Chapter 12: Perfect Competition
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 wellinformed about prices
How does it arise?
The minimum efficient scale of a single producer is small relative to the market
demand for the g/s.
There is room in the market for many firms
A firm’s MES is the smallest output at which longrun average cost reaches its
Each firm produces a good that has no unique characteristics so consumers do
not care which firm they buy from.
Firms in Perfect competition
A firm cannot influence the market prie b/c its production is an insignificant part
of the total market.
Economic Profit and Revenue
Economic profit is equal to total revenue minus total cost
Total cos opportunity cost of production, which includes normal profit
Total revenue equals (price x quantity)
Marginal revenue is the change in total revenue that results from a oneunit
increase in the quantity sold.
o Calculated by dividing the change in total revenue by the change in
The firm can sell any quantity it chooses at the market price. Therefore, the
demand curve for the firm’s product is a horizontal line at the market price, the
same as the firm’s marginal revenue curve.
o A horizontal demand curve illustrates a perfectly elastic demand
o A sweater from a different store is a perfect substitute but the market
demand for sweaters is not perfectly elastic: its elasticity depends on the
substitutability of sweaters for other g/s
The Firm’s decisions
The 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 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 and revenue curves we can find the level of output that
maximizes the firm’s economic profit.
o Economic profit equals total revenue minus total cost
Marginal Analysis and the Supply Decision Chapter 12: Perfect Competition
Marginal analysis (=compares marginal revenue, MR, with marginal cost, MC)
o As output increases, the firm’s marginal revenue is constant but its
marginal cost eventually increases.
o If MR> MC > there is an economic profit
o If MR a decrease in output increases economic profit
o If MR=MC > economic profit is maximized and either an increase or a
decrease in output decreases economic profit
Temporary Shutdown Decision
If the firm isn’t making money they need to determine whether this is going to be
permanent or temporary
o If they decide it’s going to be tempora
o ry, then they need to compare the losses of shutting down temporarilyand
producing no output and continuing to produce
o Economic loss= TFC+ (AVCP)*Q
If a firm shuts down, it produces no output (Q=0)
• It has to pay only fixed costs but no variable costs
• If AVC>price, the loss> TFC and firm shuts down
Shutdown point (=the price and quantity at which it is indifferent b/w producing
and shutting down).
o At this point, the firm is minimizing its loss and its loss equals TFC
o If price falls below AVC firm shuts down temporarily and continues to
incur a loss equal to TDC
o At prices above minimum AVC but below average total cost, the firm
produces lossminimizing output and incurs a loss, but the loss is less than
The Firm’s Supply Curve
Derived from the MC and AVC
When the price> minimum AVC the firm maximizes profit by producing the
output at which MC=price
o If price increases, the firm increases its output (moves along marginal cost
When the price ATC, a firm makes an economic profit