3 What Is Perfect Competition? How Perfect Competition ArisesPerfect competition arises when:the firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the market.each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm’s good they buy.
4 What Is Perfect Competition? Price TakersIn 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? Figure below illustrates a firm’s revenue concepts.Part (a) shows that market demand and market supply determine the market price that the firm must take.The firm can sell any quantity it chooses at the market price, so marginal revenue equals price and the demand curve for the firm’s product is horizontal at the market price.
6 What Is Perfect Competition? The demand for a firm’s product is perfectly elastic because one firm’s sweater 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 What Is Perfect Competition? A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces.So the firm must decide:1. How to produce at minimum cost2. What quantity to produce3. Whether to enter or exit a marketWe start by looking at the firm’s output decision.
8 The Firm’s Output Decision At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs.At intermediate output levels, the firm makes an economic profit.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.
9 The Firm’s Output Decision 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.
10 The Firm’s Output Decision Temporary Shutdown DecisionIf the firm makes an economic loss, it must decide to exit the market or to stay in the market.If the firm decides to stay in the market, it must decide whether to produce something or to shut down temporarily.The decision will be the one that minimizes the firm’s loss.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.
11 The Firm’s Output Decision Loss ComparisonsThe firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR).Economic loss = TFC + TVC – TR= TFC + (AVC – P) x QIf the firm shuts down, Q is 0 and the firm still has to pay its TFC.So the firm incurs an economic loss equal to TFC.This economic loss is the largest that the firm must bear.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.
12 The Firm’s Output Decision The Shutdown PointA firm’s shutdown point is the price and quantity at which it is indifferent between producing and shutting down.This point is where AVC is at its minimum.It is also the point at which the MC curve crosses the AVC curve.At the shutdown point, the firm is indifferent between producing and shutting down temporarily.The firm incurs a loss equal to TFC from either action.
13 The Firm’s Output Decision The shutdown point. Minimum AVC is $17 a sweater. If the price is $17, the profit-maximizing output is 7 sweaters a day. The firm incurs a loss equal to the red rectangle.When to increase and when to decrease output. Students need repeated reminders that to determine whether a firm can increase profit by changing output, price, and marginal cost are the only things to consider. Questions that throw average total cost into the mix often cause confusion.
14 Output, Price, and Profit in the Short Run Profits and Losses in the Short RunMaximum 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 12.8 on the next slide shows the three possible profit outcomes.
15 Output, Price, and Profit in the Short Run 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.
19 The Firm’s Output Decision The Firm’s Supply CurveA perfectly competitive firm’s 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 at a price below the shutdown point, the firm produces nothing.
20 The Firm’s Decisions How the firm’s supply curve is constructed. If price equals minimum AVC, $17 in this example, the firm is indifferent between producing nothing and producing at the shutdown point, T.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.
28 Monopoly and How It Arises How Monopoly ArisesA monopoly has two key features:No close substitutesBarriers to entryNo Close SubstituteIf a good has a close substitute, even if it is produced by only one firm, that firm effectively faces competition from the producers of the substitute.A monopoly sells a good that has no close substitutes.
29 Monopoly and How It Arises Barriers to EntryA constraint that protects a firm from potential competitors are called barriers to entry.Three types of barriers to entry areNaturalOwnershipLegal
30 Monopoly and How It Arises Natural Barriers to EntryNatural barriers to entry create natural monopoly.A natural monopoly is a market in which economies of scale enable one firm to supply the entire market at the lowest possible cost.Ownership Barriers to EntryAn ownership barrier to entry occurs if one firm owns a significant portion of a key resource.During the last century, De Beers owns 90 percent of the world’s diamonds.
31 Monopoly and How It Arises Legal Barriers to EntryLegal barriers to entry create a legal monopoly.A legal monopoly is a market in which competition and entry are restricted by the granting of aPublic franchise (like the U.S. Postal Service, a public franchise to deliver first-class mail)Government license (like a license to practice law or medicine)Patent or copyright
32 Monopoly and How It Arises Monopoly Price-Setting StrategiesFor a monopoly firm to determine the quantity it sells, it must choose the appropriate price.There are two types of monopoly price-setting strategies:A single-price monopoly is a firm that must sell each unit of its output for the same price to all its customers.Price discrimination is the practice of selling different units of a good or service for different prices. Many firms price discriminate, but not all of them are monopoly firms.
40 Price DiscriminationPrice discrimination is the practice of selling different units of a good or service for different prices.To be able to price discriminate, a monopoly must:1. Identify and separate different buyer types.2. Sell a product that cannot be resold.Price differences that arise from cost differences are not price discrimination.Price discrimination may not be fair, but it is efficientBe sure that the students understand that aside from equity considerations, resources will be allocated more efficiently in a monopoly market under any price discrimination scenario than under a single-price scenario.