# MICROECONOMICS - CLUTCH CH PERFECT COMPETITION.

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2 CONCEPT: THE FOUR MARKET MODELS Market structure describes the environment in which a firm operates, determined by the Perfect Competition Monopolistic Competition Oligopoly Monopoly Number of Firms Examples Barriers to Entry Profit-Maximizing Quantity Profitability Relation of Price (P=AR) and MR Relation of Price and Page 2

3 CONCEPT: CHARACTERISTICS OF PERFECT COMPETITION A market is perfectly competitive when: Nature of Good: The goods for sale are Setting Price: The buyers and sellers are both - Lots of buyers - Lots of sellers - Each market participant has influence on price Entry and Exit: Firms can enter and exit the market. Example Product: The demand curve facing the individual firm is different from the demand curve for the entire industry. Market for Wheat Individual Firm s Demand Perfect competition is the only market structure where a firm s demand curve is Page 3

4 CONCEPT: REVENUE IN PERFECT COMPETITION Revenue is the money coming into the firm from sales: Revenues are the to the firm Average Revenue Marginal Revenue AR = TR Q = TR MR = Q Average Revenue = Average Revenue = Demand Curve In perfect competition, price is fixed (set by market): Q = 1 Sell one more unit for TR = Marginal Revenue = True for True for In perfect competition: AR = MR = P EXAMPLE: Numerical example showing constant marginal revenue in perfect competition Market Price per Bushel of Wheat = \$4 Quantity (Q) Total Revenue (TR) Total Cost (TC) 0 \$ \$ \$ \$ \$ \$ \$24.00 Profit Marginal Revenue Marginal Cost Change in Profit Page 4

5 CONCEPT: PROFIT ON THE GRAPH The profit-maximizing quantity will always occur where Profit-maximizing could also mean P = = The profit or loss is defined by the following formula: Profit = (Price ) Quantity Step 1: Find profit-maximizing quantity where MR = Step 2: Find Price (on Demand Curve) and at that quantity P = AR = MR P = AR = MR If P > If P = If P < Page 5

6 PRACTICE: Use this graph to answer the following questions: If the firm decreases its production from Q2 to Q1, it will a) Increase its profit b) Decrease its profit c) Reduce its marginal revenue d) Increase its marginal revenue If the price is P1, the firm maximizes profit by producing a) Q1 b) Q2 c) Q3 d) Nothing If the price is P1, the firm is a) Suffering an economic loss b) Earning an economic profit c) Breaking even d) None of the above Page 6

7 CONCEPT: SHORT RUN SHUTDOWN DECISION A firm might decide to shut down in the short-run due to the current market conditions (i.e. market price, cost levels). When a firm shuts down, they produce no output When a firm exits the market, they produce no output The relevant costs in a short-run shutdown decision are In the short-run, fixed costs must remain fixed costs A sunk cost is a cost that be recovered - No refunds - Contractually committed EXAMPLE: A farmer paid \$1,000 to rent a field for the season. Seeds cost \$200. Should the farmer produce this season? Revenue from sales = \$500 Revenue from sales = \$100 No Production: Production: No Production: Production: Best Scenario: Best Scenario: The firm shuts down if price falls below the of the curve. The minimum of the AVC curve is called the shutdown point Shutdown if: TR < VC Divide by Q: Shutdown if: AVC Summary of Short Run Output and Profit Should firm produce? Yes, if P > AVC No, if P < AVC If yes, what quantity? Produce where MR = Economic profit? Yes, if P > No, if P < The AVC is only relevant for our short-run shutdown decision! Page 7

8 PRACTICE: The makers of edible underpants are faced with the following production costs: Quantity Total Fixed Costs Total Variable Costs The price for a pair of edible underpants is \$50. In the short-run, the firm should: a) Shut down because price is less than average total cost. b) Shut down because it cannot make a profit. c) Produce one unit because, at this output, marginal revenue equals marginal cost. d) Produce four units because, at this output, the loss is minimized. The price for a pair of edible underpants is \$50. In the short-run, the firm s total revenue is: a) \$0 b) \$50 c) \$200 d) None of the above The price for a pair of edible underpants is \$50. In the short-run, the firm s profit (or loss) is: a) \$200 profit b) \$40 loss c) \$100 loss d) Break-even Page 8

9 PRACTICE: Use this graph to answer the following questions: The firm shuts down at any price below: a) P1 b) P2 c) P3 d) P4 What is the least amount of output, assuming the firm does not shut down? a) 5 units b) 8 units c) 10 units d) 11 units If the price falls from P4 to P3, then output will decrease by a) 0 units b) 1 unit c) 2 units d) 3 units Page 9

10 CONCEPT: LONG RUN EXIT/ENTER DECISION A firm will exit the market if it earn a profit. A firm will enter the market if it earn a profit. When a firm shuts down, they produce no output When a firm exits the market, they produce no output The relevant costs in a long-run exit decision are In the long-run, all costs are There are no in the long run. EXAMPLE: A farmer is considering if he should continue to rent a field for the upcoming season at a price of \$1,000. Seeds cost \$200. Should the farmer produce this season? Revenue from sales = \$500 Revenue from sales = \$100 No Production: Production: No Production: Production: Best Scenario: Best Scenario: The firm shuts down if price falls below the of the curve. The minimum of the curve is the entry/exit point Exit if: Divide by Q: Exit if: Enter if: TR < TC AVC Price Profit Short-Run Production Long-Run Production Page 10

11 CONCEPT: INDIVIDUAL SUPPLY CURVE IN THE SHORT RUN AND LONG RUN A firm does not shut down when price is The firm s short-run supply curve in perfect competition is the portion of above AVC A firm does not exit the market when price is The firm s long-run supply curve in perfect competition is the portion of above AVC Page 11

12 CONCEPT: MARKET SUPPLY CURVE IN THE SHORT RUN AND LONG RUN In the short-run, the number of firms in the market is The market s short-run supply curve in perfect competition is the of individual firm s curves. P Individual Firm P Market Supply with 1,000 firms Market Supply \$10 \$10 \$5 \$ In the long-run, firms earn economic profit Q Q Profit or Loss = (P ) Q Short-run profits (P > ) Short-run losses (P < ) Long-run Equilibrium Individual Firm: Zero Profit Long-run Market Supply P P Market Supply Q Q Page 12

13 CONCEPT: CHANGES IN DEMAND AND LONG RUN EQUILIBRIUM Shifts in the demand curve can create short-run profits or losses, but eventually return to the same long-run equilibrium. In the short run, firms can earn economic profit or loss. In the long run, firms earn no economic profit. Market Firm Short-run Supply In Long-Run Equilibrium Long-run P 1 P 1 Supply P = = Demand Q (market) Q (firm) Short-run Supply Increase in Demand Long-run P 1 Supply P 1 D 1 D 2 Q (market) Q (firm) S 1 S 2 Short-Run Profit Leads Firms to Enter Long-run Supply P 1 D 1 D 2 Q (market) Q (firm) Page 13

14 PRACTICE: Use this graph to answer the following questions: If the price is P1, the firms are a) Earning an economic profit and some firms will exit b) Suffering an economic loss and some firms will exit c) Earning an economic profit and some firms will enter d) Suffering an economic loss and some firms will enter Suppose the cost curves apply to all firms in the industry. If the initial price is P1, in the long run, the market a) Supply will decrease b) Demand will decrease c) Supply will increase d) Demand will increase PRACTICE: A new study shows that eating raw garlic keeps vampires away (vampires have become a huge problem). This news shifts the demand curve for raw garlic to the right. In response, new firms enter the garlic market. While firms are entering the market, the price of raw garlic and the profit of each existing firm. a) Falls; rises b) Rises; falls c) Rises; rises d) Falls; falls Page 14

15 CONCEPT: PERFECT COMPETITION AND EFFICIENCY Perfectly competitive markets both productive efficiency and allocative efficiency. Productive Efficiency producing at the - The lowest possible cost is - In the long run, perfect competition forces firms to produce at Allocative Efficiency production represents - Producing means producing up to the point that the = Allocative Efficiency in Perfect Competition 1. The price of a good represents the MB to consumers of the last unit sold. (P = MB) 2. In perfect competition, firms produce up to the point where the price (MR) equals marginal cost. (P = ) 3. Thus, firms produce up to the point where MB to consumers equals to producers. (P = MB = ) Page 15

16 PRACTICE: Use the following graphs to answer the questions below: Single Firm Market S P MR P = = minimum D Q f Q m The firm is a price taker because: a) It has a U-shaped curve b) The profit-maximizing point occurs where equals c) The curve has an upward slope d) The MR curve is horizontal When this firm is producing the profit-maximizing output: a) Total revenue is equal to total cost b) It earns an economic profit c) Only allocative efficiency is reached (i.e. no productive efficiency) d) Only productive efficiency is reached (i.e. no allocative efficiency) When P = = minimum for individual firms, in the entire market: a) Consumer surplus is larger than producer surplus b) Producer surplus is larger than consumer surplus c) Supply and demand are the same d) Total surplus is at a maximum Page 16

17 CONCEPT: FOUR MARKET MODEL SUMMARY Perfect Competition Number of Firms Examples Barriers to Entry Profit-Maximizing Quantity Long-Run Profitability Relation of Price (P=AR) and MR Relation of Price and Page 17