Home Page Econ 2 Files Econ 2 Lecture Notes Lecture 21: Perfect Competition in the Long Run

|  Search

Economics 2

Lecture 21: Perfect Competition in the Long Run

the shutdown decision
firm's short-run supply curve
zero long run profits
consumer surplus
producer surplus
welfare effects of rent control

Printer Friendly Version

The Shutdown Decision

A perfectly competitive firm can generate profits or losses in the short run.

Should a firm earning an economic loss stay in business in the short run? In the short-run, certain costs, such as rent on land and equipment, must be paid whether or not any output is produced. These are the firm's fixed costs. When the firm is deciding whether or not to produce any output at all (the level of output is given by MR=P=MC), the firm looks only at its variable costs. The firm will produce if it can earn sufficient revenue to pay the variable costs.

• produce if TR > TVC (if P > AVC)
• shutdown if TR < TVC (if P < AVC)

Firm's Short-Run Supply Curve

Recall that a perfectly competitive firm in the short run will

• produce if TR > TVC (if P > AVC) and produce the quantity at which P = MR =MC
• shutdown if TR < TVC (if P < AVC)

The short-run supply curve of a perfectly competitive firm is the portion of its Marginal Cost curve above the Average Variable Cost curve.

Zero Long Run Profits

In the long-run, firms can enter and exit the industry. Economic profits will encourage firms to enter the industry. The increase in the number of sellers will increase supply and cause the market price to fall until the profits disappear. Firms will leave the industry when economic losses are being incurred. The decrease in the number of sellers decreases supply and causes the price to rise until the losses vanish. In the long run, firms in a perfectly competitive market earn zero economic profit. Also, in the long run, the price in a perfectly competitive market will equal the minimum of long-run average costs. Firms will be producing the good at the least cost. Therefore, perfect competition results in economic efficiency.

Consumer Surplus

Recall from chapter 6 that the demand curve measures the value an individual places on each unit of the good. The height of the demand curve shows the amount she is willing to pay for an additional unit of the good.

The consumer pays less than she would be willing to for the good. Consumer surplus is the difference between what a consumer is willing to pay and the market price of the good.

Producer Surplus

The height of the supply curve measures the cost of producing an additional unit of the good. This is the lowest price the firm is willing to accept for an additional unit of the product.

Producer surplus is the difference between the price firms would have been willing to accept and the price they actually receive. Graphically, producer surplus is the area above the supply curve below the market price.

Consumer surplus is the area below the demand curve above the market price. The sum of consumer surplus and producer surplus is the total surplus. When the total surplus increases, society is better off.

The total suplus is maximized at the market equilibrium quantity. Since a perfectly competitive market produces the market equilibrium quantity, perfect competition maximizes the sum of consumer and producer surplus.

Welfare Effects of Rent Control

We can use changes in consumer surplus and producer surplus to analyze how policy change affect welfare. When consumers surplus rises, consumers as a group are better off; if producers surplus falls, producers are worse off. Consumers surplus is the area under the demand curve above the market price while producers surplus is the area above the supply curve below the market price.

David A. Latzko Business and Economics Division Pennsylvania State University, York Campus office: 13 Main Classroom Building phone: (717) 771-4115 fax: (717) 771-4062 e-mail: web: www.yk.psu.edu/~dxl31