List the characteristics of a perfectly competitive industry and firm, and use them to judge whether a real market is close to perfectly competitive Mon
8b.2
Explain how a price-taking firm determines its profit-maximizing quantity of output Mon
8b.3
Determine whether a competitive firm earns a profit, breaks even, or incurs a loss, using both a table and a graph Mon + Wed
8b.4
Explain what it means if MR > MC, MR = MC, or MR < MC Mon
8b.5
Explain how a firm decides whether to shut down in the short run, and why its short-run supply curve is the part of its MC curve above minimum AVC Wed
8b.6
Distinguish accounting profit from economic profit, and explain why free entry and exit drive economic profit to zero in the long run Wed
Goal: the most profitPart 1 · Mon
→
So produce where MR = MCPart 1 · Mon
→
Price taker: MR = P, so P = MCPart 1 · Mon
→
P vs ATC and AVC: profit? shut down?Part 2 · Wed
→
Long run: enter or exitPart 2 · Wed
Same farm, same cost table as Unit 8a—plus one cost we left out.
Before anything else · hands up
What is a firm trying to do?
When economists build a model of a firm in a market, what do they assume its goal is? Vote for one.
AInnovate
Usually a way to earn more profit.
BProvide jobs
A side effect: hire when a worker adds more revenue than cost.
CMaximize profit
✓ Answer
The assumption for every firm in this course.
DProtect the environment
Matters once rules, taxes or buyers make pollution costly.
ESell as much as possible
Not the goal: Hannah raised output but cut profit.
Economists assume a firm chooses what to do to make profit = total revenue − total cost as large as possible. Real firms care about more, but this one assumption predicts a lot.
From the goal to a rule · LO 8b.4
Should the orchard pick one more basket?
The cider mill pays the same for every basket: that is MR. Pickers are paid by the hour, so a basket’s cost (MC) depends on how long it takes to pick. Pick the first basket?
Why MC rises: you always pick the easiest apples first, so each extra basket takes longer.
One more basket changes profit by MR − MC. Keep picking while MR > MC; stop before MR < MC.
The rule · LO 8b.4
The most profit is where MR = MC
MR > MC
The next unit adds more than it costs: profit is still rising. Produce more.
MR = MC
The next unit adds nothing: the top of the hill. Stay here.
MR < MC
The last unit cost more than it brought in: profit is falling. Produce less.
Every firm, in every market, follows this rule. What the market decides is the firm’s MR.
MR = MC does not mean zero profit: every basket before the last one added profit (the green area). So what decides a firm’s MR? Its market. A story first.
A story first · LO 8b.1
The sardine coast
Out at seaBoats and buyers moveOne priceCome and go
Every morning, many small boats catch sardines, and many buyers wait at beaches along the coast. A sardine is a sardine. Every boat has a phone, and so does every buyer: at dawn, everyone can see what each beach is paying.
A made-up coast with made-up prices, modeled on the sardine coast of Kerala, India. Page 10 shows the real story.
Now take the story apart · LO 8b.1 · guess first
Four ingredients of perfect competition
On the sardine coastThe ingredient
Many boats, and many buyers at every beach
→
Many buyers and many sellers
No one boat or buyer is big enough to move the price.
What if it’s missing? Page 8 →
A sardine is a sardine
→
Identical products
Buyers don’t care whose boat it came from.
What if it’s missing? Page 9 →
Phones: everyone knows what every beach pays
→
Perfect information
Every boat and every buyer knows the going price.
What if it’s missing? Page 10 →
Boats and buyers come and go as they please
→
Free entry and exit
Anyone can start fishing, or stop. It matters most in the long run.
Back on Wednesday, with ATC
With these, every boat is a price taker: ask more than the going price and buyers walk to the next boat. Next: take away one ingredient at a time and watch what breaks.
Take one ingredient away · 1 of 3 · LO 8b.1
What if there aren’t many buyers or sellers?
Many boats, many buyersOne company owns every boatOne cannery buys every fish
Back on the coast: many boats, many buyers, one price of $5. Now take away “many.”
Made-up prices. Real cases: a few big meatpackers buy most U.S. cattle (page 14); the only vet in a small town (page 11).
Take one ingredient away · 2 of 3 · LO 8b.1
What if the fish aren’t identical?
A sardine is a sardineOne boat ices its fishEvery boat is different
Every boat sells the same sardines, and every boat sells at the going price, $5. Buyers don’t care which boat they buy from.
Made-up prices. Coming up: craft breweries, where every beer is different (page 12; more in Unit 9).
Take one ingredient away · 3 of 3 · LO 8b.1
What if there are no phones?
No phonesEvery boat goes homePhones arrive
Kerala, India, before 1997. Same coast, same boats, same buyers, but no phones. Out at sea, a boat can’t know which beach has buyers waiting, or what they pay.
Based on R. Jensen (2007), “The Digital Provide,” Quarterly Journal of Economics: after phones, fishermen’s profits rose about 8% and fish prices fell about 4%. Prices on the boards are made up.
Close to perfect competition? · Market 1 of 4 · hands up
The only vet in a small town
One animal clinic serves the whole town; the next vet is a long drive away. Close to perfect competition, or not? Vote first.
Many buyers and many sellers
✗Many pet owners, but only one seller.
Identical products
✓A checkup is a checkup… but there is no other clinic to compare.
Free entry and exit
✗Years of school and a license, and the town may be too small for a second clinic.
Perfect information
✓You can call and ask the price.
Not perfect competition. With no nearby rival, the vet can charge more without losing every customer.
Close to perfect competition? · Market 2 of 4 · hands up
Craft breweries
Dozens of local breweries, each with its own label and its own fans. Close to perfect competition, or not? Vote first.
Many buyers and many sellers
✓Lots of breweries and lots of beer drinkers.
Identical products
✗Every beer is different, and fans will pay more for their favorite.
Free entry and exit
✓New breweries open all the time.
Perfect information
✓Prices are on the menu.
Not perfect competition. Because the products differ, each brewery can set its own price. (Unit 9: monopolistic competition.)
Close to perfect competition? · Market 3 of 4 · hands up
Souvenir stalls for tourists
Every stall sells the same T-shirts, but nothing has a price tag, and tourists don’t know the going price. Close to perfect competition, or not? Vote first.
Many buyers and many sellers
✓Many stalls, many tourists.
Identical products
✓The same shirt at every stall.
Free entry and exit
✓Anyone can rent a stall.
Perfect information
✗No price tags: tourists don’t know what the shirt usually sells for.
Not quite: information is missing, so a seller can charge an uninformed tourist more. The sardine coast before phones, on land.
Close to perfect competition? · Market 4 of 4 · hands up
Cattle sold to meatpackers
Many ranchers raise cattle, but a few big meatpacking companies buy most of them. Close to perfect competition, or not? Vote first.
Many buyers and many sellers
✗Many sellers, but only a few buyers, each big enough to push the price down.
Identical products
✓Cattle are graded; a steer of one grade is much like another.
Free entry and exit
✗Building a new packing plant costs a fortune.
Perfect information
✓Prices are reported, though many deals are private.
Not perfect competition. A few big buyers can push down the price ranchers get. (More in Unit 9.)
Close to perfect competition? · a number for “many sellers” · LO 8b.1
How concentrated is a market? CR4
The four-firm concentration ratio (CR4) = the combined market share of the four largest firms in a market.
Meatpacking: each company’s share of the market (made-up numbers)
Read it: the four biggest firms control 87%; all the other firms together share 13%.
Not “the biggest firm has 87%.”
Hands up · vote first
In a perfectly competitive market, should CR4 be high or low?
A · HighNo A few firms are big enough to move the price: “many sellers” fails.
B · Low✓ Answer Many sellers, each too small to move the price.
The sardine coast (made-up count)
Perfect competition: CR4 close to 0%. A high CR4, like 87%, means “many buyers and sellers” fails.
Back to the sardine coast, after phones · LO 8b.2 · hands up
You caught 10 sardines. What price do you ask?
Going price: $5 a sardine; buyers can walk to any boat. Like every firm, you want the most profit.
To make the most profit, you take the price: you are a price taker. One boat is too small to move the coast’s price; the only thing you choose is how many fish to catch and sell. Caught 20 instead of 10? Still $5 each: every extra sardine brings in another $5.
LO 8b.2 · two different demand curves
One market, two demand curves
The coast’s market: slopes down
If sardines cost more everywhere, families buy fewer. Supply and demand along the whole coast set the $5.
Your boat: perfectly elastic
Unit 6: “Perfectly elastic: one penny more and you sell nothing.” At $5 you can sell 10 sardines or 20. Price Elasticity of Demand = ∞.
Trap: “In perfect competition, demand is perfectly elastic.” Only the firm’s demand. The market demand curve still slopes down.
LO 8b.2 · price = marginal revenue
Every extra sardine brings in the same $5
Your boat at the going price of $5
Sardines Q
Total revenue TR = $5 × Q
Marginal revenue MR = ΔTR ÷ ΔQ
0
$0
—
1
$5
($5 − $0) ÷ (1 − 0) = $5
2
$10
($10 − $5) ÷ (2 − 1) = $5
5
$25
($25 − $10) ÷ (5 − 2) = $5
10
$50
($50 − $25) ÷ (10 − 5) = $5
20
$100
($100 − $50) ÷ (20 − 10) = $5
MR =ΔTRΔQ
Divide by the change in Q: going from 5 to 10 sardines adds $25 for 5 more fish.
For a price taker, P = MR at every quantity. MR is a flat line at the price: the flat demand line on the last slide.
LO 8b.2 & 8b.4 · putting it together
For a price taker, MR = MC means P = MC
Your boat: MC by haul, price $5
1
MR = P = $5Your boat is a price taker: every sardine sells for $5. So MR = MC becomes P = MC.
2
Make every haul with MC ≤ $5Hauls 1–3: 26 sardines. Each green block is that haul’s change in profit: $36 + $16 + $6.
3
Stop before haul 4Its sardines cost $6 each to catch, above the price line: it would cut profit by $4.
4
Reading the ruleTable: the largest Q whose MC is at or below P. Smooth curve: where the price line crosses MC.
Each haul costs the same $24 in fuel and crew time, but nearby schools thin out, so each haul brings up fewer fish.
Unit 9’s firms use the same MR = MC rule, but their MR is below the price, so they end up with P > MC.
LO 8b.2 & 8b.4 · new situations · true or false?
You be the judge
WheatWheat sells for $6 a bushel. Harvesting one more acre brings in 50 bushels and costs $250 in fuel and labor. The farmer should harvest that acre.
TrueMR = 50 × $6 = $300, more than MC of $250. Harvesting adds $50 to profit.
DairyA dairy’s 101st cow would bring in $12 a day in milk and cost $15 a day in feed and labor. More milk means more profit, so the dairy should add the cow.
FalseMR $12 < MC $15: profit falls $3 a day. More output is not the goal; more profit is.
CottonCotton is selling for 70¢ a pound. A grower with a big crop of the same grade can earn more by asking 75¢.
FalseBuyers can get identical cotton for 70¢. A price taker sells nothing above the going price.
Taco truckA taco truck sets its own prices, so it is not a price taker. That means the MR = MC rule doesn’t apply to it.
FalseEvery firm that wants the most profit uses MR = MC. What changes from firm to firm is MR.
HoneyA beekeeper’s profit per jar is highest at 300 jars, but at 300 jars MR is still above MC. The beekeeper should make more than 300 jars.
TrueThe goal is total profit. While MR > MC, each extra jar still adds profit, even as profit per jar falls.
Your turn · LO 8b.2–8b.3 · quiz format
A muscadine vineyard
A muscadine grower sells crates of grapes to a winery at the going market price.
Crates Q
0
1
2
3
4
5
6
7
8
TR
$0
$50
$100
$150
$200
$250
$300
$350
$400
TC
$40
$75
$100
$120
$150
$190
$245
$320
$420
(a) What is the market price?
(b) What quantity maximizes profit?
(c) What is the maximum profit?
(a) TR ÷ Q = $50 ÷ 1 = $50
(b)5 crates: the 5th crate costs $40 (< $50); the 6th costs $55 (> $50)
(c) $250 − $190 = $60
Crates Q
0
1
2
3
4
5
6
7
8
MC per crate
—
$35
$25
$20
$30
$40
$55
$75
$100
Profit
−$40
−$25
$0
$30
$50
$60
$55
$30
−$20
Part 1 · wrap-up
Three things to take away
1
Goal: the most profit → produce where MR = MCProfit rises while MR > MC and falls once MR < MC. True for every firm.
2
Four ingredients make every seller a price takerMany buyers and sellers, identical products, free entry and exit, full information. Ask more than the going price and you sell nothing.
3
A price taker: MR = P, so produce where P = MCIn a table: the largest quantity whose MC is at or below P.
Wednesday: back to Pine Hollow. Is it really making money? And when the price falls, do you keep digging at a loss?
ARE 201 · Unit 8b · Part 2
Profit, Loss, and When to Walk Away
LO 8b.6 · two ways to count cost · hands up
Accounting cost vs. economic cost
Your summer. You could run a taco truck, or take an internship that pays $10,000. You pick the truck. Was it a good idea? Vote first.
Implicit costs are never negative, so total economic cost ≥ accounting cost and economic profit ≤ accounting profit. They are equal only when implicit costs are zero.
LO 8b.6 · reading economic profit
Zero economic profit is not failure
Economic profit > 0
You beat your next-best option. Others will want in.
Economic profit = 0
You earn exactly what your next-best option pays: a normal profit.
Economic profit < 0
Your next-best option pays more. In time, you leave.
Economic profit ≤ accounting profit. They are equal only when implicit costs are zero.
Quick check · select all
A firm’s accounting profit is $2,000. Which could be its economic profit?
$2,500No Impossible: implicit costs can’t be negative
$2,000Could be If implicit costs are $0
$500Could be Implicit costs $1,500
−$300Could be Implicit costs $2,300
LO 8b.3 · profit on a graph
Profit is a rectangle: (P − ATC) × Q
Pine Hollow, economic costs (fixed cost $1,000)
Price:
Pick a price. First find Q where P meets MC; then read ATC at that Q.
P = MC at about 200 bu; ATC there is about $8. Profit ≈ ($10 − $8) × 200 = about $400.
P = MC at Q = 200, where MC crosses the bottom of ATC ($8.00). The price line just touches ATC. Profit = $0: break-even.
P = MC at Q = 180; ATC there = $1,480 ÷ 180 = $8.22. Loss = ($8.22 − $5) × 180 = $580.
P > ATC
profit
P = ATC
break even
P < ATC
loss
LO 8b.3 · the break-even price
Break-even price = the bottom of ATC
Any firm
1
Find the lowest point of ATCProfit per unit is P − ATC; the lowest ATC is the lowest price that avoids a loss.
2
MC crosses ATC right thereUnit 8a: marginal pulls the average.
3
Read that price off the vertical axisPine Hollow: $8.00 at 200 bushels, the price in Harvest Boss.
Trap: the break-even price is not “today’s price.” It is the price at which economic profit would be zero.
Your turn · LO 8b.3 · read the graph
A collard greens grower
A price-taking collard grower
(a) At P = $17, how many cases does the grower produce? Profit or loss, and how much?
(b) At P = $8? Profit or loss, and how much?
(c) What is the break-even price?
(a) MC = $17 at 60; ATC = $13. Profit = ($17 − $13) × 60 = $240
(b) MC = $8 at 40; ATC = $13. Loss = ($13 − $8) × 40 = $200
(c) Lowest ATC: $12 (at 50 cases)
Keep (b) in mind: losing $200… should it keep producing?
LO 8b.5 · losing money, still open · hands up
Why stay open at a loss?
A rainy August. You rented the truck for the month and already paid $2,000, no refund. Rain keeps customers away: you will lose money whether you open or not. Open or close for August? Vote first.
If you close for August
Sales
$0
Ingredients + helper only if open
$0
Rent owed either way
−$2,000
Profit
−$2,000
If you open for August
Sales (1,000 × $3.00)
$3,000
Ingredients + helper only if open
−$1,800
Rent owed either way
−$2,000
Profit
−$800
LO 8b.5 · when losing money means closing · hands up
When should you shut down?
Same rainy August, same $2,000 rent, but so many taco trucks crowd the beach that a taco now sells for $1.50 instead of $3.00. You’d still sell 1,000. Open or close? Vote first.
If you close for August
Sales
$0
Ingredients + helper only if open
$0
Rent owed either way
−$2,000
Profit
−$2,000
If you open for August
Sales (1,000 × $1.50)
$1,500
Ingredients + helper only if open
−$1,800
Rent owed either way
−$2,000
Profit
−$2,300
LO 8b.5 · the shutdown price
Shutdown price = the bottom of AVC
Any price-taking firm
1
Open only if sales cover variable costTR ≥ VC ⇔ P ≥ AVC. Fixed cost is owed either way.
2
Lowest AVC = shutdown priceMC crosses AVC right there.
3
Below min AVC: shut downLose only the fixed cost (taco truck at $1.50: the $2,000 rent).
4
Between min AVC and min ATC: keep producingLose less than closing (taco truck at $3.00: $800, not $2,000).
Taco truck: AVC = $1.80 a taco, so its shutdown price is $1.80. Shut down ≠ exit: closing for August still pays the rent.
Your turn · LO 8b.5 · read the graph
Operate or shut down?
The collard grower again · fixed cost $300 a day
(1) At P = $8 the grower makes 40 cases and loses $200. Operate or shut down?
(2)Shut down. $4 is below AVC at every output. Loss = fixed cost, $300.
(3)$5, the bottom of AVC (at 30 cases).
LO 8b.5 · the firm’s supply curve
Why the firm’s supply curve is its MC curve
Above the shutdown point, each market price maps to the Q where P = MC. The collard grower again:
Price
Cases
Why
$17
60
P = MC
$12
50
P = MC
$8
40
P = MC (loss, but P > AVC)
$5
30
P = min AVC: the shutdown point
$4
0
below min AVC: shut down
For P ≥ minimum AVC
The firm operates and chooses the quantity where P = MC.
For P < minimum AVC
The firm shuts down, so quantity supplied is zero.
Short-run firm supply = the rising part of MC above minimum AVC. Market supply adds up every firm’s quantity at each price.
LO 8b.6 · the long run
Short run vs. long run
The key difference is what the firm can adjust.
Short run
At least one input is fixed.
Fixed costs remain even if Q = 0.
The firm may keep operating with a loss if P > AVC.
Decision: produce, or temporarily shut down.
Taco truck: close for a rainy August, but the rent is still owed.
Long run
All inputs can be adjusted.
Fixed commitments, like a lease, can expire.
A firm does not stay forever in an industry with negative economic profit.
Decision: stay, enter, or exit.
Taco truck: don’t renew the truck rental; sell tacos no more.
Shutdown is a short-run production decision. Exit is a long-run industry decision.
Monday’s fourth ingredient, free entry and exit (page 7), is what lets firms come and go in the long run. In the long run, firms compare P with ATC: is there economic profit?
LO 8b.6 · long run · entry
Economic profit triggers entry
Profits attract new firms and expand industry supply.
1
Economic profitAt $17, P > ATC: each firm earns economic profit. Outsiders want in.
2
New firms enterMore sellers: market supply shifts right (Unit 4: number of sellers is a supply shifter). Price falls to $14.50; profit shrinks.
3
Entry stops at min ATCPrice falls to $12 = minimum ATC. Economic profit = 0: no reason left to enter.
Entry shifts market supply right → market price falls → each firm’s economic profit shrinks.
LO 8b.6 · long run · exit
Economic loss triggers exit
Persistent losses cause some firms to leave the industry.
1
Economic lossAt $8, P < ATC: each firm loses money. (P > AVC, so in the short run it keeps producing.)
2
Some firms exitWhen leases expire, some firms leave: market supply shifts left. Price rises to $10; losses shrink.
3
Exit stops at min ATCPrice rises to $12 = minimum ATC. Economic profit = 0: the firms that remain no longer want to leave.
Exit shifts market supply left → market price rises → losses shrink for the firms that remain.
LO 8b.6 · long-run equilibrium
Long-run competitive equilibrium
Entry and exit stop when no firm has an incentive to change the number of firms in the market.
Economic profit > 0
→
Firms enter
→
Supply shifts right
→
Price falls
→
Profit shrinks to 0
Economic loss
→
Firms exit
→
Supply shifts left
→
Price rises
→
Loss shrinks to 0
P = MR = MC = minimum ATC
Firm decision
Each firm chooses Q* where P = MC.
Profit outcome
P = ATC → zero economic profit.
Industry outcome
No incentive for further entry or exit.
Competition removes economic profit, not the owner’s opportunity-cost pay: zero economic profit is a normal profit (page 26).
Check · LO 8b.6 · hands up
What happens in the long run?
Vote first
Firms in a perfectly competitive industry are earning positive economic profit. What happens in the long run?
AFirms raise price above the market priceNo Price takers can’t: buyers switch to other sellers.
BNew firms enter, supply shifts right, and price falls✓ Answer Profit is the signal that draws in new firms.
CFirms exit, supply shifts left, and price risesNo That is what happens after losses.
DProfit persists because each firm is a price takerNo Free entry competes the profit away.
1. ProfitExisting firms have P > ATC.
2. EntryNew firms are attracted to the industry, increasing market supply.
3. Long runPrice falls until P = minimum ATC and economic profit is zero.
Economic profit is a signal that changes the number of firms, not a reason for one firm to change its price.
Unit 8b · wrap-up
The complete firm decision rule
Use this order every time you solve a perfect-competition graph problem.
1
Take market P as givenPerfect competition → price taker.
2
Find Q* where P = MR = MCUse the rising MC curve.
3
Compare P with ATCP > ATC: profit. P = ATC: break-even. P < ATC: loss.
4
If there is a loss, compare P with AVCP ≥ AVC: operate. P < AVC: shut down (short run).
5
Think long runProfit → entry. Persistent loss → exit. Equilibrium: zero economic profit at P = minimum ATC.