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Chapter 8: Perfect Competition

by: David Falcone

Chapter 8: Perfect Competition ECON 2005

David Falcone
Virginia Tech

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These notes cover Chapter 8: Perfect Competition and will be tested on Exam 2. All information comes from Aplia/ Principles of Microeconomics by William A. Mceachern.
Principles of Economics
Steve Trost
Class Notes
perfect competition, homogeneous, standardized, pricetakers, pricemakers, MR=MC, Shortrun, Longrun, Marginalrevenue, Marginalcost, Avergaerevenue, MP=MR=AR, Constantcostindustry
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This 12 page Class Notes was uploaded by David Falcone on Thursday September 8, 2016. The Class Notes belongs to ECON 2005 at Virginia Polytechnic Institute and State University taught by Steve Trost in Fall 2015. Since its upload, it has received 4 views.

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Date Created: 09/08/16
Perfect Competition: Chapter 8  Perfect Competition (PC) o Perfect competition- An industry structure with many fully informed buyers and sellers of a standardized product and no obstacles to entry or exit of firms in the long run. o Homogeneous or standardized products (aka commodities)- Undifferentiated products; products that are identical to, or indistinguishable from, one another. o Five characteristics of perfectly competitive markets  There are many small firms – price takers – and many small consumers  When one small firm changes price there is little effect o Perfectly elastic – many substitutes  The firms sell a homogeneous product (commodity)  All firms must sell goods that are basically interchangeable o Consumers will only care about price since there are no quality differences o Perfectly elastic – many substitutes  Everyone (buyers and sellers) has access to full information  All buyers and sellers can “see” the demand and cost curves and know what price they should buy or sell for  There is unrestricted entry and exit to the market, (but not necessarily “costless”)  Unprofitable firms can leave the market and new firms can enter profitable markets  This entry may cost $$ but there are no barriers keeping firms from entering  If firms are not allowed to enter, then markets may not achieve the lowest possible price  Prices are not fixed or regulated by the state  Prices must be allowed to move to the equilibrium price for a market to be truly competitive   The demand curve facing an individual farmer is, therefore, a horizontal line drawn at the market price  Price Takers o The perfectly competitive firm is what is known as a price taker  It has NO price policy (i.e. it cannot set price – it can only accept/react to it) o The firm’s output has no effect on the overall market price or quantity. Because of this, for a perfectly competitive firm, P=MR=AR, where  P=Market Clearing Price (where market S and D curves intersect  MR=Marginal Revenue=revenue associated with selling one more unit  AR=Average Revenue=TR/q  MR=AR since MR is not rising or falling o In the short run, to maximize profits, the firm would choose the level of output such that MR=MC.  PC Firms: Short Run Profits o The firm maximizes economic profit by finding the quantity at which total revenue exceeds total cost by the greatest amount o o Profit is maximized at the rate of output where total revenue exceeds total cost by the greatest amount.  Profit is greatest when 12 bushels are produced per day. o o  Marginal Revenue Equals Marginal Cost o Marginal revenue- The firm’s change in total revenue from selling an additional unit; a perfectly competitive firm’s marginal revenue is also the market price (Perfectly Competitive firm MR= Market price)  In perfect competition, marginal revenue is the market price o The firm increases production as long as each additional unit of output adds more to total revenue than to total cost—that is, as long as marginal revenue exceeds marginal cost o Golden rule of profit maximization- To maximize profit or minimize loss, a firm should produce the quantity at which marginal revenue equals marginal cost; this rule holds for all market structures o Marginal Cost- The change in cost to the firm to produce an additional unit  Economic Profit in the Short Run o Because the perfectly competitive firm can sell any quantity for the same price per unit, marginal revenue is also average revenue, or AR  AR- Total revenue divided by quantity, or AR= TR/q; in all market structures, average revenue equals the market price  o In the short run a firm can:  earn positive economic profits  earn zero economic profits  suffer economic losses but continuing to operate to reduce or minimize those losses  shut down and bear losses just equal to fixed costs o Minimizing Losses  A firm that shuts down in the short run must still pay its fixed cost. But, by selling some output, the revenue generated may cover all the firm’s variable cost and a portion of its fixed cost.  A firm produces rather than shuts down if total revenue exceeds the variable cost of production o Aka revenue covers variable costs   Because the price is $3, the total revenue curve now has a slope of 3, so it’s flatter than at a price of $5. The total revenue curve now lies below the total cost curve for all output rates. The vertical distance between the two curves measures the loss at each output rate. If the farmer produces nothing, the loss is the fixed cost of $15 per day. The vertical distance between the two curves is minimized at 10 bushels, where the loss is $10 per day.  Operating profit (or loss) or net operating revenue: Total revenue minus total variable cost (TR - TVC).  If revenues exceed variable costs, operating profit is positive and can be used to offset fixed costs and reduce losses, and it will pay the firm to keep operating  If revenues are smaller than variable costs, the firm has negative operating profit (loss) that push total losses above fixed costs. In this case, the firm can minimize its losses by shutting down.  Marginal Revenue Equals Marginal Cost o Marginal revenue equals marginal cost at an output of 10 bushels per day. At that output, the market price of $3 exceeds the average variable cost of $2.50. Because price exceeds average variable cost, total revenue covers variable cost plus a portion of fixed cost. Specifically, $2.50 of the price pays the average variable cost, and the remaining $0.50 helps pay some of average fixed cost (average fixed cost equals average total cost of $4.00 minus average variable cost of $2.50). This still leaves a loss of $1 per bushel, which when multiplied by 10 bushels yields an economic loss of $10 per day, identified in panel (b) by the pink-shaded rectangle.  The bottom line is that the firm produces rather than shuts down if there is some rate of output where the price at least covers average variable cost    Shutting down in the Short Run o if average variable cost exceeds the price at all rates of output, the firm shuts down  After all, why produce if doing so only adds to the loss? For example, a wheat price of $2 would fall below the average variable cost at all rates of output. Faced with such a low price, a farmer would shut down and lose just fixed cost, rather than produce and lose both fixed cost plus some variable cost. o Shutting down is not the same as going out of business  In the short run, even a firm that shuts down keeps productive capacity intact—paying rent, insurance, and property taxes, keeping water pipes from freezing in the winter, and so on  A firm that shuts down “Fixed cost is sunk cost in the short run, whether the firm produces or shuts down.” does not escape fixed cost  An icecream shop shutting down in the winter o MR=MC is the profit maximizing quantity, but it doesn’t always ensure a positive profit  Profit must cover variable costs aka price must be above AVC  The Short-Run Firm Supply Curve o  At  P1 &P2 shutdown o P2 is the shutdown point  P3 keep producing to minimize shot run losses  P4 keep producing o Break even point  P5 keep producing because you earn a profit  Short-run firm supply curve- A curve that shows how much a firm supplies at each price in the short run; in perfect competition, that portion of a firm’s marginal cost curve that intersects and rises above the low point on its average variable cost curve  The Short-Run industry Supply Curve o Short-run industry supply curve- A curve that indicates the quantity supplied by the industry at each price in the short run; in perfect competition, the horizontal sum of each firm’s short-run supply curve o  Firm Supply and Market Equilibrium o  A perfectly competitive firm supplies the short-run quantity that maximizes profit or minimizes loss. When confronting a loss, a firm either produces an output that minimizes that loss or shuts down temporarily. Given the conditions for perfect competition, the market converges toward the equilibrium price and quantity.  Perfect Competition in the Long Run o In the long run, however, a firm has time to enter and leave and to adjust its size—that is, to adjust its scale of operations. In the long run, there is no distinction between fixed and variable cost because all resources under the firm’s control are variable.  All costs are variable, so marginal cost encompasses everything o Short-run economic profit attracts new entrants in the long run and may cause existing firms to expand. Market supply thereby increases, driving down the market price until economic profit disappears.  Zero Economic Profit in the Long Run o In the long run, firms in perfect competition earn just a normal profit, which means zero economic profit o Market supply adjusts as firms enter or leave or change their size. This long-run adjustment continues until the market supply curve intersects the market demand curve at a price that corresponds to the lowest point on each firm’s long-run average cost curve, or LRAC curve o Because the long run is a period during which all resources under a firm’s control are variable, a firm in the long run is forced by competition to adjust its scale until average cost is minimized o A firm that fails to minimize average cost will not survive in the long run o  The Long-Run Adjustment to a Change of Demand o Effects of an Increase of Demand   Short-run economic profit attracts new firms to the industry in the long run. But new entry shifts out market supply, forcing the market price down until economic profit disappears o Effects of a Decrease of Demand   Now suppose that market demand declines, as reflected in panel (b) by a leftward shift of the market demand curve  Each firm responds in the short run by reducing quantity supplied  Note, the price must still be above the average variable cost, because the firm’s short-run supply curve, MC, is defined as that portion of the firm’s marginal cost curve at and above its average variable cost curve.  A short-run loss forces some firms out of business in the long run. As firms exit, market supply decreases, or shifts leftward, so the price increases along market demand curve  Firms continue to leave until the market supply curve decreases  The Long-Run Industry Supply Curve o Long-run industry supply curve- A curve that shows the relationship between price and quantity supplied by the industry once firms adjust in the long run to any change in market demand  Constant Cost Industries o Constant Cost industry- An industry that can expand or contract without affecting the long-run per-unit cost of production; the long-run industry supply curve is horizontal  Increasing-Cost Industries o Increasing-cost industries- An industry that faces higher per-unit production costs as industry output expands in the long run; the long- run industry supply curve slopes upward o o To Review: Firms in perfect competition can earn an economic profit, a normal profit, or an economic loss in the short run. But in the long run, the entry or exit of firms and adjustments in each firm’s size squeeze economic profit to zero. Firms in a perfectly competitive industry earn only a normal profit in the long run. This is true whether the industry in question experiences constant costs or increasing costs in the long run. Notice that, regardless of the nature of costs in the industry, the market supply curve is more elastic in the long run than in the short run. In the long run, firms can adjust all their resources, so they are better able to respond to changes in price. One final point: Firms in an industry could theoretically experience a lower average cost as industry output expands in the long run, resulting in a downward-sloping long-run industry supply curve. But such an outcome is considered so rare that we do not examine it.  Productive Efficiency: Making Stuff Right o Productive efficiency- The condition that exists when production uses the least-cost combination of inputs; minimum average cost in the long run  Allocative Efficiency: Making the Right Stuff o Just because production occurs at the least possible cost does not mean that the allocation of resources is the most efficient one possible. The products may not be the ones consumers want  Likewise, firms may be producing goods efficiently but producing the wrong goods—that is, making stuff right but making the wrong stuff o Allocative efficiency- The condition that exists when firms produce the output most preferred by consumers; marginal benefit equals marginal cost  The demand and supply curves intersect at the combination of price and quantity at which the marginal value, or the marginal benefit, that consumers attach to the final unit purchased, just equals the opportunity cost of the resources employed to produce that unit.  When the marginal benefit that consumers derive from a good equals the marginal cost of producing that good, that market is said to be allocatively efficient.   What’s so perfect about perfect competition? o If the marginal cost of supplying a good just equals the marginal benefit to consumers, does this mean that market exchange confers no net benefits to participants? No. Market exchange usually benefits both consumers and producers o o Producers in the short run also usually derive a net benefit, or a surplus, from market exchange, because what they receive for their output exceeds the least they would accept to supply that quantity in the short run  Recall that the short-run market supply curve is the sum of each firm’s marginal cost curve at and above its minimum average variable cost o Producer surplus- A bonus for producers in the short run; the amount by which total revenue from production exceeds variable cost  Any price that exceeds average variable cost, which is $5 in this example, generates a producer surplus. A high enough price could yield economic profit o The combination of consumer surplus and producer surplus shows the gains from voluntary exchange o Social Welfare- The overall well-being of people in the economy; maximized when the marginal cost of production equals the marginal benefit to consumers  Even though marginal cost equals marginal benefit for the final unit produced and consumed, both producers and consumers usually derive a surplus, or a bonus, from market exchange. Voluntary exchange usually makes both sides of the market better off. Voluntary exchange is typically win-win. And competition usually improves product quality as well


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