Jeremy Wong & Cynthia Ji Perfect Competition Jeremy Wong & Cynthia Ji

What is Perfect Competition? A market where no participants are large enough to set the price of a product Many conditions exist for a perfectly competitive market Therefore there are few if any, truly competitive markets Mainly used as a benchmark for other market structures Let’s take a look at some of the conditions of a perfectly competitive market!

Conditions Large number of buyers and sellers Buyers Sellers

Brand A = Brand B = Brand C = Brand D Conditions Homogenous/identical products (e.g. no brand loyalty) Example: All window cleaning solutions are the same Brand A = Brand B = Brand C = Brand D

Conditions No barriers to entry and exit from market A company can easily enter into a market for a product and just as easily leave that market.

Conditions No advantages for established firms Firm A (left) Firm B (below) Although well established, Firm B does not have any advantages over Firm A

Conditions No power to set the market price No one firm has market power, the ability to influence the price of a product.

Price determined by industry supply and demand

As a result, the industry demand will be downward sloping demand curve but the firm’s demand will be perfectly elastic (horizontal line).

Conditions Suppliers only supply a small portion of the total industry output Example: Manufacturers only have a small market share in the Luxury Automotive Industry

Conditions Consumers and producers have perfect market knowledge Example: Consumers will know all the available prices for a MacBook Pro

Conditions The aim of firms is to maximize profit

Definitions Total Revenue (TR) – Amount of money that a firm makes by selling its products (TR=Price x Quantity) Ex: A firm sells 200 apples for $2 each. The total revenue from selling apples would be 200 multiplied by 2 for a TR of $400. Average Revenue (AR) – How much revenue a firm receives for a typical unit sold (total revenue divided by number of units sold) Ex: A firm makes $400 from selling 100 widgets. Their average revenue would be 400 divided by 100 to give an AR of $4.

Definitions Average Total Cost (ATC) – Total cost of producing all units divided by the number of units produced. Includes the opportunity cost of producing the good. Ex: It costs $200 to produce 100 gadgets. By dividing 200 by 100, we get an ATC of $2.

Definitions Normal Profit – Exists when total revenue is equal to total costs (minimum profit needed to run the business and the long term profit for perfectly competitive markets). Opportunity cost is not considered. Economic/Abnormal Profit – When total revenue is greater than total costs, it is the difference between these two values (can only be achieved in the short term in a perfectly competitive market)

Marginal Revenue = Marginal Cost Maximizing Profit Producers can’t set price but can determine how much of a product to produce in order to maximize profit. Marginal Revenue = Marginal Cost Marginal Cost (MC) The change in the total cost that arises when quantity produced changes by 1 unit Calculation: ___change in total cost___ change in output quantity Marginal Revenue (MR) The additional revenue generated by increasing product sales by 1 unit Calculation: __change in total revenue__ change in output quantity In perfect competition, MR = AR = Price = Demand

Marginal Revenue # of Units Total Revenue Marginal Revenue 1 15 2 25 10 3 30 5 In a perfectly competitive market, marginal revenue is the same as the average revenue per unit: # of Units Total Revenue Marginal Revenue 1 15 2 30 3 45

Short run profit There can be a positive economic profit which is maximized at the point where MC=MR

Figure 1 Profit Maximization for a Competitive Firm Costs The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue. and Revenue MC MC 2 Q ATC P = MR 1 2 AR Q MAX AVC MC 1 Q Quantity Copyright © 2004 South-Western

Short run profit How to maximize profit: When MR > MC  increase Q When MR < MC  decrease Q When MR = MC  profit maximized How to calculate profit: Profit=qe(P-ATC)

Figure 5 Profit as the Area between Price and Average Total Cost (a) A Firm with Profits Price ATC MC Profit ATC Q P P = AR MR Quantity (profit-maximizing quantity) Copyright © 2004 South-Western

Figure 5 Profit as the Area between Price and Average Total Cost (b) A Firm with Losses Price MC ATC ATC Q Loss P = AR MR Quantity (loss-minimizing quantity) Copyright © 2004 South-Western

Long run profit Economic profit = 0

Long run profit Why is economic profit 0? If economic profit is greater than 0: More firms will enter the market Supply increases, price decreases Profit decrease and Marginal Revenue decrease Average Total Cost = Marginal Revenue If economic profit is less than 0: Firms will leave the market Supply decreases, price increases Profit increase and Marginal Revenue increase

Why Stay if No Economic Profit is made? Profit=total revenue – total cost Total cost include all the opportunity cost of the firm The long-run market supply curve is horizontal at this price. In a zero-profit equilibrium, the revenue compensates the time and money the owners spent to keep the business going Normal profit is still being made

Market Supply with Entry and Exit (a) Firm ’ s Zero-Profit Condition (b) Market Supply Price Price MC ATC P = minimum ATC Supply Quantity (firm) Quantity (market) Copyright © 2004 South-Western

Shutting Down or Exiting Shutdown – A firm’s short run decision to stop production for a period of time due to market conditions. Exit – A firm’s long run decision to leave the market entirely Variable Costs – Expenses that change depending on the amount of output. Fixed Costs – Stays the same no matter the amount of output.

Decision to Shut Down in the Short Run A firm shuts down its revenue is less than the variable cost of production. Shut down if Total Revenue < Total Variable Cost Converting this into per unit comparison: Price < Average Variable Cost

The Competitive Firm’s Short Run Supply Curve Costs Firm ’ s short-run supply curve If P > ATC, the firm will continue to produce at a profit. MC ATC If P > AVC, firm will continue to produce in the short run. AVC Firm shuts down if P < AVC Quantity Copyright © 2004 South-Western

Short run supply curve The short run supply curve for the firm is the portion of its marginal cost curve that lies above average variable cost since the firm would shutdown once price falls below the average variable cost.

Decision to Exit in the Long Run The firm exits if the revenue it would get from producing is less than its total cost. Exit if Total Revenue < Total Cost Converting this into per unit comparison: Exit if Price < Average Total Cost

Decision to Enter in the Long Run A firm will enter the industry if such an action would be profitable. Enter if TR > TC Converting this into per unit comparison: Enter if P > ATC

Figure 4 The Competitive Firm’s Long-Run Supply Curve Costs Firm ’ s long-run supply curve MC = long-run S Firm enters if P > ATC ATC Firm exits if P < ATC Quantity Copyright © 2004 South-Western

Long run supply curve The long run supply curve for the firm is the marginal cost curve above the minimum point of its average total cost curve since the firm would exit the market once price falls below average total cost.

Shift in Demand in the Short Run and Long Run An increase in demand raises price and quantity in the short run. Firms earn profits because price now exceeds average total cost. In the long run, the increase in supply will push the equilibrium point to the original price with increased quantity.

An Increase in Demand in the Short Run and Long Run (a) Initial Condition Firm Market Price Price ATC MC S Short-run supply, 1 D Demand, 1 1 Q A P 1 Long-run supply P 1 Quantity (firm) Quantity (market)

An Increase in Demand in the Short Run and Long Run (b) Short-Run Response Firm Market Price Price D 2 ATC MC Profit S 1 Q 2 P B P 2 D 1 Q 1 A P 1 P Long-run 1 supply Quantity (firm) Quantity (market) Copyright © 2004 South-Western

An Increase in Demand in the Short Run and Long Run (c) Long-Run Response Firm Market Price Price D 2 S MC ATC 1 S 2 B P 2 A Q 3 C P 1 P Long-run 1 supply D 1 Quantity (firm) Q Q Quantity (market) 1 2 Copyright © 2004 South-Western

Efficiency Allocative Efficiency – The firm produces only goods that are most desirable and high in demand (P=MC)

Productive Efficiency – The firm produces goods at the lowest possible cost which is a point on the Production Possibilities Curve (production at minimum ATC)

Comparing short run and long run Economic Profit Yes No Productively Efficient Allocatively Efficient

QUIZ

Question 1 Which of the following is not a valid option for a perfectly competitive firm? Increasing its output Decreasing its output Increasing its price Increasing its resources

Question 1 Which of the following is not a valid option for a perfectly competitive firm? Increasing its output Decreasing its output Increasing its price Increasing its resources

Question 2 In the long run, a perfectly competitive firm will achieve all but which of the following? Economic profit Allocative efficiency Productive efficiency Normal profit

Question 2 In the long run, a perfectly competitive firm will achieve all but which of the following? Economic profit Allocative efficiency Productive efficiency Normal profit

Question 3 If the price a firm receives for its product is equal to the marginal cost of producing that product, the firm is: Always earning an economic profit Always productively efficient Always allocatively efficient Always experiencing an economic loss

Question 3 If the price a firm receives for its product is equal to the marginal cost of producing that product, the firm is: Always earning an economic profit Always productively efficient Always allocatively efficient Always experiencing an economic loss

Question 4 A firm that is producing at the lowest possible average cost is always: Earning an economic profit Productively efficient Dominating the other firms in the market Not producing enough output

Question 4 A firm that is producing at the lowest possible average cost is always: Earning an economic profit Productively efficient Dominating the other firms in the market Not producing enough output

Question 5 A perfectly competitive firm should always: Earn an economic profit Increase its price if it is experiencing an economic loss Produce the quantity where its marginal cost equals its marginal revenue Produce at the productively efficient level of output

Question 5 A perfectly competitive firm should always: Earn an economic profit Increase its price if it is experiencing an economic loss Produce the quantity where its marginal cost equals its marginal revenue Produce at the productively efficient level of output

Question 6 If a profit maximizing perfectly competitive firm is selling 1000 units at a price $10 and its average total cost is $8, the firm is experiencing: A total profit of $2 A total profit of $2000 A price greater than its marginal cost An economic loss

Question 6 If a profit maximizing perfectly competitive firm is selling 1000 units at a price $10 and its average total cost is $8, the firm is experiencing: A total profit of $2 A total profit of $2000 A price greater than its marginal cost An economic loss

Question 7 Which is most likely to happen if a perfectly competitive firm is experiencing an average revenue greater than its average cost? Price will increase Other firms will enter the market Other firms will leave the market Demand will decrease

Question 7 Which is most likely to happen if a perfectly competitive firm is experiencing an average revenue greater than its average cost? Price will increase Other firms will enter the market Other firms will leave the market Demand will decrease

Question 8 If a perfectly competitive firm is experiencing an economic loss, which of the following will happen? Firms will enter the market, price will decrease Firms will enter the market, price will increase Firms will exit the market, price will decrease Firms will exit the market, price will increase

Question 8 If a perfectly competitive firm is experiencing an economic loss, which of the following will happen? Firms will enter the market, price will decrease Firms will enter the market, price will increase Firms will exit the market, price will decrease Firms will exit the market, price will increase

Question 9 A perfectly competitive firm that is in long run equilibrium will Earn an economic profit, be allocatively efficient, be productively efficient Not earn an economic profit, be allocatively efficient, be productively efficient Not earn an economic profit, not be allocatively efficient, be productively efficient Not earn an economic profit, not be productively efficient, be allocatively efficient

Question 9 A perfectly competitive firm that is in long run equilibrium will Earn an economic profit, be allocatively efficient, be productively efficient Not earn an economic profit, be allocatively efficient, be productively efficient Not earn an economic profit, not be allocatively efficient, be productively efficient Not earn an economic profit, not be productively efficient, be allocatively efficient

Question 10 A perfectly competitive firm produces widgets in the long run. The market demand for widgets suddenly increases. The firm will Experience an economic loss Experience an economic profit and produce more in the short run Experience an economic profit and produce less in the short run Experience no economic profit in the short run

Question 10 A perfectly competitive firm produces widgets in the long run. The market demand for widgets suddenly increases. The firm will Experience an economic loss Experience an economic profit and produce more in the short run Experience an economic profit and produce less in the short run Experience no economic profit in the short run

Question 11 The firm maximizes profit at which output? R S T U J

Question 11 The firm maximizes profit at which output? R S T U J

Question 12 The firm’s shutdown price is Less than $15 $50 Above $60 Between $50 and $60 $60

Question 12 The firm’s short run shutdown price is Less than $15 $50 Above $60 Between $50 and $60 $60