12.4 SUMMARY

1. In a perfectly competitive market all producers are price-taking producers and all consumers are price-taking consumers—no one’s actions can influence the market price. Consumers are normally price-takers, but producers often are not. In a perfectly competitive industry, all producers are price-takers.

2. There are two necessary conditions for a perfectly competitive industry: there are many producers, none of whom have a large market share, and the industry produces a standardized product or commodity—goods that consumers regard as equivalent (perfect substitutes). A third condition is often satisfied as well: free entry and exit into and from the industry.

3. A producer chooses output according to the optimal output rule: produce the quantity at which marginal revenue equals marginal cost. For a price-taking firm, marginal revenue is equal to price and its marginal revenue curve is a horizontal line at the market price. It chooses output according to the price-taking firm’s optimal output rule: produce the quantity at which price equals marginal cost. However, a firm that produces the optimal quantity may not be profitable.

4. 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.

5. 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. 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. 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.

6. 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.

7. The industry supply curve depends on the time period. The short-run industry supply curve is the industry supply curve given that the number of firms is fixed. The short-run market equilibrium is given by the intersection of the short-run industry supply curve and the demand curve.

8. The long-run industry supply curve is the industry supply curve given sufficient time for entry into and exit from the industry. In the long-run market equilibrium—given by the intersection of the long-run industry supply curve and the demand curve—no producer has an incentive to enter or exit. The long-run industry supply curve is often horizontal. It may slope upward if there is limited supply of an input, resulting in increasing costs across the industry. It may even slope downward, the case of decreasing costs across the industry. But it is always more elastic (flatter) than the short-run industry supply curve.

9. In the long-run market equilibrium of a competitive industry, profit maximization leads each firm to produce at the same marginal cost, which is equal to market price. Free entry and exit means that each firm earns zero economic profit—producing the output corresponding to its minimum average total cost. So the average total cost of production of an industry’s output is minimized. The outcome is efficient because every consumer with a willingness to pay greater than or equal to marginal cost gets the good.