Economics 2010 Lecture 12 Perfect Competition

Competition  Perfect Competition  Firms Choices in Perfect Competition  The Firm’s Short-Run Decision  The Firm’s Supply Curve  The Industry Supply Curve

Perfect Competition  Perfect competition occurs in a market where: £ There are many firms, each selling an identical product £ There are many buyers £ Firms in the industry have no advantage over potential new entrants (no barriers to entry) £ Firms and buyers are well informed about the prices of the products of each firm in the industry

Perfect Competition  In perfect competition, each firm is a price taker  Examples of firms in perfect competition: £ Wheat farms £ Fisheries £ Paper

Firms Choices in Perfect Competition  In a perfectly competitive market, a firm must make four key decisions: £ Whether to enter the industry £ If enter, whether to stay in the industry or leave it £ If stay, whether to produce or to temporarily shut down £ If produce, how much to produce (and how to produce it)

Firms Choices in Perfect Competition  In the short run we can only choose: £ whether to produce or to temporarily shut down £ If we do produce, how much to produce

The Firm’s Short-Run Decision  All decisions are about profit--which action makes the maximum profit Economic profit = total revenue - total cost  Total revenue = Price x Quantity  [Remember, total cost includes normal profit, an opportunity cost]

Normal profit  The entrepreneurial ability and time of the entrepreneur needs to be rewarded by the normal profit in an industry  Risky industries, or industries which demand high entrepreneurial skills are probably paying off higher profits  Also remember that any money you invest has a opportunity cost because you could have invested it in your next best option instead

 The revenue curves in perfect competition are: £ Average revenue £ Marginal revenue £ Total revenue  The following figure shows the revenue curves of a firm in perfect competition Revenue in Perfect Competition

 First, market’s or industry’s demand and market supply determine the price that the firm takes as given Revenue in Perfect Competition

 The firm can sell any quantity it chooses at this price Revenue in Perfect Competition

 The demand curve the firm faces is perfectly elastic  Average revenue (AR) = marginal revenue (MR) Revenue in Perfect Competition

 The firm’s total revenue curve is linear  An increase in the quantity sold brings a proportional increase in total revenue (TR) Revenue in Perfect Competition

 The firm’s short-run problem is to choose the output that maximizes profit.  We can solve this problem by looking at either: £ total cost and total revenue, or £ marginal cost and marginal revenue The Firm’s Short-Run Decision

 This figure shows the firm’s profit maximizing output by using total cost and total revenue  At low output rates, the firm incurs an economic loss  The reason is that it has some fixed costs, remember? The Firm’s Short-Run Decision

 At an output rate of 4 sweaters a day, the firm breaks even  At output rates above 12 sweaters a day, the firm again incurs an economic loss  This time, the reason is now diminishing returns, remember? The Firm’s Short-Run Decision

 At 12 sweaters a day, the firm breaks even  Between 4 and 12 sweaters a day, the firm makes an economic profit  The maximum profit occurs at 9 sweaters a day  Here, total revenue is $225, total cost is $183, and economic profit is $42 The Firm’s Short-Run Decision

 Here we derive the firm’s profit maximizing output by using the profit curve  The profit curve reaches its maximum at 9 sweaters a day The Firm’s Short-Run Decision

 Now we show profit maximizing output by using marginal analysis  Marginal revenue equals marginal cost The Firm’s Short-Run Decision

 Profit maximization does not guarantee a profit  When price equals marginal cost, average total cost, ATC, can be greater than, equal to, or less than price  Profit maximization can mean loss minimization The Firm’s Short-Run Decision

 The following figures show the three possible outcomes: £ economic profit £ break even £ economic loss The Firm’s Short-Run Decision

ATC is less than AR (price)

 Here, the firm breaks even  The price is $20 and the profit- maximizing quantity is 8  ATC equals AR The Firm’s Short-Run Decision

 Here, the firm incurs an economic loss  The price is $17 and the profit- maximizing quantity is 7  ATC exceeds AR The Firm’s Short-Run Decision

 The shutdown point is the point at which the firm's maximized profit is the same regardless of whether the firm produces or temporarily shuts down  The shutdown point is the point of minimum average variable cost The Firm’s Short-Run Decision

 If price equals minimum AVC, the profit is the same from producing as from shutting down temporarily and paying the fixed costs  Either way, the firm incurs a loss equal to total fixed cost  If the firm produced with AVC greater than price, its loss would exceed total fixed cost The Firm’s Short-Run Decision

 Let us show the shutdown decision and the shutdown point The Firm’s Short-Run Decision

The Firm’s Supply Curve  A perfectly competitive firm's supply curve shows how the firm's profit maximizing output varies as the market price varies  A perfectly competitive firm's supply curve is the firm's marginal cost curve above the point of minimum average variable cost

 This shows the firm’s supply curve  We begin with the firm’s cost curves in part (a) The Firm’s Supply Curve

 For prices above minimum AVC, a change in price brings a change in the quantity supplied along the MC curve The Firm’s Supply Curve

 At minimum AVC, the firm is indifferent between supplying 7 and supplying zero  Both are points on the firm’s supply curve The Firm’s Supply Curve

 But nothing in between 7 and zero is on the supply curve  The firm will never supply 1,…,6 sweaters a day  At prices below minimum AVC, the quantity supplied is zero  Let’s look at the supply curve The Firm’s Supply Curve

 At prices below minimum AVC, the quantity supplied is zero along the price axis.  Then there is a jump from zero to the shutdown point The Firm’s Supply Curve

 And at prices above minimum AVC, the quantity supplied is traced by the MC curve The Firm’s Supply Curve

The Industry Supply Curve  The short-run industry supply curve  The horizontal sum of the firm’s supply curves

 This figure shows the industry supply curve  It is like the firm’s curve except it has no break at the shutdown price The Industry Supply Curve

Industry equilibrium in the short run and the long run Next