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Topic 8 - Perfect Competition.pdf

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University of Toronto St. George
James Pesando

Topic 8 – Perfect Competition st th (Week eight Nov 1 - Nov 10 ) Outline: 1. Definition; 2. Total Revenue, Marginal Revenue, and Average Revenue; 3. Profit Maximizing Output -- MC = MR = P; -- Firm’s MC curve = Firm’s SS curve (if P > AVC); -- Shut down point; 4. Level of Profits; 5. Entry and exit; 6. Short-Run and Long-Run Impact of a shift in Demand; 7. Long-Run market supply curve;  Definition Perfect Competition: -- Many buyers and sellers of identical product (so action of each buyer or seller exerts no impact on the market price); -- Freedom of entry and exit of firms (no barrier to entry/exit) Key Implication: -- Each firm is a price taker, meaning each firm faces an infinitely elastic demand curve at the market price; --- In the short run, the number of firms is fixed; In the long run, the number of firms can vary. Individual Firm Market Price Price PPrice PPrice Notation: ee SS ee DD/SS – market demand/supply dd/ss – Individual firm’s demand/ dd = market price market price supply. DD Quantity Quantity  TR/AR/MR for perfectly competitive firm TR Total Revenue Q X P AR Average Revenue TR / Q (price) MR Marginal Revenue △TR/△Q (the revenue of producing an additional unit of output) (is price, since the firm faces perfectly elastic demand) MR = P for perfectly competitive firm.  Profit-Maximizing Output -- At what level of output should a firm choose to produce to maximize profit? At Q , MR > MC: the revenue of producing an additional unit of Price Individual Firm 1 PPrice output exceeds the cost of it; the firm should expand MC output; ee At Q 2 MR < MC: the cost of producing an additional unit of output exceeds the revenue of it; the firm should MR = P contract output; At Q 0 MR = MC: the revenue of producing an additional unit of output equals the cost of it; this is the profit – Q 1 Q0 Q2 Quantity maximizing level of output for the firm. Perfectly competitive firm produces at the profit-maximizing level where MR = MC. -- Firm’s supply curve and MC curve Price Firm PPrice The firm’s supply curve measures: MC -- quantity of output a firm is willing to produce at certain price. ee 12 11 If the price if 10, which is also the firm’s MR, the firm will produce at 10 15 units where MC is 10 = MR. In essence, because the firm’s marginal cost curve determines the 15 16 17 Quantity quantity of goods the firm is willing to supply at given price, it is the competitive firm’s supply curve. Therefore, the supply curve of a perfectly competitive firm is its MC curve, and it reflects the profit-maximizing rule. -- Shut Down Point: Application 1 – A barber shop with 6-month lease Question: Should the barber ship stay open until the lease expires? 1. Revenue: Q = 100; P = $15. TR = 100 X 15 = $1,500. 2. Costs: lease is $500/mo.; wages for barbers and other variable costs total $1,200/mo. TC = TFC + TVC = $1,700/mo. (assume no implicit costs). -- If the shop stays open: profit = -$200; If the shop shuts down: profit = -$500 (the shop still needs to pay the lease); -- Therefore, the shop should stay open as long as total revenue can cover total variable cost. (fixed costs are not calculated since the firm needs to pay them anyway.) TR > TVC also means P > AVC (TR/Q > TVC/Q) Production level (ss curve): When P > AVC (the firm stays open), ss = MC curve; When P < AVC (the firm shuts down), ss=0. Price PPrice Insights ee 1. Firms shut down if TR < TVC (fixed costs are irrelevant); Firm’s short-runMC supply curve 2. TR < TVC (TR/Q) < (TVC/Q) ATC P < AVC; 3. Firm’s supply curve = firm’s MC curve where P > AVC AVC (P > AVC, ss = MC; P < AVC, ss=0.) Shut-down Point Quantity  Level of Profit Q: if MR = MC and the firm is producing at a profit-maximizing level of output, is the firm then earning an economic profit? A: not sufficient information. To calculate economic profit, ATC is needed. (compare P with ATC). Level of Profit: TR > TC Economic Profits (TR/Q) > (TC/Q) P > ATC TR = TC Breaks Even (TR/Q) = (TC/Q) P = ATC TR < TC Economic Loss (TR/Q) < (TC/Q) P < ATC 1. Economic Profits (P > ATC) Price PPrice MC ee Profit-Ma
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