In the short run, economic profit is maximized when MR = MC = P. This is because if marginal revenue was less than marginal cost, you are losing money on the last unit, so you should decrease production until MR = MC. The reverse is also true. Profits are also maximized when total revenue - total cost is at its maximum positive value.

In the long run, a purely competitive firm will earn zero economic profits, which means they will earn their normal rate of return. Why? When economic profits are positive, returns are greater than the opportunity cost. This attracts new entrants, increasing supply to the market and forcing the market price down to the point where zero economic profits are available. This result is driven by the no barriers to entry assumption. Equilibrium in the long run occurs when P = MC = ATC.

Remember: The term zero economic profit does not mean that the firm is not making money, rather it means the firm is making a normal return. Thus, accounting profits may be positive, but accounting profits adjusted for the opportunity cost of running the business will be zero.

d: Describe the short-run supply curve for a company and for a competitive market.

Recall that price takers should produce where P = MC. At a price below P1 the firm will shut down. Between P1 and P2 the firm will continue to operate in the short run. At P2 the firm is earning a normal return. Above P2 the firm is making economic profits and will expand its production along the MC line. Thus, the short-run supply curve for a firm is its MC line above the AVC curve. The short-run market supply curve is the horizontal sum of the MC curves for the firms in the industry. Because firms will supply more units at higher prices, the short-run market supply curve slopes upward to the right.

e: Contrast the role of constant-cost, increasing-cost, and decreasing-cost industries in determining the shape of a long-run market supply curve.

The long-run supply curve indicates the minimum price at which firms will supply various output levels. The shape of the supply curve depends on the shape of the industry’s production cost schedule.

Constant cost industries - production costs remain constant as output expands. The supply curve will be perfectly elastic (i.e. horizontal).

Increasing cost industries - production costs rise as output increases. Supply will be directly related to price (i.e. sweep upward to the right).

Decreasing cost industries - production costs decline as production increases. As price declines, demand increases, which reduces production costs, and supply rises. Thus, the supply slopes downward to the right (Atypical).

f: Explain the impact of time on the elasticity of supply.

Supply elasticity and the role of time: The market supply curve is more elastic in the long run than in the short run. This means the long-run supply curve is flatter than the short-run curve. This occurs because in the long run, firms in an industry can adjust the fixed nature of their costs. Basically, it costs less to adjust output slowly in response to a change in demand - hence, the market supply curve is more elastic in the long-run (a greater change in quantity supplied for a given change in price).

2.D: Price-Searcher Markets with Low Entry Barriers

a: Describe the conditions that characterize competitive price-searcher markets.

Monopolistic competition is another name for competitive price searcher markets. The following market and product features define monopolistic competition:

There are a large number of independent sellers.

Each produces a differentiated product.

In a market with low barriers to entry.

Producers face a downward sloping demand curve and demand is highly elastic.

b: Explain how price searchers choose price and output combinations.

Monopolistic competitors face downward sloping demand curves due to the differential products. This demand curve is highly elastic (flat) due to the availability of close substitutes. Think about the market for toothpaste - all toothpaste is basically the same, but differentiation occurs due to taste preferences, influential advertising, and the reputation of the seller. However, if the price of Crest skyrocketed, you could easily switch to Colgate.

The price/output decision: In the short-run, price searchers maximize profits by producing where MR = MC, and charges price from the demand curve. Here, the firm earns positive economic profits because price exceeds average total cost. In the long-run, new firms have since entered the market, absorbing some market demand. This shifts the demand curve down to the point where price = ATC (there are zero economic profits). The monopolistic competitor will continue to produce at the quantity where MR = MC.

c: Summarize the debate about the efficiency of price-searcher markets with low barriers to entry, including the concepts of contestable markets, entrepreneurship, allocative efficiency, and price discrimination.

Contestable markets are markets with low costs of entry and exit, thus any firm can start up operations with little risk. Contestable markets lead to efficient production and zero economic profits. This can happen even if the number of firms is small. Just the threat of entry is enough to keep prices low. It must be determined if a market is contestable, and how it can be made contestable if it is not.

Economic models often leave entrepreneurship out of the model because entrepreneurs use subjective judgment to determine the best course of action. Entrepreneurs gather information about possible alternatives in complex situations. Therefore, the simple versions of basic economic theories do not model those decisions. Entrepreneurs who discover and introduce more efficient production and new products add significantly to economic progress.

The potential allocative inefficiency of the monopolistic competitor is not clear. There is the social cost of not producing at the output level where price = MC, long run average cost is not minimized, excessive advertising may take place, and fewer producers could operate more efficiently. However, these negatives may be outweighed by increased product diversity.

Price discrimination reduces the allocative inefficiencies that result from pricing above marginal cost. The major benefit is more output. The firm gains from those customers with inelastic demand curves while still providing goods to customers with more elastic demand curves. This may even cause production to take place when it would not otherwise.

d: Explain how price discrimination increases output and reduces allocative inefficiency.

Price Discrimination is the practice of charging different consumers different prices for the same product or service.

For price discrimination to work the seller must:

Have a downward sloping demand curve

Have at least two identifiable groups of customers with different price elasticities of demand for the product

Must be able to prevent the customers paying the lower price from reselling the product to the customers paying the higher price

Company gains from price discrimination: As long as a firm has groups of customers with downward facing demand curves, profits can be increased through price discrimination.

Winners and losers: Price discrimination reduces the allocative inefficiencies that result from pricing above marginal cost. The major benefit is more output. The firm gains from those customers with inelastic demand curves while still providing goods to customers with more elastic demand curves. This may even cause production to take place when it would not otherwise.

e: Explain why competition is an important disciplinary force in a market with low barriers to entry.

Competition promotes economic progress for the following three reasons:

Competition promotes efficient production and consumer satisfaction. Firms that cannot maintain an efficient production level cannot survive. Likewise, if a firm does not produce the goods that consumers want, then the consumers will go elsewhere.