Pure Competition in the Short-Run

Assumptions of Perfect Competition Pure competition is rare in the real world. However, the model provides a standard for evaluating the efficiency in market economies. There are three major features of perfectly competitive markets 1) Many Buyers and Sellers: no seller or buyer is large enough to have any control over prices. A perfect competitor is a price taker 2) Standard Product: the products are homogeneous (identical) 3) Easy Entry and Exit: there are no barriers to entry or exit from the industry

Short-run versus Long-run Short-run: is the time period in which at least one input is fixed This implies that in the short-run firms can neither enter or exit the market Long-run: is the time period in which all inputs can be adjusted This implies that in the long-run new firms can enter and existing firms can exit the market

Perfect Competitor’s Demand A perfect competitor is a price taker This means that the firm takes the prices determined in the market place by supply and demand Therefore, the demand curve faced by the individual firm in the market is perfectly elastic. That is, customers will buy all that any individual firm might want to produce at the going market price and none at a higher price. Because firms are profit maximizers it is irrational to sell at a lower price, as sales will not increase

Example; T-Shirt Production

Output under Perfect-Competition Question: How much should a firm produce? The answer depends on the firms objective. Economists usually assume the firms objective is to maximize profits Profit = Total revenue (TR) – Total costs (TC) There are three key revenue relationships that we need to examine for perfect competition 1) Total Revenue (TR) Total revenue is the total earnings from selling a product TR = Price (P) × Quantity (Q)

Average revenue is the firms total revenue per unit of output 2) Average Revenue (AR) Average revenue is the firms total revenue per unit of output AR = TR ÷ Q = PQ ÷ Q = P 3) Marginal Revenue (MR) Marginal revenue is the extra revenue earned when the firm sells another unit of output MR = ∆ TR ÷ ∆ Q

Short-run Equilibrium There are two ways to determine the level of output at which a competitive firm will realize maximum profit or alternatively minimize loss Marginal revenue-marginal cost approach Total-revenue-total cost approach Marginal Revenue –Marginal Cost Approach: the firm compares the amount each additional unit output adds to revenue (marginal revenue) and the additional cost each unit of output adds (marginal cost). In the short run, this approach predicts profit will be maximized, or loss minimized for a firm at MR = MC.

There are several important features of this method The firm will shut down unless MR at least meets MC This is profit maximizing condition in all market structures Can be restated for perfect competition as P = MC

Total-Revenue-Total Cost Approach: the firm produces at the output level where total revenue exceeds total cost by the largest amount Example; Suppose that the market for sweaters is a perfectly competitive market. A firm that producers sweaters is selling them at an equilibrium price of $25 per sweater. Q TR MR TC MC Profit 1 25 45 -20 2 50 66 21 -16 3 75 85 19 -10 4 100 15 5 125 114 14 11 6 150 126 12 24 7 175 141 34 8 200 160 40 9 225 183 23 42 10 250 210 27

Using marginal analysis we can determine the profit maximizing output by comparing MR and MC Profit-Maximizing Rule: states that profit is maximized when marginal revenue equals marginal cost (MR = MC) If MR > MC the firm should increase the output If MR = MC the firms profit is maximized If MR < MC the firm should decrease the output

Alternatively, we can use the Total revenue-Total cost approach by finding the maximum difference between TR and TC Total profit can also be used to determine where it is at a maximum

Profit and Losses in the Short-Run Even when the firm produces its profit-maximizing output, the firm may earn negative, zero or positive profits Recall, Profit = TR – TC = PQ – TC = [(PQ ÷ Q) – (TC ÷ Q)] × Q = [P – AC] × Q To determine whether a firm is making an economic profit or incurring and economic loss, we compare the firms average total cost at the profit- maximizing output with the market price There are three possible cases when determining the profit maximizing or cost-minimizing output

If P < ATC then Profit < 0 (i.e. the firm’s profit is negative) If P = ATC then Profit = 0 (i.e. the firm breaks even) If P > ATC then Profit > 0 (i.e. the firm’s profit is positive)

Economic Losses Question: What would a profit-maximizing firm do if it suffers a loss? Recall if P < ATC the firms profits will be negative. The firm then has two options 1) Shut-down (i.e. the firm produces nothing) Loss = Fixed Cost (FC) 2) Continue to produce a positive level of output Loss = TC – TR = FC + VC - TR

Shut-down price: a firm making an economic loss in the short-run will continue to produce a positive level of output as long as we have P ≥ AVC P < AVC P = AVC P > AVC Price $10 Output 160 AVC $11 $9 AFC $6 $7 $8 ATC $17 Continue − $1120 Shut-down − $960 − $1280

There are two cases that need to be examined in order to determine whether a firm should shut-down. Case 1: If P > AVC TR > VC The firm should continue producing in the short-run because it can cover all its variable costs and some of its fixed costs That is, the firm’s loss will be less than its FC if it continues to produce Hence, it should remain in business because fixed costs (FC) have to be paid even if the firm produces nothing Suppose the firm is making losses PABC However, the revenue QAP is greater than the variable cost QED

The firm makes DEAP to set against fixed costs to set against fixed costs of DEBC Case 2: If P < AVC TR < VC The firm should shut down because it cannot cover its variable costs (VC) or any of its fixed costs (FC)

That is, the firm’s loss will be larger than its FC if it continues to produce. Hence, the firm should shut-down for any price lower than the minimum average variable cost (AVC) The shut-down condition is P =MR = MC = AVC

Short-run Supply Curve A firms supply curve shows how much output will be produced at different prices Perfect competitors determine the quantity to produce where P = MC and they shut down when P < AVC Thus, a perfectly competitive firm’s supply curve is the portion of the marginal cost curve above the AVC curve

A firm’s supply curve is its MC curve above AVC