Ch. 12 : Firms in Perfectly Competitive Markets

ECONOMICS 2420

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Chapter Objectives :

Learn what characteristics make a market competitive

Examine how competitive firms decide how much output to produce

Examine how competitive firms decide when to shut down production temporarily Price≤ AVC (SR)

Examine how competitive firms decide whether to exit or enter a market in the LR Price > minimum LRAC=> enter; Price< minimum LRAC=> exit (LR)See how firm behavior determines a market’s short-run and long-run supply decisions to achieve efficiency

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1. The four broad market structures are:

Perfect competition- family farm and stock market

Monopoly- Local electric department, local gas company –Microsoft in Windows OS?

Monopolistic Competition- gas station, fast food restaurant, grocery stores, e-commerce

Oligopoly- auto industry, steel industry

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2. Criteria for market classification

» The number of small firms in the industry

» The type of product firms produce- homogenous VS differentiated products

»Entry conditions into the industry (Easy VS Difficult)

»Free information about product price and availability

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3. Features of Perfection competition

Large number of small producers

Firms sell identical or homogenous product

Easy entry into the industry

Perfect information about price and product availability

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4a. The demand for a competitive firm is perfectly elastic (horizontal)

It implies that the typical firm in the industry can sell any amount provided it charges the market determined price( So each firm is so small and has no influence on the price=> the firm is said to be a “price taker”)

b. For a competitive firm the demand(D)=P=AR=MR. Illustrate

Total, Average , And Marginal Revenue For A Competitive Firm

Quantity Price Total Revenue

Average Revenue

Marginal Revenue

(Q)gallon (P)$ (TR=P.Q) (AR=TR/Q) (MR=ΔTR/ΔQ)

1 6 6 6 6 2 6 12 6 6 3 6 18 6 6 4 6 24 6 6 5 6 30 6 6 6 6 36 6 6 7 6 42 6 6 8 6 48 6 6

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5. SR Profit Maximization by the MR=MC Rule: A numerical Example

Q Total Revenue

Total Cost

AVC Profit ($)

MR MC

gallon (TR)$ (TC)$ $ (TR-TC) =ΔTR/ΔQ =ΔTC/ΔQ

0 0 3 0.0 -3 - - 1 6 5 2.0 1 6 2 2 12 8 2.5 4 6 3 3 18 12 3.0 6 6 4 4 24 17 3.5 7 6 5 5 30 23 4.0 7 6 6 6 36 30 4.5 6 6 7 7 42 38 5.0 4 6 8 8 48 47 5.5 1 6 9

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5. The objective of any business firm is to maximize profit or minimizing losses.

This objective can be realized by producing the rate of output for which the Marginal Revenue = Marginal Cost

The firm must produce 5 units to maximize profit Notice it is only at Q= 5 that is maximum.Why not at Q=4?

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6. In the short-run, a competitive firm may make profit, just break-even, even operate at a loss if AVC<Price<ATC, go out of business if price<AVC.

a. The profit making case : Price>ATC

b. The break-even case: Price=ATC

c. Loss minimization by staying in business: AVC<Price<ATC

d. Going out of business case: Price<AVC

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7. The short-run supply curve for a competitive producer is the portion of its marginal cost above the minimum point on the AVC. Illustrate.

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8. Perfectly competitive firms will operate at maximum efficiency and produce at minimum cost (LRAC) in the long run.

a. Long run equilibrium for a typical competitive firm occurs

when: Price = Marginal revenue = Minimum LRAC = LRMC.

b. In the LR, a competitive firm has zero economic profit and zero economic losses due to free entry into and exit of firms out of the industry.

Therefore, there is neither an inducement for new firms to enter nor for existing firms to exit from the industry in the long-run. Why? Illustrate.If they are not making profits, what is the incentive to stay in business?

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9. The long run industry supply curve shows the quantities that the industry supplies at different prices after entry and exit of firms is completed. It is:

a. Horizontal supply for a constant cost industry

b. Upward sloping supply for an increasing cost industry.

c. Downward sloping supply for a decreasing cost industry.

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10. The Performance of Competitive Markets

. Positive Aspects of Perfect Competition

a. Competition forces firms in this industry to use a technology that yields the lowest possible per unit cost (minimum LRAC) as implied by Price = minimum LRAC ==>Technical efficiency or production efficiency

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b. The equality of price and marginal cost implies that competition leads to resources allocation efficiency so that firms produce what consumers want.

Price = Marginal Cost=> Allocative efficiency

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Some Criticisms of Perfect Competition

(1) It provides little incentive for innovation

(2) It fails to capture the spillover costs and benefits-externalities

(3) It leads to a lack of product variety (identical products)

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