CH 14: Perfect Competition

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1 CH 14: Perfect Competition

2 Characteristics of Perfect Competition 1. Both buyers and sellers are price takers A price taker is a firm (or individual) who takes the price determined by market supply and demand If a firm charges above the market price they will not sell any units (will not earn revenue)

3 2. There are many firms Characteristics of Perfect Competition 3. There are NO barriers to entry Easy entry and exit of firms

4 Characteristics of Perfect Competition 4. Firms products are identical (that means the competitor s goods are perfect substitutes) 5. There is complete information Consumers know all about the market including prices, products, and available technology

5 Characteristics of Perfect Competition 6. Firms are profit-maximizing P=D=MR=AR (Use MR. DARP to remember the labeling) The demand curve is perfectly elastic (since the firm is a price taker) Price will be determined by market equilibrium Marginal revenue (MR) is the same as price Average revenue (AR), the revenue generated per unit sold, is the same as MR

6 Perfect Competition: Demand Curve Market graph The market demand curve is always downward sloping Firm graph The demand curve is derived from market equilibrium It is always a horizontal line a perfectly elastic demand curve This is because the firm is a price taker Therefore, P=MR=D=AR

7 Perfect Competition: Supply Curve Because the marginal cost curve tells how much of a good a firm will supply at a given price, the portion of the marginal cost curve above AVC is the firm s supply curve

8 Profit Maximizing Level of Output The goal of the firm is to maximize profits Profit=TR-TC (Total revenue Total costs) For a perfectly competitive firm, profit is (P ATC)(Q) at the profit-maximizing level of output

9 Profit Maximizing Level of Output The profit-maximizing condition of a perfectly competitive firm is: MC = MR Marginal cost (MC) is the change in total cost associated with a change in quantity Marginal revenue (MR) is the change in total revenue associated with a change in quantity Every time a perfectly competitive firm sells a unit, they earn marginal revenue Since they are a price taker, P=MR (which also equals AR)

10 Profit Maximizing Level of Output A firm maximizes total profit, not profit per unit If MR > MC, a firm can increase profit by increasing output If MR < MC, a firm can increase profit by decreasing output

11 Graphing Perfect Competition There are two graphs: One is the market/industry graph The other is the firm graph They are drawn as side-by-side graphs

12 Graphing Perfect Competition Start with a standard supply and demand graph to represent the market (label this graph market) Identify market price and quantity (P 1 and Q 1 ) Take equilibrium price over to your second graph by drawing a dotted line

13 Graphing Perfect Competition On your second graph, label it firm Draw your marginal cost curve Draw your ATC (location varies depending on if the firm is making a profit, loss, or zero economic profit) Make a big dot where MC intersects MR this is your profit maximizing P and Q Take the big dot all the way down to the quantity axis

14 Drawing the Graph: Perfect Competition Profit in the Short Run P Market P Firm Since P>ATC at the profit maximizing MC quantity, S this firm is earning a profit ATC P 1 P 1 Profit P = D = MR = AR Q 1 D Q Q profit max Q

15 Drawing the Graph: Perfect Competition Loss in the Short Run P Market P Firm Since P<ATC at the profit maximizing MC ATC quantity, this firm is S earning a loss P 1 P 1 Loss P = D = MR = AR Q 1 D Q Q profit max Q 14-15

16 Drawing the Graph: Perfect Competition Zero Economic Profit (Normal Profit) in the Long Run P Market P Firm Since P=ATC at the profit maximizing MC quantity, this firm is S earning zero ATC economic profit P 1 P 1 P = D = MR = AR Q 1 D Q Q profit max Q

17 Perfect Competition in the Long-Run In the long run perfect competitors make zero economic profit (normal profit) WHY? Due to the entry and exit of firms If a profit is being made firms will keep entering the market and compete away the profit

18 Perfect Competition in the Long-Run Normal profit is the amount the owners would have received in their next best alternative (breakeven point; where TR=TC) Economic profits are profits above normal profits (where TR exceeds TC)

19 The Shutdown Point for Perfectly Competitive Firms In the short run, fixed costs are sunk costs they must be paid whether or not the firm produces anything A firm pays attention to its variable costs when deciding to shutdown As long as a firm is covering its variable costs it should continue producing When price falls below AVC is when the firm should shutdown

20 The Shutdown Point for Perfectly Competitive Firms The shutdown point is the point below which the firm will be better off if it shuts down rather than if it stays in business If P>min of AVC, then the firm will still produce, but earn a loss If P<min of AVC, the firm will shut down If a firm shuts down, it still has to pay its fixed costs P Shutdown P Q profit max AVC MC ATC P = D = MR = AR Q

21 Perfect Competition: Practice What happens to the graphs if market demand increases? P Market P Firm MC S 1 ATC P 2 P 1 P 2 P 1 Profit D 2 =P 2 =MR 2 =AR 2 D 1 =P 1 =MR 1 =AR 1 D 2 Q 1 Q 2 D 1 Q Q 1 Q 2 Q

22 P P Perfect Competition: Practice MC ATC P = D = MR = AR Is this firm making a profit, loss, or zero economic profit? Shade the area that represents total costs Q profit max Q

23 P Perfect Competition: Practice MC ATC Is this firm making a profit, loss, or zero economic profit? Profit P Profit P = D = MR = AR Shade the area that represents total costs Grey box Total costs Q profit max Q

24 Perfect Competition: Constant-cost Industry In a constant-cost industry, we assume that the entry and exit of firms has no impact on the cost curves of the firms in the market MC and ATC will not change

25 Perfect Competition: Increasing cost Industry In an increasing cost industry we assume that the entrance of new firms increases the demand for the factors of production This might increase the cost of employing those resources When this happens, the cost curves shift upward

26 Perfect Competition: Increasing cost Industry Graphically, what would happen in an increasing cost industry? The entrance of new firms would drive down the price of output and increase the cost curves profit would be eliminated more quickly here than in a constant-cost industry The new long run price would be higher than in a constantcost industry

27 Perfect Competition: Decreasing cost Industry The other option is a decreasing cost industry (yet to see this in the FRQs) This is when the entry of new firms decreases the price of key inputs and causes the cost curves to shift downward Could be due to economies of scale and lower per unit-costs

28 Perfect Competition: Decreasing cost Industry The entrance of new firms lowers the price of the output and decrease the cost curves Takes longer for profit to be eliminated than in the constantcost industry More firms can enter this market and the new long run price would be lower than in a constant cost industry

29 Chapter Summary The necessary conditions for perfect competition are: 1. Buyers and sellers are price takers 2. The number of firms is large 3. There are no barriers to entry 4. Firms products are identical 5. There is complete information 6. Sellers are profit-maximizing entrepreneurial firms

30 Chapter Summary Competitive firms maximize profit where MR = MC Profit is (P ATC)(Q) at the profit-maximizing level of output Perfectly competitive firms shut down if P < AVC The supply curve of a competitive firm is its MC curve above minimum AVC The short-run market supply curve is the horizontal sum of the MC curves above AVC for all the firms in the market

31 Chapter Summary In the short run, competitive firms can make a profit or loss. In the long run they make zero profits. If there are profits: Firms enter the industry Supply increases Price decreases, eliminating profit If there are losses: Firms leave the industry Supply decreases Price increases, eliminating losses

32 Chapter Summary Constant-cost industries have horizontal long-run supply curves Increasing cost industries have upward sloping long-run supply curves Decreasing cost industries have downward sloping supply curves