What is perfect competition?
Perfect competition is a market in which:
o Many firms sell identical products to many buyers.
o There are no restrictions on entry into the industry.
o Established firms have no advantage over new ones.
o Sellers and buyers are well informed about the prices.
Ex. Farming, fishing, wood pulping, paper milling
Arises if the minimum efficient scale (smallest output at which long-run average cost reaches its lowest level) of a
single producer is small relative to the market demand for the good or service.
Each firm is a price taker (a firm that cannot influence the price of a good or service because its production is an
insignificant part of the total market) because products are so identical.
Firm’s goal is to maximize economic profit (total revenue minus total cost)
o Total revenue: Price of its output multiplied by the number of outputs sold
o Total cost: opportunity cost of production
o Marginal revenue: Change in total revenue that results from a one-unit increase in the quantity sold.
In perfect competition, the firm’s marginal revenue equals the market price.
o Demand: Firms can sell any quantity it chooses at the market place, so the demand curve for the firm’s product
is a horizontal line at market price.
Demand for the firm’s product is perfectly elastic.
Market demand for the product depends on the substitutability of the good to other goods.
A product from one from is a perfect substitute for a sweater from any other firm.
Firms’ Decisions: Goal of competitive firms is to maximize economic profit. To achieve its goals, firms must decide
o How to produce at minimum cost
Operate with the plant that minimizes long-run average cost
Operating on the long-run average cost curve
o What quantity to produce, or to enter or exit the market
The firm’s output decision
Profit-maximization point: Economic profit is maximized when:
o Total revenue exceeds total cost by the largest amount
o Marginal revenue equals marginal cost
When MR exceeds MC, the revenue from selling one more unit exceeds the cost of producing it, and
an increase in output increases economic profit.
When MC exceeds MR, the revenue from selling one more unit is less than the cost of producing that
unit, and a decrease in output increases economic profit.
o This is following the law of supply, which states that other things remaining the same, the higher the market
price of a good, the greater is the quantity supplied of that good. Break-even point: A point at which a firm makes zero economic profit (total revenue – total cost = 0)
Temporarily shut down decision:
o If the maximum profit to be a loss, compare the loss from shutting down with the loss from producing.
Economic loss = Total fixed cost + (Average variable cost – price) x quantity
If the firm shuts down, economic loss equals total fixed cost since AVC and quantity equals 0.
If the firm produces, economic loss equals total fixed cost in addition to (TVC – total revenue)
Therefore, the firm shuts down if total variable cost exceeds total revenue