1. Perfect (or pure) Competition

2. 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

3. 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)
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4. 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
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5. 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
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6. 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
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7. 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
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8. 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
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9. 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
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10. 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
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11. 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!!!
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12. 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

13. 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.
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14. 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
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15. 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

16. 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

17. 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)
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18. Practice 18
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19. #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
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20. #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
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21. #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
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22. #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
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23. 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)
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24. 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
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25. Short-run Supply Curve25
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26. 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 26

27. 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 27
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28. 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 28
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29. 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 29
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30. 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
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31. 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
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32. 2008 Audit Exam
18.B