Summing Up: The Perfectly Competitive Firm’s Profitability and Production Conditions

In this chapter, we’ve studied where the supply curve for a perfectly competitive, price-taking firm comes from. Every perfectly competitive firm makes its production decisions by maximizing profit, and these decisions determine the supply curve. Table 12-4 summarizes the perfectly competitive firm’s profitability and production conditions. It also relates them to entry into and exit from the industry.

Profitability condition (minimum ATC = break-even price)

Result

P > minimum ATC

Firm profitable. Entry into industry in the long run.

P = minimum ATC

Firm breaks even. No entry into or exit from industry in the long run.

P < minimum ATC

Firm unprofitable. Exit from industry in the long run.

Production condition (minimum AVC = shut-down price)

Result

P > minimum AVC

Firm produces in the short run. If P < minimum ATC, firm covers variable cost and some but not all of fixed cost. If P > minimum ATC, firm covers all variable cost and fixed cost.

P = minimum AVC

Firm indifferent between producing in the short run or not. Just covers variable cost.

P < minimum AVC

Firm shuts down in the short run. Does not cover variable cost.
Table :

TABLE 12-4 Summary of the Perfectly Competitive Firm’s Profitability and Production Conditions

!worldview! ECONOMICS in Action: Farmers Move Up Their Supply Curves

Farmers Move Up Their Supply Curves

Although farmers were taking a big gamble by cutting the size of their other crops to plant more corn, their decision made good economic sense.
Dave Reede/All Canada Photos/Superstock

To reduce gasoline consumption, Congress mandated that increasing amounts of biofuel, mostly corn-based ethanol, be added to the American fuel supply—from 4 billion gallons of ethanol in 2006 to 14 billion gallons in 2013. The unsurprising result of this mandate was that the demand for corn skyrocketed, along with its price. In 2012, farmers received an average price per bushel of about $7 to $8, compared to less than $2 in 2005. Being the smart profit-maximizers that they are, American farmers responded by planting more corn and less of other crops such as cotton. By 2013, U.S. farmers had delivered five straight years of increase in acreage planted in corn.

If this sounds like a sure way to make a profit, think again. Corn farmers were taking a considerable gamble in planting more corn as their costs went up. Consider the cost of fertilizer, an important input. Corn requires more fertilizer than other crops, and with more farmers planting corn, the increased demand for fertilizer led to a price increase. In 2006 and 2007, fertilizer prices surged to five times their 2005 level; by 2013 prices were still twice as high.

The pull of higher corn prices also lifted farmland prices to record levels—levels so high that by 2013 there was talk of a bubble in farmland prices. Remember that even if a farmer owns land outright, that farmer still incurs an opportunity cost when planting rather than leasing the land or selling it to someone else. In 2013, the average price of an acre of farmland was up almost 300% over the past decade, with the price of some land increasing by as much as 1,000%.

Despite the risk and increase in costs, what corn farmers did made complete economic sense. By planting more corn, each farmer moved up his or her individual supply curve. And because the individual supply curve is the marginal cost curve, each farmer’s costs also went up because of the need to use more inputs that are now more expensive to obtain.

So the moral of the story is that 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.

Quick Review

  • A producer chooses output according to the optimal output rule. For a price-taking firm, marginal revenue is equal to price and it chooses output according to the price-taking firm’s optimal output rule P = MC.

  • A firm is profitable whenever price exceeds its break-even price, equal to its minimum average total cost. Below that price it is unprofitable. It breaks even when price is equal to its break-even price.

  • Fixed cost is irrelevant to the firm’s optimal short-run production decision. When price exceeds its shut-down price, minimum average variable cost, the price-taking firm produces the quantity of output at which marginal cost equals price. When price is lower than its shut-down price, it ceases production in the short run. This defines the firm’s short-run individual supply curve.

  • Over time, fixed cost matters. If price consistently falls below minimum average total cost, a firm will exit the industry. If price exceeds minimum average total cost, the firm is profitable and will remain in the industry; other firms will enter the industry in the long run.

12-2

  1. Question 12.2

    Draw a short-run diagram showing a U-shaped average total cost curve, a U-shaped average variable cost curve, and a “swoosh”-shaped marginal cost curve. On it, indicate the range of output and the range of price for which the following actions are optimal.

    1. The firm shuts down immediately.

    2. The firm operates in the short run despite sustaining a loss.

    3. The firm operates while making a profit.

  2. Question 12.3

    The state of Maine has a very active lobster industry, which harvests lobsters during the summer months. During the rest of the year, lobsters can be obtained from other parts of the world but at a much higher price. Maine is also full of “lobster shacks,” roadside restaurants serving lobster dishes that are open only during the summer. Explain why it is optimal for lobster shacks to operate only during the summer.

Solutions appear at back of book.