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Chapter 12

Chapter 12- Perfect Competition

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Department
Economics
Course
ECON 101
Professor
Emanuel Carvalho
Semester
Winter

Description
CHAPTER 12: Perfect Competition What is Perfect Competition?  Perfect competition is a market in which  Many firms sell identical products to many buyers  There are no restrictions on entry into the market  Established firms have no advantage over new ones  Sellers and buyers are well informed about prices  Farming, fishing, wood pulping, and paper milling, the manufacture of paper cups and shopping bags, grocery retailing, photo finishing lawn services, plumbing, painting, dry cleaning, and laundry services are all examples of highly competitive industries How Perfect Competition Arises  Perfect competition arises if the minimum efficient scale of a single producer is small relative to the market demand for the good or service  In this situation, there is room in the market for many firms  A firm’s minimum efficient scale is the smallest output at which long-run average cost reaches its lowest level  In perfect competition, each firm produces a good that has no unique characteristics, so consumers don’t care which firm’s good they buy Price Takers  Price taker: A firm that cannot influence the market price because its production is an insignificant part of the total market Economic Profit and Revenue  A firm’s goal is to maximize economic profit, which is equal to total revenue minis total cost  Total cost is the opportunity cost of production, which includes normal profit  A firm’s total revenue equals the price of its output multiplied by the number of units of output sold (price x quantity)  Marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold  Marginal revenue is calculated by dividing the change in total revenue by the change in the quantity sold Total Revenue  Total revenue is equal to the price multiplied by the quantity sold  The total revenue curve graphs the relationship between total revenue and the quantity sold  The total revenue curve is an upward-sloping straight line because it is constant Marginal Revenue  Marginal revenue is the change in total revenue that results from a one-unit increase in quantity sold  Because the firm in perfect competition is a price taker, the change in total revenue that results from a one-unit increase in the quantity sold equals the market price  In perfect competition, the firm’s marginal revenue equals the market price Demand for the Firm’s Product  The firm can sell any quantity it chooses at the market price  So the demand curve for the firm’s product is a horizontal line at the market price, the firm as the firm’s marginal revenue curve  A horizontal demand curve illustrates a perfectly elastic demand, so the demand for the firm’s product is perfectly elastic  E.g. a sweater from Campus Sweaters is a perfect substitute for a sweater from any other factory  But the market demand for sweaters is not perfectly elastic: Its elasticity depends on the substitutability of sweaters for other goods and services The Firm’s Decisions  The goal of the competitive firm is to maximize economic profit, given the constraints it faces. To achieve its goal, a firm must decide 1. How to produce at minimum cost 2. What quantity to produce 3. Whether to enter or exit a market The Firm’s Output Decision  A firm’s cost curves (total cost, average cost, and marginal cost) describe the relationship between its output and costs  A firm’s revenue curves (total revenue and marginal revenue) describe the relationship between its output and revenue  From the firm’s cost curves and revenue curves, we can find the output that maximizes the firm’s economic profit Marginal Analysis and the Supply Decision  Another way to find the profit-maximizing output is to use marginal analysis, which compares the marginal revenue MR, with marginal cost, MC  As output increases, marginal revenue is constant but marginal cost eventually increases  If marginal revenue exceeds the firm’s marginal cost (MR > MC), then the revenue from selling one more unit exceeds the cost of producing that unit and an increase in output will increase economic profit  If marginal revenue is less than marginal cost (MR < MC), then the revenue from selling one more unit is less than the cost of producing that unit and a decrease in output will increase economic profit  A firm’s profit-maximizing output is its quantity supplied at the market price  These profit-maximizing responses to different market prices are the foundation of the law of supply: Other things remaining the same, the higher the market price of a good, the greater is the quantity supplied of that good Temporary Shutdown Decision  A firm maximizes profit by producing the quantity at which marginal revenue (price) equals marginal cost  But suppose that at this quantity, price is less than average total cost  In this case, the firm incurs an economic loss  If the firm expects the loss to be permanent, it goes out of business  But if it expects the loss to be temporary, the firm must decide whether to shut down temporarily and produce no output, or to keep producing  To make this decision, the firm compares the loss from shutting down with the loss from producing and takes the action that minimizes its loss Loss Comparisons  A firm’s economic loss equals total fixed cost, TFC, plus total variable cost minus total revenue  Total variable cost equals average variable cost, AVC, multiplied by the quantity produced, Q, and total revenue equals price, P, multiplied by the quantity Q  So, Economic Loss = TFC + (AVC – P) x Q  If the firm shuts down, it produces no output (Q = 0). The firm has no variable costs and no revenue but it must pay its fixed costs, so its economic loss equals total fixed cost  If the firm produces, then in addition to its fixed costs, it incurs variable costs. But it also receives revenue  Its economic loss equals total fixed cost- the loss when shut down- plus total variable cost minus total revenue  If total variable cost exceeds total revenue, this loss exceeds total fixed cost and the firm shuts down  Equivalently, if average variable cost exceeds price, this loss exceeds total fixed cost and the firm shuts down The Shutdown Point  Shutdown point: The price and quantity at which it is indifferent between producing and shutting down  The shutdown point occurs at the price and the quantity at which average variable cost is minimum  At the shutdown point, the firm is minimizing its loss and its loss equals total fixed cost  If the price falls below minimum average variable cost, the firm shuts down temporarily and continues to incur a loss equal to total fixed cost  At prices above minimum average variable cost but below average total cost, the firm produces the loss minimizing output and incurs a loss, but a loss that is less than total fixed cost The Firm’s Supply Curve  A perfectly competitive firm’s supply curve shows how its profit maximizing output caries as the market price varies, other things remaining the same  The supply curve is derived from the firm’s marginal cost curve and average variable cost curves  When the price exceeds minimum average variable cost, the firm maximizes profit by producing the output at which marginal cost equals price  If the price rises, the firm increases its output- it moves up along its marginal cost curve  When the price is less than minimum average variable cost, the firm maximizes profit by temporarily shutting down and producing no output  The firm produces zero output at all prices between minimum average variable cost  When the price equals minimum average variable cost, the firm maximizes profit either by temporarily shutting down and producing no output or by producing the output at which average variable cost ids a minimum-the shutdown point  The firm never produces a quantity between zero and the quantity at the shutdown point Output, Price, and Profit in the Short Run Market Supply in the Short Run  Short-run market supply curve: Shows the quantity supplied by all the firms in the market at each price when each firm’s plant and the number of firms remain the same  The supply curve is derived from the individual supply curves  The quantity supplied by the market at a given price is the sum of the quantities supplied by all the firms in the market at that price  The market supply curve is a graph of the market supply schedule Short-Run Equilibrium  Market demand and short-run market supply determine the market price and market output A Change in Demand  Changes in demand brings changes to short-run market equilibrium Profit and Losses in the Short Run  In short-run equilibrium, although the firm produces the profit maximizing output, it does not necessarily end up making an economic profit  Refer to Economic Profit = (P-ATC)xQ Three Possible Short-Run Outcomes  Pg. 282 1. Break even 2. Economic profit 3. Economic loss Output, Price, and Profit in the Long Run Entry and Exit  Entry occurs in a market when new firms come into the market and the number of firms increases  Exit occurs when existing firms leave a market and the number of firms decrease  Firms respond to economic profit and economic loss by either entering or exiting a market  New firms enter a market in which existing firms are making an economic profit  Firms exit a market in which they are incurring an economic loss  Temporary economic profit and temporary economic loss do not trigger entry and exit  It is the persistent prospect  Entr
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