No Free Lunch: Economics for a Fallen World: Third Edition, Revised

Chapter Eight: Market Structure: From competition to monopoly 184 Farmer Joe will produce at Q*, since that quantity equates marginal revenue with marginal cost. In the short run, there may be profits or losses as indicated by the shaded areas because of the fixed costs. If fixed costs are low enough, Farmer Joe may see an average total cost curve such as ATC 3 , which has the ATC at Q* less than the average revenue (the price) that Farmer Joe will receive. Farmer Joe will therefore earn a profit on all the bushels of corn he sells equal to the orange shaded area in Figure 8.2 . Alternatively, his fixed costs could be high, such as with ATC 1 , and he could suffer a loss equal to the blue shaded rectangle since his average cost is greater than the price he will receive. Profits or losses are only a short-run phenomenon in competitive markets; in the long run, firms will enter or exit the industry to ensure a zero economic profit. Earning zero economic profit can still allow for an accounting profit—this just means that whatever the standard profit level is for other potential applications of the firm’s resources, they make exactly the standard return, which we call zero economic profit. We can see how this works in Figure 8.3 . If firms are experiencing economic profits, other businesses will expand into that industry to share in that profit. Or if firms are suffering losses, they will exit the market to deploy their scarce capital in other markets where they will not lose money. Farmer Joe will ultimately produce only on ATC 2 , at the quantity Q*, where his average total cost equals his average revenue received, which equals the price of the commodity. Any other output level or cost structure will not be an equilibrium or long-run level under perfect competition. This long-run position is said to offer both allocative and productive efficiency. Efficiency sounds like a good thing, so we ought to be happy with perfect competition! Allocative efficiency simply means that the marginal buyer values a good or service at exactly the price he or she pays: the marginal benefit for the good they buy equals the marginal cost paid (which is the price). Productive efficiency sounds pretty good too (perhaps you have a mental image of a Toyota plant with cars being built like clockwork ?). Productive efficiency occurs when firms produce a quantity where they minimize their average total cost. As illustrated in Figure 8.2 , Farmer Joe’s long-run production is at Q* with the minimum level for average total cost; he can’t produce at a lower cost. Q* is therefore both allocatively and productively efficient. Figure 8.3, Zero Economic Profit. Assume that the wheat market were to allow a positive economic profit (as opposed to the “normal” accounting profit), such as might be the case with S 1 curve, where the S* curve is the equilibrium supply curve with zero profit. With a positive economic profit, other entrepreneurs will “sniff out” the profits and redirect their capital to expand production into the industry with positive profits. The combined effect of the multitude of entrepreneurs doing this shifts the supply curve out and will continue until there are no further economic profits at S*. Likewise, if there are entrepreneurs suffering loss, they will exit the market and supply will be reduced, as from S 2 to S*. As supply is reduced, market prices increase, thus restoring profit to the normal level. P ($) Q (#) Q * P * Q 1 P 1 S * D S 1 S 2 Q 2 P 2 Allocative efficiency: when the marginal buyer receives a benefit that matches the cost to produce the good. Productive efficiency: occurs when firms produce at their minimum average total cost.