Micro Perfect Competition Essentials 1 WCC

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1 Micro erfect Competition Essentials 1 WCC Industry structure/characteristics affects how demand curves and revenue behave for a firm. erfectly Competitive Industry Characteristics 1) There are a large number of firms Result: No firm can really affect the market price by changing output. 2)No barriers to entry or exit exist Result: Its easy for firms to get in and out of this industry in the long run. 3)Firms and products are homogeneous. Results: Consumers pay no attention to brands. They focus only on price. 4)erfect information exists. Results: It s impossible to lie successfully. erfect competition What does the demand curve look like? It is important to distinguish between the industry (market) demand curve and the firm demand curve. As a whole consumers only care about the market price of this homogeneous product. At a higher market price we want less, while at a lower price we want more. Thus, the industry demand curve has a negative slope. roducts are homogeneous therefore no one will pay more than the market price. A large number of firms exist, therefore each firm s output is too small to affect the market price. Each firm has no ability to charge more than the market price, and no desire to charge less. A firm s demand curve is horizontal. erfectly competitive firms are price takers. Graph.C. Industry S.C. Firm E E D D E

2 What do the revenue curves look like for the perfectly competitive firm? Average Revenue Average Revenue is always calculated by dividing Total Revenue by uantity AR = TR / Total Revenue is calculated by multiplying rice by uantity TR = ( x ) Subsitute ( x ) in for TR in the first equation and cancel out the s AR = ( x ) = Average revenue is always equal to price, so the average revenue curve is always the demand curve. Marginal Revenue MR is defined as the change in Total Revenue due to a change in output. MR = TR / In the case of perfect competition, you have a horizontal demand curve. Thus producing another unit always adds the same amount to Total Revenue,. So, MR =. Therefore, the marginal revenue curve is the same as the demand curve. This will only be true under perfect competition. Total Revenue Marginal fill in the blank is always the slope of Total fill in the blank. Therefore, Marginal Revenue is the slope of Total Revenue. Since MR for the perfectly competitive firm is always equal to price, which doesn t change as output changes, MR is constant. Thus, Total Revenue is linear and has a slope equal to. (This is nice to know, but we don t include this curve in our graph of the firm.) Demand and revenue curves for the perfectly competitive firm.c. Firm E

3 How much output should a perfectly competitive firm produce? Start by adding the cost curves we developed previously. If a firm produces at all, we ve learned that profit is maximized when firms produce when it produces where MR =. The intersection of the and MR curves gives us our profit maximizing level of output *. Graph rofit maximizing output for a perfectly competitive firm * Is this firm actually making a profit at this optimal level of output, *? Keep in mind that rofit = TR TC. Total Revenue is easy to calculate. o TR = x * Total Cost is a bit harder to calculate at first. o Remember that AC = TC / * o We can rearrange that equation to get TC = x * lug both of these in for TR and TC in the profit equation. rofit = ( x *) ( x *) or rofit = ( ) x * o In order for rofit to be positive, must be bigger than at *. o In the graph below, we see that is greater than at *. o The firm is earning a profit and that profit is neasured by the size of the shaded box.

4 Graph erfectly competitive firm earning a profit * * Not all firms earn profits, however. What should a firm do if <? Should it shut down immediately? Here we need to think about shut down conditions. What should the firm do if <? If <, the firm should shut down immediately. It isn t even earning enough on each unit it produces to cover its variable costs. Every unit it produces drives it further into the red. What should the firm do if < <? shutdown? If <, the firm will lose money if it continues to produce. However, if some of its fixed costs are sunk costs, it will also lose money if it shuts down immediately. o Sunk costs are costs that were paid up front and cannot be recovered. o If the firm shuts down immediately, its losses will be equal to those sunk costs. o AFC is the difference between the and curves. So TFC (sunk costs) is simply that vertical distance multiplied by the quantity. In this case the profit maximizing firm has to chose the option that loses the least money. o Sometimes profit maximization means loss minimization. If is less than, but greater than, the firm does lose money if it keeps producing. However, because is greater than, every unit the firm produces covers its variable costs and earns back a bit of the fixed costs. o The two graphs below show that the firm loses less by contining to produce in the short run than it does if it shuts down immediately.

5 Graph Losses for a firm with sunk costs if it shuts down immediately * * * Graph Losses for a firm if it keeps producing in the short run * * * Summarizing shut down conditions Situation Action If > The firm is earning a profit and should keep producing. IF < The firm is losing money and should shut down immediately. If < < The firm is losing money, but should produce in the short run and shut down in the long run.

6 We know what the perfectly competitive firm s demand curve looks like, but what does its supply curve look like? The perfectly competitive firm s missing short run supply curve Remember, a supply curve simply shows the quantity a of a good that a producer is willing and able to produce at each price. We know that all firms produce a level of output where MR =, if they produce at all. Under perfect competition, MR =, since the MR curve and the demand curve are one and the same. So, we can simply draw in different demand curves and see where they intersect to find the best level of output at each price. Therefore, since it is the demand curves intersection with the that determines the level of output the firm is willing and able to supply, it is the itself above the curve that is the is the firm s short run supply curve. If drops below min, the firm shuts down immediately. Graphs 4 D 3 = AR 3 = MR 3 3 D 2 = AR 2 = MR 2 1 D 1 = AR 1 = MR 1 0 D 0 = AR 0 = MR 0