ECO101H1 Lecture Notes - Lecture 3: Organic Food, Demand Curve, Profit Maximization

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6 Feb 2016
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PERFECT COMPETITION
What is a Competitive Market?
The Meaning of Competition
- Competitive market a market with many buyers and sellers trading identical products
so that each buyer and seller is a price taker.
- A competitive market, sometimes called a perfectly competitive market, has two
characteristics:
1. There are many buyers and many sellers in the market.
The actions of any single buyer or seller in the market have a negligible
impact on the market price. Each takes market price as given
2. The goods offered by the various sellers are largely the same.
Because each seller can sell all he wants to at the going price, he has little
reason to charge less, and if he charges more, buyers will go elsewhere
Price takers are buyers and sellers in competitive markets must accept the
price the market determines
3. Firms can freely enter or exit the market in the long run
The Revenue of a Competitive Firm
- Firm in competitive market tries to maximize profit (total revenue – total cost)
- Total revenue is proportional to the amount of output
- Questions to analyze revenue:
oHow much revenue does the company receive for the typical unit?
oHow much additional revenue does the company receive if it increases production
by 1?
- Total Revenue (TR)
oPrice times the quantity (P x Q)
- Average Revenue (AR)
oTotal revenue divided by the quantity sold
oTells us how much revenue a firm receives for the typical unit sold
oFor all firms, average revenue equals the price of the good.
- Marginal Revenue (MR)
oChange in total revenue from the sale of each additional unit of output
oFor competitive firms, marginal revenue equals the price of the good.
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Supply Curve
1. Exists only in perfect competition
2. Reflects profit-maximizing behaviour
Example 1.
You are an organic farmer (no pesticides). There is a sharp increase in the demand for organic
foods.
Questions:
1. Will you earn (economic profits)?
Yes.
2. Will these (economic) profits continue over the long run?
No, as other farmers switch to organic crops, until the economic profits are
competed away.
Insight:
- For economic profits to persist over the long run, there must be obstacles (barriers to
entry) that prevent new firms from entering and competing.
Example 2 – Organic Foods: A Perfectly Competitive Market
What is it?
1. Many buyers and sellers of an IDENTICAL product (so that actions of each buyer or
seller do not influence market price).
2. Firms can enter or exit the industry (No Barriers to Entry or Exit).
Key Features:
1. Each firm is a PRICE TAKER and faces a perfectly elastic demand curve at market price.
2. Number of firms is fixed in the short run, but can vary in long run.
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Example 3.
The price elasticity of demand faced by an individual coffee grower is closest to:
a. 0.01
b. 0.10
c. 1.0
d. 10.0
e. 1000
Total Revenue, Average Revenue, Marginal Revenue for Perfectly Competitive Firms
Example 4.
Q P TR (P x Q) AR
(TR/Q)
MR (Difference in
TR/ Difference in Q)
16666
2 6 12 6 6
3 6 18 6 6
4 6 24 6 6
5 6 30 6 6
Perfectly Competitive Firm: MR = P
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