n What’s New in this Edition?
Chapter 15 is an updated version of Chapter14 in the fifth edition.
n Where We Are
In this chapter, we examine theprofit-maximizing decisions made by a perfectly competitive firm in the shortrun and the long run. To do so, we use the groundwork on firms’ costs laid inthe previous chapter.
n Where We’ve Been
In Chapter 15 we use the foundation builtin Chapter 14, which studied firms’ production and costs. The cost materialcovered in Chapter 14 remains important also in Chapters 16, 17, and 18.
n Where We’re Going
After thischapter, we continue studying firms’ behavior by looking at the demand andmarginal revenue curves for monopolies, oligopolies and monopolisticallycompetitive firms. We will see operating decisions faced by these firms and wecan compare them with those made by perfectly competitive firms.
IN THECLASSROOM
nClass Time Needed
This chapter is very important. Perfectcompetition is the standard against which other industries are compared, so donot rush through this material. You should plan on spending at least two and ahalf class sessions and possibly even three.
Anestimate of the time per checkpoint is:
· 11.1 A Firm’s Profit-MaximizingChoices—60 to 80 minutes
· 11.2 Output, Price, and Profitin the Short Run—30 to 50 minutes
·
Classroom Activity: For Chapters 15, 16, 17, and 18 with your guidance your studentscan create a chart similar to the one below. For each market structure, haveyour students suggest real-world examples of industries that fit the marketstructure, tell how prices are set, what problems and what benefits theconsumer and producer face in each market structure, and what role thegovernment might play in each market structure. You also can add othertopics—is there an economic profit in the long run?; can the firm pricediscriminate?; are there barriers to entry?; is there product differentiation?;and so forth. The information can by put on the course web site, or assembledfor a handout to be given at the end of presentation of Chapter 18.
| Perfect |
| Monopolistic |
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| Examples | ||||
| Setting price | ||||
| Consumer advantages | ||||
| Consumer drawbacks | ||||
| Producer advantages | ||||
| Producer drawbacks | ||||
| Role of government |
CHAPTER LECTURE
n 11.1 A Firm’s Profit-Maximizing Choices
Lecture Launcher: Begin by drawing aspectrum of market types noting the four market structures to be studied inthis and the next chapters. Let your students know that you will be comparinghow a firm in each of these marketstructures chooses its equilibrium price and equilibrium quantity. Putting thisdiagram on the board provides a good foundation for the following chapters.
Perfectcompetitionexists when
Many firms sell identical products to many buyers
There are no restrictions on entry into the industry
Established firms have no advantage over existing ones
Sellers and buyers are well informed about prices
Lecture Launcher: Once you discuss the characteristics that define perfectcompetition (many firms selling an identical product to many buyers, norestrictions on entry, established firms have no cost advantage over new firms,and sellers and buyers are well informed about prices) it is natural to giveexamples of perfectly competitive markets. The examples that always spring to mind are agriculturalin nature. Often students, particularly those in urban areas, wonder why theywill spend so much of their time studying agriculture. You need to combat thenatural view that the model of perfect competition applies only to farms. Thereare two, complementary paths you can take:
First,tell your students that although agriculture certainly meets all therequirements of perfect competition, a lot of other industries come close. Ifthey live in an area with plenty of gas stations, the market for gasoline maybe close to perfect competition – each station is selling virtually identicalproduct in close proximity to competitors, which forces each station to be aprice taker. If you have a mall near by, you can assign your students to walkthrough the mall and take note of the different types of businesses and listthose that they think are closest to perfect competition. Businesses such asshoe stores, jewelry, toy stores, book stores, hair salons, and so forth areall commonly found in malls and are all relatively close to being in perfectlycompetitive markets. For instance, you can point out to the students that onejewelry store’s products aren’t identical to those of any other jewelry store,but they are very close substitutes. So, although the jewelry market does notexactly meet the definition of a perfectly competitive market, nonetheless itis likely close enough so that if we want to understand the forces that affectfirms within this industry, perfect competition is a reasonable starting point.
Second, you can use a physical analogy.Ask your students how many of them have taken physics and encountered theassumption of a perfect vacuum. A perfect vacuum cannot exist and our world isnot close to being a perfect vacuum. Yet physicists often use the model of aperfect vacuum to understand our physical world. For example, to predict howlong it will take a 50 pound steel ball to hit the ground if it is dropped fromthe top of the Empire State Building,you will be very close to the actual time if you assume a perfect vacuum anduse the formula that applies in that case. Friction from the atmosphere isobviously not zero, but assuming it to be zero is not very misleading. Incontrast, if you want to predict how long it will take a feather to make thesame trip, you need a fancier model! Economists use the model of “perfectcompetition” in a similar way to understand our economic world. Emphasize tostudents that although no real world industry meets the full definition ofperfect competition, the behavior of firms in many real world industries andthe resulting dynamics of their market prices and quantities can be predictedto a high degree of accuracy by using the model of perfect competition.
Other market types are:
Monopoly, a market for a good or service that has no close substitutes and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms.
Monopolistic competition, a market in which a large number of firms compete by making similar but slightly different products.
Oligopoly, a market in which a small number of firms compete.
Have the students consider the markets forgoods for which they are familiar to see if any meet the strict criteria forperfect competition. The markets that come closest are agricultural markets,though others such as lawn service, laundromats, fishing, plumbing, and so on,come close. Students sometimes “worry” that these markets are not exactexamples of perfect competition. Reassure them that the model of perfectcompetition gives us a great deal of understanding into the workings ofextremely competitive real world markets and the real world firms in the markets.
A firm’s objective is to maximize economic profit, which is the difference between total revenue (the price of the firm’s output multiplied by the quantity sold) and its total cost of production. Part of the total cost is the normal profit.
qLandMine: Every term you probably have students who ask, “Dofirms really choose the output that maximizes profit?” To answer this question,perhaps before it is asked, it is useful to explain to your students that many big firms routinely maketables using spreadsheets of total revenue, total cost, and economic profit.But most firms, and certainly most small firms, don’t make such calculations.Nonetheless, they do make their decisions at the margin. They can figure outhow much it will cost to hire one more worker and how much output that workerwill produce. So they can figure out their marginal cost—wage rate divided bymarginal product. They can compare that number with the price. They arechoosing at the margin as our model of perfect competition assumes.
Price Taker
Perfectly competitive firms are price takers, a firm that cannot influence the market price and so it sets its own price equal to the market price.
qLand Mine: Show what ismeant by the term “price taker” by drawing the market supply and market demand curves and the resultingequilibrium price on the left side of the board and then draw the firm’s demand and marginal revenuecurves on a separate graph to the right of the first figure. Draw a dotted lineacross from the market graph to the firm graph. Really emphasize the fact thatthe market demand differs from the firm’s demand because the firm is such asmall part of the market. Students consistently confuse the difference betweenthe market demand and the firm’s demand, so the more time you spend clearlyexplaining this distinction, the better.
Revenue Concepts
Because the firm is a price taker, its marginal revenue—which is the change in total revenue that results in a one-unit increase in the quantity sold—is equal to the market price and remains constant as output sold increases. The firm’s demand is perfectly elastic and the firm’s demand curve is a horizontal line at the market price.
Profit-MaximizingOutput
The firm produces the quantity of output for which the difference between total revenue and total cost is at its maximum because this difference is its economic profit.
· Marginalanalysis can be used to determine the profit maximizing quantity. The firm comparesthe marginal revenue(which remains constant with output) to the marginal cost (which changes with output) of producing different levels ofoutput.
· When MR > MC, thenthe extra revenue from selling one more unit exceeds the extra cost ofproducing one more unit, so the firm increasesits output to increase its profit.
· WhenMR < MC, then the extra cost of producing one more unit exceeds the extrarevenue from selling one more unit, so the firm decreases its output to increase its profits.
· WhenMR = MC, then the extra cost of producing one more unit equals the extrarevenue from selling one more unit, so the firm’s profit is maximized at thislevel of output. In the figure, the firm maximizes its profit by producing q.
Marginal Analysis and the Supply Decision
As output rises, MR is constant, but MC eventually increases. If MR exceeds MC, increasing output leads to increasing economic profit. But when MC is greater than MR, a decrease in economic profit will result from selling additional output.
Temporary Shutdown Decision:
Inthe event that market prices fall so low that a firm cannot cover its costs,the firm must consider its options. These depend upon expectations of the durationof low prices.
Loss When Shut Down: If the firm stops production temporarily, it earns no revenue but there are no variable costs. Fixed costs constitute the only losses so the total economic loss equals the fixed cost.
Loss When Producing: If the firm carries on producing, it incurs both fixed and variable costs while gaining some revenue. The economic loss is revenue minus the sum of total fixed cost plus total variable cost. If total revenue is greater than total variable cost, the firm’s total economic loss is less than its fixed costs, so the firm stays open. But where total revenue is less than total variable costs, the firm’s economic losses exceed total fixed costs so the firm closes.
qLandMine:Students can have ahard time understanding why operating at an economic loss can be the bestaction. I use a story to help them see this point, Wally’s Wiener World hot dogcart. Wally has four costs: his variable costs for his hot dogs, buns, andmustard and his fixed cost for the interest he pays for the loan he used to buyhis cart. (If you choose, you can make up numbers for each of these costs.)When price is greater than average variable cost, P>AVC, Wally can pay for his hot dogs, buns, and mustard, andpart of the interest cost, his fixed cost. I show that because he can pay partof his fixed cost, he should stay open. But if P < AVC, Wally can’t even pay for all the dogs, buns, andmustard, much less pay for the interest on his loan. In this circumstance,Wally is better off by shutting down.
The Shutdown Point:
· Iftotal revenue is less than variable costs, then P > AVC. In this case, the firm shuts down temporarily, thuslimiting its losses to total fixed costs.
· Iftotal revenue equals variable costs, then P= AVC. In this case, the firm is indifferent between shutting downtemporarily or carrying on, because in either case the economic loss will equalfixed costs.
qLandMine: Explainingwhether a firm exits, temporarily shuts down, or produces even though it has aneconomic loss is difficult because the last two topics are tough for thestudents to understand. Exit is the easiest for them to understand because theyhave seen firms fail throughout their life. But, temporary shutdown is harderto explain. You can help them with the intuition by pointing out that therationale for temporary shutdown isn’t confined to perfect competition and thatthey can see the phenomenon right around the corner. Many restaurants close onSunday evening and Monday. Many hairdressers close on Sunday and Monday. Amusementparks significantly cut back on the days and hours they are open during the winter.Ski resorts don’t stay open during the summer. Why? Your students will easilyfigure out that total revenue is less than total variable cost and equivalentlythat price is less than average variable cost. The mechanics of the shutdown analysis will be a lot easier to explainonce the students have thought about these real situations with which they arefamiliar.
The Firm’sShort-Run Supply Curve
The firm will temporarily shut down in the short run when price falls below the price that just allows it to cover its total variable cost. The minimum AVC is the lowest price at which the firm will operate because if it operated with a lower price, the firm’s loss would be greater than if it shut down. The loss when the firm shuts down is equal to its fixed cost.
As long as the firm remains open, it produces where MR = MC. So the firm’s supply curve is its MC curve above the minimum AVC. At prices below the minimum AVC, the firm shuts down and supplies zero.
qLandMine: You always will have students asking why thefirm bothers to produce the precise unit of output for which MR = MC. Indeed, it is simply amazinghow many students “worry” about this one particular unit of output! Try thefollowing: Draw the conventional upward-sloping MC curve and horizontal MRcurve. Make sure to draw these so that the firm will produce a good deal ofoutput. Then, starting at 0, move a bit to the right along the horizontal axisand stop at a point. Tell the students that this point measures 1 unit ofoutput and ask them if this unit should be produced. The answer ought to beyes, because you have arranged matters so MR> MC. Pick some numbers—say, MR= $10 and MC = $1. Ask your studentswhat the profit is for this unit and what the firm’s total profit is if itproduces only 1 unit. The answers are $9 and $9. Below the x-axis, label two rows, one called “profit on the unit” and theother “total profit.” Put $9 and $9 in each space under your 1 unit of output.Then move your finger a bit more along the horizontal axis until you come towhere you will define the second unit of output. Ask your students if thissecond unit should be produced. Again, the answer ought to be yes, because youhave arranged matters so MR > MC.Pick another number for MC, say $2.Ask your students what the profit is on this unit and what the firm’s totalprofit is if it produces 2 units. The answers are $8 and $17. Stress that the total profit is what intereststhe firm and the total profit equals the sum of the profit from the first unit plus the profit from the second unit.Pick a couple of more units and use numbers until you fell it is safe togeneralize that the firm produces a unit of output as long as MR > MC. Then, slide your finger tothe right, stopping at closer and closer intervals, asking the class if thatparticular unit should be produced. Always stress that the firm’s total profitcontinues to increase, albeit more and more slowly. As you get closer to themagical MR-equal-to-MC point, make your stopping intervalseven closer. Finally, when you reach MR =MC, tell the students that although this specific unit yields no profit, tohave stopped anywhere before it meansthat the firm would have lost some profit. So, only by producing where MR = MC will the firm obtain the maximumtotal profit.
Monday is typically the slowestday in the restaurant industry. So why do most restaurants stay open on Monday?The answer is that even if a restaurant incurs an economic loss on Monday, itstill might increase its total profit by remaining open. The point is that aslong as the restaurant can cover all its variable costs—the cost of the food,the cost of the servers, and so on—it likely will be able to pay some of itsfixed costs using the revenue left over after paying its variable costs. Aslong as the restaurant can pay some of its fixed costs on Monday, its totalprofit by staying open exceeds what its total profit would be if it closed. Solosing money on Monday might be good business!
