Market Structures Perfect Competition

Characteristics Many sellers Identical goods and services All sellers charge the same prices (no control over prices) Everyone has perfect information Demand faced by each seller is perfectly elastic (horizontal demand curve)

P S Intersection of market supply and demand determines MARKET price and quantity Individual firms take the price given to them from the market PM D Q QM Market Price faced by firm is determined by the market (all firms TAKE the market price)

P P S MC D=MR PM PF D Q QM QF Q Firm Market Supply curve for firms is MC curve Firms will produce where MC=MR MC D=MR PM PF D Q QM QF Q Firm Market MC is a checkmark shape because of law of diminishing marginal returns Firm demand curve is horizontal (perfectly elastic)

Scenario 1 Short Run economic Profits

P P S MC ATC D=MR PM PF D Q QM QF Q Firm Market At QF, ATC is below MR. This means per unit costs at that quantity are LESS THAN revenue. Firms are making profit. Economic profit ATC D=MR PM PF D Gap between MC=MR and ATC represents profit. Q QM QF Q Firm Market Perfect Competition – Short Run Profits

P P S MC ATC D=MR PM PF D Q QM QF Q Firm Market At QF, ATC is below MR. This means per unit costs at that quantity are LESS THAN revenue. Firms are making profit. Economic profit ATC D=MR PM PF Profit D Gap between MC=MR and ATC represents profit. Q QM QF Q Firm Market Perfect Competition – Short Run Profits

What happens next? If firms are experiencing short run economic profits, this will attract NEW firms to the market. It is easy to enter this market structure so more firms will want to start selling this product. What happens to supply of the product? The MARKET supply curve will shift RIGHT. What happens to equilibrium price and quantity? Equilibrium price will fall and equilibrium quantity will rise What happens to the price the firm receives? It will fall and D=MR will shift down

P P S MC S2 ATC D=MR PM PF D2=MR2 PF2 D QM Q QF2 QF Q Market Firm Profit D2=MR2 PM2 PF2 D QM Q QM2 QF2 QF Q Market Firm After new firms enter the market…

New firms will keep entering the market until the economic profit is wiped out and firms earn only normal profit

Scenario 2 Short run economic losses

P P S MC ATC D=MR PM PF D Q QM QF Q Firm Market At QF, ATC is above MR. This means per unit costs at that quantity are MORE THAN revenue. Firms are making losses. ATC D=MR PM PF D Gap between MC=MR and ATC represents loss. Q QM QF Q Firm Market Perfect Competition – Short Run Losses

P P S MC ATC D=MR PM PF D Q QM QF Q Firm Market Loss D=MR PM PF D Q QM QF Q Firm Market Perfect Competition – Short Run Losses

What happens next? If firms are experiencing short run economic losses, this will drive firms out of the market. It is easy to exit this market so some firms will want to stop selling this product. What happens to supply of the product? The MARKET supply curve will shift LEFT. What happens to equilibrium price and quantity? Equilibrium price will rise and equilibrium quantity will fall What happens to the price the firm receives? It will fall and D=MR will shift up

S2 P P S MC ATC D2=MR2 D=MR PM PF PF2 D QF2 QM Q QF Q Market Firm Loss D=MR PM PF PF2 D QF2 QM Q QM2 QF Q Market Firm After new firms leave the market…

Some firms will keep leaving the market until the economic loss is wiped out and firms earn only normal profit

Scenario 3 Short run Shutdown

P P MC S ATC AVC D=MR PM PF D Q QM QF Q Firm Market At QF, ATC is above MR. This means per unit costs at that quantity are MORE THAN revenue. Firms are making losses. Also AVC is equal to or above MR. At this point firms are only covering VC and no FC. AVC D=MR PM PF D Q QM QF Q Firm Market Gap between MC=MR and ATC represents loss. Perfect Competition – Short Run Shutdown

P P MC S ATC AVC D=MR PM PF D Q QM QF Q Firm Market At QF, ATC is above MR. This means per unit costs at that quantity are MORE THAN revenue. Firms are making losses. Also AVC is equal to or above MR. At this point firms are only covering VC and no FC. AVC Loss D=MR PM PF D Q QM QF Q Firm Market Gap between MC=MR and ATC represents loss. Perfect Competition – Short Run Shutdown

What happens next? At this point because ATC AND AVC are above MR so firms are experiencing deep losses. They are only able to cover Variable costs (if AVC = MR) but no Fixed costs. If AVC = MR firms are indifferent about operating and will usually choose to shutdown. If AVC > MR firms cannot even cover variable costs and will shutdown.

What happens to supply of the product? The MARKET supply curve will shift LEFT. What happens to equilibrium price and quantity? Equilibrium price will rise and equilibrium quantity will fall What happens to the price the firm receives? It will rise and D=MR will shift up Some firms will keep leaving the market until the economic loss is wiped out and firms earn only normal profit

Scenario 4 Long Run Equilibrium (breakeven)

P P MC S ATC D=MR PM PF D Q QM QF Q Firm Market At QF, ATC is equal to MR. This means per unit costs at that quantity are EQUAL TO revenue. Firms are making no economic profit but are making normal profit. ATC D=MR PM PF D Q QM QF Q Firm Market Perfect Competition – Long Run (Breakeven)

What happens next? Long run equilibrium occurs when the optimal number of sellers are in the market. No economic profits or losses are incurred and firms are producing the optimal quantity for costs and revenue.