1. Lecture 7 Chapter 20: Perfect Competition 1Naveen Abedin

2.  Firms are the entities that use resources/inputs to produce goods and services.  Every firm operates within a certain type of market structure  A market structure is a firm’s particular environment or setting which influences the firm’s pricing and output decisions.  The four different types of market structures are: 1) Perfect Competition 2) Monopoly 3) Monopolistic Competition 4) Oligopoly Naveen Abedin2

3. 1) There are many sellers and many buyers, none of whom is large in relation to total sales and total purchases, respectively. The size of each buyer and seller is so small compared to the entire market, that each individual buyer or seller upon market demand and supply. 2) Each firm produces and sells a homogenous (completely identical) product 3) Perfect Information: Buyers and sellers have all relevant information available about prices, product quality and source of supply 4) There are no barriers to entry or exit – firms can enter or leave the industry at any time because of low entry and exit costs. Naveen Abedin3

4.  A price taker is a seller that does not have the ability to control the price of the product he/she sells. Instead, the seller takes the price set by the market.  There are three reasons why a perfectly competitive firm is a price taker: (a) Small relative to the entire market (b) Sells homogenous product (c) Consumers have all the relevant information about the market available Naveen Abedin4

5.  As a consequence of the firm being a price taker, the demand curve is perfectly horizontal- no matter what quantity the firm decides to sell, it cannot sell the product at a price higher than the market equilibrium price. Naveen Abedin5

6.  Perfectly competitive firms sell at the market equilibrium price.  If firms try to sell at a price higher than the market price, then they lose all their customers because (a) their individual market share is so small (b) firms sell homogenous products and (c) customers have perfect information.  If firms try to sell at a price lower than the market price, then they are selling at a suboptimal (not the best) price Naveen Abedin6

7.  Recall, Total Revenue = Price × Quantity  Marginal Revenue is the change in Total Revenue (TR) that results from selling one additional unit of output (Q). It is the additional earnings generated from increasing output by one more unit.  TR = P × Q  ∆TR = P ×∆Q  Since Price does not change, the entire change in Total Revenue comes from change in quantity.  Therefore  So, Marginal Revenue = Price  Be careful – MR = P is only true perfectly horizontal demand curves Naveen Abedin7

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9.  It is rare to find a perfect example for Perfect Competition market structure.  Closest approximations can be found for stock markets, agricultural markets.  This type of a market structure is studied because it is an ideal market environment. Naveen Abedin9

10.  Since Marginal Revenue = Price, and Demand = Price, Marginal Revenue = Demand Profit Maximizing Firm  What quantity of output should firms produce in order to maximize their profits?  Ans: The firm will continue to increase its quantity of output as long as marginal revenue is greater than the marginal cost.  Recall that Marginal Revenue is the additional earnings generated from increasing output by one more unit. And Marginal Cost is the additional cost generated by increasing output by one more unit. As long as Additional Revenue > Additional Cost, the firm is making Additional Profit.  Therefore, in order to maximize profits, the firm should continue producing output until Marginal Revenue = Marginal Cost.  Marginal Revenue = Marginal Cost is known as the Profit Maximizing Condition. Naveen Abedin10

11.  Recall that Marginal Revenue = Marginal Cost is the Profit Maximizing condition.  Since Marginal Revenue = Price for a perfectly competitive firm, Marginal Revenue = Price = Marginal Cost is the profit maximizing condition of output for perfectly competitive firms.  Hence perfectly competitive firms will produce as long as Price = Marginal Cost. Naveen Abedin11

12.  Resource Allocative Efficiency is achieved when the value consumers place on a good or service equal to the cost of the resource used up in production.  Price = Marginal Cost : Condition for Resource Allocative Efficiency Naveen Abedin12

13. 1) Profit = Total Revue – Total Cost. A firm breaks- even when Total Revenue = Total Cost Total Revenue = Price × Quantity If you divide TR and TC by Quantity, the break-even point occurs when Price = ATC Therefore, when TR = TC → Price = AC, we have break-even. When TR>TC → Price>AC, so the firm makes profits. When TR<TC → Price<AC, firm makes loss. 2) Total Cost = Explicit Costs + Implicit Costs, so when the firm is breaking even, they are making Zero Economic Profits. This is known as Normal Profits. When TR > TC → Price>AC, the firm is making positive Economic Profit. This is known as Supernormal Profit or Economic Profit. Naveen Abedin13

14. 3) Profit Maximizing level of output occurs where Marginal Revenue = Marginal Cost. Recall that Marginal Revenue is the slope of Total Revenue curve, and Marginal Cost is the slope of Total Cost curve. The point where the slope of Total Revenue equals to the slope of Total Cost, Profit is Maximized. Naveen Abedin14

15.  Case 1: Price is above Average Total Cost, Price > ATC, hence the firm is making Economic Profit.  Profit-maximizing quantity = 100 units  Market equilibrium price = $15  Total Revenue = $15 X 100 = $1500  TC/Q = ATC, hence Total Cost = ATC X Q = $11 X 100 = $1100  Profits = $1500 = $1100 = $400 (firm is making Economic Profit)  Total Variable Cost = $7 X 100 = $700  Total Fixed Cost = $1100 - $700 = $400 Naveen Abedin15

16.  Case 2: Price is below Average Variable Cost, Price < AVC, hence the firm is making a loss. In this situation, it is better for the firm to shut-down.  Profit-maximizing quantity = 50 units  Market equilibrium price = $4  Total Revenue = $4 X 50 = $200  TC/Q = ATC, hence Total Cost = ATC X Q = $13 X 50 = $650  Profits = $200 - $650 = -$450 (firm is making loss)  Total Variable Cost = $5X 50 = $250  Total Fixed Cost = $650 - $250 = $400 Naveen Abedin16

17.  Case 3: Price is below Average Total Cost, but above Average Variable Cost. AVC < Price < AC. The firm is making a loss but can continue operating the short-run.  Profit-maximizing quantity = 80 units  Market equilibrium price = $9  Total Revenue = $9 X 80 = $720  TC/Q = ATC, hence Total Cost = ATC X Q = $10 X 80 = $800  Profits = $720 - $800 = -$80 (firm is making loss)  Total Variable Cost = $5X 80 = $4000  Total Fixed Cost = $800 - $400 = $400 Naveen Abedin17

18.  Case 1: Firm is making economic profit, so it will continue to operate in the short-run  Case 2: Firm is making a loss. It’s price is below Average Variable Cost. The operating loss is $450. If the firm shuts down, its loss will be equal to Total Fixed Cost, $400. Shutdown loss is lower than Operating loss, so the firm should shutdown.  Case 3: Firm is making a loss. The operating loss is $80. If the firm shuts down, its loss will be equal to Total Fixed Cost, $400. Operating loss is less than Shutdown loss, so the firm will continue to operate in the short-run.  In the long-run, the firm shuts down whenever it is making a loss. Naveen Abedin18

19.  Profit-maximizing quantity of output can be found at the intersection of Price (demand curve) and the Marginal Cost curve.  If Price is below Average Variable Cost, the firm shuts down.  Therefore, the short-run supply curve of a perfectly competitive firm is the portion of its marginal cost that lies above average variable cost curve.  If price is above Average Variable Cost, the firms will produce the output corresponding to the intersection of Marginal Cost and Marginal Revenue, where Marginal Revenue is equal to Price. Naveen Abedin19

20.  The number of firms in the industry in the short- run may not equal to the number of firms in the industry in the long-run.  When firms in the short-run are making economic profits (Price > ATC), other firms attracted by this profit, enter the industry and increase the market supply. Market supply curve shifts to the right, and decreases equilibrium price till (Price = ATC). Thus firms make Normal Profits in the long-run  When firms in the short-run are making losses, some of the firms whose Price < Average Variable Cost exit the industry. This reduces market supply and shifts the supply curve to the left, increasing equilibrium price till Price = ATC. Hence firms make Normal Profits in the long-run. Naveen Abedin20

21. 1) Since firms make Normal Profits in the Long-run there is no incentive for firms to enter of exit from the industry. 2) Firms continue to produce at profit- maximizing level of output, Price = Marginal Revenue = Marginal Cost Naveen Abedin21

22.  Firms achieve Productive Efficiency in the long-run, because when perfectly competitive firms are making Normal Profits, Price = Marginal Revenue = Marginal Cost = min. ATC  Productive efficiency exists when a firm produces output at the lowest possible per-unit cost. Naveen Abedin22