Economics 1021A/B Chapter Notes - Chapter 12: Variable Cost, Marginal Revenue, Opportunity Cost
Course CodeECON 1021A/B
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 or price.
o Shutdown point: The price and quantity at which it is indifferent between producing and shutting down.
Occurs when price and quantity at which average variable cost is a minimum.
Loss is minimised, and equals total fixed cost.
Firm’s supply curve:
o When price is above minimum AVC, the supply curve is the same as the MC curve.
o When price is below minimum AVC, the supply curve runs along the vertical axis, and the firms shuts down.
o When price equals minimum AVC, the shutdown point is located.
Output, Price, and Profit in the Short Run
Short-run market supply curve: Curve that shows the quantity supplied by all the firms at each price when each firm’s
plant and the number of firms remain the same.
Each firm takes the price as given, and produces its profit-maximization output.
When change in demand occurs, the price changes and the firms change their production accordingly.
In short run equilibrium, the firm’s profit maximization point may cause:
o Break-even (when MC = ATC = MR)
o Economic profit (when MC = MR > ATC)
o Economic loss (when MC = AVC = MR < ATC)
Output, Price and Profit in the Long Run
Entry & Exit:
o New firms enter a market in which existing firms are making economic profit.
o As new firms enter a market,
Supply increases, and the market supply curve shifts rightward, while demand remains unchanged.
Market price falls
Economic profit of each firm decreases.
o Firms exit a market in which they are incurring economic loss.
o As firms leave a market,
Supply decreases and the market supply curve shifts leftward while demand remains unchanged.
Market price increases.
The market price rises and the loss incurred by remaining firms decrease.
o Entry and exit stops when firms make zero economic profit.
Long-run equilibrium: In the long run, it is impossible to incur an economic loss or profit.
Changing Tastes and Advancing Technology
When there is a permanent change in demand,
o The industry demand curve shifts leftward.
o The price falls, and firms incur economic losses.
o The market shifts to short-run equilibrium.
o Some firms exit the market.
o The market returns to long-run equilibrium, with decreased number of firms and demand.
External economies: Factors beyond the control of a firm that lowers the firm’s costs as the market output increase.
External diseconomies: Factors outside the control of a firm that raises the firm’s costs as the market output increases.
o With no external economies or diseconomies, a firm’s cost remains constant as the market output changes.
Long-run market supply curve: A curve that show how the quantity supplied in a market varies at the market price
varies after all the possible adjustments have been made, including changes to each plant’s firm.
Competition and Efficiency
Efficiency: Resources are efficiently used when:
o Marginal social benefit equals marginal social cost
o Quantity demanded equals quantity supplied
o Consumer surplus equals producer surplus
An efficient use of resources requires that consumers be on their demand curve, firms be on their supply curve, and the
market be in equilibrium.