Perfect Competition Review for AP Economics (page 3)

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Updated on Mar 2, 2011

Decision to Shut Down

Firms obviously do not enjoy producing at a loss and desperately hope that the market price improves so that profits are possible. However, if firms are incurring losses, they must decide whether it is economically rational to operate at all. The decision to shut down, or produce zero, in the short run is sometimes the optimal strategy. To see why, consider what happens when a firm begins to produce. When a perfectly competitive firm decides to produce any level of output greater than zero, two things happen.

  1. It collects total revenue (TR) = P × qe, and
  2. It incurs variable costs (TVC). Of course the firm also incurs total fixed costs, but it incurs those costs anyway, regardless of the level of output.

If the firm, by producing in the short run, can collect total revenues that at least exceed the total variable costs, then it continues to produce, even at a loss. However, if producing output incurs more variable cost than revenue collected, why bother? Shut down, hope for better times, and suffer losses equal to TFC. This comparison provides us a decision rule for shutting down in the short run.

  • If TR ≥ TVC, the firm produces qe where MR = MC.
  • If TR < TVC, the firm shuts down and q = 0.

The Shutdown Point

We can see the shutdown point in Figure 9.5 by converting the above decision rule into a per unit comparison. Dividing total revenue and total variable cost by qtells us to shut down if P< AVC. This is the identical decision rule; it is just a per unit comparison of revenue and variable cost.

  • If P ≥ AVC, the firm produces qe where MR = MC.
  • If P< AVC, the firm shuts down and q = 0.

In Figure 9.5, there are four prices shown.

  • PH is the highest price. At qh, the firm earns enough total revenue to cover all costs. Π > 0.
  • PM is the middle price. At qm, the firm's TR exceeds TVC but only covers part of the TFC. Π < 0.
  • PD is the shutdown price. At qd, the firm's TR just covers TVC and the firm is at the shutdown point. If price falls any lower, the firm does not produce.
  • PL is the lowest price. At q1, the firm's TR cannot even cover TVC and so the firm shuts down, producing q= 0. Π = –TFC.

Perfect Competition

Short-Run Supply

As you can see in Figure 9.5, when the price fluctuates between PH and PD, the firm finds a new profit maximizing quantity where P = MR = MC. If price increases, quantity supplied increases. If price decreases, quantity supplied decreases. This is a restatement of the Law of Supply. This movement upward and downward along the marginal cost curve implies that MC serves as the supply curve for the perfectly competitive firm. The only exception is when the price falls below the shutdown point (minimum of AVC) and the firm quickly decides to produce nothing. The market supply curve is simply the summation of all firms' MC curves.

  • The MC curve above the shutdown point serves as the supply curve for each perfectly competitive firm.
  • The market supply curve is therefore the sum of all of the MC curves. S = Σ MC.

Long-Run Adjustment

The short run is a period of time too brief for firms to change the size of their plants. This means that it is also too short for existing firms to exit the industry in bad times and too short for new entrepreneurs to enter the industry in good times. The "free entry and exit" characteristic of perfect competition assures us that in the long run, we can expect to see firms either exiting or entering, depending upon whether profits or losses are being made in the short run. We'll first examine the case where short-run positive profits are made in the carrot industry and then the situation where short-run losses are incurred.

  • In virtually all of the past AP Microeconomics exams, free-response questions have appeared that test the students' knowledge of perfect competition and the difference between the short- and long-run equilibria.

Short-Run Positive Profits

Figure 9.6 illustrates the perfectly competitive carrot industry where the market price is above average total cost. Firms are earning positive short-run profits, as illustrated by the shaded rectangle.

Perfect Competition

So what next? Well many entrepreneurs on the outside of this market are attracted by the positive short-run profits being made by carrot producers. Given sufficient time (i.e., the long run), these new firms enter the market. With more carrot producers, the market supply curve shifts outward, driving down the price. As the price falls, the profit rectangle gets smaller and smaller until it actually disappears. At the point where P= MR = MC = ATC each carrot farmer is now breaking even with Π = 0. Would the next potential carrot farmer enter the market? Unlikely, as the entry of one more firm pushes the price down just enough to where losses are actually incurred. Thus this break-even point is described as the long-run equilibrium. The market quantity has increased and each firm produces less at the lower price. Figure 9.7 illustrates the movement toward the long-run equilibrium.

The long-run adjustment to short-run positive profits can be summarized as:

Perfect Competition

What's So Great About Breaking Even?

Remember there is a distinction between accounting profit and economic profit. Economic profit subtracts the next best opportunity costs of your resources from total revenue. If you are still breaking even after subtracting what you might have earned in all of those other opportunities, you can't feel cheated. In other words, you are making a fair rate of return on your invested resources and you have no incentive to take them elsewhere. Sure, you would like to earn more than zero economic profit (a.k.a. "normal profit") but the characteristics of perfect competition rule this out.

Short-Run Losses

Figure 9.8 illustrates short-run losses with a price below ATC but above the shutdown point. The long-run adjustment story might sound familiar, only with market forces moving in the opposite direction.

Perfect Competition

Again, we should ask "What next?" Some existing firms in this market begin to exit the industry. With fewer carrot producers, the market supply curve shifts inward, driving up the price. As the price rises, the loss rectangle gets smaller and smaller until again it disappears. At the point where PLR = MR = MC = ATC each remaining carrot farmer is now breaking even with Π = 0. Would another carrot farmer exit the market? Possibly, but the exit of one more firm bumps up the price just enough so that a small positive profit is earned, prompting one firm to enter and get us back to the break-even point. Arrival at the break-even point is once again the long-run equilibrium. The market quantity has decreased, but each surviving firm produces more at the higher price. Figure 9.9 illustrates the movement toward the long-run equilibrium.

The long-run adjustment to short-run losses can be summarized as:

Perfect Competition

Summarizing in Table 9.5, there are four possible short-run scenarios and resulting long-run adjustments to the perfectly competitive equilibrium, which always ends in the same place.

Are There Variations on This Story and Do I Need to Know Them?

Yes and maybe. Throughout this section we have made an assumption that entry and exit of firms has no impact on the cost curves of firms in the market. In other words, we have been assuming a constant cost industry. Recent AP Microeconomics exams have made references to constant cost industries and (maybe) caused unnecessary confusion for test takers. It is always possible that future exams will refer to constant, increasing or decreasing cost industries so you should probably become familiar with these terms. A quick explanation and you will not be one of the confused.

Suppose that entry of new firms into a profitable carrot market increases the demand for key resources like land, labor, and capital. Increased demand for these resources might increase the cost of employing those resources. When this happens, the cost curves for firms in the carrot industry start to shift upward. This situation is described as an increasing cost industry. Graphing this situation gets sticky, but if you follow the logic you will be fine. The entry of new firms drives down the price of the output andincreases the cost curves so the profit is eliminated more quickly than with our constant cost industry. Fewer firms eventually enter this version of the carrot market and the new long-run price is higher than it is in a constant cost industry.

A decreasing cost industry is one in which the entry of new firms actually decreases the price of key inputs and causes the cost curves to shift downward. This might occur because producers of the key inputs expand production and experience economies of scale and lower per-unit costs. Since the entry of new firms lowers the price of the output and decreases the cost curves, it takes longer for the profit to be eliminated than in our constant cost industry. More firms can eventually enter this market and the new long-run price is lower than it would be in a constant cost industry.

Review questions for this study guide can be found at:

Market Structures, Perfect Competition, Monopoly, and Things Between Review Questions for AP Economics

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