What You Will Learn in this Chapter

• 
  What a perfectly competitive market is and the characteristics of a perfectly competitive industry
• 
  How a price-taking producer determines its profit-maximizing quantity of output
• 
  How to assess whether or not a producer is profitable and why an unprofitable producer may continue to operate in the short run
• 
  Why industries behave differently in the short run and the long run
• 
  What determines the industry supply curve in both the short run and the long run

Doing What Comes Naturally

Whether it’s organic strawberries or satellites, how a good is produced determines its cost of production.

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FOOD CONSUMERS IN THE UNITED States are concerned about health issues. Demand for natural foods and beverages, such as bottled water and organically grown fruits and vegetables, increased rapidly over the past two decades, at an average growth rate of 20% per year. The small group of farmers who had pioneered organic farming techniques prospered thanks to higher prices.

But everyone knew that the high prices of organic produce were unlikely to persist even if the new, higher demand for naturally grown food continued: the supply of organic food, although relatively price-inelastic in the short run, was surely price-elastic in the long run. Over time, farms already producing organically would increase their capacity, and conventional farmers would enter the organic food business. So the increase in the quantity supplied in response to the increase in price would be much larger in the long run than in the short run.

Where does the supply curve come from? Why is there a difference between the short-run and the long-run supply curve? In this chapter we will use our understanding of costs, developed in Chapter 6, as the basis for an analysis of the supply curve. As we’ll see, this will require that we understand the behavior both of individual firms and of an entire industry, composed of these many individual firms.

Our analysis in this chapter assumes that the industry in question is characterized by perfect competition. We begin by explaining the concept of perfect competition, providing a brief introduction to the conditions that give rise to a perfectly competitive industry. We then show how a producer under perfect competition decides how much to produce. Finally, we use the cost curves of the individual producers to derive the industry supply curve under perfect competition. By analyzing the way a competitive industry evolves over time, we will come to understand the distinction between the short-run and long-run effects of changes in demand on a competitive industry—such as, for example, the effect of America’s new taste for organic food on the organic farming industry. We will conclude with a deeper discussion of the conditions necessary for an industry to be perfectly competitive.