Perfect (or pure) Competition

Perfectly elastic demand Perfect Competition Many small firms Standardized product No need to advertise “Price takers” Free entry and exit Perfectly elastic demand Average revenue Marginal revenue Price 9-2

Demand for Perfectly Competitive Firms (A Horizontal straight line) Why are they Price Takers? If a firm charges above the market price, NO ONE will buy. They will go to other firms There is no reason to price low because consumers will buy just as much at the market price. Since the price is the same at all quantities demanded, the demand curve for each firm is… Perfectly Elastic (A Horizontal straight line) Copyright ACDC Leadership 2015

The Competitive Firm is a Price Taker Price is set by the Industry (all firms) Firm P S P Demand $10 $10 D Q 5000 Q Copyright ACDC Leadership 2015

The Competitive Firm is a Price Taker Price is set by the Industry What is the additional revenue for selling an additional unit? 1st unit earns $10 2nd unit earns $10 Marginal revenue is constant at $10 Notice: Total revenue increases at a constant rate MR equal Average Revenue Firm P Demand $10 MR=D=AR=P Q 5 5 Copyright ACDC Leadership 2015

For Perfect Competition: Demand = MR (Marginal Revenue) The Competitive Firm is a Price Taker Price is set by the Industry For Perfect Competition: Demand = MR (Marginal Revenue) What is the additional revenue for selling an additional unit? 1st unit earns $10 2nd unit earns $10 Marginal revenue is constant at $10 Notice: Total revenue increases at a constant rate MR equal Average Revenue Firm P Demand $10 MR=D=AR=P Q 6 6 Copyright ACDC Leadership 2015

Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! To maximum profit firms must make the right output Firms should continue to produce until the additional revenue from each new output equals the additional cost. Example (Assume the price is $10) Should you produce… …if the additional cost of another unit is $5 …if the additional cost of another unit is $9 …if the additional cost of another unit is $11 Copyright ACDC Leadership 2015

Profit Maximizing Rule Short-Run Profit Maximization MR=MC Short-Run Profit Maximization What is the goal of every business? To Maximize Profit!!!!!! To maximum profit firms must make the right output Firms should continue to produce until the additional revenue from each new output equals the additional cost. Example (Assume the price is $10) Should you produce… …if the additional cost of another unit is $5 …if the additional cost of another unit is $9 …if the additional cost of another unit is $11 8 Copyright ACDC Leadership 2015

Lets put costs and revenue together to calculate profit. Industry Firm (price taker) P S P MC Demand $7 $7 ATC D Q 10,000 Q Copyright ACDC Leadership 2015

How much output should be produced? How much is Total Revenue? How much is Total Cost? Is there profit or loss? How much? P $9 8 7 6 5 4 3 2 1 MC MR=D=AR=P Profit = $18 ATC Total Cost=$45 Total Revenue =$63 Q 1 2 3 4 5 6 7 8 9 10 Copyright ACDC Leadership 2015

The profit maximizing rule is also the loss minimizing rule!!! Suppose the market demand falls. What would happen if the price is lowered from $7 to $5? The MR=MC rule still applies but now the firm will make an economic loss. The profit maximizing rule is also the loss minimizing rule!!! Copyright ACDC Leadership 2015

How much output should be produced? How much is Total Revenue? How much is Total Cost? Is there profit or loss? How much? MC $9 8 7 6 5 4 3 2 1 ATC Cost and Revenue Loss =$7 MR=D=AR=P Total Cost = $42 Total Revenue=$35 Q 1 2 3 4 5 6 7 8 9 10

Assume the market demand falls even more Assume the market demand falls even more. If the price is lowered from $5 to $4 the firm should stop producing. Shut Down Rule: A firm should continue to produce as long as the price is above the AVC When the price falls below AVC then the firm should minimize its losses by shutting down Why? If the price is below AVC the firm is losing more money by producing than they would have to pay to shut down. Copyright ACDC Leadership 2015

P<AVC. They should shut down Producing nothing is cheaper than staying open. Price MC $9 8 7 6 5 4 3 2 1 ATC Fixed Costs=$10 AVC TC=$35 MR=D=AR=P TR=$20 Q 1 2 3 4 5 6 7 8 9 10 Copyright ACDC Leadership 2015

Short-Run Supply Curve Firms produce where MR=MC Cost and Revenues (Dollars) Quantity Supplied MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 This Price is Below AVC And Will Not Be Produced Q2 Q3 Q4 Q5 9-15

Short-Run Supply Curve Firms produce where MR=MC Examine the MC for the Competitive Firm Cost and Revenues (Dollars) Quantity Supplied MC Above AVC Becomes the Short-Run Supply Curve S Break-even (Normal Profit) Point MC e P5 MR5 d ATC P4 MR4 c AVC P3 MR3 b P2 MR2 a P1 MR1 Shut-Down Point (If P is Below) Q2 Q3 Q4 Q5 9-16

Profit Maximizing Rule MR = MC Three Characteristics of MR=MC Rule: Rule applies to ALL markets structures (PC, Monopolies, etc.) The rule applies only if price is above AVC Rule can be restated P = MC for perfectly competitive firms (because MR = P) Copyright ACDC Leadership 2015

Practice 18 Copyright ACDC Leadership 2015

#1 MC MR=D=AR= P ATC Quantity $16 15 10 9 14 5 1. Should the firm produce? 2. What output should the firm produce? 3. What is the TR and TC at that output? 4. How much profit or loss? Yes 10 TR=$140 TC=$100 $16 15 10 9 5 Profit=$40 Price MC MR=D=AR= P 14 ATC Quantity 3 7 10 12 Copyright ACDC Leadership 2015

#2 MC ATC AVC MR=D=AR=P Quantity 24 20 12 18 15 What output should the firm produce? What is TR at that output? What is TC? How much profit or loss? 6 $90 $120 Loss= $30 24 20 12 Price MC ATC 18 AVC 15 MR=D=AR=P Quantity 3 6 8 10 Copyright ACDC Leadership 2015

#3 MC ATC AVC MR=D=AR=P Quantity $12 10 11 9 1. What output should the firm produce? 2. What is TR at MR=MC point? 3. What is TC at MR=MC point? 4. How much profit or loss? Zero Shutdown (Price below AVC) $45 $55 Loss=Only Fixed Cost $5 $12 10 Price MC ATC AVC 11 9 MR=D=AR=P Quantity 5 6 7 8 Copyright ACDC Leadership 2015

#4 MC MR=D=AR= P ATC Quantity $12 11 6 5 10 3 1. Should the firm produce? 2. What output should the firm produce? 3. What is the TR and TC at that output? 4. How much profit or loss? Yes 10 TR=$100 TC=$60 $12 11 6 5 3 Profit=$40 Price MC MR=D=AR= P 10 ATC Quantity 3 7 10 12 Copyright ACDC Leadership 2015

Assume the firm can sell each unit at a price of $30 Maximizing Profit Assume the firm can sell each unit at a price of $30 How many units should the firm produce to maximize profit? What is the total revenue at that quantity? How much is the profit? Output Variable Cost Fixed Total Marginal $0 $20 - 1 $12 2 $22 3 $27 4 $40 5 $60 6 $100 5 Units $150 Total Revenue ($30 x 5) $70 Profit ($150 - $80) Copyright ACDC Leadership 2015

Maximizing Profit Output Variable Cost Fixed Total Marginal $0 $20 - 1 $12 2 $22 3 $27 4 $40 5 $60 6 $100 TR MR Profit - $30 -$2 $60 $18 $90 $43 $120 $150 $70 $180 5 Units $150 Total Revenue ($30 x 5) $70 Profit ($150 - $80) Notice that at 6 units the firm is still making profit. It’s just not maximizing profit Copyright ACDC Leadership 2015

Short-run Supply Curve 25 Copyright ACDC Leadership 2015

Marginal Cost and Individual Supply Notice: As price increases, the quantity increases $50 45 40 35 30 25 20 15 10 5 MC ATC MR5 Cost and Revenue AVC MR4 MR3 MR2 MR1 Q 1 2 3 4 5 6 7 9 26

Short-run Supply Curve: MC above AVC Marginal Cost and Supply Notice: The firm will not produce when MC is below AVC $50 45 40 35 30 25 20 15 10 5 MC = Supply Short-run Supply Curve: MC above AVC ATC Cost and Revenue AVC Q 1 2 3 4 5 6 7 9 27 Copyright ACDC Leadership 2015

Marginal Cost and Supply If variable costs increase (ex: per unit tax) MC2=Supply2 $50 45 40 35 30 25 20 15 10 5 MC1=Supply1 AVC Cost and Revenue AVC When MC increases, SUPPLY decrease Q 1 2 3 4 5 6 7 9 28 Copyright ACDC Leadership 2015

Marginal Cost and Supply What if variable costs decrease (ex: subsidy)? MC1=Supply1 $50 45 40 35 30 25 20 15 10 5 MC2=Supply2 AVC Cost and Revenue AVC When MC decreases, SUPPLY increases Q 1 2 3 4 5 6 7 9 29 Copyright ACDC Leadership 2015

Marginal Cost and Supply What happens to quantity if fixed costs increase? Price MC MR=D=AR= P PF ATC1 ATC Quantity stays the same because MC/Supply doesn’t change Quantity QF Copyright ACDC Leadership 2015

Per Unit vs. Lump Sum A PER UNIT tax or subsidy affects the VARIABLE COSTS so MC, AVC, and ATC will shift. This WILL affect the quantity produced A LUMP SUM tax or subsidy only affects FIXED COSTS so only AFC and ATC will shift. MC stays the same. This WILL NOT affect the quantity produced 31 Copyright ACDC Leadership 2015

2008 Audit Exam 18.B