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0:00
[Music] Hello! I am Dr. William E. Schlosser, you know me as an Economist. You may also know me as an Ecologist. But more than anything, you are going to know me as an educator. I’m Dr. Bill and I welcome you to my classroom!
0:40
In recent years, the demand for healthier food has increased. Many people have begun buying organically grown fruits and vegetables at farmers' markets. Lured by higher profits, increasing numbers of farmers began participating in these markets. But the additional supply of produce has forced down prices and reduced profits. Many farmers have found that the profits they earn from selling in farmers' markets are no longer higher than what they earn by selling to supermarkets.
1:18
A perfectly competitive market meets the conditions of (1) many buyers and sellers, (2) all firms selling identical products, and (3) no barriers to new firms entering the market. Firms in perfectly competitive market are unable to affect the prices of the goods they sell and are unable earn economic profits in the long run.
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[Music] In the beginning, we grew just the typical things that I was going for the family—tomatoes, beans, and zucchini. I would watch what people were buying at the market and thing. That would be a good thing to grow. We start everything from seed. Generally, I would choose four or five different varieties.
2:20
If something didn’t sell well, I would eliminate it. My goal was to provide fresh produce and salad greens to the local community. When I first started, the first things I planted were spinach, lettuce, and different types of greens. I wanted to be in the market for providing salad greens. We do a lot of beets, but we also grow over 40 different crops in a given year. We’ve taken persimmons, garlic, and mushrooms to market.
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Two weeks ago, a couple bought persimmons—they weren’t that familiar with them.
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Last week, they brought us back a couple of pieces of persimmon pie! I grew chilies myself in my little garden in town—chilies and tomatoes. Anything you’d typically find in a house garden, I wanted to have more of. Eventually, I started getting seeds from various places. Friends would bring me seeds from their travels, and I started collecting more and more unusual varieties. Then I began swapping
3:34
seeds with growers in other countries. One thing was clear: I didn’t want to spend my days picking 100-foot-long rows of green beans. That just didn’t inspire me. Flowers inspired me—both aesthetically and economically. Flowers can be the most profitable crop per square foot on a small farm if they’re well grown and well marketed. Since we have a small farm, I needed it to be profitable while also appealing to me aesthetically. We price our products in several ways.
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We look at what similar products are selling for in local grocery stores and food co-ops. We also walk through the market to see what other farmers are charging. Sometimes, I’ll directly ask another vendor, What are you selling this for today? Our expenses are higher per item because we’re a small farm. Many of the customers at the farmers market understand this. Our food is also higher in nutrients because we feed our soil properly.
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They’re getting more nutrients per dollar, even if they’re getting less weight per dollar. At the beginning of the season, when there’s not much zucchini in the market, the price is a little higher. Time also plays a big role in pricing. For example, okra takes forever to pick, but you can generally charge a little more for it. My prices, I’d say, are more intuitive than scientific. It’s not as though I calculate every detail, like the exact cost to produce something and
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the labor involved. I go with what feels right, but I think my estimates are pretty close. Running this farm is very expensive. Our flower bouquets are usually the most expensive at any market, but I believe they’re worth it, and I think my customers believe that too. I pay my employees well, and it’s working. If it weren’t, I’d be forced to price lower and absorb the difference. But it is working—we rarely come home from the market with anything left. [Music]
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Farmer's Market produce is the ultimate example of a perfectly competitive marketplace. By definition these markets support the produce that grows locally, so the crops could be grown by the buyers but either they do not have the land and time to grow it themselves, they do not plan ahead, or they would rather exchange their money for the green products sold grown by others. As you listened to the sellers commenting about
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their strategies in the farmer's markets, you listened to how they deal with being price takers. In perfectly competitive markets, sellers take the floating price and only get variation because of service they add on.
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Through the next three chapters in class, we will explore Perfectly competitive markets, monopolistically competitive markets, and Monopolies and Oligopolies. The last two appear as different chapters in the textbook, but we will combine them together for discussions here.
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These market structures are easily recognizable, when you come loaded with the ability to recognize them. As consumers, we enter retail clothing stores without looking for monopolistically competitive retailers, but when you view them with this moniker you will understand their pricing and advertising strategies. You may start to look to your mobile phone provider with different market control understanding to discover how and when you will use aggressive negotiation
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techniques to get the best deal possible. We start with the perfectly competitive markets to consider how you can make bulk volume purchases to reduce their cost of sales and capture savings for the goods you buy.
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[Music]
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Prices in perfectly competitive markets are determined by the intersection of market demand and supply curves. Consumers and firms must accept the market price if they want to buy and sell in a competitive market. A price taker is a buyer or seller that is unable to affect the market price. Each buyer and seller in a perfectly competitive market is too small to affect the market price.
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A firm in a perfectly competitive market is selling exactly the same product as many other firms. This is the gallon of milk, the dozen eggs, or a bushel of wheat. Therefore, the seller can sell as much as it wants at the current market price, but it cannot sell anything at all if it raises the price even by 1 cent. As a result, the demand curve for a perfectly competitive firm's output is a horizontal line. Whether the wheat farmer sells 6,000 bushels
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per year or 15,000 bushels this has no effect on the market price of $7. The producer is a price taker. In a perfectly competitive market, price is determined by the intersection of market demand and market supply. In the left side panel, the demand and supply curves for wheat intersect at a price of $7 per bushel. An individual wheat farmer like Farmer Parker cannot affect the market price for wheat. Therefore, as the right side panel shows,
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the demand curve for Farmer Parker's wheat is a horizontal line. To understand this figure, it is important to notice that the scales on the horizontal axes in the two panels are very different. In the left side panel, the equilibrium quantity of wheat is 2.25 billion bushels, and in the right side panel, Farmer Parker is producing only 15,000 bushels of wheat.
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[Music]
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It is reasonable to assume that the objective of a producer is to maximize profit, which is equal to total revenue minus total cost. To maximize profit, a firm must produce that quantity of output where the difference between total revenue (TR) and total cost (TC) is as large as possible. Since producers have no control over price, it puts them in position to become the low-cost producer.
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Reduce your costs and you increase your profits. Right away you gain a perfect understanding of why farmers are so well known for building their large family farms with three generations all participating in the growing and harvest together to drive trucks, operate harvesters, record output, and make the family farm operation efficient. It is more economically efficient to pay family members to work the farm then to bring on others.
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A firm's average revenue (AR) is equal to total revenue divided by the quantity of the product sold. Average revenue is also equal to the market price. Marginal revenue (MR) is the change in total revenue from selling one more unit of a product. For a firm in a perfectly competitive market, price is equal to both average revenue and marginal revenue.
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We start here to really develop the principles of cost accounting to consider how price is both your average revenue and your marginal revenue. It means that when you sum your total revenue and divide it by the number of goods you sold, you get the price per unit. This is only true in perfect competition. Price does not change because you as a producer cannot affect price. You do not own enough of the total market to make an impact on it.
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Marginal revenue is the value you receive from selling the last unit, or the next unit of your produce. Since it does not change in the perfectly competitive marketplace, Marginal Revenue is your price, is your average revenue.
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You might be thinking that if price does not change, then the best way to make more money is to make more product! Sure, grow more apples, make your wheat heads bigger, engineer garlic heads with more cloves! Right away you realize that anything you do to increase your genetic production will cost money. As that marginal cost column climbs with increasing production levels, your ultimate profit decreases.
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Seek the profit-maximizing level of output. When combining Total Revenue and Total Cost, the sweet spot is where these come together for maximum profit.
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When I show you these simplified tables of only 10 rows the solution appears obvious.
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In reality you will be looking at dozens, or even hundreds of quantities of production scattered across many fields as you seek financially optimal production levels. The mathematical clincher is to find where Marginal Revenue is as close as possible to Marginal Cost. I say, as close as possible, because sometimes you cannot produce parts of a good, like half a beef steer, or half an egg:you need to be all in, or all out. Right here we sit on a critical part of this
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discussion to look closely at marginal cost. I want you to give close attention to how that column of numbers is calculated. It is the change in cost when producing the next unit of output. It is moving from producing 3 units to 4 units. Three cost $18.50 and 4 cost $21.00, the difference is $2.50 and THAT is your marginal cost of producing that one additional unit of the good. Repeat it for the entire column, a super-fast
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calculation in Excel, and you have a powerful decision making tool at your disposal. We will use that one again on a graph just two screen ahead.
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These cost curves of total revenue and total cost are really fairly realistic as we see low production at 1 bushel shows costs higher than revenue. And after 10 bushels, marginal costs are greater than marginal benefits so again the producer is out of profitability range. It is the area between these two lines showing a constant climb in marginal revenue with a variable cost curve indicating that sought after zone where profitability is maximized.
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Farmer Arnzen maximizes his profit where the vertical distance between total revenue and total cost is the largest, which occurs at an output of 7 bushels.
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I said we would come back to Marginal Revenue from Table 12.2 and here we are. I took that schedule and graphed it. Remember how marginal cost went from $4 at 1 unit and dropped to $2.50, then to $2.00 between 3 and 4 units. Marginal cost started a climb after that. Minimizing marginal cost is not really where optimality is found, this is the case where you need to spend more to make more. Farmer Arnzen's marginal revenue (MR) is equal to a constant $7 per bushel.
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Farmer Arnzen maximizes profit by producing wheat up to the point where the marginal revenue of the last bushel produced is equal to its marginal cost, or MR = MC. In this case, at no level of output does marginal revenue exactly equal to its marginal cost. The closest Farmer Arnzen can come is to produce 7 bushels of wheat. He will not want to continue to produce once marginal cost is greater than marginal revenue
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because that would reduce his profits. Both the previous graph and this graph show alternative ways of thinking about how Farmer Arnzen can determine the profit-maximizing quantity of wheat to produce. They give the same answer, and always will.
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The marginal revenue curve for a perfectly competitive firm is the same as its demand curve. As long as marginal revenue is greater than marginal cost, the firm's profits are increasing, and it will expand production. When marginal revenue is equal to marginal cost, the firm will make no additional profit by increasing production, so it will have maximized its profits. The profit-maximizing level of output is
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also where the difference between total revenue and total cost is greatest. Because price is equal to marginal revenue for a perfectly competitive firm, price equals marginal cost at the profit-maximizing level of output.
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[Music]
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Profit is expressed in terms of average total cost (ATC). Doing this will allow us to show profit on a cost curve graph. Because profit equals TR minus TC, and TR is price multiplied by quantity: Profit = (P x Q) - TC. If we divide both sides of this equation by Q, we have: Profit divided by quantity, equals price time quantity divided by quantity minus total cost divided by quantity. Or profit divided by quantity equals price minus average total cost.
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This equation tells us that profit per unit equals price minus average total cost. We obtain the expression for the relationship between total profit and average total cost by multiplying through by Q: Profit = (P - ATC) x Q. This confirms that a firm's total profit is equal to the quantity produced multiplied by the difference between price and average total cost.
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Graphically we bring them together right here. This is a figure you will revisit often in microeconomics as it shows basic concepts into the meaning of operational efficiency, and profits. Start with our perfectly elastic horizontal demand curve equal to our marginal revenue curve. Put up the marginal cost curve we just looked into. Next our average total cost curve arcs in. A firm maximizes profit at the level of output at which marginal revenue equals marginal cost.
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The difference between price and average total cost equals profit per unit of output. Total profit equals profit per unit multiplied by the number of units produced. Total profit is represented by the area of the green-shaded rectangle, which has a height equal to (P - ATC) and a width equal to Q. Boom! You have just found where profit is maximized, it was where marginal cost equaled marginal revenue and when you did that you found the quantity to produce, and even the
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profitability made by producing right here!
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Some folks who should know better will trip up by assuming production should happen where marginal cost equals average total cost. Your marginal cost is less than your marginal revenue at this level of production so you are leaving money on the table by not producing up to the profit maximizing level. It is not always possible to operate in a profitable level of production. It might be caused by short term market problems, unanticipated supply price shocks, or new
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competition with super-low production costs. You want to stay in business, maybe to sustain market share, so you seek the level of output where your loss is as small as possible. I faced this situation in 1997 when I was selling timber products in the Asian market, mainly to Japan and South Korea. The 1997 Asian financial crisis threatened all regional economies with economic meltdown. Timber log buyers lowered their prices as few
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were able to remain in business. We felt the crisis would recover within the year and we were prepared to stay in operation because shutdown and restart options carried high costs we did not want to bear. I sought the loss-minimizing level of output where marginal cost equaled marginal revenue. We were able to capture and maintain market share in the West Cost Japan delivered log market. Now, we can take a look at how this is seen.
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Here we can see where marginal revenue equals marginal cost, the point I am looking for! But, price also equals average total cost, and the firm breaks even because its total revenue will be equal to its total cost. In this situation, the firm makes zero economic profit. But, it is not loosing money either.
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Now see how price is below average total cost, and the firm experiences a loss. The loss is represented by the area of the red-shaded rectangle, which has a height equal to (ATC - P) and a width equal to Q. Do you see how the decision to produce where marginal revenue equals marginal cost is satisfied? It is the place to find your quantity of optimal production. It happened even though your average total cost is higher than marginal revenue.
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Profits are negative, but they are as small a negative number as could be achieved. This is where my logging operation was in late 1997 and early 1998. We reduced production by setting aside certain areas, building transportation infrastructure, and streamlining log sorting and handling operations. We also negotiated long-term price agreements with buyers so our market share would substantiate the losses we experienced.
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When the markets began recovery in 1998 we were able to float the competitive market prices upwards into profitable operations.
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Whether a firm makes a profit depends on the relationship of price to average total cost. There are three possibilities: (1) P > ATC, which means the firm makes a profit; (2) P = ATC, which means the firm breaks even; and (3) P < ATC, which means the firm experiences losses. [Music]
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In the short run, a firm suffering losses has only two choices: (1) Continue to produce or (2) stop production by shutting down temporarily. During a temporary shutdown, a firm must still pay its fixed costs. If by producing the firm would lose an amount greater than its fixed costs, it should shut down. In analyzing the firm's decision to shut down, we assume that its fixed costs are sunk costs. A sunk cost is a cost that has already
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been paid and cannot be recovered. The firm should treat its sunk costs as irrelevant to its decision making. One option the firm does not have is to raise its price. If a perfectly competitive firm raises its price, it would lose all its customers and sales would drop to zero.
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If the price the firm can charge drops below average variable cost, the firm will still have a smaller loss if it shuts down and produces no output. So, the firm's marginal cost curve is its supply curve for prices at or above average variable cost. Because the marginal cost curve intersects the average variable cost curve where the average cost curve is at its minimum point, the firm's
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supply curve is its marginal cost curve above the minimum point of the average variable cost curve. The shutdown point is the minimum point on a firm's average variable cost curve; if the price falls below this point, the firm shuts down production in the short run.
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Because price equals marginal revenue for a firm in a perfectly competitive market, the firm will produce where P = MC. For any given price, we can determine the quantity of output the firm will supply from the marginal cost curve, so the marginal cost curve is the firm's supply curve. But the firm will shut down if the price falls below average variable cost. This is the critical decision point to face. The marginal cost curve crosses the average
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variable cost at the firm's shutdown point at the output level QSD. For prices below PMIN, the supply curve is a vertical line, perfectly inelastic, along the price axis, which shows that the firm will supply zero output at those prices. The red line is the firm's short-run supply curve. I bring your attention back to the idea of the marginal cost curve for one producer. Of course, every producer has a marginal cost
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curve and when we make the market supply curve, we will combine these individual marginal cost curves by adding the quantity supplied by each producer at the market price level. The market supply curve in a perfectly competitive industry is determined by adding up the quantity supplied by each firm in the market at each price. We can derive the market supply curve by adding up the quantity that each firm in the market is willing to supply at each price.
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On the left side panel, one wheat farmer is willing to supply 15,000 bushels of wheat at a price of $7 per bushel. If every wheat farmer supplies the same amount of wheat at this price and if there are 150,000 wheat farmers, the total amount of wheat supplied at a price of $7 will equal 15,000 bushels per farmer * 150,000 farmers = 2.25 billion bushels of wheat. This amount is one point on the market supply curve for wheat shown on the right side panel.
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We can find the other points on the market supply curve by determining how much wheat each farmer is willing to supply at each price.
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[Music]
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Economic profit is equal to a firm's revenues minus all its costs, implicit and explicit. A firm is unlikely to earn an economic profit for very long. Other firms that are just breaking even have an incentive to enter the market so they can earn economic profits. The more firms there are in an industry, the further to the right is the market supply curve. Entry into the market will continue until all firms are just breaking even. Firms can suffer economic losses in the short run.
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An economic loss is the situation in which a firm's total revenue is less than its total cost, including all implicit costs. As long as price is above average variable cost, a firm suffering a loss will continue to produce in the short run. But in the long run, firms will exit an industry if they are unable to cover all their costs. Initially, Farmer Gillette and other farmers selling carrots in farmers' markets are able
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to charge $15 per box and earn an economic profit. Farmer Gillette's economic profit is represented by the area of the green box in panel (b). Panel (a) shows that as other firms begin to sell carrots in farmers' markets, the market supply curve shifts to the right, from S1 to S2, and the market price drops to $10 per box.
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Panel (b) shows that the falling price causes Farmer Gillette's demand curve to shift down from D1 to D2, and she reduces her output from 10,000 boxes to 8,000. At the new market price of $10 per box, carrot growers are just breaking even: Their total revenue is equal to their total cost, and their economic profit is zero.
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When the price of carrots is $10 per box, Farmer Gillette and other farmers are breaking even. A total quantity of 310,000 boxes is sold in the market. Farmer Gillette sells 8,000 boxes. Panel (a) shows a decline in the demand for carrots sold in farmers' markets from D1 to D2 that reduces the market price to $7 per box. Panel (b) shows that the falling price causes Farmer Gillette's demand curve to shift down from D1 to D2 and her output to
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fall from 8,000 to 5,000 boxes. At a market price of $7 per box, farmers have economic losses, represented by the area of the red box. As a result, some farmers will exit the market, which shifts the market supply curve to the left.
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Panel (c) shows that exit continues until the supply curve has shifted from S1 to S2 and the market price has risen from $7 back to $10. Panel (d) shows that with the price back at $10, Farmer Gillette will break even. In the new market equilibrium in panel (c), total sales of carrots in farmers' markets have fallen from 310,000 to 270,000 boxes.
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Economic profits attract firms to enter an industry. The entry of firms forces down the market price until the typical firm is breaking even. Economic losses cause firms to exit an industry. The exit of firms raises the market price until the typical firm is breaking even. This process results in a long-run competitive equilibrium. Long-run competitive equilibrium is the situation in which the entry and exit of firms has resulted in the typical firm breaking even.
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The long-run equilibrium price is at a level equal to the minimum point on the typical firm's average total cost curve.
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The long-run supply curve is a curve that shows the relationship in the long run between market price and the quantity supplied. In the long run, a perfectly competitive market will supply whatever amount of a good consumers demand at a price determined by the minimum point on the typical firm's average total cost curve.
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Panel (a) shows that an increase in demand for carrots sold in farmers' markets will lead to a temporary increase in price from $10 to $15 per box, as the market demand curve shifts to the right, from D1 to D2. The entry of new firms shifts the market supply curve to the right, from S1 to S2, which will cause the price to fall back to its long-run level of $10. Panel (b) shows that a decrease in demand
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will lead to a temporary decrease in price from $10 to $7 per box, as the market demand curve shifts to the left, from D1 to D2. The exit of firms shifts the market supply curve to the left, from S1 to S2, which causes the price to rise back to its long-run level of $10. The long-run supply curve shows the relationship between market price and the quantity supplied in the long run. In this case, the long-run supply curve is a horizontal line; perfectly elastic.
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Think about market conditions to a perfectly competitive market place: many buyers and sellers, all firms sell identical products, and there are no barriers to entry. Does this apply to iPhone apps? Anyone with some programming skills, creativity, and a computer can write the apps. A few programmers entered the market on day one of iPhone's introduction and made a profit quickly. That attracted attention and many people entered the market.
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Get rich quick faded quickly and the perfectly competitive market became established.
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Any industry in which the typical firm's average costs do not change as the industry expands production will have a horizontal long-run cost curve. Industries where this result holds true are called constant-cost industries. If an input used in producing a good is available in only limited quantities, the cost of the input will rise as the industry expands. In this case, the long-run supply curve will slope upward. Industries with upward-sloping long-run supply
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curves are called increasing-cost industries. This situation can be seen in the wine making industry as more bottles of a particular variety of wine are produced, the price of the grapes used to make the wine will increase. As a result, the average total cost curve for the typical firm shifts up and the firm's breakeven price increases. In some cases, the typical firm's average costs fall as the industry expands,
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and the long-run supply curve will slope downward. Industries with downward-sloping long-run supply curves are called decreasing-cost industries.
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[Music]
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In a market system, consumers get as many carrots as they want, produced at the lowest average cost possible. The forces of competition will drive the market price to the minimum average cost of the typical firm.
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Productive efficiency is the situation in which a good or service is produced at the lowest possible cost. Managers of firms strive to earn an economic profit by reducing costs. But in a perfectly competitive market, other firms quickly copy ways of reducing costs, so that in the long run, only consumers benefit from cost reductions. Allocative efficiency aims to target consumer preferences and creates products that get you to spend your scarce money resources on that good.
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It might be that new wine variety with the climbing cost curve that catches your allocative efficiency interest, or the brand of smart phone you most wanna have.
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Competitive firms not only produce goods and services at the lowest possible cost, they also produce the goods and services that consumers value most. Perfect competition achieves allocative efficiency, a state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to
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the marginal cost of producing it. Productive efficiency and allocative efficiency are useful benchmarks against which to compare the actual performance of the economy.
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Perfectly competitive markets come in scales of perfection. Wheat farming is considered one of the closest markets to this scenario because of the lack of differentiation around North America and around the world. Apples are close to perfect competition, but really there are a lot of apple varieties and certain areas are better at growing certain varieties than others. This is differentiation of the product. We will see in Monopolistically Competitive
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industries how differentiation divides perfectly competitive marketplaces. Stay tuned.
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[Music]
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