P a g e | 1
Ch 9 – Besanko
I. competitive market - a market with many buyers and sellers trading identical products so that
each buyer and seller is a price taker.
A) Four characteristics of a perfectly competitive market
a. Fragmented market: Many buyers and sellers so all are Price takers
b. Undifferentiated products: Identical goods no matter who produces them.
c. Perfect information about prices – perfect info on prices and quality.
d. Equal access to resources: Free entry and exit in the long run.
B) Implications for the operation f competitive markets:
1. All participants are price takers.
2. Law of one price: transactions between buyers and sellers occur at a single
3. Free entry
C) Examples of near perfect competition:
1. Commodities markets – wheat, copper, etc.
2. Market for Roses
3. Catfish farming
-highly fragmented (>1000 in U.S. alone)
-perfect info on prices – monthly reports of catfish prices
-undifferentiated product – catfish from one farm is a perfect substitute for
catfish from another
-Free entry – low costs of entry, MES is 80-100 ponds, well-understood
II. Profit maximization by a Price taking firm
1. All firms (even in non competitive markets) maximize profits where MR = MC.
2. In prefect competition, MR=P because of horizontal demand curve; so
perfectly competitive firms max profit where P = MC. 3. profit π = TR(Q) – TC(Q)
4. profit π = q x (P – AC)
B. Economic profit, not accounting profit, is the relevant profit for firm decision-making
Economic costs include both explicit and implicit costs. Typical implicit costs are:
1) foregone income, i.e. the opportunity cost of the owner’s time, and 2)
foregon interest, i.e. the opportunity cost of capital.
EVA (economic value added) – a widely used measure of economic profit =
accounting profit – minimum return on invested capital demanded by the
firm’s investors. A positive EVA means that the company delivered a return
on invested capital greater than that demanded by its investors.
EX: 9.1. The annual accounting statement of revenues and costs for a local flower shop
shows the following:
Employee Salaries $170,000
If the owners of the firm closed its operations, they could rent out the land for $100,000.
They would then avoid incurring any of the expenses for employees and supplies. Calculate
the shop’s accounting profit and its economic profit. Would the owners be better off
operating the shop or shutting it down? Explain.
The accounting costs are
Employee Salaries $170,000
Accounting profit = Revenue – Accounting Cost = $250,000 -
$195,000 = $55,000
The economic costs are
Employee Salaries $170,000
Opportunity cost of land $100,000
Total Economic Cost $295,000
Economic profit = Revenue – Economic Cost = $250,000 -
$295,000 = - $45,000
The negative economic profit indicates that the owners would be better off by $45,000 if they
shut down the shop and rent out the land. P a g e | 3
C. Profit maximization in Perfect Competition
1. chooses q to max profit given the market price
2. maximizes profit π when both of the following conditions hold:
a. P = MC
b. MC is increasing
NOTE: There are two places where P=MC, one is a profit min and one is a profit max.
At the maximum, MC will be increasing.
A P.C. firm faces a horizontal demand curve at the market price, P.
D. Short – Run
1. At least one input (such as plant size) is fixed.
2. Number of firms in the industry is fixed – no entry or exit
E. SR Costs for P.C. firm
(output sensitive costs)
(unavoidable cost even if Q=0)
(avoidable only when Q = 0)
Ex: Rose-growing firm. If the firm produces 0 output, it can stop using pesticide and
fertilizer, which are variable costs. The long-term lease on the land is a sunk fixed cost if
the land cannot be sublet to another farmer for another use. The costs of heating the
greenhouses is a nonsunk fixed cost – it does not depend on output if Q>0 but it can be
avoided when the firm shuts down and Q=0.
F. SR supply curve for P.C. firm when all fixed costs are sunk
TFC = NSFC +SFC
Now NSFC = 0.
So TFC = SFC → the relationship from principles about total costs: STC = TFC + TVC.
Dividing by Q, we get the usual average relationship from principles: SAC = AFC + AVC
Firm’s SR supply = MC above minimum AVC. (shutdown) P a g e | 5
As long as the firm covers its AVC, it should continue to operate in the SR at a loss. As
long as P>AVC, the firm reduces its loss by continuing to operate. If the firm shuts down
and Q=0, then the loss=TFC. If the firm operates at P>AVC, it can reduce the loss by
TFC – q x (P – AVC). See graph below... Ex: This is why restaurants remain open at lunchtime when there are few customers.
As long as the TR from customers > TVC (the cost of the chef and waitress to produce
meals), then the restaurant should stay open at lunch.
Ex: 9.8 Dave’s Fresh Catfish is a northern Mississippi farm that operates in the perfectly
competitive catfish farming industry. Dave’s short-run total cost curve is
STC(Q)=400+2Q+0.5Q , where Q is the number of catfish harvest per month. The
corresponding short-run marginal cost curve is SMC(Q)=2+Q . All of the fixed costs
(a) What is the equation for the average variable cost ( )?
(b) What is the minimum level of average variable costs?
(c) What is Dave’s short-run supply curve?
(a) TVC=2Q+0.5Q 2 so AVC=TVC/Q=2+0.5Q.
AVC Q SMC=AVC
(b) The minimum level of occurs at the where , or
, or . The minimum level ofAVC is thus 2.
(c) Since all fixed costs are sunk, the firm will not produce if the price is below the minimum
level of ., or 2. For prices above 2, the quantity supplied is found by equating
price to marginal cost, or , which implies . Thus, the firm’s
short-run supply curve is P a g e | 7
s(P)=P –2if P2
G. SR supply with sunk and nonsunk fixed costs
TFC = SFC + NSFC
The only difference in the analysis is that we need to treat NSFC like a variabl