Principles of Economics

1. Principles of Economics Session 6

2. Topics To Be Covered • Market Structure • Characteristics of Perfectly Competitive Market • Profit Maximization for a Competitive Firm • Zero-Profit Point and Shut-Down Point • Short-Run Supply Curve • Long-Run Supply Curve • Producer Surplus • Pricing Information

3. Market Structure • Perfect Competition • Monopoly • Oligopoly • Monopolistic Competition

4. Characteristics of Perfectly Competitive Market • Many buyers and sellers • Product homogeneity • Free entry and exit • Price taking

5. Product Homogeneity • The products of all firms are perfect substitutes. • Examples: Agricultural products, oil, copper, iron, lumber

6. Free Entry and Exit • Buyers can easily switch from one supplier to another. • Suppliers can easily enter or exit a market.

7. Price Taking • The individual firm sells a very small share of the total market output and, therefore, cannot influence market price. • The individual consumer buys too small a share of industry output to have any impact on market price. • Buyers and sellers in competitive markets are said to be price takers, for they must accept the price determined by the market.

8. $4 d $4 D Demand Facedby a Competitive Firm P P Industry Firm Q Q

9. Price Elasticity of Demand • Individual producer sells all units for $4 regardless of the producer’s level of output, so price under $4 is irrational. If the producer tries to raise price, sales are zero. • The price elasticity of demand for products of a single firm is E=∞

10. Revenue of a Perfectly Competitive Firm Total revenue for a firm is the selling price times the quantity sold. TR=P×Q

11. Revenue of a Perfectly Competitive Firm Average revenue tells us how much a firm receives for the typical unit sold.

12. Revenue of a Perfectly Competitive Firm Marginal revenue is the change in total revenue from an additional unit sold.

13. Demand, Price, AR, and MR P Firm $4 d=P=AR=MR Q

14. Profit Maximization for the Perfectly Competitive Firm The goal of a competitive firm is to maximize profit. This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.

15. The firm maximizes profit by producing the quantity at which MR=MC. Costs and Revenue MC2 P=MR1 P = AR = MR MC1 Q1 QMAX Q2 Profit Maximization for the Perfectly Competitive Firm MC ATC AVC 0 Quantity

16. Profit Maximization for the Perfectly Competitive Firm • When MR > MC,Q increasewill increase profit • When MR < MC, Qdecrease will increase profit • When MR = MC,economic profit is maximized

17. TR Slope of TR = MR Profit Maximization for the Perfectly Competitive Firm Revenue ($s per year) 0 Output (units per year)

18. TC Slope of TC = MC Profit Maximization for the Perfectly Competitive Firm Cost $ (per year) 0 Output (units per year)

19. TC TR A B q1 Profit MR=MC Profit Maximization for the Perfectly Competitive Firm Cost, Revenue, Profit ($s per year) 0 Output (units per year)

20. TC TR A B q2 q3 Profit Profit Maximization for the Perfectly Competitive Firm Cost, Revenue, Profit ($s per year) Profits are maximized when MC = MR. 0 Output (units per year) q1

21. The Marginal Principle • The marginal principle is the fundamental notion that people will maximize their income or profits when the marginal costs and marginal benefits of their actions are equal. • A profit-maximizing firm will set its output at that level where marginal cost equals price (MC=P).

22. Costs and Revenue Profit P P = AR = MR QMAX Firms Making Profits MC ATC AVC 0 Quantity

23. Costs and Revenue Loss P P = AR = MR QMAX Firms Incurring Losses MC ATC AVC 0 Quantity

24. Costs and Revenue Zero-Profit Point P P = AR = MR QMAX Zero-Profit Point MC ATC AVC 0 Quantity

25. Zero-Profit Point • Total cost includes all the opportunity costs of the firm. • In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going. • Although the economic profit is zero, the firm has realized its normal profit.

26. Costs and Revenue P P = AR = MR ● QMAX Shut-Down Point MC ATC AVC Shut-Down Point 0 Quantity

27. Shut-Down Point When AVC＜P ＜ATC, why does the firm continue production?

28. Shutdown vs. Exit • A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. • Exit refers to a long-run decision to leave the market.

29. Shutdown vs. Exit The firm considers its sunk costs when deciding to exit, but ignores them when deciding whether to shut down. Sunk costs are costs that have already been committed and cannot be recovered.

30. Summary of Production Decisions • Profit is maximized when MC = MR • If P > ATC the firm is making profits. • If AVC < P < ATC the firm should produce at a loss. • If P < AVC < ATC the firm should shut-down.

31. Costs and Revenue The Firm’s Short-Run Supply Curve The portion of MC above AVC is the competitive firm’s short-run supply curve. MC ATC AVC 0 Quantity

32. Firm’s short-run supply curve. If P > ATC, keep producing at a profit. If P > AVC, keep producing in the short run. If P < AVC, shut down. Production and Supply Curve Costs ATC AVC 0 Quantity

33. The Response of a Firm to a Change in Product Price When the price of a firm’s product changes, the firm changes its output level, so that the marginal cost of production remains equal to the price.

34. S MC1 MC2 MC3 P2 P1 15 21 Industry Supply in the Short Run The short-run industry supply curve is the horizontal summation of the supply curves of the firms. $ per unit Quantity 0 2 4 5 7 8 10

35. Costs and Revenue Output in the Long Run In the long run all costs are variable MC ATC=AVC 0 Quantity

36. The Firm’s Long-Run Decision to Exit or Enter a Market In the long-run, the firm exits if the revenue it would get from producing is less than its total cost. Exit if TR < TC Exit if TR/Q < TC/Q Exit if P < ATC

37. The Firm’s Long-Run Decision to Exit or Enter a Market A firm will enter the industry if such an action would be profitable. Enter if TR > TC Enter if TR/Q > TC/Q Enter if P > ATC

38. The portion of MC above ATC is the firm’s long-run supply curve Firm enters if P > ATC Firm exits if P < ATC The Competitive Firm’s Long-Run Supply Curve Costs MC ATC 0 Quantity

39. The Firm’s Short-Run vs. Long-Run Supply Curves • Short-Run Supply Curve • The portion of its marginal cost curve that lies above average variable cost. • Long-Run Supply Curve • The marginal cost curve above the minimum point of its average total cost curve.

40. Profit ATC Q Long-Run Profit of the Competitive Firm Price MC ATC P P = AR = MR 0 Quantity Profit-maximizing quantity

41. ATC Loss Long-Run Loss of the Competitive Firm Price MC ATC P P = AR = MR 0 Quantity Q Loss-minimizing quantity

42. The Long Run: Market Supply with Entry and Exit • Firms will enter or exit the market until profit is driven to zero. • In the long run, price equals the minimum of average total cost. • The long-run market supply curve is horizontal at this price if the input prices remains constant, but it will be upward sloping if the input prices rises.

43. S1 LMC P1 LAC S2 $30 P2 D Q1 Q2 Long-Run Competitive Equilibrium Profit attracts firms, and supply increases until profit = 0 $ per unit of output $ per unit of output Firm Industry $40 q2 Output Output

44. Economic profits attract new firms. Long-run supply curve S1 S2 MC AC C P2 P2 A B SL P1 P1 D1 D2 q1 q2 Q1 Q2 Long-Run Supply in aConstant-Cost Industry $ per unit of output $ per unit of output Output Output

45. Due to the increase in input prices, long-run equilibrium occurs at a higher price. S1 S2 SMC1 LAC2 SMC2 SL P2 LAC1 P2 P3 B P3 A P1 P1 D1 D1 q1 q2 Q1 Q2 Q3 Long-Run Supply in anIncreasing-Cost Industry $ per unit of output $ per unit of output Output Output

46. The Long Run: Market Supply with Entry and Exit • At the end of the process of entry and exit, firms that remain must be making zero economic profit. • The process of entry & exit ends only when price and average total cost are driven to equality. • Long-run equilibrium must have firms operating at their efficient scale.

47. Firms Stay in Business with Zero Profit • Profit equals total revenue minus total cost. • Total cost includes all the opportunity costs of the firm. • In the zero-profit equilibrium, the firm’s revenue compensates the owners for the time and money they expend to keep the business going.

48. Costs and Revenue Producer Surplus P P = AR = MR QMAX Producer Surplus MC ATC 0 Quantity

49. Price of Steel Price after trade World price Price before trade Exports Domestic quantity demanded Domestic quantity supplied Producer Surplus in an Exporting Country Domestic supply Domestic demand 0 Quantity of Steel

50. Price of Steel Producer Surplus in an Exporting Country Domestic supply A Exports Price after trade World price D B Price before trade C Domestic demand 0 Quantity of Steel