Perfect Competition: review

Perfect competition is an industry in which

There are many buyers and many sellers in the market.

The goods offered by the various sellers are identical.
There are no restrictions to entry into/ exit from the industry.
Sellers and buyers are price takers
Each firms output is a perfect substitute for the output of the other
firms
Each firm faces horizontal demand curve at equilibrium market price

Part (a) shows that market demand and market supply determine the
market price that the firm must take.
Part (b) shows the firms total revenue curve (TR)the relationship
between total revenue and quantity sold.
What about MR curve?

 firms marginal revenue equals price

the demand curve faced by the firm is horizontal at the
market price.

The Firms Output Decision

Profit-Maximizing Output
A perfectly competitive firm chooses the output
that maximizes its economic profit.
One way to find the profit-maximizing output is to
look at the firms the total revenue and total cost
curves.

The Firms Output Decision

Total revenue minus total cost

is economic profit (or loss),
shown by the curve EP in part
(b).
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The Firms Output Decision

At low output levels,
the firm incurs an
economic loss
At intermediate output
levels, the firm makes an
economic profit.

The Firms Output Decision

At high output levels,
the firm again incurs an
economic lossnow
the firm faces steeply
rising costs because of
diminishing returns.
The firm maximizes its
economic profit when it
produces 9 sweaters a day.

The Firms Output Decision

Marginal Analysis and Supply Decision
The firm can use marginal analysis to determine
the profit-maximizing output.
profit is maximized by producing the output at
which MR = MC

The Firms 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 is
maximized.

Output, Price, and Profit

in the Short Run
Profits and Losses in the Short Run
To determine whether a firm is making an
economic profit or incurring an economic loss, we
compare the firms average total cost at the
profit-maximizing output with the market price.

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What if the firm makes loss?

So far we have been analyzing the question of how much a
competitive firm will produce.
In some circumstances, however, the firm will decide to shut down
and not produce anything at all.

FIRMS SHORT-RUN DECISION TO

SHUT DOWN
If a firm is making losses, 2 things are possible:
1) Shut down operations immediately
2) Continue to operate
A shut down refers to a short-run decision not to produce anything during a
specific period of time

The decision will be the one that minimizes the firms losses.

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 Distinguish between a temporary shutdown of a firm and the

permanent exit of a firm from the market.
Shut down refers to short run decision to produce q=0
Exit refers to a long-run decision to leave the market.
The short-run and long-run decisions differ because
- Firms cannot avoid fixed costs in the short run
- Thus, a firm that shuts down temporarily still has to pay its fixed costs
(eg. Rent)

Firm can avoid fixed costs in the long run

- a firm that exits the market saves both its fixed (none) and its variable
costs.

What determines a firms shut down decision?

Loss Comparison
Option: Shut down
Economic profit = TR - TVC - TFC
= (P- AVC ) q - TFC
If the firm shuts down, q = 0
But the firm still has to pay TFC
If the firm shuts down its profit = -TFC < 0
So the firm incurs an economic loss equal to TFC

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Option: continue to operate

If the firm continues to produce, it earns both revenue and

incurs variable costs.
-What about fixed costs?
-What is profit =?
The decision on whether or not to produce depends solely on
whether revenue exceed variable costs

 The firm shuts down if the revenue from production is less than its
variable costs of production.

Shut down if TR < TVC

Equivalently, if P < AVC

If price < average variable cost, the firm is better off stopping production

 A firms shutdown point is where AVC is at its

minimum.
It is also the point at which the MC curve crosses
the AVC curve.
The firm incurs a loss equal to TFC

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The Firms Output Decision

Minimum AVC is 17
If the price is 17, the
profit-maximizing
output is 7
The firm incurs a
loss equal to the red
rectangle.

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The Firms Output Decision

If the price is
between 17 and
20.14, the firm
produces the
quantity at which
marginal cost
equals price.

The firm covers all

its variable cost and
at least part of its
fixed cost.
It incurs a loss that
is less than TFC.

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The Firms Output Decision

The Firms Supply Curve
A perfectly competitive firms supply curve shows how the firms
profit-maximizing output varies as the market price varies, other
things remaining the same.
Since the firm produces the output at which MR = MC = P, the firms
supply curve is linked to its marginal cost curve
At a price below the shutdown point (AVCmin) the firm produces
nothing.
The competitive firms short-run supply curve is the portion of its
marginal-cost curve that lies above average variable cost

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Supply curve of a perfectly

competitive firm
If the price is 25, the firm
produces 9, the quantity at which
P = MR= MC.
If the price is 31, the firm
produces 10, the quantity at
which P = MR= MC.
firms short-run supply curve is
MC above the AVCmin

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Exercise

Output, Price, and Profit

in the Short Run
Market Supply in the Short Run
The short-run market supply curve shows the quantity supplied by all
firms in the market at each price
the number of firms remain the same (since short run)
The technology remains same
Thus market supply curve is the sum of MC curves (above AVC) of all
firms

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In short-run equilibrium, a firm has the following

possibilities:
economic profit (>0)
break even (=0)
incur an economic loss (<0)

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Output, Price, and Profit

in the Short Run
In part (a) price equals average total cost and the
firm makes zero economic profit (breaks even).

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Output, Price, and Profit

in the Short Run
In part (b), price exceeds average total cost and
the firm makes a positive economic profit.

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Output, Price, and Profit

in the Short Run
In part (c) price is less than average total cost and the firm
incurs an economic losseconomic profit is negative.

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Output, Price, and Profit in the Long Run

Entry and Exit
New firms enter an industry in which existing
firms make an economic profit.
Existing firms exit an industry in which they incur
an economic loss.

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FIRMS LONG-RUN DECISION TO EXIT OR ENTER A MARKET

Exit the market if profit < 0

Exit if TR < TC
P < ATC
If the firm exits, it will lose all revenue from the
sale of its product, but now it saves total costs of
production.

 A firm will enter the market if such an action

is profitable
profit > 0
if P > ATC

 A Competitive firms long-run profit-maximizing strategy:

If the firm is in the market, it produces the quantity at which p= MR= MC.
If the price is less than ATC at that quantity, the firm will exit the market.
The competitive firms long-run supply curve is the portion of its
MC curve that lies above ATC

 Profit = (P - ATC).Q

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Adjustment process in LR
Consider the case where firms make positive profit
Implication: new firms will enter the market.
Entry will expand the number of firms,
Increase the quantity of the good supplied
drive down prices and profits
How long will firms enter?
As long as existing firms are still making profit
When will this adjustment process stop?

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Output, Price, and Profit

in the Long Run
When the market price is 25, firms in the market
are making positive economic profit.

Output, Price, and Profit

in the Long Run
New firms have incentive to enter the market.
When they do, the market supply increases and the
market price falls.

Output, Price, and Profit

in the Long Run
Firms enter as long as firms are making economic profits.
In the long run, the market supply increases, the market price
falls
firms eventually make zero economic profit.

Adjustment process in LR
Conversely, what if firms in the market are making losses?
then some existing firms will exit the market
Their exit will reduce the number of firms, decrease the quantity of the
good supplied,
and drive up prices and profits
When will this adjustment process stop?
At the end of this process of entry and exit, firms that remain in the
market must be making zero economic profit

3/27/2016

Note:
Competitive firms produce so that P = MR = MC
Free entry and exit forces P = ATC
Implication: P = MC = ATC
MC = ATC occurs when the firm is operating at the minimum of ATC

3/27/2016

Competitive firms earn zero profit in the long

run.
Why would competitive firms stay in business if
they make zero profit?

3/27/2016

Suppose a farmer had to invest 1 million to open his farm

Also, he had to give up another job that would have paid him
30,000 a year.

Implication:
Interest foregone @ 5% = 50000
Wages foregone = 30000
Opportunity cost of money and time = 80000
Economic profit = Revenue Explicit cost Implicit cost =0
Accounting profit = Revenue Explicit cost = Implicit cost = 80,000 >0
Thus revenue from farming compensates him for the opportunity costs
of time and money
3/27/2016