08 perfect competition

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Chapter 8 Perfect Competition

• Key Concepts• Summary• Practice Quiz• Internet Exercises

©2000 South-Western College Publishing

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In this chapter, you will learn to solve these economic puzzles:Why is the demand curve horizontal for a

firm in a perfectly competitive market?

Why would a firm stay in business while

losing money?

In the long-run, can alligator farms earn an

economic profit?

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Who was Adam Smith?The father of modern

economics who wrote The Wealth of Nations, published in 1776

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What did Adam Smith say about Competitive Forces?

They are like an “invisible hand” that leads people who simply pursue their own interests to serve the interests of society

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What is the purpose of this chapter?

To explain how competitive markets determine prices, output, and profits

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What isMarket Structure?

A classification system for the key traits of a market, including the number of firms, the similarity of the products they sell, and the ease of entry and exit

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What isPerfect Competition?1. many small firms2. homogeneous product3. very easy entry and exit4. price taker

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What doesHomogeneous mean?Goods that cannot be

distinguished from one another; for example, one potato cannot be distinguished from another potato

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What is a Price Taker?A seller that has no

control over the price of the product it sells

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What determines price?Supply and demand

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$80$60$40$20

5 10 15 20

$100$120$130$140

25 30 35 40 45D

S

Market Supply and DemandP

Q

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What determines the individual firm’s Demand Curve?A horizontal line at

the market price

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$80$60$40$20

5 10 15 20

$100$120$130$140

25 30 35 40 45

DIndividual firm demand

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Why is this horizontal line the firm’s

Demand Curve?If the firm charges more

than this price, it will not sell anything, and it has no incentive to charge less than this price

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Why does the firm have no incentive to charge less

than the market price?It can sell everything it

brings to market at the market price

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What does the Perfectly Competitive Firm control?

The only thing it controls is how many units it produces

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How many units should this firm produce?

The number of units whereby it will maximize its profits, or at least minimize its losses

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What are the two methods to determine how many

units to produce?• TR and TC

• MR and MC

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Using the Total Revenue - Total Cost method, where

should a firm produce?Where the distance

between TR and TC is the greatest

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$400

$100

1 2 4

$300

$200

5

$500

3

Quantity of Output

TRMaximize Profit TC

P

Q

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$100

-$50

1 2 4

$50

0

5

$150

3

Quantity of Output

TR

Maximize Profit OutputP

Q

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What isMarginal Revenue?

MR = TR / 1 output

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What isMarginal Cost?

MC = TC / 1 output

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Using the Marginal Revenue and Marginal

Cost method, where should a firm produce?

MR = MC

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Why should a firm continue to produce as

long as MR > MC?As long as MR is > than

MC, money is being made on that last unit

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Why will a firm not produce that unit where MR < MC?

At the unit of output where MR < MC, money is

being lost on that last unit

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Why does P = AR in Perfect Competition?Each additional unit sold

is adding the market price to TR and TR divided by P = AR

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

ATC

AVC

MCP = MR = AR

ProfitP

rice

& C

ost

per

un

it MR=MC

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$40$30$20$10

1 2 3 4

$50$60$70

5 6 7 8 9

ATCAVC

MC

P=MR=ARLoss

Pri

ce &

Cos

t p

er u

nit MR=MC

P

Q

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$40$30$20$10

1 2 3 4

$50$60$70

5 6 7 8 9

ATC

AVC

MC

P=MR=AR

Short-Run Shutdown

MR=MC

P

Q

Loss

Pri

ce &

Cos

t p

er u

nit

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Price (MR) is below minimum average

variable cost

Firm will shut down

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What is the Perfectly Competitive Firm’s Short-

Run Supply Curve?The firm’s marginal cost

curve above the minimum point on its average variable cost curve

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$40$30$20$10

1 2 3 4

$50$60$70

5 6 7 8 9

ATC

AVC

MCMR3

MR2

MR1

Firm’s Short-Run Supply CurveP

Q

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What is the Industry’s Supply Curve?

The summation of the individual firm’s MC curves that lie above their minimum AVC points

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$100

25

$80$60$40$20

5 10 15 20

$120$130

30 35 40 45

S = MCIndustry EquilibriumP

Q

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What is a Normal Profit?The minimum profit

necessary to keep a firm in operation

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In the long-run, what happens when Economic

Profits are made?When firms make more than

a normal profit, firms enter the industry, as supply increases, a downward pressure is put on prices

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In the long-run, what happens when Losses are made?

When firms make less than a normal profit, firms leave the industry, as supply decreases, an upward pressure is put on prices

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In the long-run, where is Equilibrium?

At the market price that enables firms to make a normal profit

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What exists at long-run perfectly competitive

equilibrium?P = MR = SRMC = SRATC = LRAC

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$40$30$20$10

1 2 3 4

$50$60$70

5 6 7 8 9

SATC

LRAC

SRMC

MR

Equilibrium

Long-Run Competitive EquilibriumP

Q

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$80$60$40$20

5 10 15 20

$100$120$130

25 30 35 40 45

D


Q

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What different types of industries can exist

in the long-run?• Constant-cost • Decreasing-cost• Increasing-cost

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What is aConstant-cost Industry?An industry in which the

expansion of industry output by the entry of new firms has no effect on the firm’s cost curves

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What does the long-run supply curve look like in

a Constant-cost industry?It is perfectly elastic,

which is horizontal

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Increase in demand sets a higher equilibrium price


Entry of new firmsincreases supply


Initial equilibriumprice is restored

Initial equilibriumprice is restored

Perfectly elastic long-runsupply curve

Perfectly elastic long-runsupply curve

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What is a Decreasing-cost Industry?

An industry in which the expansion of industry output by the entry of new firms decreases the firm’s cost curves

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What does the long-run supply curve look like in a Decreasing-cost industry?

It is downward sloping

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Equilibrium priceand ATC decreaseEquilibrium priceand ATC decrease

Downward sloping long-runsupply curve

Downward sloping long-runsupply curve

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What is an Increasing-cost Industry?

An industry in which the expansion of industry output by the entry of new firms increases the firm’s cost curves

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What does the long-run supply curve look like in a Increasing-cost industry?

It is upward sloping

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Equilibrium priceand ATC increaseEquilibrium priceand ATC increase

Upward sloping long-runsupply curve

Upward sloping long-runsupply curve

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Key Concepts

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Key Concepts• What is Perfect Competition?

• What is a Price Taker?

• What determines price?

• What determines the individual firm’s Demand Curve?

• Why does the firm have no incentive to charge less than the market price?

• Using the Marginal Revenue and Marginal Cost method, where should a firm produce?

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Key Concepts cont.• Why does MR = P in Perfect Competition?

• What is a Normal Profit?

• In the long-run, what happens when Economic Profits are made?

• In the long-run, what happens when Losses are made?

• In the long-run, where is equilibrium?

• What different types of industries can exist in the long-run?

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Summary

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Market structure consists of three market characteristics: (1) the number of sellers, (2) the nature of the product, (3) the case of entry into or exit from the market.

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Perfect competition is a market structure in which an individual firm cannot affect the price of the product it produces. Each firm in the industry is very small relative to the market as a whole, all the firms sell a homogeneous product, and firms are free to enter and exit the industry.

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A price-taker firm in perfect competition faces a perfectly elastic demand curve. It can sell all it wishes at the market-determined price, but it will sell nothing above the given market price. This is because so many competitive firms are willing to sell at the going market price.

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The total revenue-total cost method is one way the firm determines the level of output that maximizes profit. Profit reaches a maximum when the vertical difference between the total revenue and the total cost curves is at a maximum.

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$400

$100

1 2 4

$300

$200

5

$500

3

Quantity of Output

TRMaximize Profit TC

P

Q

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The marginal revenue equals marginal cost method is a second approach to finding where a firm maximizes profits. Marginal revenue is the change in total revenue from a one-unit change in output. Marginal revenue for a perfectly competitive firm equals the market price.

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The MR = MC rule states that the firm maximizes profit or minimizes loss by producing the output where marginal revenue equals marginal cost. If the price (average revenue) is below the minimum point on the average variable cost curve, the MR = MC rule does not apply, and the firm shuts down to minimize its losses.

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

ATC

AVC

MCP = MR = AR

ProfitP

rice

& C

ost

per

un

it MR=MC

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$40$30$20$10

1 2 3 4

$50$60$70

5 6 7 8 9

ATCAVC

MC

P=MR=ARLoss

Pri

ce &

Cos

t p

er u

nit MR=MC

P

Q

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$40$30$20$10

1 2 3 4

$50$60$70

5 6 7 8 9

ATC

AVC

MC

P=MR=AR

Short-Run Shutdown

MR=MC

P

Q

Loss

Pri

ce &

Cos

t p

er u

nit

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The perfectly competitive firm’s short-run supply curve is a curve showing the relationship between the price of a product and the quantity supplied in the short run. The individual firm always produces along its marginal cost curve above its intersection with the average variable cost curve. The perfectly competitive industry’s short-run supply curve is the horizontal summation of the short-run supply curves of all firms in the industry.

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$100

25

$80$60$40$20

5 10 15 20

$120$130

30 35 40 45


Q

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Long-run perfectly competitive equilibrium occurs when the firm earns a normal profit by producing where price equals minimum long-run average cost equals minimum short-run average total cost equals short-run marginal cost.

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$40$30$20$10

1 2 3 4

$50$60$70

5 6 7 8 9

SATC

LRAC

SRMC

MR

Equilibrium

Long-Run Competitive EquilibriumP

Q

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A constant-cost industry is an industry whose total output can be expanded without an increase in the firm’s average total cost. Because input prices remain constant, the long-run supply curve in a constant-cost industry is perfectly elastic.

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A decreasing-cost industry is an industry in which lower input prices result in a downward-sloping long-run supply curve. As industry output expands, the firm’s average total cost curve shifts downward, and the long-run equilibrium market price falls.

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An increasing-cost industry is an industry in which input prices rise as industry output increases. As a result, the firm’s average total cost curve rises, and the long-run supply curve for an increasing-cost industry is upward sloping.

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Chapter 8 Quiz

©2000 South-Western College Publishing

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1. A perfectly competitive market is not characterized by a. many small firms.b. a great variety of different products.c. free entry into and exit from the market.d. any of the above.

B. Perfect competition is characterized by goods that cannot be distinguished from one another.

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2. Which of the following is a characteristic of perfect competition?a. Entry barriers.b. Homogeneous products.c. Expenditures on advertising.d. Quality of service.

B. A homogeneous product is one that cannot be distinguished from the others, for example, one potato looks just like another potato.

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3. Which of the following are the same at all levels of output under perfect competition? a. Marginal cost and marginal revenue.b. Price and marginal revenue.c. Price and marginal cost.d. All of the above.

B. Price equals marginal revenue because each unit is sold at the same price; therefore, every additional unit sold adds the price to total revenue.

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4. If a perfectly competitive firm sells 100 units of output at a market price of $100 per unit, its marginal revenue per unit is a. $1.b. $100.c. more than $1, but less than $100.d. less than $100.

B. Marginal revenue is defined as the addition to total revenue when selling one unit.

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5. Short-run profit maximization for a perfectly competitive firm occurs when the firm’s marginal cost equals a. average total cost.b. average variable cost.c. marginal revenue.d. all of the above.

C. Profits are maximized or losses are minimized at the unit of output where MR = MC. If MR were > than MC, an additional unit would be produced. If MR were < MC, that last unit would not be produced.

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6. A perfectly competitive firm sells its output for $100 per unit, and the minimum average variable cost is $150 per unit. The firm shoulda. increase output.b. decrease output, but not shut down.c. maintain its current rate of output.d. shut down.

D. At this output a firm’s losses exceed its fixed costs; it would therefore lose more money by staying open than by closing down.

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$40$30$20$10

1 2 3 4

$50$60$70$80

5 6 7 8 9

ATC

AVC

MC

P=MR=AR

Short-Run Shutdown

Pri

ce &

Cos

t p

er u

nit

MR=MC

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7. A perfectly competitive firm’s supply curve follows the upward sloping segment of its marginal cost curve above the a. average total cost curve.b. average variable cost curve.c. average fixed cost curve.d. average price curve.

B. The supply curve does not extend below the AVC curve because below this price the firm would close down; there would not be a supply curve.

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$10

$5

500 1,000

$15

$20

1,500 2,000

ATC

AVC

MCP

rice

& C

ost

per

un

it

B

C

D

A

Exhibit 15

Q

P

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8. Assume the price of the firm’s product in Exhibit 15 is $15 per unit. The firm will produce a. 500 units per week.b. 1,000 units per week.c. 1,500 units per week.d. 2,000 units per week.e. 2,500 units per week.

D. This is the number of units in which MR = MC.

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9. The lowest price in Exhibit 15 at which the firm earns zero economic profit in the short-run is a. $5 per unit.b. $10 per unit.c. $20 per unit.d. $30 per unit.

B. This is the minimum point of the ATC curve at which P = ATC. Exactly a normal profit is being made, that is, zero economic profit.

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10. Assume the price of the firm’s product in Exhibit 15 is $6 per unit. The firm should a. continue to operate because it is earning an

economic profit.b. stay in operation for the time being even

though it is earning an economic loss.c. shut down temporarily.d. shut down permanently.

B. At this price, the firm’s losses are less than its fixed costs; it will therefore lose less money by staying open than closing.

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11. Assume the price of the firm’s product in Exhibit 15 is $10 per unit. The maximum profit the firm earns is a. zero.b. $5,000 per week.c. $1,500 per week.d. $10,500 per week.

A. In perfect competition, Price = AR = MR = the firm’s short-run demand curve. When P = ATC, the firm’s revenues equal its costs, so zero economic profits are made. Normal profit is included as a part of the firm’s cost data because it is a necessary expense of operating the business.

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12. In Exhibit 15, the firm’s total revenue at a price of $10 per unit pays for a. a portion of total variable costs.b. a portion of total fixed costs.c. none of the total fixed costs.d. all of the total fixed costs and total

variable cost.D. At a price of $10, the firm is making an economic profit - more than enough money is being made to meet its fixed costs.

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13. As shown in Exhibit 15, the short-run supply curve for this firm corresponds to which segment of its marginal cost curve? a. A to D and all points above.b. B to D and all points above.c. C to D and all points above.d. B to C only.

B. A supply curve shows how many units will be produced at various prices. The firm’s supply curve is its MC curve which lies above its AVC curve because it will always produce where MR (AR, P) = MC.

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14. In long-run equilibrium, the perfectly competitive firm’s price equals which of the following? a. Short-run marginal cost.b. Minimum short-run average total cost.c. Marginal revenue.d. All of the above.

D. Long-run equilibrium is at the price in which a normal profit is being made. Normal profit is when P(AR) = ATC in long-run equilibrium.

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15. In a constant-cost industry, input prices remain constant as? a. the supply of inputs fluctuates.b. firms encounter diseconomies of scale.c. workers become more experienced.d. firms enter and exit the industry.

D. A constant-cost industry is when the entry or exit of firms has little impact on a firm’s cost curves.

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16. Suppose that , in the long run, the price of feature films rises as the movie production industry expands. We can conclude that movie production is a (an) a. increasing-cost industry.b. constant-cost industry.c. decreasing-cost industry.d. marginal-cost industry.

A. An industry in which the expansion of industry output by the entry of new firms increases the firm’s cost curves

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17. Which of the following is true of a perfectly competitive market? a. If economic profits are earned, then the

price will fall over time.b. In long-run equilibrium, P = MR =

SRMC = SRATC = LRAC.c. A constant-cost industry exists when

the entry of new firms has no effect on their cost curves.

d. All of the above.

D. All of the above statements are true.

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08 perfect competition