. The long-run market equilibrium is given by the intersection of the long-run industry supply curve and the demand curve a. At long-run market equilibrium, no producer has incentive to enter or exit b. The long-run industry supply curve is often horizontal, but it may slope upward if there is limited supply of an input, which then results in increasing costs across an industry c. The long-run industry supply curve may slope downward if there are decreasing costs across an industry d. The long-run industry supply curve is always more elastic than the short-run industry supply curve...