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All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 3 DEFINITION AND CHARACTERISTICS OF A PERFECTLY COMPETITIVE MARKET Definition A market in which there are many buyers and sellers, the products are homogeneous and sellers can easily enter and exit from the market. MICROECONOMICS3 Characteristics Large number of buyers and sellers – firms are price takers.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 4 Homogenous or standardized product – the buyers do not differentiate the products of one seller to another seller. Free of entry and exit into the market. Role of non-price competition is insignificant. Perfect knowledge of the market – all the sellers and buyers in perfect competition market will have perfect knowledge of that market. DEFINITION AND CHARACTERISTICS OF A PERFECTLY COMPETITIVE MARKET (CON’T)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 5 PRICE DETERMINATION IN A PERFECTLY COMPETITIVE FIRM Market The price is determined by the intersection of the market supply curve and the market demand curve. Price Quantity Q* RM10 DD SS Since firms are price takers, they face a horizontal demand curve. Demand curve in perfect competition is horizontal or perfectly elastic. Therefore, Price = MR = AR. P = MR = AR RM10 Quantity Price Firm

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 6 PROFIT MAXIMIZATION IN A PERFECTLY COMPETITIVE FIRM Using Table: Profit maximization is determined by scanning through the profit at each level, and the level which gives the highest profit is the profit maximizing output. (1) Quantity (per kg per dAy) (2) Price (per kg per dAy) (3) Total Revenue (TR) (4) Total Cost (TC) 5) Profit/ Lloss 0 10 20 30 40 50 60 70 10 0 100 200 300 400 500 600 700 60 140 210 290 390 500 630 800 -60 -40 -10 10 0 -30 -100 1. Using Total approach TOTAL REVENUE – TOTAL COST APPROACH

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 7 TR, TC Quantity 40 TR Highest vertical difference TC PROFIT MAXIMIZATION IN A PERFECTLY COMPETITIVE FIRM Using Graph: TR curve is a straight line through the origin. The maximum profit is where the vertical difference is the highest.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 8 PROFIT MAXIMIZATION IN A PERFECTLY COMPETITIVE FIRM 2. Using Marginal approach MARGINAL REVENUE – MARGINAL COST APPROACH Using Table: The profit maximizing output level is obtained following the MR = MC rule. 0 10 20 30 40 50 60 70 10 0 100 200 300 400 500 600 700 - 10 - 8 7 8 10 11 13 17 (1) Quantity (per kg per day) (2) Price (per kg per day) (3) Total Revenue (TR) (4) Marginal Revenue (MR) (5) Total Cost (TC) (6) Marginal Cost (TC) (7) Profit/ Lloss -60 -40 -10 10 0 -30 -100 60 140 210 290 390 500 630 800

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 9 MR, MC Quantity MC MRRM10 40 PROFIT MAXIMIZATION IN A PERFECTLY COMPETITIVE FIRM Using Graph: TR curve is a straight line through the origin. The maximum profit is where the vertical difference is the highest.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 10 The demand function for a product sold by a perfect competitor is given as Q D = 20 – P and the marginal cost is MC = −10 + 3Q. Calculate profit maximizing price and quantity. PROFIT MAXIMIZATION USING THE EQUATION METHOD

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 11 Solution For profit maximization to take place, we use the MR = MC rule. Firstly, we need to derive the demand curve. GivenQ=20 − P P=20 − Q MR =20 − Q(since in perfect competitive firm, P = MR = AR) PROFIT MAXIMIZATION USING THE EQUATION METHOD (CON’T)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 12 MR =MC 20 − Q=−10 + 3Q 4Q = 30 Q =7.5 Substitute Q = 7.5 into P = 20 − Q P = 20 − 7.5 P = 12.5 PROFIT MAXIMIZATION USING THE EQUATION METHOD (CON’T)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 13 SHORT-RUN SUPPLY CURVE Point a is not considered a supply curve since at any point below the minimum of AVC, the firm would shut down its operation and the quantity supplied would be zero. The figure shows the AC, AVC and MC. There are five different market prices. The horizontal demand curve at each price is shown. MC P = MR = AR AC P 2 = MR 2 = AR 2 AVC P 1 = MR 1 = AR 1 P 3 = MR 3 = AR 3 P 4 = MR 4 = AR 4 a b d e The portion of marginal cost curve which lies above the average variable cost curve is the firm’s supply curve. cPrice (RM) Quantity 40 60 20 5 10 Supply curve of a competitive firm is the upward portion of MC above minimum of AVC as shown by points b, c, d and e.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 14 A competitive firm earns economic profit Economic profit or supernormal profit is the profit earned by a competitive firm when TR>TC. PROFIT At output Q* respectively the firm earns economic profit or supernormal profit equal to the area shaded. MC The marginal cost curve intersects the demand curve at point B. A competitive firm maximizes its profit when MR = MC. The firm’s demand curve is horizontal at the price of RM20 where AR = MR. PROFIT MAXIMIZATION IN THE SHORT RUN Price (RM) Quantity The profit maximizing price and output is P* and Q*. P = MR = AR ATC Q* P* 20 B

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 15 A competitive firm at breakeven The firm’s demand curve is horizontal at the price of RM20 where AR = MR. The marginal cost curve intersects the demand curve at point B. A competitive firm maximizes its profit when MR = MC. The profit maximizing price and output is P* and Q*, respectively. At output Q*, the firm is at breakeven and earns normal profit. Normal profit or breakeven profit is necessary for a firm to stay in business (TR =TC). Price (RM) Quantity P = MR = AR MC ATC Q* P* B 20 PROFIT MAXIMIZATION IN THE SHORT RUN (CON’T)

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 16 A competitive firm suffers economic losses ATC Economic losses or subnormal profit is the losses incurred by a competitive firm when TR<TC. LOSSES At output Q*, the firm suffers economic losses or subnormal profit equal to the area shaded. MC The marginal cost curve intersects the demand curve at point B. A competitive firm maximizes its profit when MR = MC. B Price (RM) Quantity Q* P* 20 P = MR = AR The firm’s demand curve is horizontal at the price of RM20 where AR = MR. PROFIT MAXIMIZATION IN THE SHORT RUN (CON’T) The profit maximizing price and output is P* and Q* respectively.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 17 SHUT DOWN PRICE Price (RM) Quantity P = MR = AR MC ATC Q* B 20 5 If price falls below RM5, the firm would incur more operating losses than fixed cost and the firm must shut down. At the price of RM5, the losses incurred by the firm is equal to the fixed cost. AVC A firm can continue production until the price is equal to minimum average variable cost (AVC). A firm will continue its operations even if it suffers losses. PROFIT MAXIMIZATION IN THE SHORT RUN (CON’T) LOSSES TOTAL FIXED COST Shut down point is at the point where the price equals to minimum AVC.

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 18 20 MarketFirm Price (RM) Quantity Q* DD SS SS 1 15 P = MR = AR Quantity 20 60 PROFIT P1 = MR1 = AR1 MC AC The economic profit attracts newcomers to the industry. As a result, many firms will enter the market and this will lead to an increase in supply. Price is determined by the intersection of the market supply curve and the market demand curve. Supply curve will shift to the right and equilibrium market price will fall to RM15. Firms that earn supernormal profits in short run will only be able to earn normal or zero profits in long run due to entry of newcomers. The competitive firm sells 60 kg of chicken and earns an economic profit shown by the shaded area. PROFIT MAXIMIZATION IN THE SHORT RUN (CON’T) EFFECT OF ENTRY Price (RM) 15

All Rights ReservedMicroeconomics © Oxford University Press Malaysia, 2008 9– 19 10 MarketFirm Quantity Q* DD SS SS 1 15 The losses in short run forces those sellers who cannot cover their AVC or TVC to leave the market. As many firms exit the market, this will lead to a decrease in the market supply. The competitive firm sells 60 kg of chicken and suffers losses shown by the shaded area. Firms that suffer losses in short run can still continue their operation. As in long run they are able to earn normal or zero profits due to exit of the firms. PROFIT MAXIMIZATION IN THE LONG RUN EFFECT OF EXIT Price (RM) P = MR = AR Quantity 20 60 P1 = MR1 = AR1 MC AC 15 LOSSES Supply curve will shift to left and equilibrium market price will rise to RM15