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Chapter 13

Chapter 13 Full Notes

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ECON 1131

Chapter 13 Perfect Competition Perfect competition is the only market structure that operates strictly in accordance with the laws of Supply and Demand Review of Perfect Competition  Industry contains a large number of firms  The firms produce identical products, no product differentiation by firm  Consumers and firms have correct information about all relevant aspects of the market, such as prices  There are no barriers to entry or exit of firms in the long run, resources are free to move in or out of the market in response to profits and losses  Determination of price and quantity: q end p aee determined by the combined interaction of market supply and market demand  The demand curve of an individual firm: the demand curve facing an individual firm is horizontal/perfectly elastic at the level of equilibrium price p regardless of the shape of the market demand curve o Each firm is so insignificant in the overall market that its actions have no effect on market price o If one firm raises its price above the equilibrium price, its customers will simply buy the product from another firm o These two properties force perfectly competitive firms to be price takers  The profit maximizing supply rule, P=MC: each firm produces and sells the output, qe,t which price equals marginal cost Profit and Loss  We assume that competitive firms select the output at which price equals marginal cost because this is the output that maximizes profit  “Maximum profit” doesn’t necessarily mean it’s good- could mean investors are making a great return or they could be making just as much as any other investor TheAll-or-None Profit Test  Afirm continues to produce only if total revenue is at least as large as the variable cost of production- but this has different implications for the short run and the long run The Short-Run Shut-Down Point  SRTC= FC + SRVC  The all-or-none rule implies that the firm might continue producing in the short run even if it incurs losses  Sunk cost: a firm’s fixed cost in the short run, arising from decision about factors of production that were made in the past  According to the rule, total revenue need only be sufficient to cover the firms variable costs, not its total cost  In the short run the firm has two options o 1) Produce the profit maximizing level of output at which P=MC o 2) Shut down its operations entirely and cease production  The firm’s obligation to pay its fixed commitments continues for the duration of the short run no matter what the firm does o The fixed costs sets a limit on the amount of loss the firm is willing to sustain  Shut-down point: a market situation in which a firm’s total revenue equals short- run variable cost (p=avc), so that the firm is indifferent between producing and not producing (either way they will lose an amount equal to the fixed costs) The Long-Run Break Even Point  LRTC=LRVC  The all-or-non rule implies that total revenue must cover the full cost of production  Break-even point: a market situation in which a firm’s total revenue equals its long-run total cost (P=LRAC), so that economic profit is zero  Why do owners accept break-even production? Where is their ROI? o Distinction between cost based on standard accounting tax principles and total cost measured from an economic perspective o Break-even in terms of accounting: total revenue is just sufficient to cover total operating expenses o Break-even in an economic sense: if the total revenue is sufficient to pay all the firm’s operating expenses with enough left over to provide the owners a return on their capital equal to the return available from the next best investment alternatives  Amarket situation in which a firm makes a profit in economic terms is a highly favorable situation The Various Average Cost Curves  Total and variable costs must be expressed on a per-unit basis because marginal cost and price are both per unit measures  SRTC = FC + SRVC, so SRTC/q = FC/q + SRVC/q ORAC =AFC +AVC sr  Short run total cost divided by output (AC sr is short run average total cost Average Fixed Cost  AFC: at every output, the firm’s fixed cost divided by its output  Business people often refer to the pattern of declining average fixed cost as the “spreading of overhead expenses”  Fixed cost is a sunk cost and does not figure into the firm’s-decision making process Average Cost  AC: at every output, the firm’s total cost divided by its output  SRAC is reflecting the pattern that short-run total cost rises proportionately less than output at low levels of output and then rises proportionately more than output at higher levels of output  The Law of Diminishing Returns takes over as production nears the physical limits of its capacity in the short run, causing a sharp increases in unit cost Average Variable Cost  AVC: the portion of total cost that changes as output increases or decreases  AVC is well belowAC at lowsrevels of output whenAFC is still a substantial percentage of total unit cost  As output increases,AFC approaches zero, andAVC approaches AC sr Marginal Cost  The MC curve passes through the minimum points of both theAVC and theAC sr sr curves The Short-Run Equilibrium For a Representative Firm:  The q aed p areedetermined by the intersection of the market demand and market supply curves  The demand curve is perfectly elastic at p , theefirms are price takers  The profit maximizing output occurs at the intersection of d and MC f sr  Computing profit or loss in the short run: o TR= q * pe e o SRTC= q *AC sr o Short-run profit= TR- SRTC  If P eAC , tsr firm makes a profit  If P eAC , tsr firm incurs a loss  If P eAC , tsr firm breaks even *graphs pg 326-327  Do firms continue to product in the short run with losses? o Yes- as long as total revenue exceeds variable cost o Test for shutting down is whether P exceeds AVC at the profit maximizing level of output  In the short run a competitive firm’s supply curve is the portion of its marginal cost curve that lies above the minimum value of its AVC curve  The minimum value of AVC defines the shut-down point at which a firm’s willingness to supply, even in the short run, ceases The Long Run in Perfect Competition Two new possibilities arise as the short run turns into the long run:  1) Existing firms can adjust all the factors of production that were fixed in the short run. They review their input decisions in the long run, with the goal of minimizing their costs of production.  2) New firms can enter the industry, and existing firms can leave the industry. The decision to enter or leave an industry depends on investors’expectations of future profits. Adjusting Previously Fixed Factors of Production  AC and AVC are one in the same in the long run o AC = lrTC/q  BothAC anlrMC are Ulrhaped because of the presence of economies of scale at low levels of output and diseconomies of scale at high levels of output  AC lr relatively flat over a wide range of output on either side of its minimum point
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