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Perfect Competition
Perfectly competitive market: all participants are price-takers
Perfectly competitive industry: all producers are price-takers
Price-taker: whose action has no effect on market price
Price-taking producer: market price does not change because of the quantity he sells.
Price-taking consumer: market price does not change because of the amount he buys.
Perfect Competition: Characteristics
Many buyers and sellersand each is so small that no one can affect price individually (for sellers, no one has large enough market share)
All firms produce a homogeneous product (identical / standardized)at least consumers think so
Free entry and exiteach firm has complete knowledge about production and cost; no regulation limit
Producer Decision-Making:
Goal: Maximize Profit = TR – TC–TC = TFC + TVC = wL + rK
–ATC = TC / Q
–MC = Δ(TC)/ΔQ
Recall: Short-Run Costs - Summary
at Q=0, VC=0, but FC>0 when MC is declining, ATC and AVC bo
th decline at an increasing rate when MC starts increasing, ATC and A
VC may both be decreasing but at a decreasing rate
MC intersects AVC and ATC at their minimum, respectively
Total Revenue: TR
TR = PQ AR = PQ/Q = P MR = Δ(PQ)/ΔQ
= (ΔP*Q)/ΔQ + (P*ΔQ)/ΔQ= (ΔP /ΔQ ) Q + P(ΔQ/ΔQ )= (ΔP /ΔQ ) Q + PPerfect competition:MR = P = AR (ΔP =0)
Short-Run optimal output levelin a perfectly competitive market
Goal: maximize profit– Demand facing the industry: downward slo
ping– Demand facing the firm: horizontal at P
(all are price takers, and no one is large enough to affect market price)
Optimal output level determined by
D=P=MR=MC
Profit-Maximizing Output
Decision rule:
is maximized when MR = MC
(think: why?)
profit is maximized at the quantity of outp
ut where the marginal revenue of the las
t unit produced is equal to its marginal c
ost.
Questions to consider:
How much is fixed cost? Is marginal cost calculated based on tot
al cost or variable cost? Why is marginal revenue constant at $1
8? What is net gain? Is the goal to maximize net gain?
Again: under perfect competition
MR = Δ(PQ)/ΔQ
= (ΔP*Q)/ΔQ + (P*ΔQ)/ΔQ
= (ΔP /ΔQ ) Q + P(ΔQ/ΔQ )
When ΔP=0 (price taking)
MR =P
Decision rule:
is maximized when MR=P=MC
The Price-Taking Firm’s Profit-Maximizing Quantity of Output
The profit-maximizing point is where the marginal cost curve crosses the marginal revenue curve (which is a horizontal line at the market price).
The Short-Run Production Decision
A firm will cease production in the short-run if the market price falls below the shut-down price, which is equal to minimum average variable cost.
Short-Run optimal output level: various profit situations
Rule: produce at MR=P=MC.– Positive Economic Profit:
when D=MR=P>ATC at MR=P=MC– Operating at a loss:
when AVC<D=MR=P<ATC at MR=P=MC– Shut Down:
when D=MR=P<AVC at MR=P=MC
The break-even price:
the market price at which the firm earns zero profit (P=ATC).
Principles:
MC tells how much to produce (produce up to the amount where MR=P=MC)
ATC tells how much profit or loss is made if the firm decides to produce (profit = (P - ATC) * Q).
AVC tells whether to keep producing (keep producing only when P>AVC at P=MC)
Employeesper day
0 0 0 40
1 80 12 0.150 52 0.650
2 200 24 0.120 64 0.320
3 260 36 0.138 76 0.292
4 300 48 0.160 88 0.293
5 330 60 0.182 100 0.303
6 350 72 0.206 112 0.320
7 362 84 0.232 124 0.343
Bottlesper day
Variable cost
($/day)
Average variable cost
($/unit of output)
Total cost
($/day)
Average total cost($/unit of output)
0.15
0.10
0.20
0.30
0.40
0.60
1.00
Marginal cost
($/bottle)
Table 6.4, P.176Also example: AVC and ATC
The Short-Run Supply
A firm will cease production in the short-run if the market price falls below the shut-down price, which is equal to minimum average variable cost.
Short-Run Supply
for the firm: supply curve is upward sloping because of the law of increasing cost (S=MC).
for the industry: the supply curve is upward sloping, flatter than single firm supply curve, and steeper than the horizontal summation firm supplies.
The Short-Run Market Equilibrium
There is a short-run market equilibrium when the quantity supplied equals the quantity demanded, taking the number of producers as given.
The Effect of an Increase in Demand in the Short-Run and the Long-Run
D↑ P↑ non-zero profits entry S↑ P↓ back to zero profit
(on LRS curve)
Comparing the Short-Run and Long-Run Industry Supply Curves
The long-run industry supply curve is always flatter—more elastic—than the short-run industry supply curve. This is because of entry and exit:
Long-Run optimal output level:
All firms will be producing where P=LMC=LAC and economic profit will be zero because of free entry and exit.
Firms enjoy big economic rent if they own the resources that have higher productivity than similar resources owned by others.
The Long-Run Market Equilibrium
A market is in long-run market equilibrium when the quantity supplied equals the quantity demanded, given that sufficient time has elapsed for entry into and exit from the industry to occur.
Conclusions:
In a perfectly competitive industry in equilibrium, the value of marginal cost is the same for all firms.
In a perfectly competitive industry with free entry and exit, each firm will have zero economic profits in long- run.
The long-run market equilibrium of a perfectly competitive industry is efficient: no mutually beneficial transactions go unexploited.