Introduction Characteristics of Perfect Competition Large number of buyers and sellers. Firms sell identical product. No barriers to entry or exit. Buyers and sellers have perfect information Perfect Comp. is our "Benchmark" Model meaning it is not very realistic, but will be used to compare with more realistic models 3

Firm's Demand Curve Consumers are Price-takers Firms They take the market price as given and purchase according to their demand curve. Firms Because a firm makes the same thing as so many other firms, if an individual firm changes its price, it will lose ALL of its business. So it has to sell the product at the market price. Note that it can sell as much as it wants at that price 4

Firm’s Demand Curve $ p* D Q 5

Firm's Horizontal Demand Curve At P > p*, Sales = 0 At P < p*, Less Profits then if Sell at p* p* found from Market Equilibrium Price 6

Market Demand Curve Downward Sloping Obeys the Law of Demand 7

Marginal Revenue Marginal Revenue is the increase in revenue from selling one more unit If the firm gets price p* for every unit it sells, then p* is the marginal revenue at all quantities. MR = D in TR D in Q Horizontal Demand Curve means MR = P

Profit Maximization We assume that the firm is profit maximizing. Profit = Total Revenue - Total Cost Total Revenue is P*Q. We know what the Total Cost curve looks like, so let’s graph both

Total Revenue and Total Cost TR TC $ Q

Profit Maximizing Since the perfectly competitive firm cannot choose the price, the only choice left for the firm is to choose how much to produce. The firm will choose the quantity where TR-TC is the largest, in other words - where the difference between the TR and TC curves is the biggest

Total Revenue and Total Cost TR TC $ Q* Q

Profit Maximizing Note that the slope of the TR and TC curves are the same at this quantity. This means the the derivative of TR is the same as the derivative of TC at Q*. There is a way we can find Q* without calculus, though. We will need to graph the MR and MC curves

Profit Max without Calculus $ MC MR Q1 Q2 Q3 Q4 Q

Profit Maximizing Consider the quantity Q1 in the previous graph At that quantity MR>MC, meaning that the additional revenue from selling one more is greater than the cost of making one more. This means the firm will make more profit by making one more, so they will The same is true at Q2

Profit Maximizing But at Q3, MR=MC, meaning that the firm will get exactly as much money from selling one more as it cost them to make one more. So the firm has no interest in making one more

Profit Maximizing And at Q4, MR<MC, meaning that it costs more to make one more than it will bring in when it is sold. This means the firm will lose money. So the firm would want to decrease production to bring MC down

The Golden Rule A profit maximizing firm will always produce where MC=MR. In the case of Perfect Competition, we know MR=P, so we could also say that a profit maximizing firm produces where P=MC.

Firm’s Supply Curve In other words, given a price, the firm looks to the MC curve and produces that quantity. This is a supply curve. The Perfectly Competitive firm’s MC curve (the upward sloping portion of it, at least) is its Supply Curve

Profit We can also determine exactly how much profit the firm is making. We know profit = total revenue - total cost Since ATC=TC/Q, we know ATC*Q=Total Cost We also know that total revenue = P*Q So Profit=(p*Q)-(ATC*Q)=(p-ATC)*Q, or graphically...

Profit p MC ATC p* MR AVC atc Q* Q 21

Profit p MC ATC AVC Q MR p* The Area of this Rectangle is the Profit 22

Loss Note that as long as p>ATC at q*, there will be a profit. But it may be possible that no matter how much is produced, the firm will still lose money In this case the Q* is the quantity where the firm loses the least amount of money For example...

Loss p MC ATC AVC atc p* MR Q* Q 24

Loss p MC ATC AVC atc The area is the loss p* MR Q* Q 25

The decision of whether to stay open Just because a firm is losing money in the short run doesn’t mean it should close its doors. Often we hear of major firms like IBM posting a loss, but they stay open When does a firm shut down? Break Even Point - P = ATC Firm is earning normal profits. 26

The decision of whether to stay open If AVC<P*<ATC, then the firm is losing money, BUT they are getting enough revenue to pay all of the variable cost and some of the fixed cost. If they shut down, they will have to pay all of the fixed cost with no revenue. So they are better off staying open and being able to pay some of the fixed costs than shutting down and not being able to pay ALL of the fixed cost.

The Shut Down Point Shut-down Point - P = min AVC Firm Supply Curve Firm is indifferent between staying in business and going out of business. Firm Supply Curve MC curve at or above the Shut-down Point

Market Supply Sum of Individual Firm's Supply Curves Upward Sloping - Obeys Law of Supply 29

Profit Maximizing in the Short Run In the short run, the firm takes the market price, given by the intersection of the market supply and demand curves. The firm then produces where MC=MR and takes a profit or loss as long as P>AVC

Profit Maximizing in Short Run D Q Q Market Firm 31

Profit Maximizing in Short Run D Q Q Market Firm 32

Profit Maximizing in Short Run MR p* D Q Q Market Firm 33

Profit Maximizing in Short Run MC P MR p* D Q Q Market Firm 34

Profit Maximizing in Short Run MC P MR p* ATC D Q Q Market Firm 35

Profit Maximizing in Short Run MC P MR p* ATC AVC D Q Q Q* Market Firm 36

Profit Maximizing in Short Run MC P MR p* ATC AVC D Q Q Q* Market Firm 37

Profit Maximizing in Short Run MC P MR p* Profit ATC AVC D Q Q Q* Market Firm 38

Profit Maximizing in Short Run It is also possible that the market price is so low (of the ATC is so high) that the firm will lose money

Profit Maximizing in Short Run (Losses) MC P ATC AVC Loss p* MR D Q Q Q* Market Firm 40

The Long Run Recall that the long run is defined as the time it takes for fixed costs to change.In other words - all costs are variable. The ATC curve equals the AVC curve Also recall that Perfect Competition assumes that there is costless and entry and exit. In other words people can start up firms or shut down firms without any cost whatsoever

Perfect Comp. in the Long Run If there are profits being made in an industry, firms will enter. If there are losses in an industry, firms will leave But what happens to the market when things like this happen? Consider the previous example where the firm was making profits in the short run 42

Profit Maximizing in Short Run MC P MR p* Profit ATC D Q Q Q* Market Firm 43

Profit Maximizing in Long Run Firms see this profit and enter the industry More firms in an industry means market supply increases This drive price down and profits down Firms continue to enter until the price is driven down so low that profits are zero. Then no more firms want to enter and there is a long run equilibrium

Profit Maximizing in Long Run S S P MC P MR p* ATC MR D Q Q Q* Q* Market Firm 45

Profit Maximizing in Long Run Note that price is driven down to the bottom of the ATC curve In the long run, since profits MUST be zero, MR (price) will have to cross the MC curve where it intersects the ATC curve.

Losses in the Long Run But what if there are losses in the long run? If there are any losses in the long run, firms will want to leave the industry When firms leave, market supply decreases This drives up price and drives down losses Firms leave as long as there are losses. Once profits hit zero, firms stop leaving. Consider the example from earlier...

Losses in the Long Run S S P MC P ATC MR p* MR D Q Q Q* Market Firm 48

In the Long Run... In the Long Run in a perfectly competitive market... there are ALWAYS zero profits P=MC=ATC The firm produces at the lowest possible cost