Firms in Perfect CompetitionA Simplified Market

Mankiw Chapter 14

Basic Characteristics

There are many buyers and many sellers in the market.

The goods offered by the various sellers are largely the same.

Firms can freely enter and exit the market.

Definition: a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker.

Competitive Firm

The Competitive Firm has an internal supply curve (MC), to determine what quantity to produce at a specific price.

The supply and demand of the overall market determine the price.

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MC

ATC

AVC

AFC

Competitive Market

All of the individual firms’ supply curves add to form the Market Supply

The Market Demand is determined by consumers.

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6MC

ATCAVCAFC

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6MC

ATCAVCAFC

MC

ATCAVCAFC

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6MC

ATCAVCAFC

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6MC

ATCAVCAFC

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6MC

ATCAVCAFC

+ + + + =

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D

MarketPrice

Firm Supply & Demand

Within the firm, the MC curve acts as supply and MR acts as demand.

We can get the MR curve from MR = AR = P MR = (∆ Q x P)/∆ Q = P AR = (Q x P)/Q = P

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$2.00

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MC

ATC

AVC

AFC

P=MR

Profit Maximization (Graphically)

Each firm reflects the competitive market it is part of: Focuses on MC (firm supply) and MR (firm demand) Profit Max occurs at MR = MC; “equilibrium point”

At this point, the cost of an additional item exceeds the revenue for producing it.

Firm Demand (MR) is perfectly inelastic.

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$1

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MC

ATC

AVC

AFC

P=MR

Profit Max

Finding Profit (Graphically)

Total Profit = Total Revenue – Total Costs Total Costs = ATC x Q Total Revenue = Price x Q Total Profit = (P – ATC) x Q

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$1

$2

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MC

ATC

AVC

AFC

P=MR

Profit Max

Total Profit

Finding Profit (Table)

Price Quantity

MC(=TC/Q)

MR(=P)

Marginal Profit

(MR-MC)2.7 90 1.9 2.7 0.82.7 100 2.1 2.7 0.62.7 110 2.3 2.7 0.42.7 120 2.5 2.7 0.22.7 130 2.7 2.7 02.7 140 2.9 2.7 -0.22.7 150 3.1 2.7 -0.42.7 160 3.3 2.7 -0.62.7 170 3.5 2.7 -0.8

Long Run v. Short Run

Short Run – Firms make decisions at the current time. Variable Costs can be changed. (ie. more staff, more field

hands, using more energy for machinery) Fixed Costs are fixed. (ie. planting more seeds, factory

building rent)

Long Run – Firms make decisions over time. Variable Costs are still variable. Fixed Costs can also change. (ie. rent a 2nd factory

building)

The Decision to Shut Down or Exit

Shut Down – Closing down for the day. Occurs in the short run. When a firm determines that it cannot cover its

variable costs, it decides to not ‘produce’ until conditions change.

Even if a firm is not making a profit (P is below the ATC), it can defer the fixed costs.

However, if it cannot cover the variable costs, the total deficit is greater when producing.

The Decision to Shut Down or Exit

Exit – Leaving the market for and indefinite time. Occurs in the long run. When a firm takes losses in the long run, it decides

to leave the market – no incentive to stay. This results in other firms taking less losses – 0 long

run profit.

Long Run Profit

Because firms can enter and exit, they will enter until the total market profit is 0. If firms are making a profit, other firms will also want to

make profit; however, this will shift supply right and lower price.

If firms have a consistent loss, some will leave the market until all other firms make 0 profit.

0 50 100 150 200 250 300$0

$1

$2

$3

$4

$5

$6

MC

ATC

AVC

AFC

P=MR

Example

Questions? Comments?

Thanks for listening!