The Model of Perfect Competition Microeconomics - Dr. D. Foster

Perfect Competition - An Ideal Firms are primarily distinguished from each other by the degree of competition they face: Profit maximization. The Model of Perfect Competition. Allocative and Productive efficiencies. Long-run costs and adjustments Perfect Competition Monopoly Monopolistic Competition Oligopoly

Profit Maximizing Rule Marginal Revenue = Marginal Cost (MR) (MC) No matter what kind of firm we are talking about, they will max. profit when: Marginal Revenue = Marginal Cost (MR) (MC) If MR > MC, you are foregoing profit. If MR < MC, you are foregoing profit.

Perfect Competition identical All goods are identical. --One cannot be (usefully) distinguished from another. Many Many buyers and sellers. --No one can affect price through their actions. no barriers There are no barriers to entry/exit. --Firms cannot earn economic profit in the long run. information Buyers & sellers have perfect information. --A single price will prevail in the market.

Perfect Competition priceMR (This is the “demand” for the firm’s output & is perfectly elastic.) Market price = price to the firm = MR (This is the “demand” for the firm’s output & is perfectly elastic.) MC q* Q QeQe PePe P S D $ P e = MR = d q A Firm The Market q1q1 q2q2

Perfect Competition How can we tell if a firm makes a profit? Calculate: Total Revenue = Pq* & Total Cost = ATC q* Econ Profit = TR - TC $ MR = d q A Firm PePe MC q* ATC

Scenario #1 - Positive Profit The ATC must be less than the price, so that calculated profit is positive. $ MR = d q A Firm PePe MC q* ATC What will happen in this industry in the long run?

Scenario #2 - Zero Econ Profit The ATC must be equal to the price, so that calculated profit is zero. A Firm $ MR = d q PePe MC q* ATC What will happen in this industry in the long run?

Scenario #3 - Negative Profit I The ATC must be more than the price, so that calculated profit is negative. What will happen in this industry in the long run? $ MR = d q A Firm PePe MC q* ATC AVC Will this firm stay in business in the short run? It depends...

Scenario #3 - Negative Profit II: The Shutdown Point The firm will shut down, right away, if the Price (MR) is less than the AVC… or, if the total loss > fixed costs What will happen in this industry in the long run? $ MR = d q A Firm PePe MC q* ATC AVC Fixed Costs Do worksheet on perfect competition.

Perfect Competition & Efficiency Allocative Efficiency Allocative Efficiency (What to produce?) Productive Efficiency Productive Efficiency (How to produce?) occurs when Price = Marginal Cost Why ? occurs where output level is at the minimum ATC Why ?

Perfect Competition & Efficiency Allocatively Efficient Perfectly competitive firms are always Allocatively Efficient Perfectly competitive firms always charge a price = MC. Why? $ MR = d q PePe MC q* ATC In the LR, perfectly competitive firms produce at min. ATC. Why? Productively Efficient In the LR, perfectly competitive firms are Productively Efficient

Perfect Competition in LR We know that in SR, firms can earn a positive, or negative, economic profit. What happens in the long run? Q QeQe PePe P S D The Market Q QeQe PePe P S D If econ profits are positive, entry occurs S* If econ profits are negative, exit occurs S*

Perfect Competition in LR If a firm earns positive economic profit, in the long run that will be dissipated as firms enter. Q QeQe PePe P S D The Market $ MR = d q A Firm PePe MC q* ATC S* MR* = d* Pe*Pe* q* In the LR, this firm earns 0 econ profit.

Perfect Competition in LR If a firm earns negative economic profit, in the long run that will be eliminated as firms exit. Q QeQe PePe P S D The Market $ MR = d q A Firm PePe MC q ATC In the LR, this firm earns 0 econ profit. q* MR* = d* Pe*Pe* S*

Perfect Competition in LR If the market is in equilibrium... econ profits = 0. If demand increases (e.g., incomes rise), what happens in SR and LR in this market? D* S3S3 Q QeQe PePe P S D The Market S1S1 S2S2 D* Q QeQe PePe P S D The Market LRS 1 LRS 2 LRS 3

The Paradox of Taxing Economic Profit no consequences In the short run, there are no consequences! MC q Q QeQe PePe P S $ P e = MR = d q A Firm The Market D D* ATC q* MR* = d* P* Q*

The Paradox of Taxing Economic Profit no consequences In the short run, there are no consequences! long run But, what about the long run? Firms no longer earn an economic profit. No firms will enter into this market. The price will not fall; the output will not rise.

Long Run Costs $ q A Firm ATC 1 ATC 2 ATC 3 LRAC q* Economies of scale Diseconomies of scale

Long Run Costs Special Case - The Flat Bottomed LRAC $ q A Firm LRAC q1q1 Constant Returns to scale q2q2 Firms of varying size survive together; q 1 is the “minimum efficient scale.”

The Model of Perfect Competition Microeconomics - Dr. D. Foster