Chapter 11 Firm Production under Idealized
Competitive Conditions
cost curve) than it receives in additional revenue (as indicated by the demand curve, which
beyond q
2
is below the MC curve).
At q
2
(and anywhere else), the firm’s profit equals total revenue minus total cost (TR
– TC). To find total revenue, we multiply the price, P
1
(which also equals average revenue)
by the quantity produced, q
2
(TR = P
1q2
). Graphically, total revenue is equal to the area of
the rectangle bounded by the price and quantity, or 0P
1aq2
.
Similarly, total cost can be found by multiplying the average total cost of production
(ATC) by the quantity produced. The ATC curve shows us that the average total cost of
producing q2 computer chips is ATC
1
. Therefore total cost is ATC
1q2
, or the rectangular area
bounded by 0ATC
1
bq
2
. The profits of the company are therefore P
1q2
– ATC
1
q
2
, which is the
same, mathematically, as q
2
(P
1
– ATC
1
). This quantity corresponds to the area representing
total revenue, OP
1
aq
2
, minus the area representing total cost, 0ATC
1
bq
2
. Profit is the shaded
rectangle bounded by ATC
1
P
1
ab.
FIGURE 11.5 The Profit-Maximizing Perfect Competitor
The perfect competitor’s demand curve is established by the market-clearing price [part (a)]. The
profit-maximizing perfect competitor will extend production up to the point where marginal cost
equals marginal revenue (price), or point a in part (b). At that output level—q2—the firm will earn a
short-run economic profit equal to the shaded area ATC
1
P
1ab
. If the perfect competitor were to
minimize average total cost, it would produce only q
1
, losing profits equal to the darker shaded area
dca in the process.
The perfect competitor does not seek to produce the quantity that results in the lowest
average total cost. That quantity, q
1
, is defined by the intersection of the marginal cost curve
and the average total cost curve. If it produced only q
1
, the firm would lose out on some of
its profits, shown by the darker shaded area dca. (Suppose the firm is producing at q
1
. If it
expands production to q
2
, it will generate P
1
times q
2
– q
1
in extra revenue (price times the
additional units sold), an amount represented graphically by the area q
1
daq
2
.)
Chapter 11 Firm Production under Idealized
Competitive Conditions
Naturally, profit-maximizing firms will attempt to minimize their costs of production.
That does not mean they will produce at the point of minimum average total cost. Instead,
the will try to employ the most efficient technology available and to minimize their payments
for resources. That is they will attempt to keep their cost curves as low as possible. But
given those curves, the firm will produce where MC = MR, not where ATC is at its lowest
level. Managers who cannot distinguish between those two objectives will probably operate
their businesses on a less profitable basis than they might—and will risk being run out of
business.
Minimizing Short-Run Losses
In the foregoing analysis the market-determined price was higher than the firm’s average
total cost, allowing it to make a profit. Perfect competitors are not guaranteed profits,
however. The market price may not be high enough for the firm to make a profit. Suppose,
for example, that the market price is P
1
, below the firm’s average total cost curve [see Figure
11.6). Should the firm still produce where marginal cost equals marginal revenue (price)?
The answer, for the short run, is yes. As long as the firm can cover its variable cost, it should
produce q
1
computer chips.
FIGURE 11.6 The Loss-Minimizing Perfect Competitor
The market-clearing price [part (a)] establishes the perfect competitor’s demand curve [part (b)]. Because the
price is below the average total cost curve, this firm is losing money. As long as the price is above the low
point of the average variable cost curve, however, the firm should minimize its short-run losses by continuing to
produce where marginal cost equals marginal revenue [price or point b in part (b)]. This perfect competitor
should produce q
1
units, incurring losses equal to the shaded area P
1
ATC
1
ab. (The alternative would be to shut
down, in which case the firm would lose all its fixed costs.)
It is true that the firm will lose money. Its total revenues are only P
1q1
, or the area
bounded y 0P
1
bq
1
, whereas its total costs are ATC
1
q
1
, or the area 0ATC
1
aq
1
, whereas its total
Chapter 11 Firm Production under Idealized
Competitive Conditions
costs are ATC
1
q
1
, or the area 0ATC
1
aq
1
. On the graph its total losses equal the difference
between those two rectangular areas, the shaded area bounded by P
1
ATC
1
ab. Whether the
firm incurs losses is not the relevant question, however. The real issue is whether the firm
loses more money by shutting down or by operating and producing q
1
chips.
In the short run, the firm will continue to incur fixed costs even if it shuts down. If it
is not earning any revenues, its losses will equal its total fixed costs. In the last chapter we
saw that the average fixed cost of production is the vertical distance between the average
variable cost and average total cost.
In short, as long as the price is higher than average variable cost—if the price more
than covers the cost associated directly with production—the firm minimizes its short-run
losses by producing where marginal cost equals marginal revenue. Only if the price dips
below the low point of the average variable cost curve—where the marginal and average
variable cost curves intersect—will the firm add to its losses by operating. The firm will shut
down when price is at or below that point, P
s
in Figure 11.6. At prices above that point, the
firm simply follows its marginal cost curve to determine its production level. Above the
average variable cost curve, then, the marginal cost curve is in effect the firm’s supply curve.
Therefore, if a perfect competitor produces at all, it produces in a range of increasing
marginal cost—and diminishing marginal returns.
Our analysis has shown why, in the short run, fixed costs should be ignored. The
relevant question is whether a given productive activity will add more to the firm’s revenues
than to its costs. Understanding this principle, businesses may undertake activities that
superficially appear to be quite unprofitable. Some grocery stores stay open all night, even
though the owners known they will attract few customers. If all costs, including fixed costs,
are considered, the decision to operate in the early morning hours may seem misguided. The
only relevant question facing the store manager is whether the additional sales generated are
greater than the additional cost of light, goods sold, and labor. Similarly, many businesses
that are obviously failing continue to operate, for by staying open they can at least cover a
portion of their fixed costs—such as rent—that would still be due if they shut down. They
stay open until their leases expire or until they can sell out.
Producing Over the Long Run
In the long run businesses have an opportunity to change their total fixed costs. If the market
price remains too low to permit profitable operation, a firm can eliminate its fixed costs, sell
its plant and equipment, or terminate its contracts for insurance and office space. If the
market price is above average total cost, new firms can enter the market, and existing firms
can expand their scale of operation. Such long-run adjustments in turn affect market supply,
which affects price and short-run production decisions.
Chapter 11 Firm Production under Idealized
Competitive Conditions
The Long-Run Effect of Short-Run Profits and Losses
When profits encourage new firms to enter an industry and existing firms to expand, the
result is an increase in market supply, a decrease in market price, and a decrease in the
profitability of individual firms. For example, in Figure 11.7(a), the existence of economic
profits in the computer chip market means that investors can earn more in that industry than
in some others. Some investors will move their resources to the computer chip industry.
Because the number of producers increases, the supply curve shifts outward, expanding total
production from Q
1
to Q
2
and depressing the market price from P
2
to P
1
.
The expansion of industry supply and the resulting reduction in market price make
the computer chip business less profitable for individual firms. The lower market price is
reflected in a downward shift of the firm’s horizontal demand curve, from d
1
to d
2
[see
Figure 11.7(b)]. The individual firm reduces it output from q
2
to q
1
, the intersection of the
new marginal revenue (price/demand) curve with the marginal cost curve. Note that q
1
is
also the low point of the average total cost curve. Here price equals average total cost,
meaning that economic profit is zero. The firm is making just enough to cover its
opportunity and risk costs, but no more.
Losses have the opposite effect on long-run industry supply. In the long run, firms
that are losing money will move out of the industry, because their resources can be employed
more profitably elsewhere. When firms drop out of the industry, supply contracts and total
FIGURE 11.7 The Long-Run Effects of Short-Run Profits
If perfect competitors are making short-run profits, other producers will enter the market, increasing the market
supply from S
1
to S
2
and lowering the market price, from P
2
to P
1
part (a). The individual firm’s demand curve,
which is determined by market price will shift down, from d
1
to d
2
[part (b)]. The firm will reduce its output
from q
2
to q
1
, the new intersection of marginal revenue (price) and marginal cost. Long-run equilibrium will be
achieved when the price falls to the low point of the firm’s average total cost curve, eliminating economic profit
[price P
1
in (b)].
Chapter 11 Firm Production under Idealized
Competitive Conditions
production falls, from Q
2
to Q
1
in Figure 11.8(a). As a result, the price of the product rises,
permitting some firms to break even and stay in the business. Long-run equilibrium occurs
when the price reaches P
2
, where the individual firm’s demand curve is tangent to the low
point of the average total cost curve [Figure 11.8(b)]. The output of each remaining
individual firm expands (from q
1
to q
2
) to take up the slack left by the firms that have
withdrawn. Again price and average total cost are equal, and economic profit is zero.
FIGURE 11.8 The Long-Run Effects of Short-Run Losses
If perfect competitors are suffering short-run losses, some firms will leave the industry causing the market
supply to shift back from S
1
to S
2
and the price to rise, from P
1
to P
2
part (a). The individual firm’s demand
curve will shift up with price, from d
1
to d
2
[part (b)]. The firm will expand from q
1
to q
2
, and equilibrium will
be reached when price equals the low point of average total cost P
2
, eliminating the firm’s short-run losses.
The Effect of Economies of Scale
In the long run, competition forces firms to take advantage of economies of scale, if they
exist. If expanding the use of resources reduces costs, the perfect competitor must expand.
Otherwise, other firms will expand their scale of operation, increasing market supply and
forcing the market price down. Any firm that does not expand its scale will be caught with a
cost structure that is higher than the market price. In addition to mere self-preservation, the
firm also has a profit incentive for expansion. If it expands before other firms, its lower
average total cost will allow it to make greater profits for a short period of time.
Consider Figure 11.9, for instance. Initially the market is in short-run equilibrium at
a price of P
2
[part (a)]. The individual firm is on cost scale ATC
1
, producing q
1
chips and
breaking even [part (b)]. If the firm expands its scale of operation and produces where its
demand curve d
1
intersects the long-run marginal cost curve, it will make a profit equal
graphically to the shaded area ATC
1
P
2
ab. That is the firm’s incentive for expansion.
Chapter 11 Firm Production under Idealized
Competitive Conditions
FIGURE 11.9 The Long-Run Effects of Economies of Scale
If the market is in equilibrium at price P
1
in part (a). and the individual firm is producing q
1
units on short-run
average total cost curve ATC
1
[part (b)], firms will be just breaking even. Because of the profit potential
represented by the shaded area ATC
1
P
2
ab, firms can be expected to expand production to q
3
, where the long-run
marginal cost curve intersects the demand curve (d
1
). As they expand production to take advantage of
economies of scale, however, supply will expand from S
1
to S
2
in part (a), pushing the market price down
toward P
1
, the low point of the long-run average total cost curve (LRAC). Economic profit will fall to zero.
Because of rising diseconomies of scale, firms will not expand further.
If the firm does not expand and take advantage of these economies, some other firm
surely will. Then any firm still producing on scale ATC
1
will lose money. For when the
market supply expands the price will tumble toward P
1
, the point at which the long-run
average total cost curve (and the short-run curve ATC
m
) are at a minimum, and both industry
and firm profits are zero. Because of rising diseconomies of scale, firms will not be able to
expand further. Any firm that tries to produce on a smaller or larger scale—for example,
ATC
2
or ATC
3
will occur average total costs higher than the market price and will lose
money. Ultimately it will be driven out of the market or forced to expand or contract its
scale.
The Efficiency of Perfect Competition: A Critique
Our discussion of perfect competition has been highly theoretical. In real life, the
competitive market system is not as efficient as the analysis may suggest. Several aspects of
the competitive market deserve further comment from this perspective.
The Tendency Toward Equilibrium
Market forces are stabilizing: they tend to push the market toward one central point of
equilibrium. To that extent the market is predictable, and to that extent it contributes to
economic and social stability. In the real world price does not always move as smoothly
toward equilibrium as it appears to do in supply and demand models. The smooth, direct
Chapter 11 Firm Production under Idealized
Competitive Conditions
move to equilibrium may happen in markets where all participants, both buyers and sellers,
know exactly what everyone else is doing. Often, however, market participants have only
imperfect knowledge of what others are going to do, for one function of the market is to
generate the pricing and output information people need to interact with one another.
In a world of imperfect information, then, prices may not and probably will not move
directly toward equilibrium. Those who compete in the market will continually grope for the
“best” price, from their own individual perspectives. At times sellers will produce too little
and reap unusually high profits.
This process of groping toward equilibrium can be represented graphically by a
supply and demand “cobweb” [see Figure 11.10). Most producers must plan their production
at least several months ahead on the basis of prices received today or during the past
production period. Farmers, for instance, may plant for summer harvest on the basis of the
previous summer’s prices. Suppose farmers got price P
1
for a bushel of wheat last year.
Their planning supply curve, S, will encourage them to work for a harvest of only Q
1
bushels
this year. Given that limited output and the rather high demand at price P
1
, however, the
price farmers actually receive is P
4
. The price of P
4
in turn induces farmers to plan for a
much larger production level, Q
3
, the following year. The market will not clear for Q
3
bushels, however, until the price falls to P
2
. The next year farmers plan for a price of P
2
and
reduce their production to Q
2
—which causes the price to rise to P
3
. As you can see from the
graph, instead of moving in a straight line, the market moves toward the intersection of
supply and demand in a web-like pattern.
______________________________________
FIGURE 11.10 Supply and Demand Cobweb
Markets do not always move smoothly toward
equilibrium. If current production decisions are
based on past prices, price may adjust to supply
in the cobweb pattern shown here. Having
received price P
1
in the past, farmers will plan
to supply only Q
1
bushels of wheat. That
amount will not meet market demand, so the
price will rise to P
4
—inducing farmers to plan
for a harvest of Q
3
bushels. At price P
4
,
however, Q
3
bushels will not clear the market.
The price will fall to P
2
, encouraging farmers to
cut production back to Q
2
. Only after several
tries many farmers find the equilibrium price-
quantity combination.
Surpluses and Shortages
Some critics complain that the market system creates wasteful surpluses and shortages.
Although all resources are limited in quantity, a true market shortage can exist only if the
going price is below equilibrium. Thus shortages can be eliminated by a price increase.
Chapter 11 Firm Production under Idealized
Competitive Conditions
How much of an increase, theory alone cannot say. We do know, however, that market
forces, if allowed free play, will work to boost the price and eliminate the shortage. That
means, if course, that people of limited financial resources will be eliminated from the
market—an enduring concern that motivates many government efforts to legislate market
conditions.
Similarly, all surpluses exist because the going price is above equilibrium.
Competition will reduce the price, eliminating the surplus. In the process, of course, some
firms will be driver out of the market and into other, more productive activities. Others will
be unable to keep their employees working full-time. A frequent criticism of the market
system is that when this happens, workers have difficulty finding employment in other lines
of production. Part of the problem, however, is that labor contracts, community custom, or
minimum wage laws prevent wages from adjusting downward. If government controls
prices—that is, if prices are not permitted to respond to market conditions-—surpluses and
shortages will persist.
Marginal Benefit Versus Marginal Cost
Time lags, surpluses, and shortages notwithstanding, the competitive market can produce
efficient results in one important sense. That is that the marginal benefit of the last unit
produced equals its marginal cost (MB = MC). In Figure 11.11(a), for every computer chip
up to Q
1
, consumers are willing to pay a price (as indicated by the demand curve, D) greater
than its marginal cost (as indicated by the industry supply curve, S). The difference between
the price consumers are willing to pay—an objective indication of the product’s marginal
benefits—and the marginal cost of production is a kind of surplus, or net gain received from
the production of each unit. The net gain is composed of two surpluses, consumer surplus
and producer surplus. Consumer surplus is the difference between the total willingness of
consumers to pay for a good and the total amount actually spent. In Figure 11.11(a)
consumer surplus is the triangular area below the demand curve and above the dotted price
line, P
1
. Producer surplus is the difference between the minimum total revenue necessary
to induce producers to supply Q
1
units of output and the actual total revenue received from
selling that output. In Figure 11.11(a), producer surplus is the triangular area above the
supply curve and below the dotted price line, P
1
. By producing Q
1
units, the industry
exploits all potential gains from production, shown graphically by the shaded triangular area
in the figure. That net gain is brought about by the price that is charged, P
1
—a price that
induces individual firms to produce where the marginal cost of production equals the price,
which is also equal to consumers’ marginal benefit.
The marginal cost of production for each individual firm is also P
1
, a fact that results in the
production of Q
1
units at the minimum total cost. Parts (b) and (c) show the cost curves of
two firms, X and Y. In competitive equilibrium, firm X produces q
x
, units. Suppose that the
market output were distributed between the firms differently. Suppose, for example, that
firm X produced one computer chip less than q
x
. To maintain a constant market output of
Q
1
, firm Y (or some other firm) would then have to expand production by one unit. The
additional chip would force firm Y up its marginal cost curve. To Y, the marginal cost of the
additional chip is greater than P
1
, greater than X’s marginal cost to produce it. Competition
Chapter 11 Firm Production under Idealized
Competitive Conditions
forces firms to produce at a cost-effective output level and therefore minimizes the cost of
producing at any given level of output.
Perfectly competitive markets are attractive for another reason. In the long run,
competition forces each firm to produce at the low point of its average total cost curve.
Firms must either produce at that point, achieving whatever economies of scale are available,
or get out of the market, leaving production to some other firm that will minimize average
total cost.
_____________________________________________
FIGURE 11.11 The Efficiency of the Competitive
Market
Perfectly competitive markets are efficient in the sense
that they equate marginal benefit [shown by the demand
curve in part (a)] with marginal cost (shown by the
supply curve). At the market output level, Q
1
, the
marginal benefit of the last unit produced equals the
marginal cost of production. The gains generated by the
production of Q
1
units—that is , the difference between
cost and benefits—are shown by the shaded are in part
(a).
The perfectly competitive market is also efficient in
the sense that the marginal cost of production, P
1
, is the
same for all firms [parts (b) and (c)]. If firm X were to
produce fewer than its efficient number of units, q
x
, firm
Y would have to produce more than its efficient number,
q
y
, to meet market demand. Firm Y would be pushed up
its marginal cost curve, to the point where the cost of the
last unit exceeds its benefits. But competition forces the
two firms to produce to exactly the point where marginal
cost equals marginal benefit, thus minimizing the cost of
production.
Chapter 11 Firm Production under Idealized
Competitive Conditions
Critics stress, however, that supply is based only on the costs firms bear privately.
External costs like air, noise, and water pollution are not counted as part of the cost of
production. If the external costs of pollution were counted, the firm’s supply curve would be
lower, S
2
instead of S
1
in Figure 11.12. If producers and consumers had to pay all the costs
of production, only Q
1
units would be bought. In this sense, competition leads to
overproduction of Q
2
– Q
1
units. The cost of producing these Q
2
– Q
1
chips is the area under
the supply curve between Q
1
and Q
2
, Q
1
abQ
2
. The benefit to consumers is the area under the
demand curve, or the area Q
1
acQ
2
. The extent to which the cost of overproduction exceeds
the benefits to consumers is shown by the shaded triangular area abc.
_____________________________________________
FIGURE 11.12 Inefficiency Caused by External Costs
If external costs equal to the vertical distance bc are not
counted as costs of production, supply will be artificially
high at S
1
, and firms will overproduce by Q2 – Q
1
units.
The inefficiency, or welfare loss, form such
overproduction is shown by the shaded area abc, the
amount by which the total cost of producing Q
2
– Q
1
units (shown by curve S
2
) exceeds their total benefits
(shown by the demand curve).
Critics of the market system stress also that its cost efficiencies are achieved within a
specific distribution of resources of wealth, one that depends on the existing distribution of
property rights. The distribution of economic power inherent in these property rights, they
argue, has no particular ethical or moral significance.
Finally, critics of the market system argue that most real-world markets are not
perfectly competitive. Actual markets are not inhabited by numerous firms producing
standard commodities that can be easily duplicated by anyone who would like to enter the
market. Indeed, many markets are inhabited by a few large, powerful firms that do not take
price as a given. Many firms either are monopolies or possess a high degree of monopoly
power. Demanders and suppliers are rarely as well informed as the model suggests. The
model of perfect competition was never meant to represent all or even most markets. It is
merely one of several means economists use to think about markets and the consequences of
changes in market conditions and government policy.
Critics of the market system stress also that its cost efficiencies are achieved within a
specific distribution of resources or wealth, one that depends on the existing distribution of
property rights. The distribution of economic power inherent in these property rights, they
argue, has no particular ethical or moral significance.
. profit incentive for expansion. If it expands before other firms, its lower
average total cost will allow it to make greater profits for a short period. period. Farmers, for instance, may plant for summer harvest on the basis of the
previous summer’s prices. Suppose farmers got price P
1
for a bushel of