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ECON 208 Chapter Notes -Price Discrimination, Longrun, Marginal Revenue


Department
Economics
Course Code
ECON 208
Professor
Lee Ohanian

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Adrienne Pacini ECON 208 WEEK: October 20, 2009
COMPETITIVE MARKETS
Chapter 9
Market Structure and Firm Behaviour
Competitive Market Structure
- Market structure: all features of a market that affect the behaviour and performance of
firms in that market
o The number and size of sellers, the extend of knowledge about one another’s
actions, the degree of freedom of entry, and the degree of product differentiation
- Market power: the ability of a firm to influence the price of a product or the terms under
which it is sold
o The degree of competitiveness of the market is reflected in the influence that
individual firms have on market prices
o The less power an individual firm has to influence the market price, the more
competitive is that market structure
o Perfectly competitive market structure: when each firm has zero market power
- Competitive behaviour: refers to the degree to which individual firms actively vie with one
another for business
The Theory of Perfect Competition
The Assumptions of Perfect Competition
- A market structure in which all firms in an industry are price takers and in which there is
freedom of entry into and exit from the industry
1. All firms sell a homogenous product
o In the eyes of purchasers, every unit of the product is identical to every other unit
2. Consumers have full knowledge of all firms’ product and price
3. Each firm reaches its minimum LRAC at a level of output that is small relative to the
industry’s total output
4. No barriers to entry or exit
o Firms are free to exit and enter the industry at will
- Price taker: a firm that can alter its rate of production and sales without affecting the
market price of its product
The Demand Curve for a Perfectly Competitive Firm
- The demand curve for the entire industry is negatively-sloped
- However each individual firm faces a horizontal demand curve because variations in the
firm’s output have no effect on price
- This does not mean that the firm could actually sell an infinite amount at the market price
o “Normal” variations in the firm’s level of output have a negligible effect on total
industry output
Total, Average, and Marginal Revenue
- Total revenue: total receipts from the sale of a product (TR) = P × Q
- Average revenue: the market price when all units are sold at the same price (AR) = (P × Q) ÷
Q = P
- Marginal revenue: the change in a firm’s total revenue resulting from a change in its sales
by one unit (MR) = ΔTR ÷ ΔQ = P

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Adrienne Pacini ECON 208 WEEK: October 20, 2009
- If the market price is unaffected by variations in the firm’s output, the firm’s D curve, AR
curve, and MR curve all coincide in the same horizontal line
- For a firm in perfect competition, price is equal to marginal revenue
Short-Run Decisions
Rules for Profit-Maximization
- If the firm produces at all, it maximizes profit producing the quantity where MC = MR
- A firm should produce only if there is some level of output at which AR (price) exceeds AVC
o In the short run it has to pay its fixed costs whether or not it produces
o If it can more than cover its variable costs, it loses less by producing than it does by
shutting down
- The minimum point on the average variable cost curve (AVC) is the shut-down price
o At the shut-down price, the firm can just cover its average variable cost and so is
indifferent between producing and not producing
- As long as the price (AR) is no less than AVC, to maximize profits the firm chooses the output
where MR = MC
o But for a competitive firm, MR = P
- A competitive industry’s supply curve is the horizontal summation of the individual marginal
cost curves (above minimum of AVC curves)
Short-Run Equilibrium in a Competitive Market
- When an industry is in short-run equilibrium, two things are true:
o Market price is such that the market clears (QD = QS)
o Each firm is maximizing its profits
- Zero economic profits: the typical firm is just covering its costs
o P = ATC
- Positive economic profits: since P > ATC, the firm makes positive economic profits
- Negative economic profits: since P < ATC, profit maximization means loss minimization
Long-Run Decisions
Entry and Exit
- If existing firms have positive economic profits, new firms have an incentive to enter the
industry
o The industry will expand, pushing prices down until profits fall to zero
o Zero-profit equilibrium
- If existing firms have zero profits, there are no incentives for new firms to enter, and no
incentives for existing firms to exit
- If existing firms have economic losses, there is an incentive for existing firms to exit the
industry
o The industry will contract
o The market price will be driven up
o The remaining firms will be just covering their total costs
- The longer it takes for firms’ capital to become obsolete or too costly to operate, the longer
the firms will remain in the industry while they are still earning economic losses
- If firms costs are mostly sunk costs, the process of exit in loss-making industries will be slow
Long-Run Equilibrium
- The long run industry equilibrium occurs when there is no longer incentive for entry or exit
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