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Chapter 11

Economics 1021A Chapter 11


Department
Economics
Course Code
ECON 1021A/B
Professor
Terry Biggs
Chapter
11

Page:
of 6
Economics 1021A Chapter 12 2013-11-24
Perfect competition is a market in which:
Many firms sell identical products to many buyers.
There are no restrictions to entry into the industry.
Established firms have no advantages over new ones.
Sellers and buyers are well informed about prices.
Perfect competition arises when:
the firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the
market.
each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t
care which firm’s good they buy.
In perfect competition, each firm is a price taker.
A price taker is a firm that cannot influence the price of a good or service.
No single firm can influence the price—it must “take” the equilibrium market price.
Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s
output is perfectly elastic.
The firm can sell any quantity it chooses at the market price, so marginal revenue equals price and the
demand curve for the firm’s product is horizontal at the market price.
The demand for a firm’s product is perfectly elastic because one firm’s sweater is a perfect
substitute for the sweater of another firm.
The market demand is not perfectly elastic because a sweater is a substitute for some other
good.
The goal of each firm is to maximize economic profit, which equals total revenue minus total cost.
Total cost is the opportunity cost of production, which includes normal profit.
A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P ´ Q.
A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the
quantity sold.
A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces. The
firm must decide:
How to produce at minimum cost
At low output levels, the firm incurs an economic loss—it can’t cover its costs.
At intermediate output levels, the firm makes an economic profit.
At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs
because of diminishing returns.
Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is
maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC.
What quantity to produce
If MR = MC, economic profit decreases if output changes in either direction, so economic profit is
maximized.
Whether to enter or exit a market
If the firm makes an economic loss, it must decide to exit the market or to stay in the market.
If the firm decides to stay in the market, it must decide whether to produce something or to shut down
temporarily.
The firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR).
If the firm shuts down, Q is 0 and the firm still has to pay its TFC.
A firm’s shutdown point is the price and quantity at which it is indifferent between producing and
shutting down.
This point is where AVC is at its minimum.
It is also the point at which the MC curve crosses the AVC curve.
At the shutdown point, the firm is indifferent between producing and shutting down temporarily.
The firm incurs a loss equal to TFC from either action.
A perfectly competitive firm’s supply curve shows how the firm’s profit-maximizing output varies as the
market price varies, other things remaining the same.
Because the firm produces the output at which marginal cost equals marginal revenue, and because
marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve.
But at a price below the shutdown point, the firm produces nothing.
The short-run market supply curve shows the quantity supplied by all firms in the market at each
price when each firm’s plant and the number of firms remain the same.
The quantity supplied by the market at any given price is the sum of the quantities supplied by all the firms
in the market at that price.
At a price equal to minimum AVC, the shutdown price, some firms will produce the shutdown quantity and
others will produce zero.
At this price, the market supply curve is horizontal.
Short-run market supply and market demand determine the market price and output.
Maximum profit is not always a positive economic profit.
To determine whether a firm is making an economic profit or incurring an economic loss, we compare the
firm’s average total cost at the profit-maximizing output with the market price.
In short-run equilibrium, a firm might make an economic profit, break even, or incur an economic loss.
Only one of them is a long-run equilibrium because firms can enter or exit the market.
New firms enter an industry in which existing firms make an economic profit.
When they do, the market supply increases and the market price falls.
Firms enter as long as firms are making economic profits.
In the long run, the market price falls until firms are making zero economic profit.
Firms exit an industry in which they incur an economic loss.
When they do, the market supply decreases and the market price rises.