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11 CHAPTER Perfect Competition

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1 11 CHAPTER Perfect Competition Notes and teaching tips: 4, 6, 17, 26, 30, 34, 36, 62, and 82. To view a full-screen figure during a class, click the red “expand” button. To return to the previous slide, click the red “shrink” button. To advance to the next slide, click anywhere on the full screen figure.

2 After studying this chapter you will be able to
Define perfect competition Explain how firms make their supply decisions and why they sometimes shut down temporarily and lay off workers Explain how price and output in an industry are determined and why firms enter and leave the industry

3 What Is Perfect Competition?
Perfect competition is an industry in which Many firms sell identical products to many buyers. There are no restrictions to entry into the industry. Established firms have no advantages over new ones. Sellers and buyers are well informed about prices. The range of market types. Remind the students of what they learned in Chapter 9 about the spectrum of markets that range from perfect competition to monopoly. The perfect competition model serves as a benchmark and its predictions work in a wide range of real markets. Set the scene for appreciating the power of the perfect competition model with a physical analogy. Explain that physicists often use the model of a “perfect vacuum” to understand our physical world. For example, to predict how long it will take a 50 pound steel ball to hit the ground if it is dropped from the top of the Empire State Building, you will be very close to the actual time if you assume a perfect vacuum and use the formula that applies in that case. Friction from the atmosphere is obviously not zero, but assuming it to be zero is not very misleading. In contrast, if you want to predict how long it will take a feather to make the same trip, you need a fancier model! Economists use the model of “perfect competition” in a similar way to understand our economic world. Emphasize to students that although no real world industry meets the full definition of perfect competition, the behavior of firms in many real world industries and the resulting dynamics of their market prices and quantities can be predicted to a high degree of accuracy by using the model of perfect competition.

4 What Is Perfect Competition?
Price Takers In perfect competition, each firm is a price taker. A price taker is a firm that cannot influence the price of a good or service. No single firm can influence the price—it must “take” the equilibrium market price. Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic. Price taking. Be sure to spend a few minutes providing intuition to ensure that your students understand why firms in perfect competition are price takers: They can offer to sell for a lower price, but they’re giving profits away; and they can ask for a higher price, but no one will pay. You might like to note that if the market is not in equilibrium, the firm isn’t a price taker. If there is a shortage, firms can get away with a higher price and they ask for more. That’s how prices rise. If there is a surplus, firms offer a lower price to move their product. That’s how prices fall. But in equilibrium, there is nothing to do but take the going price. And competitive markets get to equilibrium fast.

5 What Is Perfect Competition?
Economic Profit and Revenue The goal of each firm is to maximize economic profit, which equals total revenue minus total cost. Total cost is the opportunity cost of production, which includes normal profit. A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P  Q. A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

6 What Is Perfect Competition?
The demand for the firm’s product is perfectly elastic because one of Cindy’s sweaters is a perfect substitute for the sweater of another firm. The market demand is not perfectly elastic because a sweater is a substitute for some other good.

7 The Firm’s Decisions in Perfect Competition
A perfectly competitive firm faces two constraints: 1. A market constraint summarized by the market price and the firm’s revenue curves. 2. A technology constraint summarized by firm’s product curves and cost curves (like those in Chapter 10). The goal of the firm is to make maximum economic profit, given the constraints it faces. So the firm must make four decisions: Two in the short run and two in the long run.

8 The Firm’s Decisions in Perfect Competition
Short-Run Decisions In the short run, the firm must decide: 1. Whether to produce or to shut down temporarily. 2. If the decision is to produce, what quantity to produce. Long-Run Decisions In the long run, the firm must decide: 1. Whether to increase or decrease its plant size. 2. Whether to stay in the industry or leave it.

9 The Firm’s Decisions in Perfect Competition
Profit-Maximizing Output A perfectly competitive firm chooses the output that maximizes its economic profit. One way to find the profit-maximizing output is to look at the firm’s the total revenue and total cost curves. Figure 11.2 on the next slide looks at these curves along with the firm’s total profit curve. Do firms really choose the output that maximizes profit? It is useful to explain to your students that many big firms routinely make tables using spreadsheets of total revenue, total cost, and economic profit—and make graphs—similar to those in Figure But most firms, and certainly most small firms like Cindy’s sweater knitting firm, don’t make such calculations. Nonetheless, they do make their decisions at the margin. They can figure out how much it will cost to hire one more worker and how much output that worker will produce. So they can figure out their marginal cost—wage rate divided by marginal product. They can compare that number with the price. They are choosing at the margin.

10 The Firm’s Decisions in Perfect Competition
Part (a) shows the total revenue, TR, curve. Part (a) also shows the total cost curve, TC, which is like the one in Chapter 10. Total revenue minus total cost is economic profit (or loss), shown by the curve EP in part (b).

11 The Firm’s Decisions in Perfect Competition
At high output levels, the firm again incurs an economic loss—now the firm faces steeply rising costs because of diminishing returns. The firm maximizes its economic profit when it produces 9 sweaters a day.

12 The Firm’s Decisions in Perfect Competition
Marginal Analysis The firm can use marginal analysis to determine the profit-maximizing output. Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC. Figure 11.3 on the next slide shows the marginal analysis that determines the profit-maximizing output.

13 The Firm’s Decisions in Perfect Competition
If MR > MC, economic profit increases if output increases. If MR < MC, economic profit decreases if output increases. If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.

14 The Firm’s Decisions in Perfect Competition
Profits and Losses in the Short Run Maximum profit is not always a positive economic profit. To determine whether a firm is making an economic profit or incurring an economic loss, we compare the firm’s average total cost at the profit-maximizing output with the market price. Figure 11.4 on the next slide shows the three possible profit outcomes.

15 The Firm’s Decisions in Perfect Competition
In part (c) price is less than average total cost and the firm incurs an economic loss—economic profit is negative. Operating a business at a loss. Students often have a hard time understanding why operating at an economic loss can be the best action. The key is appreciating that: The firm’s short-run decisions are made after some irrevocable commitments have generated sunk costs. The firm considers only avoidable costs when making decisions. Unavoidable costs have no impact on the decision. So for the firm to produce its revenues need only exceed avoidable costs, not total costs. The profit maximization goal doesn’t require the firm to make a positive economic profit in the short run.

16 The Firm’s Decisions in Perfect Competition
The Firm’s Short-Run Supply Curve A perfectly competitive firm’s short run supply curve shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same. Because the firm produces the output at which marginal cost equals marginal revenue, and because marginal revenue equals price, the firm’s supply curve is linked to its marginal cost curve. But there is a price below which the firm produces nothing and shuts down temporarily.

17 The Firm’s Decisions in Perfect Competition
Temporary Plant Shutdown If price is less than the minimum average variable cost, the firm shuts down temporarily and incurs an economic loss equal to total fixed cost. This economic loss is the largest that the firm must bear. The shutdown point is the output and price at which the firm just covers its total variable cost. This point is where average variable cost is at its minimum. Temporary shutdown. In our experience, this topic is the hardest for the students to understand. You can help them with the intuition by pointing out that the rationale for temporary shutdown isn’t confined to perfect competition and that they can see the phenomenon right around the corner. Many restaurants close on Sunday evening and Monday. Many hairdressers close on Sunday and Monday. Why? Your students will easily figure out that total revenue is less than total variable cost and equivalently that price is less than average variable cost. The mechanics of the shutdown analysis will be a lot easier to explain once the students have thought about these real situations with which they are familiar.

18 The Firm’s Decisions in Perfect Competition
Short-Run Supply Curve Figure 11.5 shows how the firm’s short-run supply curve is constructed. If price equals minimum average variable cost, $17 in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T.

19 The Firm’s Decisions in Perfect Competition
If the price is $25, the firm produces 9 sweaters a day, the quantity at which P = MC. If the price is $31, the firm produces 10 sweaters a day, the quantity at which P = MC. The blue curve in part (b) traces the firm’s short-run supply curve.

20 The Firm’s Decisions in Perfect Competition
Short-Run Industry Supply Curve The short-run industry supply curve shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant.

21 The Firm’s Decisions in Perfect Competition
At a price equal to minimum average variable cost—the shutdown price—the industry supply curve is perfectly elastic because some firms will produce the shutdown quantity and others will produces zero.

22 Output, Price, and Profit in Perfect Competition
Short-Run Equilibrium Short-run industry supply and industry demand determine the market price and output. Figure 11.7 shows a short-run equilibrium.


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