perfect competition 14 - ms. lopiccolo's...

Perfect Competition 14

Perfect Competition

There’s no resting place for an enterprise

in a competitive economy.

— Alfred P. Sloan

CHAPTER 14

Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.McGraw-Hill/Irwin


Characteristics of Perfect Competition

1. Both buyers and sellers are price takers

• A price taker is a firm or individual who takes the price determined by market supply and demand as given

• If a firm charges above the market price consumers will buy from their competition (and will earn no revenue)

McGraw-Hill/Irwin Colander, Economics 2



• 2. There are many firms

• 3. There are NO barriers to entry

• Easy entry and exit




• 4. Firms’ products are identical (that means the competitor’s goods are perfect substitutes)

• 5. There is complete information• Consumers know all about the market

including prices, products, and available technology

14-4



• 6. Firms are profit-maximizing

• P=D=MR=AR (MR. DARP)

• The demand curve will be perfectly elastic (the firm is a price taker)

• Price will be determined by market equilibrium

• Marginal revenue is the same as price



Perfect Competition: Demand Curve

• The market demand curve is downward sloping

• The firm’s demand curve is a horizontal line—a perfectly elastic demand curve

• This is because the firm is a price taker

• Therefore, P=MR=D=AR



Perfect Competition: Supply Curve

• Because the marginal cost curve tells how much of a good a firm will supply at a given price, the marginal cost curve is the firm’s supply curve (above AVC)

14-7


Profit Maximizing Level of Output

• The goal of the firm is to maximize profits

• Profit=TR-TC

• (Total revenue – Total costs)

14-8



• A firm maximizes profit when marginal revenue equals marginal cost (MC=MR)

• Marginal revenue (MR) is the change in total revenue associated with a change in quantity

• Every time a perfectly competitive firm sells a unit, they earn marginal revenue

• Since they are a price taker (and can only sell at market price), P=MR (which also equals AR, or average revenue)

• Marginal cost (MC) is the change in total cost associated with a change in quantity




• So, the profit-maximizing condition of a perfectly competitive firm is: MC = MR

• For a perfectly competitive firm, MR = P

• As a result, MC=MR=P

• This is the profit-maximizing condition

14-10



• A firm maximizes total profit, not profit per unit

• If MR > MC, a firm can increase profit by increasing output

• If MR < MC, a firm can increase profit by decreasing its output



Graphing Perfect Competition

• There are two graphs:

• One is the market/industry graph

• The other is the firm

• They are drawn as side-by-side graphs




• Start with standard supply and demand graphs to represent the market (label this graph market)

• Identify market price and quantity (P1 and Q1)

• Take price over to your second graph by drawing a dotted line




• On your second graph, label it firm

• Draw your marginal cost curve

• Draw your ATC (location varies depending on if the firm is making a profit, loss, or zero economic profit)

• Make a “big dot” where MC intersects MR—this is your profit maximizing P and Q

• Take the big dot all the way down to the quantity axis



Drawing the Graph: Perfect CompetitionProfit in the Short Run

P

Q

S

P1

D

P

Q

P1 P = D = MR = AR

Q1

14-15

MC

ATC

Qprofit max

Profit

Market Firm

Since P>ATC at the profit maximizing

quantity, this firm is earning

profit


Drawing the Graph: Perfect CompetitionLoss in the Short Run

P

Q

S

P1

D

P

Q

P1 P = D = MR = AR

Q1

14-16

MC ATC

Qprofit max

Loss

Market Firm

Since P<ATC at the profit maximizing

quantity, this firm is earning a

loss


Drawing the Graph: Perfect CompetitionZero Economic Profit (Normal Profit) in the Long Run

P

Q

S

P1

D

P

Q

P1 P = D = MR = AR

Q1

14-17

MC

ATC

Qprofit max

Market Firm

Since P=ATC at the profit maximizing

quantity, this firm is earning

zero economic profit


Perfect Competition in the Long-Run

• In the long run perfect competitors make zero economic profit

• WHY???

• Due to the entry and exit of firms

• If a profit is being made firms would keep entering the market

14-18


Perfect Competition in the Long-Run

• Zero profit does not mean that the entrepreneur does not get anything for his efforts

• Normal profit is the amount the owners would have received in their next best alternative (breakeven point; TR=TC)

• Economic profits are profits above normal profits (where TR exceeds TC)

14-19


The Shutdown Point for Perfectly Competitive Firms

• In the short run, fixed costs are sunk costs —they must be paid whether or not the firm produces anything

• A firm pays attention to its variable costs when deciding to shutdown

• As long as a firm is covering its variable costs it should still produce

• When price falls below AVC is when the firm should shutdown



The Shutdown Point for Perfectly Competitive Firms

• The shutdown point is the point below which the firm will be better off if it shuts down rather than if it stays in business

• If P>min of AVC, then the firm will still produce, but earn a loss

• If P<min of AVC, the firm will shut down

• If a firm shuts down, it still has to pay its fixed costs

AVC

MC

Q

P

ATC

Qprofit max

PShutdown P = D = MR = AR

14-21


SR Profit

Perfect Competition: PracticeWhat happens to the graphs if market demand increases?

P

Q

S1

P1

D1

P

Q

P1

MC

ATC

Q1

Market Firm

D2

P2P2

Q2Q1 Q2

14-22

D2=P2=MR2

=AR2D1=P1=MR1

=AR1


Perfect Competition: Practice

MC

Q

P

ATC

P = D = MR = AR

Qprofit max

P

14-23

Is this firm making a profit, loss, or zero economic profit?

Shade the area that represents total costs


Perfect Competition: Practice

MC

Q

P

ATC

P = D = MR = AR

Qprofit max

P

14-24

Is this firm making a profit, loss, or zero economic profit?ProfitShade the area that represents total costsGrey box

Profit

Total costs


A Note About Perfect Competition for FRQs

• Firms can be in a constant-cost industry OR an increasing cost industry

• In the constant-cost industry we assume that the entry and exit of firms has no impact on the cost curves of the firms in the market




• In an increasing cost industry we assume that the entrance of new firms increases the demand for the factors of production

• This might increase the cost of employing those resources

• When this happens, the cost curves shift upward




• Graphically, what would happen in an increasing cost industry?

• The entrance of new firms would drive down the price of output and increase the cost curves—profit would be eliminated more quickly here than in a constant-cost industry

• The new long run price would be higherthan in a constant-cost industry




• The other option is a decreasing cost industry (yet to see this in the FRQs)

• This is when the entry of new firms decreases the price of key inputs and causes the cost curves to shift downward

• Could be due to economies of scale and lower per unit-costs




• The entrance of new firms lowers the price of the output and decrease the cost curves

• Takes longer for profit to be eliminated than in the constant-cost industry

• More firms can enter this market and the new long run price would be lower than in a constant cost industry



Chapter Summary

• The necessary conditions for perfect competition are:

1. Buyers and sellers are price takers

2. The number of firms is large

3. There are no barriers to entry

4. Firms’ products are identical

5. There is complete information

6. Sellers are profit-maximizing entrepreneurial firms

14-30


Chapter Summary

• Competitive firms maximize profit where MR = MC

• Profit is (P – ATC)(Q) at the profit-maximizing level

of output

• Perfectly competitive firms shut down if P < AVC

• The supply curve of a competitive firm is its MC

curve above minimum AVC

• The short-run market supply curve is the horizontal

sum of the MC curves above AVC for all the firms in

the market14-31


Chapter Summary • In the short run, competitive firms can make a profit

or loss. In the long run they make zero profits.

• If there are profits:

• Firms enter the industry

• Supply increases

• Price decreases, eliminating profit

• If there are losses:

• Firms leave the industry

• Supply decreases

• Price increases, eliminating losses14-32


Chapter Summary • Constant-cost industries have horizontal long-run

supply curves

• Increasing-cost industries have upward sloping long-run supply curves

• Decreasing-cost industries have downward sloping supply curves

14-33

perfect competition 14 - ms. lopiccolo's...

Documents