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Perfect Competition Jeremy Wong & Cynthia Ji. A market where no participants are large enough to set the price of a product Many conditions exist for.

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Presentation on theme: "Perfect Competition Jeremy Wong & Cynthia Ji. A market where no participants are large enough to set the price of a product Many conditions exist for."— Presentation transcript:

1 Perfect Competition Jeremy Wong & Cynthia Ji

2 A market where no participants are large enough to set the price of a product Many conditions exist for a perfectly competitive market Therefore there are few if any, truly competitive markets Mainly used as a benchmark for other market structures Lets take a look at some of the conditions of a perfectly competitive market! What is Perfect Competition?

3 Large number of buyers and sellers Conditions Buyers Sellers

4 Homogenous/identical products (e.g. no brand loyalty) Conditions Example: All window cleaning solutions are the same Brand A = Brand B = Brand C = Brand D

5 No barriers to entry and exit from market Conditions A company can easily enter into a market for a product and just as easily leave that market.

6 No advantages for established firms Conditions Firm A (left) Firm B (below) Although well established, Firm B does not have any advantages over Firm A

7 No power to set the market price Conditions No one firm has market power, the ability to influence the price of a product.

8 Price determined by industry supply and demand

9 As a result, the industry demand will be downward sloping demand curve but the firms demand will be perfectly elastic (horizontal line).

10 Suppliers only supply a small portion of the total industry output Conditions Example: Manufacturers only have a small market share in the Luxury Automotive Industry

11 Example: Consumers will know all the available prices for a MacBook Pro Consumers and producers have perfect market knowledge Conditions

12 The aim of firms is to maximize profit Conditions

13 Total Revenue (TR) – Amount of money that a firm makes by selling its products (TR=Price x Quantity) Ex: A firm sells 200 apples for $2 each. The total revenue from selling apples would be 200 multiplied by 2 for a TR of $400. Average Revenue (AR) – How much revenue a firm receives for a typical unit sold (total revenue divided by number of units sold) Ex: A firm makes $400 from selling 100 widgets. Their average revenue would be 400 divided by 100 to give an AR of $4. Definitions

14 Average Total Cost (ATC) – Total cost of producing all units divided by the number of units produced. Includes the opportunity cost of producing the good. Ex: It costs $200 to produce 100 gadgets. By dividing 200 by 100, we get an ATC of $2. Definitions

15 Normal Profit – Exists when total revenue is equal to total costs (minimum profit needed to run the business and the long term profit for perfectly competitive markets). Opportunity cost is not considered. Economic/Abnormal Profit – When total revenue is greater than total costs, it is the difference between these two values (can only be achieved in the short term in a perfectly competitive market) Definitions

16 Marginal Revenue (MR) The additional revenue generated by increasing product sales by 1 unit Calculation: __change in total revenue__ change in output quantity In perfect competition, MR = AR = Price = Demand Producers cant set price but can determine how much of a product to produce in order to maximize profit. Marginal Revenue = Marginal Cost Maximizing Profit Marginal Cost (MC) The change in the total cost that arises when quantity produced changes by 1 unit Calculation: ___change in total cost___ change in output quantity

17 In a perfectly competitive market, marginal revenue is the same as the average revenue per unit: Marginal Revenue # of UnitsTotal RevenueMarginal Revenue # of UnitsTotal RevenueMarginal Revenue

18 There can be a positive economic profit which is maximized at the point where MC=MR Short run profit

19 Figure 1 Profit Maximization for a Competitive Firm Copyright © 2004 South-Western Quantity 0 Costs and Revenue MC ATC AVC MC 1 Q 1 2 Q 2 The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. Q MAX P = MR 1 = 2 P = AR = MR

20 When MR > MC increase Q When MR < MC decrease Q When MR = MC profit maximized How to calculate profit: Profit=q e (P-ATC) How to maximize profit: Short run profit

21 Figure 5 Profit as the Area between Price and Average Total Cost Copyright © 2004 South-Western (a) A Firm with Profits Quantity 0 Price P=AR= MR ATCMC P ATC Q (profit-maximizing quantity) Profit

22 Figure 5 Profit as the Area between Price and Average Total Cost Copyright © 2004 South-Western (b) A Firm with Losses Quantity 0 Price ATCMC (loss-minimizing quantity) P=AR= MR P ATC Q Loss

23 Economic profit = 0 Long run profit

24 More firms will enter the market Supply increases, price decreases Profit decrease and Marginal Revenue decrease Average Total Cost = Marginal Revenue If economic profit is less than 0: Firms will leave the market Supply decreases, price increases Profit increase and Marginal Revenue increase Average Total Cost = Marginal Revenue Why is economic profit 0? If economic profit is greater than 0: Long run profit

25 Why Stay if No Economic Profit is made? Profit=total revenue – total cost Total cost include all the opportunity cost of the firm The long-run market supply curve is horizontal at this price. In a zero-profit equilibrium, the revenue compensates the time and money the owners spent to keep the business going Normal profit is still being made

26 Market Supply with Entry and Exit Copyright © 2004 South-Western (a) Firms Zero-Profit Condition Quantity (firm) 0 Price (b) Market Supply Quantity (market) Price 0 P = minimum ATC Supply MC ATC

27 Shutdown – A firms short run decision to stop production for a period of time due to market conditions. Exit – A firms long run decision to leave the market entirely Variable Costs – Expenses that change depending on the amount of output. Fixed Costs – Stays the same no matter the amount of output. Shutting Down or Exiting

28 Decision to Shut Down in the Short Run A firm shuts down its revenue is less than the variable cost of production. Shut down if Total Revenue < Total Variable Cost Converting this into per unit comparison: Shut down if Price < Average Variable Cost

29 The Competitive Firms Short Run Supply Curve Copyright © 2004 South-Western MC Quantity ATC AVC 0 Costs Firm shuts down if P < AVC Firms short-run supply curve If P > AVC, firm will continue to produce in the short run. If P > ATC, the firm will continue to produce at a profit.

30 Short run supply curve The short run supply curve for the firm is the portion of its marginal cost curve that lies above average variable cost since the firm would shutdown once price falls below the average variable cost.

31 Decision to Exit in the Long Run The firm exits if the revenue it would get from producing is less than its total cost. Exit if Total Revenue < Total Cost Converting this into per unit comparison: Exit if Price < Average Total Cost

32 Decision to Enter in the Long Run A firm will enter the industry if such an action would be profitable. Enter if TR > TC Converting this into per unit comparison: Enter if P > ATC

33 Figure 4 The Competitive Firms Long-Run Supply Curve Copyright © 2004 South-Western MC = long-run S Firm exits if P < ATC Quantity ATC 0 Costs Firms long-run supply curve Firm enters if P > ATC

34 The long run supply curve for the firm is the marginal cost curve above the minimum point of its average total cost curve since the firm would exit the market once price falls below average total cost. Long run supply curve

35 Shift in Demand in the Short Run and Long Run An increase in demand raises price and quantity in the short run. Firms earn profits because price now exceeds average total cost. In the long run, the increase in supply will push the equilibrium point to the original price with increased quantity.

36 An Increase in Demand in the Short Run and Long Run Firm (a) Initial Condition Quantity (firm) 0 Price Market Quantity (market) Price 0 DDemand, 1 SShort-run supply, 1 P 1 ATC Long-run supply P 1 1 Q A MC

37 An Increase in Demand in the Short Run and Long Run Copyright © 2004 South-Western Market Firm (b) Short-Run Response Quantity (firm) 0 Price MC ATC Profit P 1 Quantity (market) Long-run supply Price 0 D 1 D 2 P 1 S 1 P 2 Q 1 A Q 2 P 2 B

38 An Increase in Demand in the Short Run and Long Run Copyright © 2004 South-Western P 1 Firm (c) Long-Run Response Quantity (firm) 0 Price MC ATC Market Quantity (market) Price 0 P 1 P 2 Q 1 Q 2 Long-run supply B D 1 D 2 S 1 A S 2 Q 3 C

39 Allocative Efficiency – The firm produces only goods that are most desirable and high in demand (P=MC) Efficiency

40 Productive Efficiency – The firm produces goods at the lowest possible cost which is a point on the Production Possibilities Curve (production at minimum ATC)

41 Short runLong run Economic Profit YesNo Productively Efficient NoYes Allocatively Efficient Yes Comparing short run and long run

42 QUIZ

43 a) Increasing its output b) Decreasing its output c) Increasing its price d) Increasing its resources Which of the following is not a valid option for a perfectly competitive firm? Question 1

44 a) Increasing its output b) Decreasing its output c) Increasing its price d) Increasing its resources Which of the following is not a valid option for a perfectly competitive firm? Question 1

45 a) Economic profit b) Allocative efficiency c) Productive efficiency d) Normal profit In the long run, a perfectly competitive firm will achieve all but which of the following? Question 2

46 a) Economic profit b) Allocative efficiency c) Productive efficiency d) Normal profit In the long run, a perfectly competitive firm will achieve all but which of the following? Question 2

47 a) Always earning an economic profit b) Always productively efficient c) Always allocatively efficient d) Always experiencing an economic loss If the price a firm receives for its product is equal to the marginal cost of producing that product, the firm is: Question 3

48 a) Always earning an economic profit b) Always productively efficient c) Always allocatively efficient d) Always experiencing an economic loss If the price a firm receives for its product is equal to the marginal cost of producing that product, the firm is: Question 3

49 a) Earning an economic profit b) Productively efficient c) Dominating the other firms in the market d) Not producing enough output A firm that is producing at the lowest possible average cost is always: Question 4

50 a) Earning an economic profit b) Productively efficient c) Dominating the other firms in the market d) Not producing enough output A firm that is producing at the lowest possible average cost is always: Question 4

51 a) Earn an economic profit b) Increase its price if it is experiencing an economic loss c) Produce the quantity where its marginal cost equals its marginal revenue d) Produce at the productively efficient level of output A perfectly competitive firm should always: Question 5

52 a) Earn an economic profit b) Increase its price if it is experiencing an economic loss c) Produce the quantity where its marginal cost equals its marginal revenue d) Produce at the productively efficient level of output A perfectly competitive firm should always: Question 5

53 a) A total profit of $2 b) A total profit of $2000 c) A price greater than its marginal cost d) An economic loss If a profit maximizing perfectly competitive firm is selling 1000 units at a price $10 and its average total cost is $8, the firm is experiencing: Question 6

54 a) A total profit of $2 b) A total profit of $2000 c) A price greater than its marginal cost d) An economic loss If a profit maximizing perfectly competitive firm is selling 1000 units at a price $10 and its average total cost is $8, the firm is experiencing: Question 6

55 a) Price will increase b) Other firms will enter the market c) Other firms will leave the market d) Demand will decrease Which is most likely to happen if a perfectly competitive firm is experiencing an average revenue greater than its average cost? Question 7

56 a) Price will increase b) Other firms will enter the market c) Other firms will leave the market d) Demand will decrease Which is most likely to happen if a perfectly competitive firm is experiencing an average revenue greater than its average cost? Question 7

57 a) Firms will enter the market, price will decrease b) Firms will enter the market, price will increase c) Firms will exit the market, price will decrease d) Firms will exit the market, price will increase If a perfectly competitive firm is experiencing an economic loss, which of the following will happen? Question 8

58 a) Firms will enter the market, price will decrease b) Firms will enter the market, price will increase c) Firms will exit the market, price will decrease d) Firms will exit the market, price will increase If a perfectly competitive firm is experiencing an economic loss, which of the following will happen? Question 8

59 a) Earn an economic profit, be allocatively efficient, be productively efficient b) Not earn an economic profit, be allocatively efficient, be productively efficient c) Not earn an economic profit, not be allocatively efficient, be productively efficient d) Not earn an economic profit, not be productively efficient, be allocatively efficient A perfectly competitive firm that is in long run equilibrium will Question 9

60 a) Earn an economic profit, be allocatively efficient, be productively efficient b) Not earn an economic profit, be allocatively efficient, be productively efficient c) Not earn an economic profit, not be allocatively efficient, be productively efficient d) Not earn an economic profit, not be productively efficient, be allocatively efficient A perfectly competitive firm that is in long run equilibrium will Question 9

61 a) Experience an economic loss b) Experience an economic profit and produce more in the short run c) Experience an economic profit and produce less in the short run d) Experience no economic profit in the short run A perfectly competitive firm produces widgets in the long run. The market demand for widgets suddenly increases. The firm will Question 10

62 a) Experience an economic loss b) Experience an economic profit and produce more in the short run c) Experience an economic profit and produce less in the short run d) Experience no economic profit in the short run A perfectly competitive firm produces widgets in the long run. The market demand for widgets suddenly increases. The firm will Question 10

63 a) R b) S c) T d) U e) J The firm maximizes profit at which output? Question 11

64 a) R b) S c) T d) U e) J The firm maximizes profit at which output? Question 11

65 a) Less than $15 b) $50 c) Above $60 d) Between $50 and $60 e) $60 The firms shutdown price is Question 12

66 a) Less than $15 b) $50 c) Above $60 d) Between $50 and $60 e) $60 The firms short run shutdown price is Question 12


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