ECONOMICS
SECOND EDITION in MODULES
Paul Krugman | Robin Wells
with Margaret Ray and David Anderson
MODULE 23 (59)
Graphing Perfect Competition
Krugman/Wells
• How to evaluate a perfectly
competitive firm’s situation
using a graph
• How to determine a perfect
competitor’s profit or loss
• How a firm decides whether
to produce or shut down in
the short run
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Interpreting Perfect Competition
Graphs
• Total profit can be expressed in terms of profit per unit.
Profit = TR – TC
(
TR
Q
TC
Q
)
=
XQ
= (P-ATC) X Q
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Profitability and the Market Price
(a) Market Price = $18
Price, cost
of bushel
The farm is profitable because
price exceeds minimum average
total cost, the break-even price,
$14.
Total profit: 5 × $3.60 = $18.00
Minimum average
total cost
MC
E
$18
14.40
14
MR = P
ATC
Profit
Z
C
The vertical distance between E
and Z: farm’s per unit profit,
$18.00 − $14.40 = $3.60
Break
even
price
0
1
2
3
4
5
6
7
Quantity of tomatoes (bushels)
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Profitability and the Market Price
(b) Market Price = $10
The farm is unprofitable because the
price falls below the minimum
average total cost, $14.
Price, cost
of bushel
Minimum average
total cost
ATC
Y
$14.67
14
C
Loss
Break 10
even
price
0
MC
MR = P
A
1
2
3
4
5
6
7
Quantity of tomatoes (bushels)
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Interpreting Perfect Competition
Graphs
• The break-even price of a price-taking firm is the
market price at which it earns zero profits.
• Whenever market price exceeds minimum average
total cost, the producer is profitable.
• Whenever the market price equals minimum average
total cost, the producer breaks even.
• Whenever market price is less than minimum
average total cost, the producer is unprofitable.
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The Short-Run Individual
Supply Curve
Price, cost of
bushel
Short-run individual
supply curve
The short-run individual supply
curve shows how an individual
producer’s optimal output
quantity depends on the market
price, taking fixed cost as given.
MC
$18
16
14
12
Shut- 10
E
AVC
B
C
A
down
price
0
ATC
1
2
3 3.5 4
Minimum average
variable cost
5
A firm will cease
production in the
short run if the
market price falls
below the shutdown price,
which is equal to
minimum average
variable cost.
6
7
Quantity of tomatoes (bushels)
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The Shut-Down Price
• There are two cases to consider:
– When the market price is below the minimum
average variable cost.
– When the market price is greater than or equal to
the minimum average variable cost.
• The minimum average variable cost determines the
shut-down price.
• When price is greater than minimum average
variable cost, the firm should produce in the short
run.
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The Shut-Down Price
• The short-run individual supply curve shows how an
individual firm’s profit maximizing level of output
depends on the market price, taking fixed cost as given.
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Changing Fixed Cost
• In the long run, firms can acquire or get rid of fixed
inputs.
• In most perfectly competitive industries the set of
firms changes in the long run as firms enter or exit
the industry.
• Exit and entry lead to an important distinction
between the short-run supply curve and the long-run
supply curve.
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Summary of the Competitive Firm’s
Profitability and Production Conditions
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Prices Are Up… But So Are Costs
• In 2005, Congress passed the Energy Policy Act, that by the
year 2012, 7.5 billion gallons of alternative oil—mostly cornbased ethanol—be added to the American fuel supply.
• One farmer increased his corn acreage by 40% after demand
for corn increased which drove corn prices up. Even though
the price of corn increased, so did the raw materials needed
to grow the corn.
• Farmers will increase their corn acreage until the marginal
cost of producing corn is approximately equal to the market
price of corn—which shouldn’t come as a surprise because
corn production satisfies all the requirements of a perfectly
competitive industry.
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1. A firm is profitable if total revenue exceeds total cost or,
equivalently, if the market price exceeds its break-even
price—minimum average total cost. If market price exceeds
the break-even price, the firm is profitable; if it is less, the firm
is unprofitable; if it is equal, the firm breaks even. When
profitable, the firm’s per-unit profit is P − ATC; when
unprofitable, its per-unit loss is ATC − P.
2. Fixed cost is irrelevant to the firm’s optimal short-run
production decision, which depends on its shut-down price—
its minimum average variable cost—and the market price.
3. When the market price is equal to or exceeds the shut-down
price, the firm produces the output quantity where marginal
cost equals the market price.
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4. When the market price falls below the shut-down price, the
firm ceases production in the short run. This generates the
firm’s short-run individual supply curve.
5. Fixed cost matters over time. If the market price is below
minimum average total cost for an extended period of time,
firms will exit the industry in the long run. If above, existing
firms are profitable and new firms will enter the industry in
the long run.
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