1. Principles of Microeconomics Chapter 14
Perfect Competition

2. Perfectly Competitive Markets
Key Characteristics:
Many buyers and sellers
Goods are identical
Firms can freely enter and exit the market
No single firm can exert price control in the market.
All firms are price takers.
To maximize revenue – can only change quantity!

3. Key Equations Total Revenue (TR) = Price x Quantity
Average Total Revenue = TR/ Quantity
Marginal Revenue = Change in TR/ Change in Q
Marginal Revenue – captures the change in revenue from one additional unit produced

4. Profit Maximizing Point of Production
Firms will maximize their profits by producing at the point where
MR = MC
If MR > MC: Increase profits by producing more
If MR < MC: Increase profits by producing less
NOTE: Marginal Revenue is constant and equal to price ONLY under perfect competition.

5. Perfection Competition
Consider Firm A which sells ping pong balls. The following table describes their revenues and costs:
After completing the table, discuss:
How many ping pong balls should Firm A produce to maximize its profits?
What do you observe about MR and MC at this point?
Output
Price
Total Revenue
Total Cost
Profit
Marginal Revenue
Marginal Cost 3 $3
$9.00 $ 4
$12.00 $ 5
$15.00 $ 6
$18.00
$ 12.75 7
$21.00
$ 16.25 8
$24.00
$ 20.00 9
$27.00
$ 24.00

6. Perfect Competition Output Price Total Revenue Total Cost Profit
Marginal Revenue
Marginal Cost 3 $3
$9.00 $
$4.50 4
$12.00 $
$5.50
$ 2.00 5
$15.00 $
$ 3.00 6
$18.00
$ 12.75
$5.25
$ 3.25 7
$21.00
$ 16.25
$4.75
$ 3.50 8
$24.00
$ 20.00
$4.00
$ 3.75 9
$27.00
$ 24.00
$3.00
$ 4.00

7. Price Change in the Market
Now assume that the price increases to $4. Analyze the impact on TR, TC, Profits, MR, MC.
Have the firm’s production decisions changed?
Graph the old and new MR, MC lines indicating the profit max point of production

8. Price Change in the Market
Output
Price
Total Revenue
Total Cost
Profit
Marginal Revenue
Marginal Cost 3 $4
$12.00 $
$7.50 4
$ 1.50
$16.00 $
$9.50
$ 2.00 5
$20.00 $
$10.50
$ 3.00 6
$24.00
$ 12.75
$11.25
$ 3.25 7
$28.00
$ 16.25
$11.75
$ 3.50 8
$32.00
$ 20.00
$ 3.75 9
$36.00
$ 24.00
$ 4.00
New Price  New Marginal Revenue New optimal point of production

9. Graphing Production DecisionsMC P
(Cost)
Firm A is a price taker
If observe price change – increase to $4 – will respond by producing more
New MR  New point where MR = MC
New profit max point of production $4
MR.2 $3
MR.1 5 9
Quantity

10. Firm’s Short Run Decisions
In the short – firm must decide if it should produce or temporarily shutdown
Temporary shutdown ≠ Exit from market
Firm is suspending production temporarily
Must still pay fixed costs
No longer pays variable costs, no longer receives revenue
SHUTDOWN WHEN:
Total Revenue < Variable Cost
TR = P X Q
AVC = VC X Q
Shutdown:
P < AVC

11. Firm’s Short Run Decisions
In the short – firm must decide if it should produce or temporarily shutdown
Temporary shutdown ≠ Exit from market
Firm is suspending production temporarily
Must still pay fixed costs
No longer pays variable costs, no longer receives revenue
SHUTDOWN WHEN:
Total Revenue < Variable Cost
TR = P X Q
AVC = VC X Q
Shutdown:
P < AVC

12. Firm’s Short Run Decisions
In the short – firm must decide if it should produce or temporarily shutdown
Temporary shutdown ≠ Exit from market
Firm is suspending production temporarily
Must still pay fixed costs
No longer pays variable costs, no longer receives revenue
SHUTDOWN WHEN:
Total Revenue < Variable Cost
TR = P X Q
AVC = VC X Q
Shutdown:
P < AVC

13. Firm’s Short Run Supply CurveMC P
(Cost) P
(Cost)
Short Run
Supply Curve
ATC
AVC
AVC
Quantity
Quantity
Because, in the short run, a firm will produce only if P ≥ AVC, the firm's short run supply curve will be its MC above AVC
If:
The Firm Will:
P ≥ AVC
Produce output level where MR = MC
P < AVC
Shut down and produce zero output

14. Firm’s Long Run Decisions
Firm must decide:
Enter a market?
Continue producing?
Exit a market?
When enter a market – TR > 0; TC > 0
Will enter if TR > TC  P > ATC
When exit a market – TR = 0; TC = 0
Will exit if TR < TC  P < ATC

15. Firm’s Long Run Decisions
Firm must decide:
Enter a market?
Continue producing?
Exit a market?
When enter a market – TR > 0; TC > 0
Will enter if TR > TC  P > ATC
When exit a market – TR = 0; TC = 0
Will exit if TR < TC  P < ATC

16. Firm’s Long Run Decisions
Firm must decide:
Enter a market?
Continue producing?
Exit a market?
When enter a market – TR > 0; TC > 0
Will enter if TR > TC  P > ATC
When exit a market – TR = 0; TC = 0
Will exit if TR < TC  P < ATC

17. Firm’s Long Run Supply CurveMC P
(Cost) P
(Cost)
Long Run
Supply Curve
ATC
ATC
AVC
AVC
Quantity
Quantity
Because, in the long run, a firm will remain in a market only if P ≥ ATC, the firm's long-run supply curve will be its MC above ATC
If:
The Firm Will:
P > ATC
Enter because economic profits are earned
P = ATC
Not enter or exit because economic profits are zero
P < ATC
Exit because economic losses are incurred

18. Firms gain positive economic profits in the short run when P > ATC
Measuring Profit
Profit = TR –TC
TR = P x Q TC = ATC x Q
Profit = (P – ATC) x Q MC P
(Cost)
ATC
Firms gain positive economic profits in the short run when P > ATC MR P
PROFIT
ATC
Quantity

19. Measuring Loss Profit = TR –TC TR = P x Q TC = ATC x Q
Profit = (P – ATC) x Q MC P
(Cost)
ATC
Firms have negative economic profits (or loss) in the short run when P > ATC
ATC
LOSS P MR
Quantity

20. Long Run Equilibrium Zero Economic Profits MR = MC P = ATC MC P (Cost)
Quantity

21. Impact of Shifts in Demand on Firm Production
Shifts in the demand curve will impact production choices of firms in the short run AND in the long run
In the short run: movement along the supply curve (MC) because new price = new MR
In the long run: shift in the supply curve because change in number of sellers

22. Impact of Shift in Demand
Increase in Demand  Increase in Price MR increases In the short run: movement along the supply curve (MC) because new price = new MR
SHORT RUN PRODUCTION MC P
(Cost) P
(Cost) S
ATC
P.2
MR.2
P.2
PROFIT
P.1
MR.1
P.1
D.2
D.1
Q.1
Q.2
Quantity
Q.1
Q.2
Quantity

23. Impact of Shift in Demand
Increase in Price  MR increases  Profits in Short Run In the long run: New Firms enter to take advantage of positive profits Shift in the supply curve because change in number of sellers
LONG RUN PRODUCTION MC P
(Cost) P
(Cost)
S.1
S.2
ATC
P.2
MR.2
P.2
P.1
MR.1
P.1
D.2
D.1
Q.1
Q.2
Quantity
Q.1
Q.2
Q.3
Quantity

24. Test your Understanding
Consider Julie’s Sneaker Shop that operates in the long run equilibrium in a competitive market. Recently, she experienced an influx of buyers due to a change in tastes and preferences for running shoes.
Illustrate Julie’s Sneaker Shop’s production decision graph and the market for sneakers graph with the effect of a change in tastes and preferences
What happens in the short run for Julie’s profits?
What happens in the long run for Julie’s profits as new firms observe these changes in the market?

25. Application Reflection
Why does this matter?
Changes in demand for a good will impact the seller’s production and supply of the good. We see this as a movement along the supply curve when demand shifts
Here we are able to observe exactly what happens from the firm’s perspective - what does a perfectly competitive firm experience in the short run and the long run when prices change due to a change in demand? In the short run, Julie’s Shop has positive economic profits! But in the long run, it returns to zero economic profits as new firms enter and competition rises even more.
What’s the most important takeaway?
Firms can experience positive economic profits in the short run but not in the long run due to the free entry/exit of firms in this market
Economic profits are not the same as accounting profits.
We can have zero economic profits but positive accounting profits
MUDDIEST POINT?

26. Key Takeaways
Perfectly competitive firms are price takers – to change their profit max point of production they can only change quantity
Face short run and long run decisions on production
Short run profit/loss depends on prices and ATC
Firms will operate in the long run with zero economic profits because of the free entry and exit of firms