ECON F211

Principles of Economics
Module 3
Snapshot of topics covered till date:

Module1
Consumer Behavior
- how consumers make choices
- maximize utility subject to budget constraint
- focus was on the demand side of the output market

Module2
Producer Behavior
Minimize cost subject to a target level of output
Given production technology
A firm’s “behavior” (price, output) depends on

The type of industry it belongs to

-How many competitors are there
-How large are the competitors
-What is the extent of competition between the firms
Motivation question:

What would happen if your local grocery store raised the price of sugar by
50 %?

What would happen if your local power supply company raises the price of
electricity by 50 %?
Motivation: Competition and market structure

If your local grocery store raised the price of sugar by 50 %, it

is most likely to see a large drop in the amount of sugar sold.

Its customers would quickly switch to other grocery stores.

In contrast, if your local power supply firm raised the price of

electricity by 50 %, it would see only a small decrease in the revenue.

Consumers would be unlikely to find another power supplier.

The difference between the sugar market and the electricity market:
There are many grocery stores in the neighborhood,
but there is only one power supply firm

This difference in market structure shapes the pricing and

production decisions of the firms that operate in these markets
MAKET STRUCTURE
We focus on the benchmark case: Perfect competition

Perfect competition: features

An industry structure in which there are many firms and many
consumers

-Each very small relative to the industry,

-Each producing identical (homogeneous) products ,
-Each firm has little / no ability to influence market prices

-OPEC?
-Patented drug?
-Pepsi , coke?
Perfect competition: features contd.

Homogeneous products:
Undifferentiated products; products that are identical or indistinguishable
from one another.

Eg. Sugar sold at different grocery stores

Typical agricultural commodities

- rice produced by farmer 1 is identical as rice produced by farmer 2
Perfect competition: features contd.

In perfectly competitive industries, there is free entry and exit

-If existing firms are making profits, then ?

-If existing firms are making losses, then ?

Perfect competition: features contd.

In perfectly competitive industries, there is free entry and exit

-If existing firms are making profits, then ?

-new firms are likely to enter the market
-No barriers to entry

-If existing firms are making losses, then ?

-they have the option to exit the market
-No barriers to exit
Perfect competition: features contd.

Implication:
Firms in perfectly competitive markets do not make decision about price.

Each firm takes market price as “given”

Thus competitive firms are “price takers”

Given the availability of perfect substitutes, if any firm charges a price >
market price, then no quantity will be sold. Why?
THE MEANING OF COMPETITION

Perfectly competitive market

a market with many buyers and sellers trading identical products so that
each buyer and seller is a price taker

Conditions:
1. There are many buyers and many sellers in the market.
2. The goods offered by the various sellers are similar / homogenous

As a result of these conditions, the actions of any single buyer or seller

in the market have a negligible impact on the market price.

Each buyer and seller takes the market price as given.

 Summary: Features of Perfect competitive market

• There are many buyers and many sellers in the market.

• The goods offered by the various sellers are identical.
• There are no restrictions to entry into/ exit from the industry.
• Sellers and buyers are price takers
 Each firm’s output is a perfect substitute for the output of the other
firms
 Each firm faces horizontal demand curve at equilibrium market price
Short run
The period of time for which two conditions hold:
The firm is operating with fixed factor of production, and
firms can neither enter nor exit an industry.

• The short run is a planning period over which the managers of a firm
must consider one or more of their factors of production as fixed in
quantity.

• For example, a car manufacturer may regard its plant size (capacity) as a
fixed factor over the next 1 year.

• Other factors of production could be changed during the year, but the
plant size must be regarded as a constant
• When the quantity of a factor of production cannot be changed during a
particular period, it is called a fixed factor of production.

• For the car manufacturer, the plant is a fixed factor of production for at
least a year.

• Note: factor (s) of production whose quantity can be changed during a

particular period is called a variable factor of production
– Eg. labor
Long run

The planning period over which a firm can consider all factors of production
as variable is called the long run

1.That period of time for which there are no fixed factors of production , i.e.
all inputs become variable

2. New firms can enter and existing firms can exit the industry.

Car manufacturer may consider alternatives such as modifying the plant,

building a new plant, or selling the plant and even leaving the business
 Given Demand Faced by a Single Firm in a Perfectly Competitive Market
Question: Output decision of a profit maximizing firm?
A representative perfectly competitive
The Market firm

Price per Ton (Rs.)

Market Supply
Price per Ton (Rs.)

P*
P*

Market Demand

Tons of Rice (per year) Tons of Rice (per year)

– firm’s marginal revenue equals price
– the demand curve faced by the firm is horizontal at the market price.

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The Profit-Maximizing Level of Output of
a Perfectly Competitive Firm
If MR > MC,
- the revenue gained by increasing output by one unit
exceeds the cost incurred by doing so

- even though the difference between the two is getting smaller,

added output means added profit.
 The Profit-Maximizing Output of
a Perfectly Competitive Firm

If MR > MC, economic profit

increases if output increases.

If MR < MC, economic profit

decreases if output increases.

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 The Profit-Maximizing Output of
a Perfectly Competitive Firm

• Marginal Analysis and Supply Decision

– The firm can use marginal analysis to determine the profit-maximizing
output.

The profit-maximizing output level is the output level where

P* = MR = MC.

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 Output, Price, and Profit in the Short Run

• Profits and Losses in the Short Run

– To determine whether a firm is making an economic profit or incurring
an economic loss, we need to compare the firm’s ATC (average total
cost) at the profit-maximizing output with the market price.

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 What if a firm makes loss?

So far we have been analyzing the question: how much a competitive firm
will produce ?

In some circumstances, however, the firm will decide to shut down and
not produce anything at all !
 Firm’s short-run decision
to Shut Down

If a firm is making losses, 2 things are possible:

1) Shut down operations immediately
2) Continue to operate

A “shut down” refers to a short-run decision not to produce anything during a

specific period of time

The decision will be the one that minimizes the firm’s losses.

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• Distinguish between a temporary shutdown of a firm and the
permanent exit of a firm from the market.

Shut down refers to short run decision to produce q=0

Exit refers to a long-run decision to leave the market.

The short-run and long-run decisions differ because

- Firms cannot avoid fixed costs in the short run
- Thus, a firm that shuts down temporarily still has to pay its fixed costs
(eg. Rent)

Firm can avoid fixed costs in the long run

- a firm that exits the market saves both its fixed (none) and its variable
costs.
What determines a firm’s shut down decision?

Loss Comparison

Option: Shut down

– Economic profit = TR - TVC - TFC

= (P- AVC ) × q - TFC
– If the firm shuts down, q = 0
– But the firm still has to pay TFC

If the firm shuts down its profit = -TFC < 0

– So the firm incurs an economic loss equal to TFC

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Option: continue to operate

If the firm continues to produce, it earns both revenue and

incurs variable costs.
-What about fixed costs?
-What is profit =?

The decision on whether or not to produce depends solely on

whether revenue exceed variable costs
• The firm shuts down if the revenue from production is less than its
variable costs of production.

• Shut down if TR < TVC

• Equivalently, if P < AVC

• If price < average variable cost, the firm is better off by stopping
production
– A firm’s shutdown point is where AVC is at its minimum.

– It is also the point at which the MC curve crosses the AVC curve.

– The firm incurs a loss equal to TFC

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 The Profit-Maximizing Output of
a Perfectly Competitive Firm
– Minimum AVC is 17

– If the price is 17, the profit-

maximizing output is 7

– The firm incurs a loss equal

to the red rectangle.

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 The Profit-Maximizing Output of
a Perfectly Competitive Firm

– If the price is between 17

and 20.14, the firm
produces the quantity at
which marginal cost equals
price.

– The firm covers all its

variable cost and at least
part of its fixed cost.

– It incurs a loss that is less

than TFC.

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 The Profit-Maximizing Output of
a Perfectly Competitive Firm

• The Firm’s Supply Curve

– A perfectly competitive firm’s supply curve shows how the firm’s
profit-maximizing output varies as the market price varies, other
things remaining the same.

– Since the firm produces the output at which MR = MC = P, the firm’s

supply curve is linked to its marginal cost curve

– At a price below the shutdown point (AVCmin) the firm produces

nothing.

– The competitive firm’s short-run supply curve is the portion of its

marginal-cost curve that lies above average variable cost

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Supply curve of a perfectly
competitive firm
– If the price is 25, the firm
produces 9, the quantity at which
P = MR= MC.

– If the price is 31, the firm

produces 10, the quantity at
which P = MR= MC.

– firm’s short-run supply curve is

MC above the AVCmin

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 Output, Price, and Profit
in the Short Run

– In part (a) price equals average total cost and the firm makes zero
economic profit (breaks even).

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 Output, Price, and Profit
in the Short Run

– In part (b), price exceeds average total cost and the firm makes a
positive economic profit.

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 Output, Price, and Profit
in the Short Run

– In part (c) price is less than average total cost and the firm incurs an
economic loss—economic profit is negative.

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In short-run equilibrium, a firm has the following
possibilities:
economic profit (>0)
break even (=0)
incur an economic loss (<0)

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Exercise
Perfectly Competitive Market
Output, Price, and Profit in the Long Run

• Entry and Exit

– New firms enter an industry in which existing firms make economic
profit.

– Existing firms exit an industry in which they incur an economic loss.

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 FIRM’S DECISION TO EXIT OR ENTER A MARKET

Exit the market if profit < 0

– TR < TC
– P < ATC

– If the firm exits, it will earn no revenue, but now it can save total cost
of production.

Enter the market if such an action leads to profit > 0

– TR > TC
– P > ATC
• A Competitive firm’s long-run profit-maximizing strategy:

• If the firm is in the market, it produces quantity at which p= MR= MC.

• If the price is less than ATC at that quantity, the firm will exit the market.

• The competitive firm’s long-run supply curve is the portion of its

MC curve that lies above ATC
• Profit = (P - ATC).Q
2/24/2019
 Adjustment process in LR

• Consider the case where existing firms make positive profit

• Implication: new firms will enter the market (possible in LR)

• Entry will expand the number of firms

– Increase the quantity of the good supplied
– drive down prices and profits

How long will firms enter?

– As long as existing firms are still making profit

When will this adjustment process stop?

2/24/2019
 Output, Price, and Profit
in the Long Run
– When the market price is 25, firms in the market
are making positive economic profit.
 Output, Price, and Profit
in the Long Run
– New firms have incentive to enter the market.
– As new firms enter, the market supply increases
and the market price falls.
 Output, Price, and Profit
in the Long Run
– Firms enter as long as firms are making economic profits.
– In the long run, the market supply increases, the market price
falls
– firms eventually make zero economic profit.
 Adjustment process in LR
• Conversely, what if firms in the market are making losses?

• then some existing firms will exit the market

• Their exit will reduce the number of firms, decrease the quantity of the
good supplied
• and drive up prices and profits

• When will this adjustment process stop?

• At the end of this process of entry and exit, firms that remain in the
market must be making zero economic profit

2/24/2019
 Output, Price, and Profit
in the Long Run
Profit = (P - ATC). Q

Zero profit condition implies P = ATC

The process of entry and exit ends only when price

and average total cost are equal.

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Note:

Competitive firms produce so that P = MR = MC

Free entry and exit forces P = ATC

Implication: P = MC = ATC

MC = ATC occurs when the firm is operating at the minimum of ATC

2/24/2019
 Competitive firms earn zero profit in the long
run.

Why would competitive firms enter and stay in

business if they eventually make zero profit?

2/24/2019
Suppose a farmer had to invest 1 million to start a farm
He had to give up another job that would have paid him
30,000 a year.

Implication:
Interest foregone @ 5% = 50000
Wages foregone = 30000
Opportunity cost of money and time = 80000

In LR equilibrium,
Economic profit = Revenue – Explicit cost – Implicit cost =0
Accounting profit = Revenue – Explicit cost = Implicit cost = 80,000 >0

Thus revenue from farming compensates him for the opportunity costs
of time and money
2/24/2019