Perfect Competition

1
Chapter 24

• Perfect Competition

2
Things to Understand

• 4 basic market structures
• Characteristics of a purely competitive firm and
  market
• Relationship of individual firm to purely
  competitive market regarding demand and marginal
  revenue (MR)
• Compute total revenue (TR) and MR
• 
  continued

3
Things to Understand

• Profit maximization / loss minimization rule
• Determination of short run price output for
  profit maximization
• Profit maximizing price, Shut down price, Break
  even price
• Short run supply curve for competitive firm
• continued

4
Things to Understand

• Long run equilibrium for competitive firm
• P MC MR minimum ATC
• How to classify industries as constant-cost,
  increasing-cost, decreasing-cost

5
4 types of markets

• Competition (pure or perfect competition)
• Monopoly
• Monopolistic competition
• Oligopoly

6
Characteristics of Perfect Competition

• Many buyers and many sellers
• No buyer/seller has market power
• Homogeneous product
• No barriers to entry or exit
• All have perfect information
• Firm has no need to lower price to sell more

7
Price Taker

• Firm that must accept the market equilibrium
  price as the firms price for its product.
• Firm so small in relation to market supply that
  it cannot influence the market price.
• Firm will lose all business if it raises price
  since product is homogeneous.
• Firm has no reason to lower price below
  equilibrium can sell all desired at going price
  because firm small in relation to market supply.

8
Total Revenue (TR)

• Price X Quantity demanded
• Total amount a firm collects from sales to
  customers

9
Marginal Revenue (MR)

• Change in total revenue when one more unit of
  output is sold
• Purely competitive firm, MR Price firm can
  always sell one more unit at the same price
• Demand curve facing the firm is perfectly
  elastic is horizontal line at market price.
  (Market demand curve downward sloping.)
• Firm price MR market equilibrium price.
• Formula
• MR change in TR / change in Q demanded

10
Farmer Jons Demand Revenue Schedule
11
Profit Maximization / Loss Minimization Rule

• Produce at the output level where MC MR and
  charge the price on the demand curve for that
  output level as long as price is above AVC
• If price is below AVC, shut down in short run to
  minimize losses
• Goal of firm is not to minimize costs or
  maximize revenues, but to maximize profits

12
Loss Minimization

• Profit TR gt TC or P gt ATC
• Break-even TR TC or P ATC
• Loss TR lt TC or P lt ATC
• Firm must make two decisions
• 1) short run decision to operate or shut down
  and
• 2) long run decision to stay in business or go
  out of business.
• In short run, firm loses FC if it shuts down.
• If firm can cover VC and at least part of its FC,
  it will lose less by operating than it will by
  shutting down.
• If VC lt TR lt TC or AVC lt P lt ATC, keep factory
  operating to minimize loss
• If VC gt TR gt TC or AVC gt P, shut factory down in
  short run to minimize losses.
• Note TR total revenue TC total cost VC
  variable cost

13
Important prices

• Profit maximizing price
• MR MC as long as P gt ATC
• Break even price
• P ATC
• Shut down price
• P lt AVC, a firm loses more by remaining open than
  by closing down

14
Competitive Firms supply curve

• Portion of its MC curve above minimum AVC
• Firm chooses output level where MC MR charges
  market equilibrium price.
• For competitive firm, profit maximizing situation
  will be
• MC MR P

15
Economic profits and long run breakeven

• Remember that economic profit Total Revenue
  Total Costs, and there are no barriers to entry
  or exit in competitive industry
• When firms on average earn economic profit,
  then
• New companies enter industry
• Market supply curve shifts to right (increase in
  supply)
• Market equilibrium price goes down until firms on
  average earn normal profits (no economic profits)

16
Economic losses and long run breakeven

• Remember that economic profit Total Revenue
  Total Costs, and there are no barriers to entry
  or exit in competitive industry
• When firms on average earn economic loss, then
• Some companies exit industry
• Market supply curve shifts to left (decrease in
  supply)
• Market equilibrium price goes up until firms on
  average earn normal profits (no economic profits
  or losses)

17
Interesting Discoveries about Long Run
Equilibrium

• P minimum ATC MR MC
• Consumers buy _at_ P minimum ATC
• As few resources as possible used to produce each
  unit of output technical efficiency

18
Interesting Discoveries about Long Run
Equilibrium

• P MC MR minimum ATC
• P conveys average value customers place on last
  unit sold of product
• MC conveys how much we value resources it takes
  to produce one more (or last) unit produced
• P gt MC last unit of output valued more than
  resources it would take to produce another unit
  should have produced more.
• P MC market producing efficient output level.
• P lt MC resources taken to produce last unit
  valued more than last unit produced should have
  produced less.

19
Long Run Cost Structures

• Constant cost industry Increase in industry
  output has no impact on cost curves of firms.
• Increasing cost industry long run per unit cost
  of production increases (LRATC shifts ups) as
  industry output increases.
• Decreasing cost industry long run per unit cost
  of production decreases (LRATC shifts down) as
  industry output increases
• NOTE This is not the same as economies to
  scale, diseconomies to scale or constant returns
  to scale which a occur when plant size varies.
  This is what happens when industry output changes.