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Unformatted text preview: 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 213 10 Perfect Competition After studying this chapter, y ou will be able to: ■ Define perfect competition ■ Explain how a firm makes its output decision and why it sometimes shuts down temporarily and lays off its workers ■ Explain how price and output are determined in a perfectly competitive market ■ Explain why firms enter and leave a competitive market and the consequences of entry and exit ■ Predict the effects of a change in demand and of a technological advance ♦ Explain why perfect competition is efficient What forces are responsible for this diversity of perfor- Airlines and producers of trucks, cars, and motor mance of production, prices, and profits? What are the bikes are facing tough times: prices are being slashed to drive causes and consequences of firms entering or leaving a mar- sales and profits are turning into losses. Airlines are cutting ket? Why do firms sometimes stop producing and temporarily back on flights, charging to check bags, drink a soda, or use a lay off their workers? blanket, and some are even going out of business. Vehicle pro- To study competitive markets, we are going to build a duction has been scaled back and workers have either been model of a market in which competition is as fierce and laid off temporarily or let go permanently. extreme as possible—more extreme than in the examples Taking a longer view, astonishing transformations have we’ve just considered. We call this situation “perfect competi- occurred over the past decade. Today, at $600 for a powerful tion.” In Reading Between the Lines at the end of the chapter, laptop, almost every student owns one. Fifteen years ago, at we’ll apply the model to the market for air transportation $6,000 for a heavy, slow portable computer, these machines services and see how the effects of high fuel prices and a fall were a rare sight on campus. in demand are playing out in that market. 213 9160335_CH10_p213-244.qxd 214 6/22/09 CHAPTER 10 9:02 AM Page 214 Per fect Competition ◆ Markets and the Competitive Environment The markets in which firms operate vary a great deal. Some are highly competitive, and profits in these markets are hard to come by. Some appear to be almost free from competition, and firms in these markets earn large profits. Some markets are dominated by fierce advertising campaigns in which each firm seeks to persuade buyers that it has the best products. And some markets display the character of a strategic game. Economists identify four market types: 1. Perfect competition 2. Monopolistic competition 3. Oligopoly 4. Monopoly Perfect competition arises when there are many firms, each selling an identical product, many buyers, and no restrictions on the entry of new firms into the industry. The many firms and buyers are all well informed about the prices of the products of each firm in the industry. The worldwide markets for corn, rice, and other grain crops are examples of perfect competition. Monopolistic competition is a market structure in which a large number of firms compete by making similar but slightly different products. Making a product slightly different from the product of a competing firm is called product differentiation. Product differentiation gives a firm in monopolistic competition an element of market power. The firm is the sole producer of the particular version of the good in question. For example, in the market for pizzas, hundreds of firms make their own version of the perfect pizza. Each of these firms is the sole producer of a particular brand. Differentiated products are not necessarily different products. What matters is that consumers perceive them to be different. For example, different brands of potato chips and ketchup might be almost identical but be perceived by consumers to be different. Oligopoly is a market structure in which a small number of firms compete. Computer software, airplane manufacture, and international air transportation are examples of oligopolistic industries. Oligopolies might produce almost identical products, such as the colas produced by Coke and Pepsi. Or they might produce differentiated products such as Boeing and Airbus aircraft. Monopoly arises when there is one firm, which produces a good or service that has no close substitutes and in which the firm is protected by a barrier preventing the entry of new firms. In some places, the phone, gas, electricity, cable television, and water suppliers are local monopolies—monopolies restricted to a given location. Microsoft Corporation, the software developer that created Windows and Vista, is an example of a global monopoly. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 215 Markets and the Competitive Environment Perfect competition is the most extreme form of competition. Monopoly is the most extreme absence of competition. The other two market types fall between these extremes. Many factors must be taken into account to determine which market structure describes a particular real-world market. One of these factors is the extent to which a small number of firms dominates the market. To measure this feature of markets, economists use indexes called measures of concentration. Let’s look at these measures. Measures of Concentration Economists use two measures of concentration: ■ ■ The four-firm concentration ratio The Herfindahl-Hirschman Index printers. In this example, 14 firms produce tires. The largest four have 80 percent of the sales, so the fourfirm concentration ratio is 80 percent. In the printing industry, with 1,004 firms, the largest four firms have only 0.5 percent of the sales, so the four-firm concentration ratio is 0.5 percent. A low concentration ratio indicates a high degree of competition, and a high concentration ratio indicates an absence of competition. A monopoly has a concentration ratio of 100 percent—the largest (and only) firm has 100 percent of the sales. A four-firm concentration ratio that exceeds 60 percent is regarded as an indication of a market that is highly concentrated and dominated by a few firms in an oligopoly. A ratio of less than 60 percent is regarded as an indication of a competitive market. The Herfindahl-Hirschman Index The Herfindahl- The Four-Firm Concentration Ratio The four-firm con- is the percentage of the value of sales accounted for by the four largest firms in an industry. The range of the concentration ratio is from almost zero for perfect competition to 100 percent for monopoly. This ratio is the main measure used to assess market structure. Table 10.1 shows two calculations of the four-firm concentration ratio: one for tire makers and one for centration ratio TABLE 10.1 Hirschman Index—also called the HHI—is the square of the percentage market share of each firm summed over the largest 50 firms (or summed over all the firms if there are fewer than 50) in a market. For example, if there are four firms in a market and the market shares of the firms are 50 percent, 25 percent, 15 percent, and 10 percent, the HerfindahlHirschman Index is 502 HHI 252 152 102 3,450. Calculating the Four-Firm Concentration Ratio Tire makers Printers Sales Firm Sales (millions of dollars) Firm Top, Inc. 200 Fran’s 2.5 ABC, Inc. 250 Ned’s 2.0 Big, Inc. 150 Tom’s 1.8 XYZ, Inc. 100 Jill’s 1.7 Largest 4 firms 700 Largest 4 firms 8.0 Other 10 firms 175 Other 1,000 firms 1,592.0 Industry 875 Industry 1,600.0 (millions of dollars) Four-firm concentration ratios: Tire makers: 700 875 100 215 80 percent Printers: 8 1,600 100 0.5 percent 9160335_CH10_p213-244.qxd 216 6/22/09 CHAPTER 10 9:02 AM Page 216 Per fect Competition Concentration Measures in the U.S. Economy Chewing Gum Monopoly The U.S. Department of Commerce calculates and publishes data showing concentration ratios and the HHI for each industry in the United States. The bars in the figure show the four-firm concentration ratio and the number at the end of each bar is the HHI. Chewing gum is one of the most concentrated industries. William Wrigley Jr. Company of Chicago employs 16,000 people and sells $5 billion worth of gum a year. It does have some competitors but they have a very small market share. Household laundry equipment, light bulbs, breakfast cereal, and motor vehicles are highly concentrated industries. They are oligopolies. Pet food, cookies and crackers, computers, and soft drinks are moderately concentrated industries. They are examples of monopolistic competition. Ice cream, milk, clothing, concrete blocks and bricks, and commercial printing industries have low concentration measures and are highly competitive. Concentration measures are useful indicators of the degree of competition in a market, but they must be supplemented by other information to determine the structure of the market. Newspapers and automobiles are examples of how the concentration measures give a misleading reading of the degree of competition. Most newspapers are local. They serve a single city or even smaller area. So despite the low concentration measure, newspapers are concentrated in their own local areas. Automobiles are traded internationally and foreign cars are freely imported into the United States. Despite the high concentration measure, the automobile industry is competitive. In perfect competition, the HHI is small. For example, if each of the largest 50 firms in an industry has a market share of 0.1 percent, then the HHI is 0.12 50 0.5. In a monopoly, the HHI is 10,000. The firm has 100 percent of the market: 1002 10,000. The HHI became a popular measure of the degree of competition during the 1980s, when the Justice Industry Herfindahl-Hirschman Index Chewing gum .. Household laundry equip. 2855 Light bulbs .. Breakfast cereal 2253 Motor vehicles 2676 Macaroni and spaghetti 2237 Chocolate products 2188 Pet food 1229 Cookies and crackers 1169 Computers 680 Soft drinks 537 Pharmaceuticals 341 Newspapers 241 Ice cream 293 Milk 181 Men‘s and boy‘s clothing 198 Women‘s clothing 61 Concrete blocks and bricks 30 Commercial printing 22 0 20 40 60 80 100 Four-firm concentration ratio (percentage) Concentration Measures in the United States Source of data: Concentration Ratios in Manufacturing, (Washington, D.C.: U.S. Department of Commerce,1996). Department used it to classify markets. A market in which the HHI is less than 1,000 is regarded as being competitive. A market in which the HHI lies between 1,000 and 1,800 is regarded as being moderately competitive. But a market in which the HHI exceeds 1,800 is regarded as being uncompetitive. The Justice Department scrutinizes any merger of 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 217 Markets and the Competitive Environment TABLE 10.2 Market Structure Perfect competition Monopolistic competition Oligopoly Monopoly Number of firms in industry Many Many Few One Product Identical Differentiated Either identical or differentiated No close substitutes Barriers to entry None None Moderate High Firm’s control over price None Some Considerable Considerable or regulated Concentration ratio 0 Low High 100 HHI (approx. ranges) Less than 100 101 to 999 More than 1,000 10,000 Examples Wheat, corn Food, clothing Automobiles, cereals Local water supply Characteristics firms in a market in which the HHI exceeds 1,000 and is likely to challenge a merger if the HHI exceeds 1,800. Limitations of a Concentration Measure The three main limitations of using only concentration measures as determinants of market structure are their failure to take proper account of ■ ■ ■ 217 The geographical scope of the market Barriers to entry and firm turnover The correspondence between a market and an industry Geographical Scope of Market Concentration meas- ures take a national view of the market. Many goods are sold in a national market, but some are sold in a regional market and some in a global one. The concentration measures for newspapers are low, indicating competition, but in most cities the newspaper industry is highly concentrated. The concentration measures for automobiles is high, indicating little competition, but the biggest three U.S. car makers compete with foreign car makers in a highly competitive global market. Barriers to Entry and Firm Turnover Some markets are highly concentrated but entry is easy and the turnover of firms is large. For example, small towns have few restaurants, but no restrictions hinder a new restaurant from opening and many attempt to do so. Also, a market with only a few firms might be competitive because of potential entry. The few firms in a market face competition from the many potential firms that will enter the market if economic profit opportunities arise. Market and Industry Correspondence To calculate concentration ratios, the Department of Commerce classifies each firm as being in a particular industry. But markets do not always correspond closely to industries for three reasons. First, markets are often narrower than industries. For example, the pharmaceutical industry, which has a low concentration ratio, operates in many separate markets for individual products—for example, measles vaccine and AIDS-fighting drugs. These drugs do not compete with each other, so this industry, which looks competitive, includes firms that are monopolies (or near monopolies) in markets for individual drugs. Second, most firms make several products. For example, Westinghouse makes electrical equipment 9160335_CH10_p213-244.qxd 218 6/22/09 CHAPTER 10 9:02 AM Page 218 Per fect Competition Market Structures in the U.S. Economy 100 A Highly Competitive Environment and, among other things, gas-fired incinerators and plywood. So this one firm operates in at least three separate markets, but the Department of Commerce classifies Westinghouse as being in the electrical goods and equipment industry. The fact that Westinghouse competes with other producers of plywood does not show up in the concentration numbers for the plywood market. Third, firms switch from one market to another depending on profit opportunities. For example, Motorola, which today produces cellular telephones and other communications products, has diversified from being a TV and computer chip maker. Motorola no longer produces TVs. Publishers of newspapers, magazines, and textbooks are today rapidly diversifying into Internet and multimedia products. These switches among markets show that there is much scope for entering and exiting a market, and so measures of concentration have limited usefulness. Oligopoly Four-firm concentration ratio above 60 percent 75 Percentage of economy How competitive are markets in the United States? Do most U.S. firms operate in competitive markets, in monopolistic competition, in oligopoly, or in monopoly markets? The data needed to answer these questions are hard to get. The last attempt to answer the questions, in a study by William G. Shepherd, an economics professor at the University of Massachusetts at Amherst, covered the years from 1939 to 1980. The figure shows what he discovered. In 1980, three quarters of the value of goods and services bought and sold in the United States was traded in markets that are essentially competitive— markets that have almost perfect competition or monopolistic competition. Monopoly and the dominance of a single firm accounted for about 5 percent of sales. Oligopoly, which is found mainly in manufacturing, accounted for about 18 percent of sales. Over the period studied, the U.S. economy became increasingly competitive. The percentage of output sold by firms operating in competitive markets (blue bars) has expanded most, and has shrunk most in oligopoly markets (red bars). Competition Four-firm concentration ratio less than 60 percent Dominant firm Market share 50 to 90 percent 50 Monopoly Market share at or near 100 percent 25 0 1939 1958 1980 Year The Market Structure of the U.S. Economy Source of data: William G. Shepherd, “Causes of Increased Competition in the U.S. Economy, 1939–1980,” Review of Economics and Statistics, November 1982, pp. 613626. © MIT Press Journals. Reprinted by permission. But also during the past decades, the U.S. economy has become much more exposed to competition from the rest of the world. The data used by William G. Shepherd don’t capture this international competition, so the data probably understate the degree of true competition in the U.S. economy. Review Quiz ◆ 1 2 3 4 What are the four market types? Explain the distinguishing characteristics of each. What are the two measures of concentration? Explain how each measure is calculated. Under what conditions do the measures of concentration give a good indication of the degree of competition in a market? Is our economy competitive? Is it becoming more competitive or less competitive? Work Study Plan 10.1 and get instant feedback. Despite their limitations, concentration measures do provide a basis for determining the degree of competition in a market when they are combined with information about the geographical scope of the market, barriers to entry, and the extent to which large, multiproduct firms straddle a variety of markets. 9160335_CH10_p213-244.qxd 7/1/09 3:47 PM Page 219 W hat Is Perfect Competition? ◆ What Is Perfect Competition? The firms that you study in this chapter face the force of raw competition. We call this extreme form of competition perfect competition. Perfect competition is a market in which ■ ■ ■ ■ Many firms sell identical products to many buyers. There are no restrictions on entry into the market. Established firms have no advantage over new ones. Sellers and buyers are well informed about prices. Farming, fishing, wood pulping and paper milling, the manufacture of paper cups and shopping bags, grocery retailing, photo finishing, lawn services, plumbing, painting, dry cleaning, and laundry services are all examples of highly competitive industries. How Perfect Competition Arises 219 Economic Profit and Revenue A firm’s goal is to maximize economic profit, which is equal to total revenue minus total cost. Total cost is the opportunity cost of production, which includes normal profit. (See Chapter 9, p. 191.) A firm’s total revenue equals the price of its output multiplied by the number of units of output sold (price × quantity). Marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. Marginal revenue is calculated by dividing the change in total revenue by the change in the quantity sold. Figure 10.1 illustrates these revenue concepts. In part (a), the market demand curve, D, and market supply curve, S, determine the market price. The market price is $25 a sweater. Campus Sweaters is one of the many producers of sweaters. So the best it can do is to sell its sweaters for $25 each. Perfect competition arises if the minimum efficient scale of a single producer is small relative to the market demand for the good or service. In this situation, there is room in the market for many firms. A firm’s minimum efficient scale is the smallest output at which long-run average cost reaches its lowest level. (See Chapter 9, p. 205.) In perfect competition, each firm produces a good that has no unique characteristics, so consumers don’t care which firm’s good they buy. Total Revenue Total revenue is equal to the price multiplied by the quantity sold. In the table in Fig. 10.1, if Campus Sweaters sells 9 sweaters, its total revenue is $225 (9 × $25). Figure 10.1(b) shows the firm’s total revenue curve (TR), which graphs the relationship between total revenue and the quantity sold. At point A on the TR curve, the firm sells 9 sweaters and has a total revenue of $225. Because each additional sweater sold brings in a constant amount—$25—the total revenue curve is an upward-sloping straight line. Price Takers Marginal Revenue Marginal revenue is the change in Firms in perfect competition are price takers. A price taker is a firm that cannot influence the market price because its production is an insignificant part of the total market. Imagine that you are a wheat farmer in Kansas. You have a thousand acres planted—which sounds like a lot. But compared to the millions of acres in Colorado, Oklahoma, Texas, Nebraska, and the Dakotas, as well as the millions more in Canada, Argentina, Australia, and Ukraine, your thousand acres are a drop in the ocean. Nothing makes your wheat any better than any other farmer’s, and all the buyers of wheat know the price at which they can do business. If the market price of wheat is $4 a bushel, then that is the highest price you can get for your wheat. Ask for $4.10 and no one will buy from you. Offer it for $3.90 and you’ll be sold out in a flash and have given away 10¢ a bushel. You take the market price. total revenue that results from a one-unit increase in quantity sold. In the table in Fig. 10.1, when the quantity sold increases from 8 to 9 sweaters, total revenue increases from $200 to $225, so marginal revenue is $25 a sweater. Because the firm in perfect competition is a price taker, the change in total revenue that results from a one-unit increase in the quantity sold equals the market price. In perfect competition, the firm’s marginal revenue equals the market price. Figure 10.1(c) shows the firm’s marginal revenue curve (MR) as the horizontal line at the market price. Demand for the Firm’s Product The firm can sell any quantity it chooses at the market price. So the demand curve for the firm’s product is a horizontal line at the market price, the same as the firm’s marginal revenue curve. 9160335_CH10_p213-244.qxd 6/22/09 Page 220 CHAPTER 10 Per fect Competition 50 S Market demand curve 25 TR 225 A Price (dollars per sweater) Demand, Price, and Revenue in Perfect Competition FIGURE 10.1 Total revenue (dollars per day) 220 Price (dollars per sweater) 9:02 AM 50 Demand for Campus sweaters 25 MR 0 10 20 Quantity (sweaters per day) D 0 9 (a) Sweater market Quantity Price sold (P) (Q) ( dollars 0 20 Quantity (thousands of sweaters per day) 9 20 Quantity (sweaters per day) (b) Campus Sweaters total revenue Total revenue Marginal revenue ( MR = Δ TR / Δ Q ) (dollars per (sweaters per ( TR = P × Q ) per day) sweater) (dollars) additional sweater) 8 25 200 9 25 225 10 25 250 . . . . . . . 25 . . . . . . . 25 (c) Campus Sweaters marginal revenue In part (a), market demand and market supply determine the market price (and quantity). Part (b) shows the firm’s total revenue curve (TR). Point A corresponds to the second row of the table—Campus Sweaters sells 9 sweaters at $25 a sweater, so total revenue is $225. Part (c) shows the firm’s marginal revenue curve (MR). This curve is also the demand curve for the firm’s sweaters. The demand for sweaters from Campus Sweaters is perfectly elastic at the market price of $25 a sweater. animation A horizontal demand curve illustrates a perfectly elastic demand, so the demand for the firm’s product is perfectly elastic. A sweater from Campus Sweaters is a perfect substitute for a sweater from any other factory. But the market demand for sweaters is not perfectly elastic: Its elasticity depends on the substitutability of sweaters for other goods and services. minimizes long-run average cost—by being on its long-run average cost curve. We’ll now see how the firm makes the other two decisions. We start by looking at the firm’s output decision. Review Quiz ◆ 1 The Firm’s Decisions 2 The goal of the competitive firm is to maximize economic profit, given the constraints it faces. To achieve its goal, a firm must decide 3 1. How to produce at minimum cost 2. What quantity to produce 3. Whether to enter or exit a market You’ve already seen how a firm makes the first decision. It does so by operating with the plant that 4 Why is a firm in perfect competition a price taker? In perfect competition, what is the relationship between the demand for the firm’s output and the market demand? In perfect competition, why is a firm’s marginal revenue curve also the demand curve for the firm’s output? What decisions must a firm make to maximize profit? Work Study Plan 10.2 and get instant feedback. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 221 T he Firm’s Output Decision ◆ The Firm’s Output Decision A firm’s cost curves (total cost, average cost, and marginal cost) describe the relationship between its output and costs (see pp. 197–201). A firm’s revenue curves (total revenue and marginal revenue) describe the relationship between its output and revenue (p. 220). From the firm’s cost curves and revenue curves, we can find the output that maximizes the firm’s economic profit. Figure 10.2 shows how to do this for Campus Sweaters. The table lists the firm’s total revenue and total cost at different outputs, and part (a) of the figure shows the firm’s total revenue curve, TR, and total cost curve, TC. These curves are graphs of the numbers in the first three columns of the table. Economic profit equals total revenue minus total cost. The fourth column of the table in Fig. 10.2 shows the economic profit made by Campus Sweaters, and part (b) of the figure graphs these numbers as its economic profit curve, EP. Economic profit is maximized at an output of 9 sweaters a day. At this output, total revenue is $225 a day, total cost is $183 a day, and economic profit is $42 a day. No other output rate achieves a larger profit. At outputs of less than 4 sweaters and more than 12 sweaters a day, the firm incurs an economic loss. At either 4 or 12 sweaters a day, the firm makes zero economic profit, called a break-even point. Total Revenue, Total Cost, and Economic Profit FIGURE 10.2 Total revenue and total cost (dollars per day) 221 TC TR Quantity (Q ) Economic loss 300 (sweaters per day) Total revenue (TR ) Total cost (TC ) Economic profit (TR – TC ) (dollars) (dollars) (dollars) 0 Economic profit (dollars per day) (a) Revenue and cost 42 20 0 –20 –40 Economic profit Economic loss 9 4 Profitmaximizing quantity (b) Economic profit and loss animation 12 Quantity (sweaters per day) EP –16 85 –10 4 100 100 0 125 114 11 150 126 24 175 141 34 200 160 40 9 225 183 42 10 250 210 40 275 245 30 300 300 0 13 9 12 Quantity (sweaters per day) 4 66 75 12 0 50 3 11 Economic loss 2 8 100 –20 7 Economic profit = TR – TC –22 45 6 183 22 25 5 225 0 1 325 360 –35 The table lists the total revenue, total cost, and economic profit of Campus Sweaters. Part (a) graphs the total revenue and total cost curves and part (b) graphs economic profit. Campus Sweaters makes maximum economic profit, $42 a day ($225 – $183), when it produces 9 sweaters a day. At outputs of 4 sweaters and 12 sweaters a day, Campus Sweaters makes zero economic profit—these are break-even points. At outputs less than 4 sweaters and greater than 12 sweaters a day, Campus Sweaters incurs an economic loss. 9160335_CH10_p213-244.qxd 9:02 AM Page 222 CHAPTER 10 Per fect Competition Marginal Analysis and the Supply Decision Another way to find the profit-maximizing output is to use marginal analysis, which compares marginal revenue, MR, with marginal cost, MC. As output increases, marginal revenue is constant but marginal cost eventually increases. If marginal revenue exceeds the firm’s marginal cost (MR > MC ), then the revenue from selling one more unit exceeds the cost of producing that unit and an increase in output will increase economic profit. If marginal revenue is less than marginal cost (MR < MC ), then the revenue from selling one more unit is less than the cost of producing that unit and a decrease in output will increase economic profit. If marginal revenue equals marginal cost (MR = MC ), then the revenue from selling one more unit equals the cost incurred to produce that unit. Economic profit is maximized and either an increase or a decrease in output decreases economic profit. Figure 10.3 illustrates these propositions. If Campus Sweaters increases its output from 8 sweaters to 9 sweaters a day, marginal revenue ($25) exceeds marginal cost ($23), so by producing the 9th sweater economic profit increases by $2 from $40 to $42 a day. The blue area in the figure shows the increase in economic profit when the firm increases production from 8 to 9 sweaters per day. If Campus Sweaters increases its output from 9 sweaters to 10 sweaters a day, marginal revenue ($25) is less than marginal cost ($27), so by producing the 10th sweater, economic profit decreases. The last column of the table shows that economic profit decreases from $42 to $40 a day. The red area in the figure shows the economic loss that arises from increasing production from 9 to 10 sweaters a day. Campus Sweaters maximizes economic profit by producing 9 sweaters a day, the quantity at which marginal revenue equals marginal cost. A firm’s profit-maximizing output is its quantity supplied at the market price. The quantity supplied at a price of $25 a sweater is 9 sweaters a day. If the price were higher than $25 a sweater, the firm would increase production. If the price were lower than $25 a sweater, the firm would decrease production. These profit-maximizing responses to different market prices are the foundation of the law of supply: Other things remaining the same, the higher the market price of a good, the greater is the quantity supplied of that good. FIGURE 10.3 Marginal revenue and marginal cost (dollars per sweater) 222 6/22/09 Profit-Maximizing Output MC Profitmaximization point 30 Loss from 10th sweater 25 MR Profit from 9th sweater 20 10 0 8 9 10 Quantity (sweaters per day) Quantity Total (Q ) revenue (sweaters (TR ) per day) (dollars) 7 175 8 200 9 225 10 250 11 Marginal revenue (MR) (dollars per additional sweater) 275 . . . . . 25 . . . . . 25 . . . . . 25 . . . . . 25 Total cost (TC ) (dollars) 141 160 183 210 245 Marginal cost (MC ) Economic (dollars per profit additional (TR – TC ) sweater) . . . . 19 . . . . 23 . . . . 27 . . . . 35 (dollars) 34 40 42 40 30 The firm maximizes profit by producing the output at which marginal revenue equals marginal cost and marginal cost is increasing. The table and figure show that marginal cost equals marginal revenue and economic profit is maximized when Campus Sweaters produces 9 sweaters a day. The table shows that if Campus Sweaters increases output from 8 to 9 sweaters, marginal cost is $23, which is less than the marginal revenue of $25. If output increases from 9 to 10 sweaters, marginal cost is $27, which exceeds the marginal revenue of $25. If marginal revenue exceeds marginal cost, an increase in output increases economic profit. If marginal revenue is less than marginal cost, an increase in output decreases economic profit. If marginal revenue equals marginal cost, economic profit is maximized. animation 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 223 T he Firm’s Output Decision You’ve seen that a firm maximizes profit by producing the quantity at which marginal revenue (price) equals marginal cost. But suppose that at this quantity, price is less than average total cost. In this case, the firm incurs an economic loss. Maximum profit is a loss (a minimum loss). What does the firm do? If the firm expects the loss to be permanent, it goes out of business. But if it expects the loss to be temporary, the firm must decide whether to shut down temporarily and produce no output, or to keep producing. To make this decision, the firm compares the loss from shutting down with the loss from producing and takes the action that minimizes its loss. Loss Comparisons A firm’s economic loss equals total fixed cost, TFC, plus total variable cost minus total revenue. Total variable cost equals average variable cost, AVC multiplied by the quantity produced, Q, and total revenue equals price, P, multiplied by the quantity Q. So Economic loss = TFC + (AVC – P) × Q. If the firm shuts down, it produces no output (Q = 0). The firm has no variable costs and no revenue but it must pay its fixed costs, so its economic loss equals total fixed cost. If the firm produces, then in addition to its fixed costs, it incurs variable costs. But it also receives revenue. Its economic loss equals total fixed cost—the loss when shut down—plus total variable cost minus total revenue. If total variable cost exceeds total revenue, this loss exceeds total fixed cost and the firm shuts down. Equivalently, if average variable cost exceeds price, this loss exceeds total fixed cost and the firm shuts down. The Shutdown Point A firm’s shutdown point is the price and quantity at which it is indifferent between producing and shutting down. The shutdown point occurs at the price and the quantity at which average variable cost is a minimum. At the shutdown point, the firm is minimizing its loss and its loss equals total fixed cost. If the price falls below minimum average variable cost, the firm shuts down temporarily and continues to incur a loss equal to total fixed cost. At prices above minimum average variable cost but below average total cost, the firm produces the loss minimizing output and incurs a loss, but a loss that is less than total fixed cost. Figure 10.4 illustrates the firm’s shutdown decision and the shutdown point that we’ve just described for Campus Sweaters. The firm’s average variable cost curve is AVC and the marginal cost curve is MC. Average variable cost has a minimum of $17 a sweater when output is 7 sweaters a day. The MC curve intersects the AVC curve at its minimum. (We explained this relationship between a marginal and average cost in Chapter 9; see pp. 198–199.) The figure shows the marginal revenue curve MR when the price is $17 a sweater, a price equal to minimum average variable cost. Marginal revenue equals marginal cost at 7 sweaters a day, so this quantity maximizes economic profit (minimizes economic loss). The ATC curve shows that the firm’s average total cost of producing 7 sweaters a day is $20.14 a sweater. The firm incurs a loss equal to $3.14 a sweater on 7 sweaters a day, so its loss is $22 a day, which equals total fixed cost. The Shutdown Decision FIGURE 10.4 Price (dollars per sweater) Temporary Shutdown Decision 223 MC 30.00 ATC 25.00 AVC 20.14 17.00 MR Shutdown point 15.00 0 4 7 13 10 Quantity (sweaters per day) The shutdown point is at minimum average variable cost. At a price below minimum average variable cost, the firm shuts down and produces no output. At a price equal to minimum average variable cost, the firm is indifferent between shutting down and producing no output or producing the output at minimum average variable cost. Either way, the firm minimizes its economic loss and incurs a loss equal to total fixed cost. animation 9160335_CH10_p213-244.qxd 9:02 AM Page 224 CHAPTER 10 Per fect Competition A perfectly competitive firm’s supply curve shows how its profit-maximizing output varies as the market price varies, other things remaining the same. The supply curve is derived from the firm’s marginal cost curve and average variable cost curves. Figure 10.5 illustrates the derivation of the supply curve. When the price exceeds minimum average variable cost (more than $17), the firm maximizes profit by producing the output at which marginal cost equals price. If the price rises, the firm increases its output—it moves up along its marginal cost curve. When the price is less than minimum average variable cost (less than $17 a sweater), the firm maximizes profit by temporarily shutting down and producing no output. The firm produces zero output at all prices below minimum average variable cost. When the price equals minimum average variable cost, the firm maximizes profit either by temporarily shutting down and producing no output or by producing the output at which average variable cost is a minimum—the shutdown point, T. The firm never produces a quantity between zero and the quantity at the shutdown point T (a quantity greater than zero and less than 7 sweaters a day). The firm’s supply curve in Fig. 10.5(b) runs along the y-axis from a price of zero to a price equal to minimum average variable cost, jumps to point T, and then, as the price rises above minimum average variable cost, follows the marginal cost curve. Review Quiz ◆ 1 2 3 Why does a firm in perfect competition produce the quantity at which marginal cost equals price? What is the lowest price at which a firm produces an output? Explain why. What is the relationship between a firm’s supply curve, its marginal cost curve, and its average variable cost curve? Work Study Plan 10.3 and get instant feedback. So far, we have studied a single firm in isolation. We have seen that the firm’s profit-maximizing decisions depend on the market price, which the firm takes as given. But how is the market price determined? Let’s find out. FIGURE 10.5 Price and cost (dollars per sweater) The Firm’s Supply Curve A Firm’s Supply Curve MC 31 MR 2 25 MR 1 AVC Shutdown point T 17 0 MR 0 7 9 10 Quantity (sweaters per day) (a) Marginal cost and average variable cost Price (dollars per sweater) 224 6/22/09 S 31 25 T 17 0 9 10 7 Quantity (sweaters per day) (b) Campus Sweaters short-run supply curve Part (a) shows the firm’s profit-maximizing output at various market prices. At $25 a sweater, it produces 9 sweaters, and at $17 a sweater, it produces 7 sweaters. At all prices below $17 a sweater, Campus Sweaters produces nothing. Its shutdown point is T. Part (b) shows the firm’s supply curve—the quantity of sweaters it produces at each price. Its supply curve is made up of the marginal cost curve at all prices above minimum average variable cost and the vertical axis at all prices below minimum average variable cost. animation 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 225 O utput, Price, and Profit in the Short Run ◆ Output, Price, and Profit FIGURE 10.6 To determine the price and quantity in a perfectly competitive market, we need to know how market demand and market supply interact. We start by studying a perfectly competitive market in the short run. The short run is a situation in which the number of firms is fixed. Price (dollars per sweater) in the Short Run Short-Run Market Supply Curve SM D 31 C 25 Market Supply in the Short Run The short-run market supply curve shows the quantity supplied by all the firms in the market at each price when each firm’s plant and the number of firms remain the same. You’ve seen how an individual firm’s supply curve is determined. The market supply curve is derived from the individual supply curves. The quantity supplied by the market at a given price is the sum of the quantities supplied by all the firms in the market at that price. Figure 10.6 shows the supply curve for the competitive sweater market. In this example, the market consists of 1,000 firms exactly like Campus Sweaters. At each price, the quantity supplied by the market is 1,000 times the quantity supplied by a single firm. The table in Fig. 10.6 shows the firm’s and the market’s supply schedules and how the market supply curve is constructed. At prices below $17 a sweater, every firm in the market shuts down; the quantity supplied by the market is zero. At $17 a sweater, each firm is indifferent between shutting down and producing nothing or operating and producing 7 sweaters a day. Some firms will shut down, and others will supply 7 sweaters a day. The quantity supplied by each firm is either 0 or 7 sweaters, and the quantity supplied by the market is between 0 (all firms shut down) and 7,000 (all firms produce 7 sweaters a day each). The market supply curve is a graph of the market supply schedules and the points on the supply curve A through D represent the rows of the table. To construct the market supply curve, we sum the quantities supplied by all the firms at each price. Each of the 1,000 firms in the market has a supply schedule like Campus Sweaters. At prices below $17 a sweater, the market supply curve runs along the yaxis. At $17 a sweater, the market supply curve is horizontal—supply is perfectly elastic. As the price 225 B 20 A 17 0 7 8 9 10 Quantity (thousands of sweaters per day) Price Quantity s upplied by Campus Sweaters Quantity supplied by market (dollars per sweater) (sweaters per day) (sweaters per day) A 17 0 or 7 0 to 7,000 B 20 8 8,000 C 25 9 9,000 D 31 10 10,000 The market supply schedule is the sum of the supply schedules of all the individual firms. A market that consists of 1,000 identical firms has a supply schedule similar to that of one firm, but the quantity supplied by the market is 1,000 times as large as that of the one firm (see the table). The market supply curve is SM. Points A, B, C, and D correspond to the rows of the table. At the shutdown price of $17 a sweater, each firm produces either 0 or 7 sweaters a day and the quantity supplied by the market is between 0 and 7,000 sweaters a day. The market supply is perfectly elastic at the shutdown price. animation rises above $17 a sweater, each firm increases its quantity supplied and the quantity supplied by the market increases by 1,000 times that of one firm. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 226 CHAPTER 10 Per fect Competition 226 Short-Run Equilibrium price, each firm maximizes profit by decreasing its output. If each firm produces 7 sweaters a day, the market output decreases to 7,000 sweaters a day. If the demand curve shifts farther leftward than D3, the market price remains at $17 a sweater because the market supply curve is horizontal at that price. Some firms continue to produce 7 sweaters a day, and others temporarily shut down. Firms are indifferent between these two activities, and whichever they choose, they incur an economic loss equal to total fixed cost. The number of firms continuing to produce is just enough to satisfy the market demand at a price of $17 a sweater. Market demand and short-run market supply determine the market price and market output. Figure 10.7(a) shows a short-run equilibrium. The short-run supply curve, S, is the same as SM in Fig. 10.6. If the market demand curve is D1, the market price is $20 a sweater. Each firm takes this price as given and produces its profit-maximizing output, which is 8 sweaters a day. Because the market has 1,000 identical firms, the market output is 8,000 sweaters a day. A Change in Demand Changes in demand bring changes to short-run market equilibrium. Figure 10.7 shows these changes. If demand increases and the demand curve shifts rightward to D2, the market price rises to $25 a sweater. At this price, each firm maximizes profit by increasing its output to 9 sweaters a day. The market output increases to 9,000 sweaters a day. If demand decreases and the demand curve shifts leftward to D3, the market price falls to $17. At this In short-run equilibrium, although the firm produces the profit-maximizing output, it does not necessarily end up making an economic profit. It might do so, but it might alternatively break even or incur an economic loss. Economic profit (or loss) per sweater is price, P, minus average total cost, ATC. So economic profit (or loss) is (P – ATC ) × Q. If price Short-Run Equilibrium S 25 Price (dollars per sweater) Price (dollars per sweater) FIGURE 10.7 Profits and Losses in the Short Run Increase in demand: price rises and firms increase production S 25 20 17 D2 20 17 Decrease in demand: price falls and firms decrease production D1 0 6 7 8 9 10 Quantity (thousands of sweaters per day) (a) Equilibrium 0 6 D1 D3 7 9 10 8 Quantity (thousands of sweaters per day) (b) Change in equilibrium In part (a), the market supply curve is S and the market demand curve is D1. The market price is $20 a sweater. At this price, each firm produces 8 sweaters a day and the market produces 8,000 sweaters a day. In part (b), if the market demand increases to D2, the animation price rises to $25 a sweater. Each firm produces 9 sweaters a day and market output is 9,000 sweaters. If market demand decreases to D3, the price falls to $17 a sweater and each firm decreases its output. If each firm produces 7 sweaters a day, the market output is 7,000 sweaters a day. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 227 O utput, Price, and Profit in the Short Run equals average total cost, a firm breaks even—the entrepreneur makes normal profit. If price exceeds average total cost, a firm makes an economic profit. If price is less than average total cost, a firm incurs an economic loss. Figure 10.8 shows these three possible short-run profit outcomes for Campus Sweaters that correspond to the three different levels of market demand that we’ve just examined. Three Possible Short-Run Outcomes Figure 10.8(a) corresponds to the situation in Fig. 10.7(a) where the market demand is D1. The equilibrium price of a sweater is $20 and the firm produces 8 sweaters a day. Average total cost is $20 a sweater. Price equals average total cost (ATC ), so the firm breaks even (makes zero economic profit). Figure 10.8(b) corresponds to the situation in Fig. 10.7(b) where the market demand is D2. The equilibrium price of a sweater is $25 and the firm produces 9 sweaters a day. Here, price exceeds average total cost, so the firm makes an economic profit. Its economic profit is $42 a day, which equals $4.67 per sweater ($25.00 – $20.33) multiplied by 9, the Break-even point ATC 25.00 20.00 MR 15.00 8 10 Quantity (sweaters per day) (a) Break even MC 30.00 ATC 25.00 Economic profit 20.33 15.00 0 9 10 Quantity (sweaters per day) (b) Economic profit In the short run, the firm might break even (make zero economic profit), make an economic profit, or incur an economic loss. In part (a), the price equals minimum average total cost. At the profit-maximizing output, the firm breaks even and makes zero economic profit. In part (b), the market price is $25 a sweater. At the profit-maximizing output, animation MR Price and cost (dollars per sweater) MC 30.00 0 profit-maximizing number of sweaters produced. The blue rectangle shows this economic profit. The height of that rectangle is profit per sweater, $4.67, and the length is the quantity of sweaters produced, 9 a day. So the area of the rectangle is economic profit of $42 a day. Figure 10.8(c) corresponds to the situation in Fig. 10.7(b) where the market demand is D3. The equilibrium price of a sweater is $17. Here, the price is less than average total cost, so the firm incurs an economic loss. Price and marginal revenue are $17 a sweater, and the profit-maximizing (in this case, lossminimizing) output is 7 sweaters a day. Total revenue is $119 a day (7 × $17). Average total cost is $20.14 a sweater, so the economic loss is $3.14 per sweater ($20.14 – $17.00). This loss per sweater multiplied by the number of sweaters is $22. The red rectangle shows this economic loss. The height of that rectangle is economic loss per sweater, $3.14, and the length is the quantity of sweaters produced, 7 a day. So the area of the rectangle is the firm’s economic loss of $22 a day. If the price dips below $17 a sweater, the firm temporarily shuts down and incurs an economic loss equal to total fixed cost. Three Short-Run Outcomes for the Firm Price and cost (dollars per sweater) Price and cost (dollars per sweater) FIGURE 10.8 227 MC 30.00 ATC 25.00 AVC 20.14 17.00 Economic loss 0 MR 7 10 Quantity (sweaters per day) (c) Economic loss the price exceeds average total cost and the firm makes an economic profit equal to the area of the blue rectangle. In part (c), the market price is $17 a sweater. At the profitmaximizing output, the price is below minimum average total cost and the firm incurs an economic loss equal to the area of the red rectangle. 9160335_CH10_p213-244.qxd 228 6/22/09 9:02 AM Page 228 CHAPTER 10 Per fect Competition ◆ Output, Price, and Profit Production Cutback and Temporary Shutdown Drop in Demand for Bikes at Harley-Davidson The high price of gasoline and anxiety about unemployment and future incomes brought a decrease in the demand for luxury goods including high-end motorcycles such as Harley-Davidsons. Harley-Davidson’s profit-maximizing response to the decrease in demand was to cut production and lay off workers. Some of the production cuts and layoffs were temporary and some were permanent. Harley-Davidson’s bike production plant in York County, Pennsylvania, was temporarily shut down in the summer of 2008 because total revenue was insufficient to cover total variable cost. The firm also permanently cut its workforce by 300 people. This permanent cut was like that at Campus Sweaters when the market demand for sweaters decreased from D1 to D3 in Fig. 10.7(b). Review Quiz ◆ 1 2 3 How do we derive the short-run market supply curve in perfect competition? In perfect competition, when market demand increases, explain how the price of the good and the output and profit of each firm changes in the short run. In perfect competition, when market demand decreases, explain how the price of the good and the output and profit of each firm changes in the short run. Work Study Plan 10.4 and get instant feedback. in the Long Run In short-run equilibrium, a firm might make an economic profit, incur an economic loss, or break even. Although each of these three situations is a short-run equilibrium, only one of them is a longrun equilibrium. The reason is that in the long run, firms can enter or exit the market. Entry and Exit Entry occurs in a market when new firms come into the market and the number of firms increases. Exit occurs when existing firms leave a market and the number of firms decreases. Firms respond to economic profit and economic loss by either entering or exiting a market. New firms enter a market in which existing firms are making an economic profit. Firms exit a market in which they are incurring an economic loss. Temporary economic profit and temporary economic loss don’t trigger entry and exit. It’s the prospect of persistent economic profit or loss that triggers entry and exit. Entry and exit change the market supply, which influences the market price, the quantity produced by each firm, and its economic profit (or loss). If firms enter a market, supply increases and the market supply curve shifts rightward. The increase in supply lowers the market price and eventually eliminates economic profit. When economic profit reaches zero, entry stops. If firms exit a market, supply decreases and the market supply curve shifts leftward. The market price rises and economic loss decreases. Eventually, economic loss is eliminated and exit stops. To summarize: ■ ■ ■ ■ ■ New firms enter a market in which existing firms are making an economic profit. As new firms enter a market, the market price falls and the economic profit of each firm decreases. Firms exit a market in which they are incurring an economic loss. As firms leave a market, the market price rises and the economic loss incurred by the remaining firms decreases. Entry and exit stop when firms make zero economic profit. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 229 O utput, Price, and Profit in the Long Run 229 A Closer Look at Entry A Closer Look at Exit The sweater market has 800 firms with cost curves like those in Fig. 10.9(a). The market demand curve is D, the market supply curve is S1, and the price is $25 a sweater in Fig. 10.9(b). Each firm produces 9 sweaters a day and makes an economic profit. This economic profit is a signal for new firms to enter the market. As entry takes place, supply increases and the market supply curve shifts rightward toward S*. As supply increases with no change in demand, the market price gradually falls from $25 to $20 a sweater. At this lower price, each firm makes zero economic profit and entry stops. Entry results in an increase in market output, but each firm’s output decreases. Because the price falls, each firm moves down its supply curve and produces less. Because the number of firms increases, the market produces more. Now, the sweater market has 1,200 firms with cost curves like those in Fig. 10.9(a). The market demand curve is D, the market supply curve is S2, and the price is $17 a sweater in Fig. 10.9(b). Each firm produces 7 sweaters a day and incurs an economic loss. This economic loss is a signal for firms to exit the market. As exit takes place, supply decreases and the market supply curve shifts leftward toward S*. As supply decreases with no change in demand, the market price gradually rises from $17 to $20 a sweater. At this higher price, losses are eliminated, each firm makes zero economic profit, and exit stops. Exit results in a decrease in market output, but each firm’s output increases. Because the price rises, each firm moves up its supply curve and produces more. Because the number of firms decreases, the market produces less. Entry, Exit, and Long-Run Equilibrium Zero economic profit MC ATC 25 MR1 20 MR* 17 MR2 Price (dollars per sweater) Price and cost (dollars per sweater) F IGURE 10.9 S1 S* S2 25 20 Long-run equilibrium 17 D 0 6 7 8 9 10 Quantity (sweaters per day) (a) Campus Sweaters Each firm has cost curves like those of Campus Sweaters in part (a). The market demand curve is D in part (b). When the market supply in part (b) is S1, the price is $25 a sweater. In part (a), each firm produces 9 sweaters a day and makes an economic profit. Profit triggers the entry of new firms and as new firms enter, the market supply curve shifts rightward, from S1 toward S*. The price falls from $25 to $20 a sweater, and the quantity produced increases from 7,200 to 8,000 sweaters. Each firm’s output decreases to 8 sweaters a day and economic profit is zero. animation 0 7.2 8.0 8.4 Quantity (thousands of sweaters per day) (b) The sweater market When the market supply is S2, the price is $17 a sweater. In part (a), each firm produces 7 sweaters a day and incurs an economic loss. Loss triggers exit and as firms exit, the market supply curve shifts leftward, from S2 toward S*. The price rises from $17 to $20 a sweater, and the quantity produced decreases from 8,400 to 8,000 sweaters. Each firm’s output increases from 7 to 8 sweaters a day and economic profit is zero. 9160335_CH10_p213-244.qxd 230 6/22/09 9:02 AM Page 230 CHAPTER 10 Per fect Competition Entry and Exit in Action Personal Computers and Farm Machines An example of entry and falling prices occurred during the 1980s and 1990s in the personal computer market. When IBM introduced its first PC in 1981, IBM had little competition. The price was $7,000 (about $16,850 in today’s money) and IBM made a large economic profit selling the new machine. Observing IBM’s huge success, new firms such as Gateway, NEC, Dell, and a host of others entered the market with machines that were technologically identical to IBM’s. In fact, they were so similar that they came to be called “clones.” The massive wave of entry into the personal computer market increased the market supply and lowered the price. The economic profit for all firms decreased. Today, a $400 computer is vastly more powerful than its 1981 ancestor that cost 42 times as much. The same PC market that saw entry during the 1980s and 1990s has seen some exit more recently. In 2001, IBM, the firm that first launched the PC, announced that it was exiting the market. The intense competition from Gateway, NEC, Dell, and others that entered the market following IBM’s lead has lowered the price and eliminated the economic profit. So IBM now concentrates on servers and other parts of the computer market. IBM exited the PC market because it was incurring economic losses. Its exit decreased market supply and made it possible for the remaining firms in the market to make zero economic profit. Long-Run Equilibrium You’ve now seen how economic profit induces entry, which in turn eliminates the profit. You’ve also seen how economic loss induces exit, which in turn eliminates the loss. When economic profit and economic loss have been eliminated and entry and exit have stopped, a competitive market is in long-run equilibrium. You’ve seen how a competitive market adjusts toward its long-run equilibrium. But a competitive market is rarely in a state of long-run equilibrium. International Harvester, a manufacturer of farm equipment, provides another example of exit. For decades, people associated the name “International Harvester” with tractors, combines, and other farm machines. But International Harvester wasn’t the only maker of farm equipment. The market became intensely competitive, and the firm began to incur economic losses. Now the firm has a new name, Navistar International, and it doesn’t make tractors any more. After years of economic losses and shrinking revenues, it got out of the farm-machine business in 1985 and started to make trucks. International Harvester exited because it was incurring an economic loss. Its exit decreased supply and made it possible for the remaining firms in the market to break even. Instead, it is constantly and restlessly evolving toward long-run equilibrium. The reason is that the market is constantly bombarded with events that change the constraints that firms face. Markets are constantly adjusting to keep up with changes in tastes, which change demand, and changes in technology, which change costs. In the next sections, we’re going to see how a competitive market reacts to changing tastes and technology and how it guides resources to their highest-valued use. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 231 C hanging Tastes and Advancing Technology Review Quiz ◆ 1 2 What triggers entry in a competitive market? Describe the process that ends further entry. What triggers exit in a competitive market? Describe the process that ends further exit. Work Study Plan 10.5 and get instant feedback. ◆ Changing Tastes and Advancing Technology Increased awareness of the health hazards of smoking has decreased the demand for tobacco products. The development of inexpensive automobile and air transportation during the 1990s decreased the demand for long-distance trains and buses. Solidstate electronics has decreased the demand for TV and radio repair. The development of good-quality inexpensive clothing has decreased the demand for sewing machines. What happens in a competitive market when there is a permanent decrease in the demand for its product? Microwave food preparation has increased the demand for paper, glass, and plastic cooking utensils and for plastic wrap. The Internet has increased the demand for a personal computer and the widespread use of the computer has increased the demand for high-speed connections and music downloads. What happens in a competitive market when the demand for its output increases? Advances in technology are constantly lowering the costs of production. New biotechnologies have dramatically lowered the costs of producing many food and pharmaceutical products. New electronic technologies have lowered the cost of producing just about every good and service. What happens in a competitive market for a good when technological change lowers its production costs? Let’s use the theory of perfect competition to answer these questions. A Permanent Change in Demand Figure 10.10(a) shows a competitive market that initially is in long-run equilibrium. The demand curve is D0, the supply curve is S0, the market price 231 is P0, and market output is Q0. Figure 10.10(b) shows a single firm in this initial long-run equilibrium. The firm produces q0 and makes zero economic profit. Now suppose that demand decreases and the demand curve shifts leftward to D1, as shown in Fig. 10.10(a). The market price falls to P1, and the quantity supplied by the market decreases from Q0 to Q1 as the market moves down along its short-run supply curve S0. Figure 10.10(b) shows the situation facing a firm. The market price is now below the firm’s minimum average total cost, so the firm incurs an economic loss. But to minimize its loss, the firm adjusts its output to keep marginal cost equal to price. At a price of P1, each firm produces an output of q1. The market is now in short-run equilibrium but not long-run equilibrium. It is in short-run equilibrium because each firm is maximizing profit; it is not in long-run equilibrium because each firm is incurring an economic loss—its average total cost exceeds the price. The economic loss is a signal for some firms to exit the market. As they do so, short-run market supply decreases and the market supply curve gradually shifts leftward. As market supply decreases, the price rises. At each higher price, a firm’s profitmaximizing output is greater, so the firms remaining in the market increase their output as the price rises. Each firm moves up along its marginal cost or supply curve in Fig. 10.10(b). That is, as some firms exit the market, market output decreases but the output of the firms that remain in the market increases. Eventually, enough firms have exited the market for the market supply curve to have shifted to S1 in Fig. 10.10(a). The market price has returned to its original level, P0. At this price, the firms remaining in the market produce q0, the same quantity that they produced before the decrease in demand. Because firms are now making zero economic profit, no firm has an incentive to enter or exit the market. The market supply curve remains at S1, and market output is Q2. The market is again in long-run equilibrium. The difference between the initial long-run equilibrium and the final long-run equilibrium is the number of firms in the market. A permanent decrease in demand has decreased the number of firms. Each firm remaining in the market produces the same 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 232 CHAPTER 10 Per fect Competition FIGURE 10.10 A Decrease in Demand Price S1 Price and cost 232 S0 MC ATC P0 P0 MR 0 P1 P1 MR 1 D0 D1 0 Q2 Q1 Q0 Quantity (a) Industry 0 q1 q0 Quantity (b) Firm A market starts out in long-run competitive equilibrium. Part (a) shows the market demand curve D0, the market supply curve S0, the market price P0, and the equilibrium quantity Q0. Each firm sells its output at the price P0, so its marginal revenue curve is MR0 in part (b). Each firm produces q0 and makes zero economic profit. Market demand decreases permanently from D0 to D1 in part (a) and the market price falls to P1. Each firm decreases its output to q1 in part (b), and market output decreases to Q1 in part (a). Firms now incur economic losses and some firms exit the market. As they do so, the market supply curve gradually shifts leftward, from S0 toward S1. This shift gradually raises the market price from P1 back to P0. While the price is below P0, firms incur economic losses and some firms exit the market. Once the price has returned to P0, each firm makes zero economic profit and has no incentive to exit. Each firm produces q0, and market output is Q2. animation output in the new long-run equilibrium as it did initially and makes zero economic profit. In the process of moving from the initial equilibrium to the new one, firms incur economic losses. We’ve just worked out how a competitive market responds to a permanent decrease in demand. A permanent increase in demand triggers a similar response, except in the opposite direction. The increase in demand brings a higher price, economic profit, and entry. Entry increases market supply and eventually lowers the price to its original level and economic profit to zero. The demand for Internet service increased permanently during the 1990s and huge profit opportunities arose in this market. The result was a massive rate of entry of Internet service providers. The process of competition and change in the Internet service market is similar to what we have just studied but with an increase in demand rather than a decrease in demand. We’ve now studied the effects of a permanent change in demand for a good. In doing so, we began and ended in a long-run equilibrium and examined the process that takes a market from one equilibrium to another. It is this process, not the equilibrium points, that describes the real world. One feature of the predictions that we have just generated seems odd: In the long run, regardless of whether demand increases or decreases, the market price returns to its original level. Is this outcome inevitable? In fact, it is not. It is possible for the equilibrium market price in the long run to remain the same, rise, or fall. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 233 C hanging Tastes and Advancing Technology External Economies and Diseconomies The long-run market supply curve (LSA) is perfectly elastic. In this case, a permanent increase in demand from D0 to D1 has no effect on the price in the long run. The increase in demand brings a temporary increase in price to PS and in the short run the quantity increases from Q0 to QS. Entry increases shortrun supply from S0 to S1, which lowers the price from PS back to P0 and increases the quantity to Q1. Figure 10.11(b) shows the case of external diseconomies. The long-run market supply curve (LSB) slopes upward. A permanent increase in demand from D0 to D1 increases the price in both the short run and the long run. The increase in demand brings a temporary increase in price to PS and in the short run the quantity increases from Q0 to QS. Entry increases short-run supply from S0 to S2, which lowers the price from PS to P2 and increases the quantity to Q2. One source of external diseconomies is congestion. The airline market provides a good example. With bigger airline market output, congestion at both airports and in the air increases, resulting in The change in the long-run equilibrium price depends on external economies and external diseconomies. External economies are factors beyond the control of an individual firm that lower the firm’s costs as the market output increases. External diseconomies are factors outside the control of a firm that raise the firm’s costs as the market output increases. With no external economies or external diseconomies, a firm’s costs remain constant as the market output changes. Figure 10.11 illustrates these three cases and introduces a new supply concept: the long-run market supply curve. A long-run market supply curve shows how the quantity supplied in a market varies as the market price varies after all the possible adjustments have been made, including changes in each firm’s plant and the number of firms in the market. Figure 10.11(a) shows the case we have just studied—no external economies or diseconomies. S1 S0 PS Price Long-Run Changes in Price and Quantity Price Price FIGURE 10.11 233 S0 S0 S2 PS PS S3 LSB P2 LSA P0 P0 P0 P3 D1 D1 D0 0 Q0 QS 0 Q1 Q0 QS D0 0 Q2 Q0 QS Quantity (b) Increasing-cost industry Three possible changes in price and quantity occur in the long run. When demand increases from D0 to D1, entry occurs and the market supply curve shifts rightward from S0 to S1. In part (a), the long-run market supply curve, LSA, is horizontal. The quantity increases from Q0 to Q1, and the price remains constant at P0. animation D1 D0 Quantity (a) Constant-cost industry LSC Q3 Quantity (c) Decreasing-cost industry In part (b), the long-run market supply curve is LSB; the price rises to P2, and the quantity increases to Q2. This case occurs in industries with external diseconomies. In part (c), the long-run market supply curve is LSC; the price falls to P3, and the quantity increases to Q3. This case occurs in a market with external economies. 9160335_CH10_p213-244.qxd 234 6/22/09 9:02 AM Page 234 CHAPTER 10 Per fect Competition longer delays and extra waiting time for passengers and airplanes. These external diseconomies mean that as the output of air transportation services increases (in the absence of technological advances), average cost increases. As a result, the long-run market supply curve is upward sloping. A permanent increase in demand brings an increase in quantity and a rise in the price. (Markets with external diseconomies might nonetheless have a falling price because technological advances shift the long-run supply curve downward.) Figure 10.11(c) shows the case of external economies. The long-run market supply curve (LSC ) slopes downward. A permanent increase in demand from D0 to D1 increases the price in the short run and lowers it in the long run. Again, the increase in demand brings a temporary increase in price to PS and in the short run the quantity increases from Q0 to QS. Entry increases short-run supply from S0 to S3, which lowers the price to P3 and increases the quantity to Q3. An example of external economies is the growth of specialist support services for a market as it expands. As farm output increased in the nineteenth and early twentieth centuries, the services available to farmers expanded. New firms specialized in the development and marketing of farm machinery and fertilizers. As a result, average farm costs decreased. Farms enjoyed the benefits of external economies. As a consequence, as the demand for farm products increased, the output increased but the price fell. Over the long term, the prices of many goods and services have fallen, not because of external economies but because of technological change. Let’s now study this influence on a competitive market. Technological Change Industries are constantly discovering lower-cost techniques of production. Most cost-saving production techniques cannot be implemented, however, without investing in new plant and equipment. As a consequence, it takes time for a technological advance to spread through a market. Some firms whose plants are on the verge of being replaced will be quick to adopt the new technology, while other firms whose plants have recently been replaced will continue to operate with an old technology until they can no longer cover their average variable cost. Once average variable cost cannot be covered, a firm will scrap even a relatively new plant (embodying an old technology) in favor of a plant with a new technology. New technology allows firms to produce at a lower cost. As a result, as firms adopt a new technology, their cost curves shift downward. With lower costs, firms are willing to supply a given quantity at a lower price or, equivalently, they are willing to supply a larger quantity at a given price. In other words, market supply increases, and the market supply curve shifts rightward. With a given demand, the quantity produced increases and the price falls. Two forces are at work in a market undergoing technological change. Firms that adopt the new technology make an economic profit, so there is entry by new-technology firms. Firms that stick with the old technology incur economic losses. They either exit the market or switch to the new technology. As old-technology firms disappear and newtechnology firms enter, the price falls and the quantity produced increases. Eventually, the market arrives at a long-run equilibrium in which all the firms use the new technology and make a zero economic profit. Because in the long run competition eliminates economic profit, technological change brings only temporary gains to producers. But the lower prices and better products that technological advances bring are permanent gains for consumers. The process that we’ve just described is one in which some firms experience economic profits and others experience economic losses. It is a period of dynamic change in a market. Some firms do well, and others do badly. Often, the process has a geographical dimension—the expanding new-technology firms bring prosperity to what was once the boondocks, and traditional industrial regions decline. Sometimes, the new-technology firms are in a foreign country, while the old-technology firms are in the domestic economy. The information revolution of the 1990s produced many examples of changes like these. Commercial banking, which was traditionally concentrated in New York, San Francisco, and other large cities now flourishes in Charlotte, North Carolina, which has become the nation’s number three commercial banking city. Television shows and movies, traditionally made in Los Angeles and New York, are now made in large numbers in Orlando. Technological advances are not confined to the information and entertainment industries. Even food production is undergoing a major technological change because of genetic engineering. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 235 C ompetition and Efficiency Review Quiz ◆ 1 2 3 Describe the course of events in a competitive market following a permanent decrease in demand. What happens to output, price, and economic profit in the short run and in the long run? Describe the course of events in a competitive market following a permanent increase in demand. What happens to output, price, and economic profit in the short run and in the long run? Describe the course of events in a competitive market following the adoption of a new technology. What happens to output, price, and economic profit in the short run and in the long run? Work Study Plan 10.6 and get instant feedback. We’ve seen how a competitive market operates in the short run and the long run, but is a competitive market efficient? ◆ Competition and Efficiency A competitive market can achieve an efficient use of resources. You first studied efficiency in Chapter 2. Then in Chapter 5, using only the concepts of demand, supply, consumer surplus, and producer surplus, you saw how a competitive market achieves efficiency. Now that you have learned what lies behind the demand and supply curves of a competitive market, you can gain a deeper understanding of the efficiency of a competitive market. 235 more video games, some people will become better off and no one will be worse off. So the initial resource allocation was inefficient. In the more technical language that you have learned, resource use is efficient when marginal social benefit equals marginal social cost. In the computer and video games example, the marginal social benefit of a video game exceeds its marginal social cost; the marginal social cost of a computer exceeds its marginal social benefit. So by producing fewer computers and more video games, we move resources toward a higher-valued use. Choices, Equilibrium, and Efficiency We can use what you have learned about the decisions made by consumers and competitive firms and market equilibrium to describe an efficient use of resources. Choices Consumers allocate their budgets to get the most value possible out of them. We derive a consumer’s demand curve by finding how the best budget allocation changes as the price of a good changes. So consumers get the most value out of their resources at all points along their demand curves. If the people who consume a good or service are the only ones who benefit from it, then the market demand curve measures the benefit to the entire society and is the marginal social benefit curve. Competitive firms produce the quantity that maximizes profit. We derive the firm’s supply curve by finding the profit-maximizing quantity at each price. So firms get the most value out of their resources at all points along their supply curves. If the firms that produce a good or service bear all the costs of producing it, then the market supply curve measures the marginal cost to the entire society and the market supply curve is the marginal social cost curve. Efficient Use of Resources Equilibrium and Efficiency Resources are used effi- Recall that resource use is efficient when we produce the goods and services that people value most highly (see Chapter 2, p. 37 and Chapter 5, p. 106). If someone can become better off without anyone else becoming worse off, resources are not being used efficiently. For example, suppose we produce a computer that no one wants and no one will ever use and, at the same time, some people are clamoring for more video games. If we produce fewer computers and reallocate the unused resources to produce ciently when marginal social benefit equals marginal social cost. Competitive equilibrium achieves this efficient outcome because for consumers, price equals marginal social benefit, and for producers, price equals marginal social cost. The gains from trade are the sum of consumer surplus and producer surplus. The gains from trade for consumers are measured by consumer surplus, which is the area below the demand curve and above the price paid. (See Chapter 5, p. 107.) The gains from trade 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 236 CHAPTER 10 Per fect Competition 236 Efficiency of Perfect Competition Price and cost Price FIGURE 10.12 S = MSC MC LRAC SRAC P* Consumer surplus MR Efficient allocation P* Producer surplus Long-run competitive equilibrium D = MSB q* 0 Q* 0 Quantity (a) A single firm Quantity (b) A market In part (a), a firm in perfect competition produces at the lowest possible long-run average total cost at q*. In part (b), consumers have made the best available choices and are on the market demand curve and firms are producing at least cost and are on the market supply curve. With no external benefits or external costs, resources are used efficiently at the quantity Q* and the price P *. Perfect competition achieves an efficient use of resources. animation for producers are measured by producer surplus, which is the area above the supply curve and below the price received. (See Chapter 5, p. 109.) The total gains from trade are the sum of consumer surplus and producer surplus. When the market for a good or service is in equilibrium, the gains from trade are maximized. Illustrating an Efficient Allocation Figure 10.12 illustrates the efficiency of perfect competition in long-run equilibrium. Part (a) shows the individual firm, and part (b) shows the market. The equilibrium market price is P *. At that price, each firm makes zero economic profit and each firm has the plant that enables it to produce at the lowest possible average total cost. Consumers are as well off as possible because the good cannot be produced at a lower cost and the price equals that least possible cost. In part (b), consumers get the most out of their resources at all points on the market demand curve, D = MSB. Consumer surplus is the green area. Producers get the most out of their resources at all points on the market supply curve, S = MSC. Producer surplus is the blue area. Resources are used efficiently at the quantity Q* and price P *. At this point, marginal social benefit equals marginal social cost, and total surplus (the sum of producer surplus and consumer surplus) is maximized. When firms in perfect competition are away from long-run equilibrium, either entry or exit is taking place and the market is moving toward the situation depicted in Figure 10.12. But the market is still efficient. As long as marginal social benefit (on the market demand curve) equals marginal social cost (on the market supply curve), the market is efficient. But it is only in long-run equilibrium that consumers pay the lowest possible price. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 237 Competition and Efficiency Review Quiz ◆ 1 2 3 4 State the conditions that must be met for resources to be allocated efficiently. Describe the choices that consumers make and explain why consumers are efficient on the market demand curve. Describe the choices that producers make and explain why producers are efficient on the market supply curve. Explain why resources are used efficiently in a competitive market. Work Study Plan 10.7 and get instant feedback. ◆ You’ve now completed your study of perfect 237 competition. Reading Between the Lines on pp. 238–239 gives you an opportunity to use what you have learned to understand the recent exit of small airlines from the U.S. airline market. Although many markets approximate the model of perfect competition, many do not. In Chapter 11, we study markets at the opposite extreme of market power: monopoly. Then we’ll study markets that lie between perfect competition and monopoly. In Chapter 12, we study monopolistic competition and in Chapter 13 we study oligopoly. When you have completed this study, you’ll have a tool kit that will enable you to understand the variety of real-world markets. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 238 READING BETWEEN THE LINES Airlines Exit Fuel Costs, Economy Down 3 Airlines http://www.washingtontimes.com April 9, 2008 The loss of three airlines in little more than a week is prompting warnings from financial analysts that the worst is not over for the industry or its passengers. Rising fuel prices and a slow economy mean higher expenses but fewer passengers. ATA Airlines, Aloha Airlines and Skybus Airlines all succumbed recently to that fatal combination. The next airline expected to go belly up is Champion Air, a Bloomington, Minn., charter service that operates 14 Boeing 727 aircraft. “Unfortunately, our business model is no longer viable in a world of $110 oil, a struggling economy and rapidly changing demand for our services,” Chief Executive Officer Lee Steele said in announcing the airline’s planned May 31 closure. … Airlines already are starting to raise prices to cover their higher fuel costs—a risky business move that could reduce demand for tickets. High fuel costs leave them few choices, analysts said. … Major carriers, like Northwest Airlines and Delta Air Lines, are stepping in to absorb some of the defunct airlines’ routes. … In a bankruptcy filing Monday in U.S. Bankruptcy Court for the District of Delaware, Skybus Chief Financial Officer Barry Barnard said his airline failed largely because of high fuel prices and a “recession” that reduced demand for flights. Copyright 2008 The Washington Times. Reprinted with permission. Further reproduction prohibited. Essence of the Story ■ ■ 238 High fuel prices and lower demand have put three airlines (ATA Airlines, Aloha Airlines and Skybus Airlines) out of business. Champion Air, a Bloomington, Minn., airline is also expected to go out of business. ■ Airlines are raising prices to cover their higher fuel costs. ■ Higher prices will decrease the quantity of tickets sold. ■ Major carriers (Northwest Airlines and Delta Air Lines) are filling the gaps left by the exit of the three airlines. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 239 Economic Analysis ■ The market for air travel is not perfectly competitive but it is highly competitive and the perfect competition model provides insights into that market. ■ The “slow economy” decreases the demand for air travel and the demand curve shifts leftward to D1. ■ The rise in fuel prices increases the airline’s costs. ■ The airline’s average total cost shifts upward to ATC1 and the marginal cost curve shifts upward to MC1. ■ In 2008, airlines were being squeezed by rising costs and falling demand. ■ Figure 1 shows an airline’s cost and revenue curves. ■ ■ Initially an airline’s average total cost curve is ATC0 and its marginal cost curve is MC0. The increase in marginal cost decreases supply and the market supply curve shifts leftward to S1. ■ The market comes to a new equilibrium. The quantity decreases but (in this example) the price doesn’t change. ■ The combination of no change in price and a rise in costs results in the airlines incurring an economic loss. ■ As the loss persists, some airlines exit. ■ When airlines exit (not shown in the figures), market supply decreases, the price rises, and the airlines remaining in the industry (like Northwest and Delta in the news article) increase production. ■ Eventually, exit stops and the market returns to long-run equilibrium but at a higher price. Figure 2 shows the market for air transportation services. ■ Initially the demand curve is D0 and the supply curve is S0. The equilibrium price is $100 a trip. ■ Airlines face a marginal revenue curve, MR, in Fig. 1 and maximize profit by producing 50 trips per day. Economic profit is zero. The market is in long-run equilibrium. Two events disturb this long-run equilibrium: (1) In what the news article calls a “slow economy,”incomes stop growing and people decide to cut back on their air travel plans; and (2) fuel costs rocket upward. Price (dollars per trip) ■ MC1 200 MC0 ATC1 150 ATC0 100 MR Rise in price of fuel increases cost and ... 50 Price (dollars per trip) ■ 200 S1 "Slow economy" decreases demand S0 150 … decreases supply 100 50 D1 0 20 40 50 60 80 Quantity (trips per day) Figure 1 An airline's cost and revenue curves 0 20 D0 60 80 40 50 Quantity (hundreds of trips per day) Figure 2 The market for air travel 239 9160335_CH10_p213-244.qxd 240 6/22/09 9:02 AM Page 240 CHAPTER 10 Per fect Competition SUMMARY ◆ Key Points Output, Price, and Profit in the Long Run (pp. 228–231) ■ Markets and the Competitive Environment (pp. 214–218) What Is Perfect Competition? (pp. 219–220) ■ ■ ■ ■ In perfect competition, many firms sell identical products to many buyers; there are no restrictions on entry; and sellers and buyers are well informed about prices. A perfectly competitive firm is a price taker. A perfectly competitive firm’s marginal revenue always equals the market price. ■ Changing Tastes and Advancing Technology (pp. 231–235) ■ The Firm’s Output Decision (pp. 221–224) ■ ■ ■ ■ The firm produces the output at which marginal revenue (price) equals marginal cost. In short-run equilibrium, a firm can make an economic profit, incur an economic loss, or break even. If price is less than minimum average variable cost, the firm temporarily shuts down. At prices below minimum average variable cost, a firm’s supply curve runs along the y-axis; at prices above minimum average variable cost, a firm’s supply curve is its marginal cost curve. ■ ■ ■ ■ The market supply curve shows the sum of the quantities supplied by each firm at each price. Market demand and market supply determine price. A firm might make a positive economic profit, a zero economic profit, or incur an economic loss. A permanent decrease in demand leads to a smaller market output and a smaller number of firms. A permanent increase in demand leads to a larger market output and a larger number of firms. The long-run effect of a change in demand on price depends on whether there are external economies (the price falls) or external diseconomies (the price rises) or neither (the price remains constant). New technologies increase supply and in the long run lower the price and increase the quantity. Competition and Efficiency (pp. 235–237) ■ Output, Price, and Profit in the Short Run (pp. 225–228) ■ Economic profit induces entry and economic loss induces exit. Entry increases supply and lowers price and profit. Exit decreases supply and raises price and profit. In long-run equilibrium, economic profit is zero. There is no entry or exit. ■ Resources are used efficiently when we produce goods and services in the quantities that people value most highly. When there are no external benefits and external costs, perfect competition achieves an efficient allocation. In long-run equilibrium, consumers pay the lowest possible price and marginal social benefit equals marginal social cost. Key Figures Figure 10.1 Figure 10.3 Figure 10.4 Figure 10.5 Figure 10.7 Demand, Price, and Revenue in Perfect Competition, 220 Profit-Maximizing Output, 222 The Shutdown Decision, 223 A Firm’s Supply Curve, 224 Short-Run Equilibrium, 226 Figure 10.8 Three Short-Run Outcomes for the Firm, 227 Figure 10.9 Entry, Exit, and Long-Run Equilibrium, 229 Figure 10.12 Efficiency of Perfect Competition, 236 Key Terms Four-firm concentration ratio 215 Herfindahl-Hirschman Index 215 Marginal revenue 219 Monopoly 214 Monopolistic competition 214 Oligopoly 214 Perfect competition 214 Product differentiation 214 Price taker 219 Short-run market supply curve, 225 Shutdown point, 223 Total revenue 219 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 241 Problems and Applications PROBLEMS and APPLICATIONS 241 ◆ Work problems 1–10 in Chapter 10 Study Plan and get instant feedback. Work problems 11–18 as Homework, a Quiz, or a Test if assigned by your instructor. 1. Lin’s fortune cookies are identical to the fortune cookies made by dozens of other firms, and there is free entry in the fortune cookie market. Buyers and sellers are well informed about prices. a. In what type of market does Lin’s operate? b. What determines the price of fortune cookies? c. What determines Lin’s marginal revenue of fortune cookies? d. If fortune cookies sell for $10 a box and Lin offers his cookies for sale at $10.50 a box, how many boxes does he sell? e. If fortune cookies sell for $10 a box and Lin offers his cookies for sale at $9.50 a box, how many boxes does he sell? f. What is the elasticity of demand for Lin’s fortune cookies and how does it differ from the elasticity of the market demand for fortune cookies? 2. Pat’s Pizza Kitchen is a price taker. Its costs are Output Total cost (pizzas per hour) (dollars per hour) 0 1 2 3 4 5 10 21 30 41 54 69 a. Calculate Pat’s profit-maximizing output and economic profit if the market price is (i) $14 a pizza. (ii) $12 a pizza. (iii) $10 a pizza. b. What is Pat’s shutdown point and what is Pat’s economic profit if it shuts down temporarily? c. Derive Pat’s supply curve. d. At what price will firms with costs identical to Pat’s exit the pizza market in the long run? e. At what price will firms with costs identical to Pat’s enter the pizza market in the long run? 3. The market is perfectly competitive and there are 1,000 firms that produce paper. The table sets out the market demand schedule for paper. P rice Quantity demanded (dollars per box) (thousands of boxes per week) 3.65 500 5.20 450 6.80 400 8.40 350 10.00 300 11.60 250 13.20 200 Each producer of paper has the following costs when it uses its least-cost plant: Output Marginal cost (boxes per week) (dollars per additional box) 200 250 300 350 400 450 500 6.40 7.00 7.65 8.40 10.00 12.40 20.70 a. b. c. d. Average variable cost Average total cost (dollars per box) 7.80 7.00 7.10 7.20 7.50 8.00 9.00 12.80 11.00 10.43 10.06 10.00 10.22 11.00 What is the market price of paper? What is the market’s output? What is the output produced by each firm? What is the economic profit made or economic loss incurred by each firm? e. Do firms have an incentive to enter or exit the paper market in the long run? f. What is the number of firms in the long run? g. What is the market price in the long run? h. What is the equilibrium quantity of paper produced in the long run? 4. Never Pay Retail Again Not only has scouring the Web for the best possible price become standard protocol before buying a big-ticket item, but more consumers are employing creative strategies for scoring hot deals. … Comparison shopping, haggling and swapping discount codes are all becoming mainstream marks of savvy shoppers … online shoppers can check a comparison service like Price Grabber before making a purchase. … CNN, May 30, 2008 9160335_CH10_p213-244.qxd 242 6/22/09 9:02 AM Page 242 CHAPTER 10 Per fect Competition a. Explain the effect of the Internet on the degree of competition in the market. b. Explain how the Internet influences market efficiency. 5. As the quality of computer monitors improves, more people are reading documents online rather than printing them out. The demand for paper permanently decreases and the demand schedule becomes Price Quantity demanded (dollars per box) (thousands of boxes per week) 2.95 4.13 5.30 6.48 7.65 8.83 10.00 11.18 500 450 400 350 300 250 200 150 If each firm producing paper has the costs set out in problem 3, a. What is the market price, market output, and economic profit or loss of each firm? b. What is the long-run equilibrium price, market output, and economic profit or loss of each firm? c. Does this market experience external economies, external diseconomies, or constant cost? Illustrate by drawing the long-run supply curve. 6. Fuel Prices Could Squeeze Cheap Flights Continental has eliminated service to airports big and small all across the nation. … The moneylosing airline market is scrapping its least-fuel efficient flights in step with the dramatic increases in energy costs. … Airlines are having difficulty keeping prices low for flights … especially as fuel prices keep rising. … Airlines have continually raised—or tried to raise—fares this year to make up for the fuel costs. … American Airlines increased its fuel surcharge by $20 a roundtrip. American had raised fares just days earlier—an increase that was matched by Delta Air Lines Inc. and UAL Corp.’s United Airlines and Continental—but retracted the increase. … United said it would start charging $15 for the first checked bag. … This follows an earlier announcement from American, which plans to begin charging $15 for the first checked bag. … CNN, June 12, 2008 a. Explain how an increase in fuel prices might cause an airline to change its output (number of flights) in the short run. b. Draw a graph to show the increase in fuel prices on an airline’s output in the short run. c. Explain why an airline might incur an economic loss in the short run as fuel prices rise. d. If some airlines decide to exit the market, explain how the economic profit or loss of the remaining airlines will change. 7. Coors Brewing Expanding Plant Coors Brewing Co. of Golden will expand its Virginia packaging plant at a cost of $24 million. The addition will accommodate a new production line that will bottle mostly Coors Light. … It also will bottle beer faster. … Coors Brewing employs roughly 470 people at its Virginia plant. The expanded packaging line will add another eight jobs. Denver Business Journal, January 6, 2006 a. How will Coors’ expansion of a plant change the firm’s marginal cost curve and short-run supply curve? b. What does this expansion decision imply about the point on Coors’ LRAC curve at which the firm was before the expansion? c. If other breweries follow the lead of Coors, what will happen to the market price of beer? d. How will the adjustment that you have described in c influence the economic profit of Coors and other beer producers? 8. In a perfectly competitive market in long-run equilibrium can a. Consumer surplus be increased? b. Producer surplus be increased? c. A consumer become better off by making a substitution away from this market? d. The average total cost be reduced? 9. Explain and illustrate graphically how the growing world population is influencing the world market for wheat and a representative individual wheat farmer. 10. Explain and illustrate graphically how the diaper service market has been affected by the decrease in the North American birth rate and the development of disposable diapers. 9160335_CH10_p213-244.qxd 6/22/09 9:02 AM Page 243 Problems and Applications Price Quantity demanded (dollars per smoothie) (smoothies per hour) 1.90 1,000 2.00 950 2.20 800 2.91 700 4.25 550 5.25 400 5.50 300 The market is perfectly competitive, and each firm has the following costs when it uses its leastcost plant: Output Marginal cost (smoothies (dollars per per hour) additional smoothie) Average variable cost Average total cost b. Why does each of these gas stations have so little control over the price of the gasoline they sell? c. How do these gas stations decide how much gasoline to make available for sale? 13. Quick Copy is one of many copy shops near campus. The figure shows Quick Copy’s costs. Cost (cents per page) 11. The market demand schedule for smoothies is 243 MC 12 ATC 10 8 6 4 (dollars per smoothie) 3 4 5 6 2.50 2.20 1.90 2.00 4.00 3.53 3.24 3.00 7.33 6.03 5.24 4.67 7 2.91 2.91 4.34 8 4.25 3.00 4.25 9 8.00 3.33 4.44 There are 100 smoothie sellers in the market. a. What is the market price of a smoothie? b. What is the market quantity of smoothies? c. How many smoothies does each firm sell? d. What is the economic profit made or economic loss incurred by each firm? e. Do firms enter or exit the market in the long run? f. What is the market price and the equilibrium quantity in the long run? 12. Money in the Tank In Marietta, where the road hugs the Susquehanna River, a Rutter’s Farm Store gas station stands on one side, a Sheetz gas station on the other. Kelly Bosley, who manages Rutter’s, doesn’t even have to look across the highway to know when Sheetz changes its price for a gallon of gas. When Sheetz raises prices, her own pumps are busy. When Sheetz lowers prices, she has not a car in sight. … You think you feel helpless at the pump? Bosley makes a living selling gas— and even she has little control over what it costs. The Mining Journal, May 24, 2008 a. Describe the elasticity of demand that each of these gas stations faces. 2 0 20 40 60 80 100 Quantity (pages per hour) If the market price of copying a page is 10 cents, calculate Quick Copy’s a. Marginal revenue. b. Profit-maximizing output. c. Economic profit. 14. Cadillac Plant Shuts Down Temporarily, Future Uncertain Delta Truss in Cadillac [Michigan] is shutting down in what [its] parent company, Pro-Build, calls “temporarily discontinuing truss production.” Workers fear this temporary shut down will become permanent. About 60 people work at Delta Truss when it’s in peak season. Right now, about 20 people work there. … A corporate letter … says “we are anticipating resuming production at these plants when the spring business begins.” 9&10 News, February 18, 2008 a. Explain how the shutdown decision will affect Delta Truss’ TFC, TVC, and TC. b. Under what conditions would this shutdown decision maximize Delta Truss’ economic profit (or minimize its loss)? c. Under what conditions will Delta Truss start producing again? d. Under what conditions will Delta Truss make the shutdown permanent and exit the market? 9160335_CH10_p213-244.qxd 244 6/22/09 9:02 AM Page 244 CHAPTER 10 Per fect Competition 15. Exxon Mobil Selling All Its Gas Stations to Distributors Exxon Mobil Corp. said Thursday it’s getting out of the retail gasoline business, following other major oil companies. … “As the highly competitive fuels marketing business in the U.S. continues to evolve, we believe this transition is the best way for Exxon Mobil to compete and grow in the future,” said Ben Soraci, the director of Exxon Mobil’s U.S. retail sales. Exxon Mobil is not alone among Big Oil exiting the retail gas business, a market where profits have gotten tougher as crude oil prices have risen. … Station owners say they’re struggling to turn a profit on gas because while wholesale gasoline prices have risen sharply, … they’ve been unable to raise pump prices fast enough to keep pace. Houston Chronicle, June 12, 2008 a. Is Exxon Mobil making a shutdown or exit decision in the retail gasoline market? b. Under what conditions will this decision maximize Exxon Mobil’s economic profit? c. How might this decision by Exxon Mobil affect the economic profit made by other firms that sell retail gasoline? 16. Another DVD Format, but This One Says It’s Cheaper No sooner has the battle for the next-generation high definition DVD format ended, with Blu-ray triumphing over HD DVD, than a new contender has emerged. A new system … called HD VMD … is trying to find a niche. New Medium Enterprises, the London company behind HD VMD, says its system’s quality is equal to Bluray’s but it costs less. … While Blu-ray players typically cost more than $300, an HD VMD unit is priced at $199. … New Medium’s price strategy will fail, said Andy Parsons, chairman of the Blu-ray Disc Association, … because it relies on a false assumption: Blu-ray technology will always be more expensive. “When you mass produce blue lasers in large quantities, hardware costs will absolutely come down,” Mr. Parsons said. “I’m sure we’ll eventually be able to charge $90 for a Blu-ray player.” The New York Times, March 10, 2008 a. Explain how technological change in Blu-ray production might support Mr. Parson’s predictions of lower prices in the long-run and illustrate your explanation with a graph. b. Even if Blu-ray prices do drop to $90 in the long run, why might the red-laser HD VMD still end up being less expensive at that time? 17. Cell Phone Sales Hit 1 Billion Mark More than 1.15 billion mobile phones were sold worldwide in 2007, a 16 percent increase from the 990.9 million phones sold in 2006. … “Emerging markets, especially China and India, provided much of the growth as many people bought their first phone,” Carolina Milanesi, research director for mobile devices at Gartner, said in a statement. “In mature markets, such as Japan and Western Europe, consumers’ appetite for feature-laden phones was met with new models packed with TV tuners, global positioning satellite (GPS) functions, touch screens and highresolution cameras.” CNET News, February 27, 2008 a. Explain the effects of the global increase in demand for cell phones on the market for cell phones and individual cell-phone producers in the short run. b. Draw a graph to illustrate your explanation in a. c. Explain the effects of the global increase in demand for cell phones on the market for cell phones in the long run. d. What factors will determine whether the price of cell phones will rise, fall, or stay the same in the new long-run equilibrium? 18. Study Reading Between the Lines about the U.S. market for air travel on pp. 238–239, and then answer the following questions. a. What are the features of the market for air travel that make it highly competitive? b. If the fuel price increase had occurred with no decrease in demand, how would the outcome differ from that on p. 239? c. Is the news article correct in its remark that it is risky for the airlines to raise prices because that move could reduce the demand for tickets? Explain your answer. d. Explain how the market for air travel gets back to a long-run equilibrium. e. Draw a graph to illustrate the market in the new long-run equilibrium. f. Draw a graph of the cost and revenue curves of an airline to illustrate the situation in the new long-run equilibrium. ...
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This note was uploaded on 02/07/2010 for the course ECON 251 taught by Professor Blanchard during the Fall '08 term at Purdue University-West Lafayette.

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