Lecture: Perfect Competition

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2 Apr 2012
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MICROECONOMICS
Perfect Competition
Overview
- defintion of perfect competition
- output, price, and employment decisions in perfectly competitive markets
- entry and exit of firms into/from the competitive market
- effects of price changes, demand changes, and technological advantages
Introduction
- perfect competition: industry in which
o many firms sell identical products to many buyers
o no restrictions to entry into the industry
o established firms have no advantages over new ones
no core competency: one firm does something very well and other
firms wish they had that ability
o sellers and buyers are well informed about prices
- perfect competition arises when:
o firm’s minimum efficient scale is small relative to market demand
allows room for many firms in the industry
o firm’s product is perceived as having no unique characteristics
consumers are indifferent as to which firm to buy from
- price takers: firm that cannot influence the price of a good or service; must
“take” equilibrium market price
o in perfect competition, all firms are price takers
products are perfect substitutes perfectly elastic demand
Economic Profit and Revenue
- firms want to maximize economic profit (total revenue – total cost)
o total cost = OC of production, and includes normal profit
o total revenue: price x quantity sold (P x Q)
o marginal revenue: change in total revenue resulting from a one-unit
increase in the quantity sold
when marginal revenue is constant, the total revenue increases by
the price of the good with every one-unit increase in sales
in perfect competition, marginal revenue = price
- firm’s demand curve for a product is horizontal (perfectly elastic) at the market
price
o this is true because on firm’s sweater is a perfect substitute for another
firm’s sweater
- market demand is not perfectly elastic because a sweater is a substitute for some
other good
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© 2010 Pearson Education Canada
At high output levels, the
firm again incurs an
economic lossnow the
firm faces steeply rising
costs because of
diminishing returns.
The firm maximizes its
economic profit when it
produces 9 sweaters a
day.
TheFirm’sOutputDecision
© 2010 Pearson Education Canada
At high output levels, the
firm again incurs an
economic lossnow the
firm faces steeply rising
costs because of
diminishing returns.
The firm maximizes its
economic profit when it
produces 9 sweaters a
day.
TheFirm’sOutputDecision
Decisions in Perfect Competition
- recall: perfectly competitive firm’s goal is to maximize economic profit, given the
constraints being faced
- firms decide:
o how to produce at minimum cost
o what quantity to produce
o wheter to enter or exit a market
A. Output Decision
- perfectly competitive firm chooses output that maximizes economic profit
o look at total revenue and total cost curves
Total revenue – Total cost = Economic Profit (EP)
profit curve is an upside-down U shape
area above the x-axis and under the EP graph is total profit
- low output levels economic loss
o cannot cover fixed costs
- intermediate output levels economic profit
- high output levels economic loss
o steeply rising costs because of diminishing returns
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© 2010 Pearson Education Canada
If MR > MC, economic
profit increases if output
increases.
If MR < MC, economic
profit decreases if output
increases.
If MR = MC, economic
profit decreases if output
changes in either
direction, so economic
profit is maximized.
TheFirm’sOutputDecision
B. Marginal Analysis and Supply Decision
- marginal analysis: method used to determine profit-maximizing output
- marginal revenue is constant, and marginal cost eventually increases with output
o profit is maximized by producing the output at which MR = MC
- MR > MC profit increases with output
o example: movement from 8 sweaters to 9 sweaters on the graph
- MR < MC profit decreases with output
o example: movement from 9 sweaters to 10 sweaters on the graph
- MR = MC profit decreases with any change in output; EP is at its maximum
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