Chapter 7. Perfect CompetitionChapter 7. Perfect CompetitionChapter 7. Perfect CompetitionChapter 7. Perfect Competition

• What is it?

• Firm behavior

• Short run

• Long run

• What is it?

• Firm behavior

• Short run

• Long run

Perfect CompetitionPerfect CompetitionPerfect CompetitionPerfect Competition

• many firms, many buyers

• identical product

• easy entry/exit for the market

• prices known

• existing firms have no advantage

• many firms, many buyers

• identical product

• easy entry/exit for the market

• prices known

• existing firms have no advantage

examplesexamplesexamplesexamples

• wheat farming

• dry cleaning

• paper cups

• wheat farming

• dry cleaning

• paper cups

Firm BehaviorFirm BehaviorFirm BehaviorFirm Behavior

• maximize profits

• TR > TC economic profits

• TR = TC normal profits

• maximize profits

• TR > TC economic profits

• TR = TC normal profits

Firm is price takerFirm is price takerFirm is price takerFirm is price taker

• cannot influence price take price as given, choose Q

• firm demand is perfectly elastic horizontal line

• MR = P firm sells all it wants at price, P

• cannot influence price take price as given, choose Q

• firm demand is perfectly elastic horizontal line

• MR = P firm sells all it wants at price, P

Profit maximizingProfit maximizingProfit maximizingProfit maximizing• firm chooses Q to max profits

where TR - TC is largest

-- where MR = MC

• why MR = MC? MR > MC

-- output adding to profit MR < MC

-- output taking away from profit

• firm chooses Q to max profits where TR - TC is largest

-- where MR = MC

• why MR = MC? MR > MC

-- output adding to profit MR < MC

-- output taking away from profit

Market for syrup (all firms)Market for syrup (all firms)Market for syrup (all firms)Market for syrup (all firms)P

Q (cans/day)

D

S

$8

100

Firm’s demand, cost curveFirm’s demand, cost curveFirm’s demand, cost curveFirm’s demand, cost curve

P

Q (cans/day)

$8 D = MR = P

MC

10

• firm is price taker

• what if price too low to earn profit? economic loss will firm exit?

• firm is price taker

• what if price too low to earn profit? economic loss will firm exit?

costs & exitcosts & exitcosts & exitcosts & exit

• firm will stay, in SR, if P > AVC

• why? if firm exits, loses TFC if P = AVC

-- loss from staying

= loss from exit

• firm will stay, in SR, if P > AVC

• why? if firm exits, loses TFC if P = AVC

-- loss from staying

= loss from exit

SR equilibriumSR equilibriumSR equilibriumSR equilibrium

• two cases economic profit economic loss

• two cases economic profit economic loss

Case 1: economic profitCase 1: economic profitCase 1: economic profitCase 1: economic profit

• P = $8, Q = 10

• ATC = $5

• profit = ($8)(10) - ($5)(10) = $30

• P = $8, Q = 10

• ATC = $5

• profit = ($8)(10) - ($5)(10) = $30

P

Q (cans/day)

$8 D = MR = P

MC

10

ATC

$5

economicprofit

case 2: economic losscase 2: economic losscase 2: economic losscase 2: economic loss

• P = $3, Q = 7

• ATC = $5

• profit = ($3)(7) - ($5)(7) = - $14

• P = $3, Q = 7

• ATC = $5

• profit = ($3)(7) - ($5)(7) = - $14

P

Q (cans/day)

$3 D = MR = P

MC

7

ATC

$5

economicloss

12.3 LR Equilibrium12.3 LR Equilibrium12.3 LR Equilibrium12.3 LR Equilibrium

• entry & exit of firms

• firms earn normal profit economic profit will be zero

• entry & exit of firms

• firms earn normal profit economic profit will be zero

why zero economic profit?why zero economic profit?why zero economic profit?why zero economic profit?

• if economic profit > zero firms enter (S shifts right) price falls profit falls to zero

• if economic profit > zero firms enter (S shifts right) price falls profit falls to zero

P

Q (cans/day)

D

S

$8

100

S’

$5

120

market for syrupmarket for syrupmarket for syrupmarket for syrup

Syrup firmSyrup firmSyrup firmSyrup firm

P

Q (cans/day)

D = MR = P

MC

ATC

$5

zeroeconomicprofit

• if economic profit < zero firms exit (S shifts left) price rises profit rises to zero

• if economic profit < zero firms exit (S shifts left) price rises profit rises to zero

P

Q (cans/day)

D

S

$5

120

market for syrupmarket for syrupmarket for syrupmarket for syrup

$3

140

S’’

P

Q (cans/day)

$3 D = MR = P

MC

7

ATC

$5

economicloss

Syrup firmSyrup firmSyrup firmSyrup firm

P

Q (cans/day)

D = MR = P

MC

ATC

$5

zeroeconomicprofit

Shifts in market demandShifts in market demandShifts in market demandShifts in market demand

• change price in SR profits or losses

• in LR affect exit/entry return to zero economic profit

• change price in SR profits or losses

• in LR affect exit/entry return to zero economic profit

SummarySummarySummarySummary

• price takers

• MR = MC determines equilibrium Q SR: economic profit or loss LR: economic profit is zero due

to entry/exit

• price takers

• MR = MC determines equilibrium Q SR: economic profit or loss LR: economic profit is zero due

to entry/exit