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Tutorial 9: Firms With No Market Power (cont.)

 

Choosing Output in the Long Run - The Role of Economic Profit

Before we get started, review a summary of the three steps taken by a firm as it analyzes the profitability of its current output level. These three steps are followed by any firm whose goal is to maximize economic profit, whether that firm has no market power, as is the case in this Tutorial, or considerable market power, as is the case in Tutorial 10.

As we discovered in Tutorial 9b, positive economic profit indicates that a firm's accounting profit exceeds its opportunity cost. How do you suppose other sellers with similar resources would respond to such news? After all, if these firms have similar resources and are not already producing this good, they are not earning an economic profit like this firm. The existence of economic profit lures them in to the market to produce, in this case, an identical product.

Similarly, negative economic profit (i.e., an economic loss) indicates that a firm's accounting profit falls short of its opportunity cost. We saw that such losses will, sooner or later (cæteris paribus), induce firms to shut down. The existence of economic losses lures firms out of the market for this product.

Economic profit thus plays a crucial role in free market capitalism. Resource owners respond to the existence of accounting profits in excess of opportunity cost by producing more of those goods. They respond to the existence of economic losses by producing less of those goods. No outside agency is needed to order firms in to or out of the market. They do so because it is in their self interest to produce more or less of the good.

Let's explore the impact of firms entering or leaving this perfectly competitive market.

 

Long-Run Competitive Equilibrium Top of page.

Remember that when we built this model, we made the simplifying assumption that the firms in this market all produced identical products and faced identical costs -- essentially they are clones. Figure 4 shows the model of a price-taking firm and we will use the model of this firm as representing all the firms in the market. As always, this firm chooses a profit-maximizing level of output of about 27.5 units per period, charging the market-set price of $150 per unit. Note that this firm is earning zero economic profits. (Do you know how the graph reveals this?)

 

Figure 4


Graph showing price-taking firm earning zero economic profit with an output such that price equals marginal cost.

 

Suppose market price falls to about $121 per unit. This firm will reduce its profit-maximizing level of output to about 21 units per period. Because of the drop in price, even though it is maximizing economic profit, the firm faces an economic loss in the short run as shown by the shaded rectangle in Figure 5 marked P(Q) < 0.

 

Figure 5


Graph showing a price-taking firm with economic losses at an output such that price equals marginal cost.

 

This economic loss indicates that the firm's accounting profit falls short of its opportunity cost. In the short run it may minimize it losses by staying open and praying for an increase in market price. But economic losses will, sooner or later (cæteris paribus), induce firms like this one to shut down. The existence of economic losses lures firms out of the market for this product. In the long run, with fewer sellers in the market, the market supply curve shifts to the left (remember the N in SP-PENT). This raises equilibrium price. As the price charged by the firm rises, so does its profit-maximizing output and, because ATC is falling here as q increases, economic losses diminish. This process continues until no firm in the industry is facing an economic loss. At that point price will have returned to $125 per unit, and this firm's output will have returned to about 27.5 units per period. Its economic profit will once again be zero.

The same sort of story can be told, in reverse, if price rises to about $175 per unit. (I'll leave the story telling to you in the Questions listed below.)

 

Now it's time to "do the thing".

Click on the following link to download the Competitive Product Market Workbook. Look over Questions 1 - 4. Answer those parts you are able with the information you learned in this part of Tutorial 9. You will answer the remaining parts of those questions after reading the last part of this Tutorial. 

Return here when you have finished.

Need help downloading the Excel file?

 

This is a good time to do, or review, GFE 20.

 

Now that we have looked at how a single firm is affected by changes in market price in the short run and in the long run, let's review the market side of things.