Economics 1021A/B Chapter Notes -Average Variable Cost, Marginal Revenue, Market Power

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24 Apr 2012
Economics Textbook Notes
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, plumbing, painting, 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.
Each firm produces a good that has no unique characteristics, so consumers don’t care
which firms good they buy.
Price Takers
A price taker is a firm that cannot influence the market price because its production is an
insignificant part of the total market.
Economic Profit and Revenue
Total Revenue
o A firm’s total revenue equals the price of its output multiplied by the
number of units of output sold (price X quantity)
o Each additional unit of a good brings in a constant amount, the total
revenue curve is an upward-sloping straight line
Marginal Revenue
o Marginal revenue is the change in total revenue that results from a one-
unit increase in the quantity sold
o The marginal revenue = Demand (MR=D=AR=P)
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.
Demand for the Firm’s Product
o 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
Perfectly elastic demand
The Firm’s Decisions
The goal of the competitive firm is to maximize economic profit. To achieve this goal, it
must decide:
1. How to produce at minimum cost
2. What quantity to produce
3. Whether to enter or exit a market
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The Firm’s Output Decision
From the firm’s cost curves and revenue curves, we can find the output that maximizes
the firm’s economic profit.
Economic profit equals total revenue minus total cost.
Marginal Analysis an the Supply Decision
Marginal analysis compares marginal revenue, MR, with marginal cost, MC. As
output increases, marginal revenue is constant but marginal cost eventually
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.
A firm’s profit-maximizing output is its quantity supplied at the market price
Temporary Shutdown Decision
At this quantity, price is less than average total cost. In this case, the firm incurs an
economic loss. Maximum profit is a loss (a minimum loss).
If the firm expects the loss to be permanent, it goes out of business
If it expects the loss the be temporary, the firm must decide whether to shut down
temporarily and produce no output, or to keep producing
Loss Comparisons
o A firm’s economic loss equals total fixed cost, TFC, plus total variable
cost minus total revenue
Economic Loss = TFC + (AVC P) X Q
o If the firm shuts down, it produced no output (Q = 0). The firm has no
variable cost and no revenue but it must pay its fixed cost, so its economic
loss equals total fixed cost
Its economic loss equals total fixed cost the loss when shut down
plus total variable cost minus total revenue
The Shutdown Point
o A firm’s shutdown point is 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 a 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
At prices above minimum average variable cost but below
average total cost, the firm produces the minimizing output
and incurs a loss
The Firm’s Supply Curve
A perfectly competitive firm’s supply curve shows how its profit-maximizing output
varies as the market price varies as the market price varies, other things remaining the
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