Perfect Competition

Production and Profit Optimal output rule for price taking firms ▫Price equals marginal cost at the price-taking firm’s optimal quantity of output. ▫Marginal revenue is equal to marginal price.  A price taking firm cannot influence the market price by its actions.  This is only true in a perfect competition market.

▫Marginal curve is horizontal line at market price.  The firm can sell as much as it like at the market price.  Regardless if it sells more or less, market price is unaffected.

When is production profitable? ▫Firms make their production decisions with the goal of maximizing economic profit.  A firm’s decision of how much to produce, and whether or not to stay in business, should be based on economic profit, not accounting profit.

What determines whether a firm earns a profit or loss? ▫Look at market price. Is it more or less than a firm’s minimum average total cost? ▫You can use the average total cost curve and marginal cost curve to show graphically the short run options for a firm.

 These curves can be use to decide whether is profitable or unprofitable.  Shows 1 of 3 options ▫If the firm produces a quantity at which total revenue is great than total cost, the firm is profitable. ▫If the firm produces a quantity at which total revenue equals total cost, the firm breaks even. ▫If the firm produces a quantity at which total revenue is less than total cost, the firm incurs a loss.

 This can be expressed in terms of revenue and cost per unit of output. ▫Profit/Q= TR/Q- TC/Q ▫TR/Q = is the market price ▫TC/Q = is average total cost

▫A firm is profitable if market price for its products is more than the average total cost of the quantity the firm produces.  If the firm produces a quantity at which P is greater than ATC, the firm is profitable  If the firm produces a quantity at which P = ATC, the firm breaks even  If the firm produces a quantity at which P is less than ATC, THE FIRM INCURES A LOSS.

GRAPHING PERFECT COMPETITION ▫PROFIT: TR-TC= (TR/Q – TC/Q) X Q OR THE EQUIVALENT PROFIT= (P-ATC) X Q

▫HOW DOES A PRODUCER KNOW WHETHER OR NOT ITS BUSINESS WILL BE PROFITABLE?  YOU MUST COMPARE MARKET PRICE TO A FIRM’S MINIMUM AVERAGE TOTAL COST  A PRODUCER WILL MAXIMIZE HIS PROFIT OR ACHIEVE ITS HIGHEST POSSIBLE PROFIT WHEN THEY FIND THE QUANTITY WHERE MARGINAL COST EQUALS PRICE.

 REQUIRES MARKET PRICE TO BE HIGHER THAN MINIMUM AVERAGE TOTAL COST.  IF MARKET PRICE IS LOWER THAN AVERAGE TOTAL COST THERE IS NO OUTPUT AT WHICH THE FIRM WILL BE PROFITABLE

▫THE MINIMUM AVERAGE TOTAL COST OF A PRICE-TAKING FIRM IS CALLED ITS BREAK- EVEN PRICE.  THIS IS THE PRICE WHERE IT EARNS ZERO ECONOMIC PROFIT (NORMAL PROFIT)

 THREE THINGS TO REMEMBER  WHENEVER MARKET PRICE EXCEEDS THE MINIMUM AVERAGE TOTAL COST, THE PRODUCER IS PROFITABLE  WHENEVER MARKET PRICE EQUALS THE MINIMUM AVERAGE TOTAL COST, THE PRODUCER BREAKS EVEN  WHENEVER THE MARKET PRICE IS LESS THAN THE MINIMUM AVERAGE TOTAL COST, THE PRODUCER IS UNPROFITABLE

SHORT-RUN PRODUCTION ▫SOMETIMES THE FIRM SHOULD PRODUCE EVEN IF PRICE FALLS BELOW MINIMUM AVERAGE TOTAL COST.  TOTAL COST INCLUDES FIXED COST AND CAN ONLY BE ALTERED IN THE LONG RUN.  ALSO FIXED COST DOES NOT DEPEND ON THE AMOUNT PRODUCED. SINCE IT CANNOT BE CHANGED IN THE SHORT RUN, FIXED COST IS IRRELEVANT TO A FIRM’S DECISION TO PRODUCE OR SHUT DOWN IN THE SHORT RUN.

THE SHUT DOWN PRICE ▫WHEN THE MARKET PRICE IS BELOW THE MINIMUM AVERAGE VARIABLE COST  THE PRICE THE FIRM RECEIVES PER UNIT IS NOT COVERING ITS VARIABLE COST PER UNIT  FIRM SHOULD CEASE PRODUCTION IMMEDIATELY BECAUSE THERE IS NO LEVEL OF OUTPUT AT WHICH THE FIRM’S TOTAL REVENUE COVERS VARIABLE COST

 IN THIS CASE THE FIRM STILL MAXIMIZES ITS PROFIT BY NOT PRODUCING  IT STILL HAS A FIXED COST IN THE SHORT RUN, BUT WILL NO LONGER HAVE VARIABLE COST.  THIS MEANS THAT THE MINIMUM AVERAGE VARIABLE COST DETERMINES THE SHUT DOWN PRICE. ▫THE PRICE AT WHICH A FIRM CEASES PRODUCTION IN THE SHORT RUN.

▫WHEN THE MARKET PRICE IS GREATER THAN OR EQUAL TO THE MINIMUM AVERAGE VARIABLE COST  THE FIRM MAXIMIZES PROFIT OR MINIMIZES LOSS BY CHOOSING THE OUTPUT LEVEL AT WHICH ITS MARGINAL COST IS EQUAL TO MARKET PRICE.

SHORT RUN INDIVIDUAL CURVE ▫SHOWS HOW AN INDIVIDUAL FIRM’S PROFIT- MAXIMIZING LEVEL OF OUTPUT DEPENDS ON THE MARKET PRICE, TAKING FIXED COST AS GIVEN.