Transcription
How's it class? So today, we're going to start talking about chapter 23. Uh, our first market structure to be to be discussed, and it's going to be the perfectly competitive market structure. But actually, before we do, let's get a quick look overview of the different market structures that we will be covering, starting from chapter 23.
So, the various market structures that we'll be discussing. We're going to start off with perfect competition because it's pretty much one extreme side of the spectrum of market structures, if we were to break it up as such. So, on the one side, we have perfect competition, and let's go all the way to the other side. And on the other side, there's the other extreme market structure, which is monopoly. And then in between, we're gonna have varying degrees where we're gonna see the perfect competition, uh, scenario and the conditions that we're discussing, and how it's gonna morph as we go from one down, all work away down to the monopoly market structure.
So, the one next to perfect competition, which has some similarities to perfect competition, is monopolistic competition. Now, that can be kind of confusing for people when they're first dealing with these market structures because they see the concept of monopoly on one side, and then on one side closer to perfect competition, they see monopolistic competition. So, you kind of got to make sure that you have those clear in your head, that monopolistic competition is actually closer to the perfect competition side rather than its monopoly. And then we have the next market structure that will be close to monopoly, is oligopoly.
So, the order that we're going to be covering these market structures, uh, is essentially going to be perfect competition, then we're going to go to the other extreme, monopoly, then we're gonna discuss monopolistic competition, and then we're gonna go to oligopoly. Now, understanding the setup of the first one, perfect competition, is going to be important because as we go moving through these different market structures, we're going to be taking what's going on here and talking about and comparing and contrasting as we go to the next ones. And then eventually, we'll be working on oligopoly, which will be looked at the last one. Oligopoly will be looked at a little differently than the first three because, uh, simply, uh, it's different concerns under the oligopoly system, and we'll also have covered a lot of relevant ideas, uh, indirectly through the first three market structures. So, please be aware that whatever you cover in the first one, uh, the first chapter that we're working with here in perfect competition, would be referred to constantly as we start understanding, comparing, and contrasting, and using perfect competition as a reference point to understand the next market structures as well.
So, getting to the perfect competitive market structure. Perfect competition is a situation where decisions of individual buyers and sellers have no effect on the market price, and it all has to do with this relative size in the marketplace. In a perfectly competitive marketplace, there's a lot of buyers and sellers, and therefore, they're too small to have any effect. Now, the perfectly competitive firm is such a small part of the total industry that it cannot affect the price of the product or service that it sells. And therefore, there's this big idea of the concept that perfectly competitive firms are price takers. They don't get to make decisions that affect the marketplace. The only decisions that they get to make are decisions that affect them, but they're essentially reacting to the environment around them and not having the ability to affect it.
So, here are the characteristics of a perfect competition scenario:
1. There's a large number of buyers and sellers.
2. There are homogenous products within there. In other words, every firm selling the same product sells a perfect substitute for the other, and vice versa. Somebody is selling a perfect substitute for your product if you are from the marketplace.
3. Buyers and sellers have equal access to information.
4. No barriers to entry or exit.
So, all of these characteristics have implications, and, uh, we can kind of break it down. Even though there's a little bit more than goes that goes beyond just what I'm saying here. But for the large number of buyers and sellers, the implication of that one is that there's no power influence over the marketplace from any individual buyer or seller. The second one, homogenous products where there's perfect substitute, that contributes to that same idea that you don't have any special power in the marketplace as a firm because whatever you try to do, somebody else is selling the same darn thing, and so you're not going to have any advantages to try to change up your situation. Number three, the buyers and sellers have equal access to information. Again, there's no advantages that you can have over the others. You will not have an advantage in production, an advantage in technology that can allow you to have greater market share or lower costs than anybody else. So, again, setting the stage where everyone is in the same boat. And then number four, no barriers to entry or exit. This is a big implication for especially the long run. The no barriers to entry or exit tells that there's going to be free flow within the industry. Anytime a situation changes, if losses are being made or profits are being made, the implication is that there's going to be a free flow either into the industry or out of the industry, thereby ending up in some sort of consistent equilibrium. And that's a very important concept to keep in mind regarding this perfectly competitive market marketplace.
Now, here's the scenario. When we analyze a perfectly competitive marketplace, we can actually use and should actually use two graphs to describe the situation. On the left side, we have the firm's, uh, we have the firm, I'm sorry, the overall perspective of the marketplace, which is the normal upward sloping supply curve and the normal downward sloping demand curve that sets an equilibrium price. Shows there that the market sets the price at five dollars. And then on the right, in panel B, we have an individual firm's perspective on the marketplace. Now, the individual firm's perspective on the marketplace changes that demand curve from downward sloping into a perfectly horizontal demand curve. Now, the reason is, is that the implication of the downward sloping demand curve is that a firm has some ability to see some changes. If they have a higher price, there would be a lower quantity demanded. If they have a lower price, they would have a higher quantity demanded. Those are the implications of the downward sloping demand curve. But that is removed in panel B because any price higher than this five dollars that's set by supply and demand in the marketplace, that the firm, if they decide to increase prices, it's gonna sell, they're gonna sell nothing. Now, they can also lower price, but why would they lower price if they don't have to, and they can sell every unit that they want to sell at five dollars? So, generally, when a firm wants to lower the price over here on the left side, at a lower price, the whole point is that they're potentially going to see an increase in quantity demanded. Well, here they can sell at whatever quantity they'll be able to unload any quantity demanded based on that five dollar demand curve. So, they have no reason to lower the price. So, that's what leaves us with this completely horizontal demand curve for an individual firm. They can't increase the price because they don't have market power, they're going to lose all all their buyers, and they have no incentive to lower the market price either.
So, to add one more concept to or to reinforce one more concept on this, is that this horizontal demand curve really indicates that the firm is a price taker, and the price of five dollars is the price that they take, and it's set by supply and demand equilibrium in the industry. Now, a lot of students sometimes lose sight of the fact because they're focused oftentimes on the peculiar look that an individual firm has for the demand curve. They do sometimes neglect to remember that there is a downward sloping demand curve in a perfectly competitive industry. It's thus that an individual firm doesn't see it as such; they see it as perfectly horizontal. But this downward sloping demand curve does exist for the industry.
So, essentially, the question for a perfectly competitive firm is, how much should the perfect competitor produce? That's really the only issue they need to address, based on being a price taker and taking that information and determining. So, they're going to make that decision based on the following: They're going to look at their total revenues, which is going to be price times quantity. They look at the total cost, which is going to be comprised of your total fixed cost plus total variable cost. Don't forget that this is we're talking about economics perspective, and this refers to that idea of economic profits versus accounting profits, where we do as economists, when we look at our costs, we look at our implicit costs, which accounting costs, our accounting profits overlooks. So, this total cost curve does include the opportunity cost as well, the implicit cost. So, don't forget that it's not just dollar values that must be written out for checks and so forth, things that can be tabulated like that, but it's also foregone opportunities that's also considered in this cost function. And so, we look at our profit as the total revenue that you earn minus the total cost, and whatever is left over is your profit. You can have positive profits, or you can also be making a loss, which we can sometimes call negative profits instead of simply labeling it as losses, typical economics speak oftentimes in various, uh, textbooks.
Now, price again, in the yellow here, is determined by the marketplace, but quantity is determined by the producer, and their goal is to maximize profit. Not nothing else. It's not to maximize revenue, it's not to minimize costs, it's to maximize profits. So, here, in looking at profit maximization, we have this situation where we look at total output and sales per hour. So, the quantity that is being sold, we look at the total costs, we look at the market price, we have total revenues, we have total profit column, then we have average total cost, out of variable cost, marginal cost, marginal revenue. Now, one of the things I hope you remember that I keep stressing is that we are a marginal decision-making science, where really the important concepts is going to often be springing out of the marginal cost and marginal revenue concepts. Now, of course, everything else is going to come into play. We're going to be using things like average total cost to determine our cost per unit. We're going to be looking at our average variable cost to determine our shutdown points in the short run. Uh, we're also going to be looking at our total profits, uh, that's also going to be relevant based on just measuring and so forth, um, so all these things are going to be incorporated into it. So, just kind of keep that in mind, but we're going to move on right now, and then we can kind of refer to some of these ideas later.
So, to build further on this profit maximization concept, we can look at panel B here on the right, that shows, uh, our various curves. We can look at our, uh, total revenue curves as well as our total cost curves. Now, our total revenue curve is simply going to be our price times quantity, and so you see that linear function going up right there in green. And though the curvy linear function that kind of we use above and below it is going to be our total cost function. Now, you can see that the information here on the left as well, where we have total costs over here, we have our total revenue here, and then of course, that total profit, which is going to be the total revenue minus total cost. So, as you can see here, our total revenue, you're earning zero, but you have total costs of ten. Ten, that's going to be this distance right here on the diagram, and that's going to be losses. So, you can see as you proceed in terms of the quantity that you produce, you're going to be earning losses up to a certain point. But then eventually, because your total cost curve is going to be dipping below our total revenue curve in the green area here, starting at this point right here, we start to earn profits. And then at some point, based on our total cost curve, remember the cost curve section where we have things like our comparative advantage and specialization, uh, where we're at some point it's going to be lowering our cost, and then we're also going to see increases based on the marginal cost pulling up our average cost and so forth. So, we're going to see situations where the top total cost curve is also going to lead us to further losses over here in the red. But we do have this profit section here in the middle. And actually, we have a situation here where we're going to have our marginal revenue equals marginal cost situation, where we're going to be maximizing our profits as well. Now, you can determine it based on the picture where our marginal, uh, I mean, where our profits is maximized, and it's shown again in this little shaded area here, the quantity that we have control over as a firm that we can produce. And then we can also look at it over here as well, when we look at our total profits are maximized as well, matched up with this quantity actually shown there as well. So, this is one view of how we can look at our, our profits and how we determine, uh, our, our maximum profits based on the maximum difference in the green area between the total revenue and our total cost curve, and we can look at it in terms of totals. I guess that's one way we can consider our profits. But another way that we're going to be focusing on, and one of the main ways in terms of conceptually, you should be thinking about profit maximization, is using that marginal decision-making approach. And again, like I mentioned, we're going to be looking at marginal cost and marginal revenue.
Now, the important concept here is that when we're looking considering our profit maximization here, we're looking at a situation, I'm sorry, where we have marginal revenue equal to marginal cost, and that's where we get it right there at that incremental stage, because remember, it's where we're going from seven to eight, the additional, the concept, the margin of the additional, the change, the next, and so forth. So, that's going to be our profit maximizing point. So, it's the where there's an equality set, where we have marginal revenue equals to the marginal cost. That's a very different way of looking at things going backwards, where we're looking at the greatest difference between total revenue and total cost, we're looking for the maximum vertical distance. Whereas the marginal method, we're looking at the equality. While you will be expected to identify the profit maximizing point using the total concept, where we're looking at the greatest distance between total revenue minus total cost, you should be aware, and you will be likely asked questions upon that, maybe in a quiz or certainly in your homework. But in terms of the marginal decision making method, this is going to be probably the dominating method that you'll be considering as we move not just through this chapter, but then following chapters as well.
So, going back to, uh, the the issue that we already mentioned, how much should the perfect competitor produce? They should look at their profit maximizing quantity, which is the quantity that maximizes total profits. It's where total revenues minus total cost is maximized, the greatest distance between total revenue and total cost, and finally, where the marginal revenue equals to marginal cost. So, be able to work with both, but the total revenue method and total cost. But be aware that marginal revenue, marginal cost is going to be the dominating method and the dominating, uh, perspective of thinking that you should be working with in most economics classes.
So, using marginal analysis to determine the profit maximizing rate of production. Don't forget that marginal revenue is going to equal to the change in total revenue divided by the change in quantity. So, marginal revenue, delta TR divided by delta Q. And because we're an incremental method, in the denominator, you're generally looking at plus or minus one unit to determine the changes, the marginal changes, uh, of what you're looking for. And then, of course, marginal cost is going to equal to the change in total cost with respect to the change in quantity. Okay, so it's this incremental method, again, generally plus or minus one unit in quantity. How does our total cost change, or how does our total revenue change?
Now, one thing I did want to point out here is that we have our firm's demand curve. So, here we have lowercase d, not uppercase D. Uppercase D denotes the marketplace demand curve. So, lowercase d denotes a perfect competitor's, uh, perspective of the demand curve that they see, this horizontal line, and it's lowercase d denoted by. But I also want you to notice that a very important concept that we keep referring to, marginal revenue is equal to this demand curve as well. So, why is our marginal revenue equal to our demand curve? So, remember that our marginal revenue equals change in total revenue with respect to change in quantity. And this change in quantity, we generally look at it in terms of incremental changes of one unit. And so, if our total revenue equals price times quantity, let's look at as quantity changes, and then we can relate this concept to our marginal revenue using this, this ratio right here to explain why we have this perfectly horizontal marginal revenue curve here.
So, look at here where I have quantity, and we have the quantity going from zero unit to one unit. And then I also want to see what happens when we have going from one unit to two units. And that's this marginal revenue ratio that we see above, where we're looking at that change in quantity. So, we're recalling that total revenue equals price times quantity, and we have market price here, constant, because we're price takers at five dollars. So, we have zero units times that quantity of zero times that five dollar price, so we have our total revenue equal to zero. Now, if we go to the next one, from one to two, so we have that our new quantity of one, I'm sorry, I misspoke, I meant to say this total revenue equals to zero is associated with this value here. And then we also want to look at when we have, uh, our total revenue when we have quantity equals to one, and then it's going to be one times five over here, one times five up here, so we have our total revenue equals to five. So, going from zero to one, which is that marginal concept, that change of that one unit from zero to one, the change in our total revenue goes from zero to five. So, it happens to be this right here on the demand curve as well. And then now we have our total revenue equals to five, that covers this one over here. But now we want to see what happens when we go to two. So, now we have two units times five for our total revenue equals to ten. Now, we're going from five units here to ten for the next incremental, that plus one up here for our marginal revenue. And again, going from five to ten, that's a marginal revenue of five. So, we're still here on five. So, as we go, and that's going to continue as we go along in increments of one here on the horizontal axis, we're going to keep seeing it's going to be five to ten, then the next one you would see fifteen, the next one total revenue you'd see twenty, the next one you would see twenty-five. And so the margin of the change as we go is going to be a change of five. Okay, so that's why we have, uh, our, our marginal revenue here equal to five all the way for respective of the quantity, and that gives us that marginal revenue curve here, which happens to also be that price-taking firm's demand curve.
So, here we have a way of incorporating those cost curves that we covered in the earlier chapter, and now we're going to incorporate it with our new demand curve, which is also counting as our marginal revenue curve, as we just covered, demand is equal to marginal revenue. So, now we're incorporating it, and we're going to be looking at measuring total profits. Now, again, the for a profit maximizing position is where marginal revenue equals to marginal cost. So, here, like we said, we have a perfectly horizontal marginal revenue curve, check. We also have our marginal cost curve, check, that we covered before. So, where we set those equal to is going, it's not shown here, actually, it's what I'm just adding now to that dot there where marginal revenue equals to marginal cost. Now, if I could zoom in, which I cannot on this one, but if I could zoom in, you would see a vertical distance between that red dot and the dot below it. And so that red dot is rep, I'm sorry, that distance is this vertical distance here that I show on the axis. That vertical distance on that straight vertical distance alone is the profit per unit. Now, that profit per unit is going to be applied to however many units we sell. So, that vertical distance, let's just say it happens to be, uh, the blue level starts above four, let's just say it's at four point five or four dollars and fifty cents, and it goes up to five dollars where they're our price taker, then it's fifty cents profit per unit. We want our total profits, we need to take that fifty cents and multiply it by that quantity that we're selling. That gives us that entire blue rectangle, which essentially the profit per unit times the quantity, the base times are the height times the base to get that total area of profits. And again, just to be clear again, we're using this average total cost curve. That average total cost curve is essentially our price per unit. So, we got our quantity that we're going to maximize our profits at. So, we went to marginal revenue equals marginal cost to determine this quantity here. And once this quantity is determined, then we can go up to the average total cost curve that I just dotted right there at our price per unit. So, we can see how much it's costing, I'm sorry, let me say it this way, our cost per unit. So, we can figure out how much we're paying in cost for every unit that we produce. And then we go to this demand curve, our marginal revenue curve, right above it, to see how much we're getting per unit. And the difference is our profits. So, again, it's be aware that the process is, first, go to marginal revenue equals to marginal cost. This gives you the profit maximizing quantity. Once you get that, then you go to your average total cost curve to get the cost per unit. And then after that, then you go to your marginal revenue equals to demand curve to get the price per unit to get your revenue per unit. And then you can figure out everything from there. So, that's the process. And therefore, profits are maximized where marginal revenue equals marginal cost. This occurs at Q equals to 7.5 units.
So, what I want to do from this point is to look at how we transition from a profit situation to a loss situation. Now, the main idea here is that we're seeing our demand curve D1 drop down to D2. What's not mentioned is what causes this drop from D1 down to D2. Now, if you recall, we had two diagrams in perspective such as this situation. So, if we're wondering what caused the demand curve to drop like this, well, it could either be a rightward shift of supply, or we could see a leftward shift of demand. Either one would have brought us down to a lower price level, shifting the demand curve like that. So, that's what's going on behind the scenes to first to, uh, facilitate the start of our discussion regarding this drop from profits down to losses, such as this situation. So, earlier, we saw where demand or marginal revenue, where we saw where marginal revenue equals to marginal cost here. But now, with this drop in demand, based on maybe what we saw earlier regarding the industry supply and demand curve, now we see demand equals to marginal revenue drop. And so, now we have a new intersection here where we get to see how much we're getting per unit. We're now getting three dollars per unit. We receive three dollars in revenue per unit, but it's costing us here up there at, it looks like four dollars and fifty cents maybe per unit right here. And so, now we have a per unit loss, and the total quantity gives us the base times height gives us this total red area in terms of losses. So, again, to reiterate, to kind of orient yourself and analyze the diagrams, you're going to always start where marginal revenue equals to marginal cost, and that's going to give us a profit maximizing quantity. And then once we get that, then we can look at our average total cost curve to look at our cost per unit. And then after that, we're going to be comparing it to our demand, I'm sorry, I'm going to make it our demand equals to marginal revenue curve to see our revenue per unit. And then we're going to figure out, calculate our profits, either per unit or total. The per unit is going to be just the vertical distance in this red area. The total is this total rectangle, base times height.
Now, our solution optimization solution of marginal revenue equals marginal cost doesn't just hold for positive profits, but it also holds for negatives or negative, our losses are negative profits. In other words, even if you're making a loss like this situation, the best scenario for you as a firm is to minimize your losses, and that is still where marginal revenue equals marginal cost.
Now, we're going to expand these ideas and focus on two different time frames. Remember, we have the short run and long run. In the short run, you're going to be stuck with certain, uh, resources. You're stuck with your physical capital, that's the assumption, and your variable resource in the short run is your labor. But you're always going to be carrying in the short run your fixed costs. Now, we're going to be looking at the short run break-even price and the short run shutdown price, and we're going to need to consider certain things. So, question: Would you continue to produce if you were recurring a loss? And would what if it was in the short run? What if it was in the long run? Well, the answer is, if the loss of staying in business is la is less than the loss from shutting down, then in other words, the the lesser of the evils is that you will continue to produce. The loss of staying in business is less than the loss from shutting down. Now, a firm temporarily shuts down when it stops producing but is still in business. You're out of business when the owner sells assets, essentially gets rid of its physical capital, unburdens itself from its facilities, from its factories, whatever. So, then what is the rule then for determining whether or not we're shutting down or continuing to operate in the short run? So, as long as your price per unit sold, your price per unit sold is greater than the average variable cost per unit produced, then the firm continues to produce in the short run. So, where do we get this price per unit sold? This price per unit sold comes from where we have our marginal revenue curve equals to our demand curve equals to the price. That's this curve right here. And then the average variable cost per unit, well, you can guess that's our average variable cost curve. So, somewhere we're going to have our average total cost curve, we're going to have our marginal cost curve, and of course, we're also going to have our average variable cost curve in this as well to help us make this decision.
So, the short run break-even price. The short run break-even price is where price equals to total revenue equals to total cost. Now, the firm is making what we call a normal rate of return on its capital investment. A normal rate of return, it's what you're expected, what you would expect to earn with whatever resources you have. Now, the short run shutdown price is below the intersection of the marginal cost curve and the average variable cost curve. So, taking a look here, we have our short run break-even point as indicated by this point here, uh, and it's where our per unit is sold for over here, okay, and our average total cost curve. But then it's possible that if the market situation changes, we see a drop in our demand and marginal revenue, so from this down to this. Okay. Now, looking at this average variable cost curve that we added to this, now we can see where the marginal revenue or price or demand curve, all these things represented by this horizontal curve, meets up with our average variable cost curve at E2. Okay, and E2 is when the price drops to E2. That is where we are going to shut down because we are not covering our average variable cost. Why are we concerned with covering our average variable cost in the short run versus the other costs as well? Well, if you think about the breakdown of costs, we have variable costs and fixed costs. Fixed costs are what you pay whether or not you're producing, whether or not you're actually hiring people and engaging in business activity. You bear that cost anyway. It's what we call a sunk cost. It must be paid irrespective of what you do. So, we don't consider those sunk costs, those fixed costs which are considered sunk costs, those are gone. It's what we're doing now. And your variable cost would include the time that you have to work it. So, if you're covering your own personal time, in other words, you're earning with your efforts, your labor, you're earning enough to cover, then you would stay in business. You're covering your variable cost, and that's any point above E2 because that's where, you know, the price is above the what the average variable cost curve is revealing to you. Once you get to that other point, then you're not covering your variable cost, you're better off just getting out of the business and devoting your time to whatever the alternative was. That is considered your normal rate of return as your kind of reference point.
So, this all comes down to this very important concept of economic profits and brings in a very important concept of zero economic profits. Now, it's very important because when we talk about zero economic profits, a lot of people think that that's a terrible thing because zero profit sounds bad, correct? But zero economic profits, well, ask this question: Why produce if you are not making economic profits? The answer is, remember, when economic profits are zero, you still, the firm can still have positive accounting profits. Zero economic profits means you're earning a normal rate of return. What you would expect to earn. Positive economic profits means you're earning above your normal rate of return, and that's a very good thing because you're doing better than what you would expect to be doing in this situation, earning a normal rate of return. So, it's very important to consider the zero economic profit concept. It's not an instinctively bad situation. Zero economic profits means you're earning what you would have expected to earn entering this industry. Okay, so zero economic profits, you're still gonna operate because you're doing what you ex, you're making what's reasonable, what you're expected to.
Shift gears a little bit and consider the supply curve for a perfectly competitive industry. Question: How do you get the short run supply curve for the individual firm? The answer is, in a competitive industry, it's the marginal cost curve at and above the point of intersection with the average variable cost curve. If you recall from that picture that we just saw here, we have our situation here where we have our demand is equal to marginal revenue curve, then we have our marginal cost curve, then we also have our average total cost curve, I'll just put the average total cost curve there, and then our average variable cost curve below it that I just added there. So, remember the average variable cost curve point that I'm just drawing right there is the point of shutdown. That's where you're going to get out of business in the short run. But in the short run, you're going to produce anywhere above that point. So, what that's saying is, this portion up here now becomes a supply curve for the firm, because in the short run, they will produce if the price is anywhere above in that, if the demand equals marginal revenue equals to the price is anywhere in that realm. So, that green area becomes the firm's individual supply curve. And a very important point again is to consider that this lower curve here is the average variable cost curve. Okay, so that's this concept here. So, much cleaner look than what I just did is looking at this where now we identified that the supply curve for the firm is also the marginal cost curve, or let me reverse that, the marginal cost curve is also the supply curve, and this point is the short run shutdown point. So, this section up here now becomes that firm supply curve. Anything below on the marginal cost curve here, that's not where they're going to operate, so it goes away. So, given the price, the quantity is determined where marginal cost equals the marginal revenue, and the short run supply equals marginal cost above the minimum average variable cost curve.
So, deriving the industry supply curve. Remember, there's many buyers and sellers in the industry. This is a simplified scenario. So, all we did was, uh, have two firms, firm A and firm B, and we'll pretend that they represent a whole bunch of bunch of firms. So, the supply curve for the industry, which is panel C, the supply curve for the industry is this symbol here, is a summation sign. So, it's the sum of the marginal cost curves. It's going to be more than two, but we don't want to have to go through all of them. But you horizontally sum them, just like we did our supply curve from chapter three, and that's how we get our marginal, industry supply curve equals the industry marginal cost curve as well. So, again, just a reminder that price determination under perfect competition is where we get our industry supply equals to our industry demand. So, all we did here is we added a little perspective to our supply curve, and we realized now that it happens to be the sum of the marginal cost curve. So, now we figure out how we get our supply curve for the market for our perfectly competitive industry, and the firm is a price taker. And again, we're looking at a representation of how we look at profits, break-even point, and losses. So, associated with the various curves here for AC1, that's where we have a break-even point for this one, where we have our costs which are higher than the price that we receive per unit. So, this one is our losses, and then this one is our profit situation.
This takes us to a more dynamic scenario where we look at the long-run industry situation, which includes this concept of exit and entry. So, that's a very important addition to that fourth characteristic of the perfectly competitive marketplace, where there's easy entry and exit into them, there's no barriers to entry and exit into the marketplace. So, these economic profits and losses, they're essentially signals for resources, or we can say firms, for signals for firms to enter an industry or to leave an industry. These profits and losses. So, the exit, entry of firms, economic profits serve as a signal for resources or firms to enter the marketplace. If you're a firm and a perfect, and you engage in a perfectly competitive industry, and you see, you're not happen to be in it now, but you see profits, remember, profits are amounts above and beyond the normal rate of return. So, you see that people are making above and beyond the normal rate of return, which you would make to expect to make, then you would enter the marketplace. On the other hand, economic losses below what you would expect to make, then you would redivert your own resources to where you would be making your normal rate of return, and therefore exit the marketplace in that situation.
So, the long run equilibrium. In the long run, the firm can change the scale of its plant, adjusting its plant size until profits are maximized. In the long run, a competitive firm produces where price equals to marginal revenue equals to marginal cost equals to the short run minimum cost average cost and the long run minimum average cost. This is our long run equilibrium. So, the diagrammatical representation of this would look like this, where we have price is equal to marginal revenue, which also equals to the average revenue, because again, divide by quantity, it's all going to be the same value. If it's price equal five dollars, it's all going to be that. And so we have this equilibrium where all those conditions that we just saw the earlier slide met. So, we have the long run average cost curve. Remember, we took out the total cost concept. The total, there's no T in there for total, because everything now is variable. So, it doesn't serve us in the long run to have to distinguish between fixed versus variable cost. Everything is variable. So, we don't have to even identify it as a total cost curve. It's just cost in the long run. Then we have our short run average cost curve, and it's also going to all be where marginal cost intersects as well. But what's really important is how do we get here when disequilibrium occurs? So, like I mentioned right before this final section, I said it was a dynamic situation. We're going to kind of analyze that dynamic situation right now, going from changes in profits and losses, entry and exit, to firm restoring into a long run equilibrium. So, right now, we're going to look at a diagrammatical representation in the perfect competition where we start off in equilibrium, then we're going to change, you see a change in the industry, which ultimately results in a change in the price in the marketplace. That change of the price is going to result in losses or profits to firms, and then those losses or profits are going to serve as signals, and that's going to result in exit or entry of firms based on whatever the situation was. And this entry and exit of firms will go back to the industry and change price in the within the industry, and this change in price will occur until we have a restored equilibrium.
So, let's look at this situation and this flow of equilibrium change in industry, losses, profits, exit, and entry, and restored equilibrium in a diagrammatical situation. So, I'm going to start off on the left side to build our equilibrium where we have on price and quantity for the industry, where we have our upward sloping supply and downward sloping demand, which sets the market price. Okay, and from here, this market price is setting as the demand curve, which also serves as, we'll just stop at the marginal revenue, even though it equals the average revenue and so forth, but demand is equal to marginal revenue. Now, again, we're in equilibrium, so I know that this in equilibrium, our average total cost curve is going to be placed right there, because that's where we're earning zero economic profits, which is not bad, remember, that's a normal rate of return, what we would expect to be earning. So, zero economic profits is not a bad thing. And for this, I also know then that my marginal cost curve will be passing through that point. So, now we are in equilibrium in the short run, long run scenario. And again, very important is where our marginal revenue equals to marginal cost, which will set our profit maximizing quantity, and I guess I'll write that as Q star right there. So, with that, we built our equilibrium scenario, check. Next thing we want to look at is going to be some sort of change in the industry, which results in a change in price. So, let's say that some sort of exogenous shock happens in the marketplace, and for whatever reason, supply shifts to the left for the industry, which gives us a new equilibrium and establishes a new price. Now, with this new price, this takes it over, takes over to the industry's perspective, and now creates a new demand, marginal revenue curve for this firm, as well as all other firms, because they're essentially identical. So, now, with this, we can look at our new marginal revenue equals to marginal cost point right here, and this new marginal revenue equals marginal cost curve gives us a new equilibrium profit maximizing quantity to the right, and I'll take it all the way down here and say Q2 for that point. Now, one thing, because of the imperfection of the drawing, but one thing you should realize is if this point right here is our minimum of the average total cost curve, then based on the parabolic nature of this, this point actually, relative to this new Q2, is actually going to be a little higher, and it's just going to be obfuscated by the limitations of my drawing. But I think if you understand that the intersection of the marginal cost curve and the average total cost curve is at its minimum, then anywhere to the right of Q star on the horizontal axis means that we're higher up on the average total cost curve based on the rel relative vertical axis. So, I'm going to draw this point and go across here. Okay, so based on our new quantity, the cost per unit is what we're getting from the average total cost curve. The price per unit is what we're getting from our new D2, MR2, and price curve. So, the vertical distance between these two points, I'll use another color for that, represents our profit per unit. So, this vertical distance here between these two points is now our profit per unit. If we want our total profits, then what we would do is we would shade that entire area there, and that's the amount of our total profits. Okay, so this is our new situation where we can see that purple rectangle earning profits in a perfectly competitive industry.
So, going back to our situation here, we saw this change, this change in the industry leading to a change in prices, which establish profits. So, going to this next stage, we're looking at the exit or entry of firms. Well, profits is a signal for firms to enter the marketplace, and this will change price. So, having cleaned this up a little, we can see now that, um, with the industry change, because of the entry or exit into firms, what did we say? We said that firms will enter the industry as long as economic profits are being made. So, if firms enter the industry on the left side, is it going to be a demand change or supply change? Firms, it's a supply side. Firms entering means supply shifts to the right. Now, do we know how far S2 will shift? Yes, we do. The signal is economic profits. So, the supply curve will continue to shift to the right until economic profits become zero. Now, assuming there's no change in marginal cost, average total cost, and so forth, then the supply curve will shift to the right, and economic profits are restored to zero, back at this original point. And then we're going to be restored back to this point, back to this point, back to this point, and that's going to be zero economic profits. And that is the flow, the dynamic flow in the short run to the long run of an economic profit scenario in a perfectly competitive marketplace. And we could do everything in reverse in a situation for economic losses. So, I could have said that, for example, demand shifted to the left, that resulted in a lower price. The lower price dropped price below. So, now firms were earning losses, and then everything would be in reverse from there. But hopefully, you can do that with your own to get some practice.
I hope this helped to understand this chapter a little bit. A lot of this information will be incorporated into understanding the future chapters and the deviations from this structure as a relative reference point for our new marketplaces to understand. So, anyway, I hope you guys understand this. If you have any questions, please let us know. Take care, stay healthy, and I will talk to you guys soon. Aloha.