1. Chapter 10
Perfect Competition

2. The Goal of Profit Maximization
Economic profit: the difference between total revenue and total cost, where total cost includes all costs—both explicit and implicit—associated with resources used by the firm.
Accounting profit is simply total revenue less all explicit costs incurred.
does not subtract the implicit costs.
Economists assume that the goal of firms is to maximize economic profit.
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3. The Four Conditions For Perfect Competition
Firms Sell a Standardized Product
The product sold by one firm is assumed to be a perfect substitute for the product sold by any other.
Firms Are Price Takers
This means that the individual firm treats the market price of the product as given.
Free Entry and Exit
With Perfectly Mobile Factors of Production in the Long Run
Firms and Consumers Have Perfect Information
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4. The Short-Run Condition For Profit Maximization
To maximize profit the firm will choose that level of output for which the difference between total revenue and total cost is largest.
Marginal revenue: the change in total revenue that occurs as a result of a 1-unit change in sales.
To maximize profits the firm should produce a level of output for which marginal revenue is equal to marginal cost on the rising portion of the MC curve.
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5. Monopoly versus Perfect Competition
In Panel A, the demand curve facing a monopolist is the market demand curve.
In Panel B, a perfectly competitive firm takes the market price as given, so the firm-specific demand curve is horizontal. The firm can sell all it wants at the market price, but would sell nothing if it charged a higher price.

6. How is the firm’s demand curve determined?
Figure 12.2
There are thousands of individual wheat farmers.
Their collective supply, combined with the overall market demand for wheat, determines the market price of wheat.
The individual farmer takes this market price as his or her demand curve.

7. Characteristics of the Four Market Structures

8. Revenue, Cost, and Economic Profit
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9. THE FIRM’S SHORT-RUN OUTPUT DECISION
The Total Approach: Computing Total Revenue and Total Cost
Using the Total Approach to Choose an Output Level
Economic profit is shown by the vertical distance between the total-revenue curve and the total-cost curve.
To maximize profit, the firm chooses the quantity of output that generates the largest vertical difference between the two curves.

10. Total Revenue and Total Cost TableQ
Total Revenue ($)
Total Cost ($)
Total Profit ($) 40
-40 1 35 68
-33 2 70 88
-18 3
105
104 4
140
118 22 5
175
130 45 6
210
147 63 7
245
169 76 8
280
199 81 9
315
239 10
350
293 57
Total profit is maximized at 8 units of output

11. Total Revenue and Total Cost Table
Total Cost, Total Revenue TC
The total revenue curve is a straight line TR
Max profit = $81 at 8 units of output
The total cost curve is bowed upward at most quantities reflecting increasing marginal cost
$280
$175
$130
Profits are maximized when the vertical distance between TR and TC is greatest
Losses
Profits
Losses Q 3 5 8

12. A useful formula for profit
We know profit equals total revenue minus total cost; and total revenue is price times quantity. So write:
Dividing both sides by Q, we obtain:
The “Q”s cancel in the first term, and the second is average total cost; so we can write:
Multiplying both sides by Q, we obtain:
The right hand side is the area of a rectangle with height (P – ATC) and length Q. We can use this to illustrate profit on a graph.

13. THE FIRM’S SHORT-RUN OUTPUT DECISION
The Marginal Approach
M A R G I N A L P R I N C I P L E
Increase the level of an activity as long as its marginal benefit exceeds its marginal cost. Choose the level at which the marginal benefit equals the marginal cost.
marginal revenue
The change in total revenue from selling one more unit of output.
marginal revenue = price
To maximize profit, produce the quantity where price = marginal cost
P = MC and P > AVC (profit max. Condition)

14. The Marginal Approach The Marginal Approach to Picking an Output Level
A perfectly competitive firm takes the market price as given, so the marginal benefit, or marginal revenue, equals the price.
Using the marginal principle, the typical firm will maximize profit at point a, where the $12 market price equals the marginal cost.
Economic profit equals the difference between the price and the average cost ($4.125 = $12 – $7.875) times the quantity produced (eight shirts per minute), or $33 per minute.

15. The Profit-Maximizing Output Level in the Short Run
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16. Marginal Cost, Marginal Revenue, and Price Graph
MC > P,
decrease output to increase total profit
MC = P
$35
P = D = MR
MC < P,
increase output to increase total profit Q
MC = P at 8 units,
total profit is maximized

17. Determining Profits Graphically: A Firm with Profit
Find output where
MC = MR, this is the profit maximizing Q MC
MC = MR
ATC
Find profit per unit where the profit max Q intersects ATC
P = D = MR P
Profits
AVC
ATC
ATC at Qprofit max
Since P>ATC at the
profit maximizing quantity,
this firm is earning profits Q
Qprofit max

18. Determining Profits Graphically: A Firm with Zero Profit
Find output where
MC = MR, this is the profit maximizing Q MC
ATC
Find profit per unit where the profit max Q intersects ATC
MC = MR
AVC
P = D = MR P
=ATC
ATC at Qprofit max
Since P=ATC at the
profit maximizing quantity,
this firm is earning
zero profit Q
Qprofit max

19. Determining Profits Graphically: A Firm with Losses
Find output where
MC = MR, this is the profit maximizing Q MC
ATC
ATC at Qprofit max
Find profit per unit where the profit max Q intersects ATC
AVC
ATC
P = D = MR
Losses P
Since P<ATC at the
profit maximizing quantity,
this firm is earning losses
MC = MR Q
Qprofit max

20. The Shutdown Condition
Shutdown condition: if price falls below the minimum of average variable cost, the firm should shut down in the short run.
The short-run supply curve of the perfectly competitive firm is the rising portion of the short-run marginal cost curve that lies above the minimum value of the average variable cost curve
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21. The Short-Run Supply Curve of a Perfectly Competitive Firm
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22. Deciding How Much to Produce When the Price Is $4

23. The Shut-Down Decision and the Shut-Down Price
When the price is $4, marginal revenue equals marginal cost at four shirts (point a).
At this quantity, average cost is $7.50, so the firm loses $3.50 on each shirt, for a total loss of $14.
Shut –Down Price:
P= min AVC
The shutdown price, shown by the minimum point of the AVC curve, is $3.00.

24. The Shut-Down Price operate if price > average variable cost
shut down if price < average variable cost
Shut –Down Price:
P= min AVC

25. Determining Profits Graphically: The Shutdown Point
The shutdown point is the point below which the firm will be better off if it shuts down than it will if it stays in business
If P>min of AVC, then the firm will still produce, but earn a loss
If P<min of AVC, the firm will shut down
If a firm shuts down, it still has to pay its fixed costs P MC
ATC
AVC
P = D = MR
PShutdown Q
Qprofit max

26. SUPPLY CURVES
The firm’s short-run supply curve is the part of the marginal-cost curve above the shut-down price (P = min AVC).
The firm’s long-run supply curve is the part of the marginal-cost curve above the break-even price (P = min ATC).

27. Economic Profit and the Break-Even Price
economic profit = (price − average total cost) × quantity produced
break-even price
The price at which economic profit is
zero; price equals average total cost.
P = min ATC

28. Short-Run Market Supply and Demand
While the firm’s demand curve is perfectly elastic, the industry’s demand curve is downward sloping
The market supply curve is the horizontal sum of all the firms’ marginal cost curves
The market supply curve takes into account any changes in input prices that might occur

29. The Short-Run Competitive Industry Supply Curve
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30. Efficiency
A competitive market is efficient when it maximizes the net benefits to its participants.
Consumer surplus is defined as the difference between the maximum amount that buyers are willing to pay for a good and its current market price.
Producer surplus is defined as the difference between the current market price of a good and the full cost of producing it. In a way it is a measure of profitability.
A perfectly competitive economy is economically efficient.

31. The Total Benefit from Exchange in a Market
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32. The Efficiency of Perfect Competition
All societies answer these basic questions in the design of their economic systems:
1. What gets produced? What determines the final mix of output?
2. How is it produced? How do capital, labor, and land get divided up among firms? In other words, what is the allocation of resources among producers?
3. Who gets what is produced? What determines which households get how much? What is the distribution of output among consuming households?
Under perfect competition:
Resources are allocated among firms efficiently.
Final products are distributed among households efficiently.
The system produces the things that people want.

33. Efficient Allocation of Resources Among Firms
The assumptions that factor markets are competitive and open, that all firms pay the same prices for inputs, and that all firms maximize profits lead to the conclusion that the allocation of resources among firms is efficient.
You should now have a greater appreciation for the power of the price mechanism in a market economy.
Each individual firm needs only to make decisions about which inputs to use by looking at its own labor, capital, and land productivity relative to their prices.
But because all firms face identical input prices, the market economy achieves efficient input use among firms.
Prices are the instrument of Adam Smith’s “invisible hand,” allowing for efficiency without explicit coordination or planning.

34. Efficient Distribution of Outputs Among Households
We all know that people have different tastes and preferences and that they will buy very different things in very different combinations.
As long as everyone shops freely in the same markets, no redistribution of final outputs among people will make them better off.
If you and I buy in the same markets and pay the same prices and I buy what I want and you buy what you want, we cannot possibly end up with the wrong combination of things.
Free and open markets are essential to this result.

35. Producing What People Want: The Efficient Mix of Output
The condition that ensures that the right things are produced is
P = MC.
 FIGURE The Key Efficiency Condition: Price Equals Marginal Cost
Society will produce the efficient mix of output if all firms equate price and marginal cost.

36. Perfect Competition versus Real Markets
We have built a model of a perfectly competitive market system that produces an efficient allocation of resources, an efficient mix of output, and an efficient distribution of output.
The perfectly competitive model is built on a set of assumptions, all of which must hold for our conclusions to be fully valid.
We have assumed that all firms and households are price-takers in input and output markets, that firms and households have perfect information, and that all firms maximize profits.
These assumptions do not always hold in real-world markets. When this is the case, the conclusion breaks down that free, unregulated markets will produce an efficient outcome.

37. The Sources of Market Failure
market failure Occurs when resources are misallocated, or allocated inefficiently. The result is waste or lost value.
There are four important sources of market failure:
(1) Imperfect market structure, or noncompetitive behavior.
(2) The existence of public goods.
(3) The presence of external costs and benefits.
(4) Imperfect information.

38. Imperfect Markets Public Goods
In imperfectly competitive markets, with fewer firms competing and limited entry by new firms, prices will not necessarily equal marginal costs.
As a consequence, in a market with firms that have some market power, where firms do not behave as price-takers, we are not guaranteed an efficient mix of output.
Public Goods
public goods, or social goods Goods and services that forgive collective benefits on members of society. Generally, no one can be excluded from enjoying their benefits. The classic example is national defense.

39. Imperfect Information
Externalities
externality A cost or benefit imposed or bestowed on an individual or a group that is outside, or external to, the transaction.
Imperfect Information
imperfect information The absence of full knowledge concerning product characteristics, available prices, and so on.

40. Long-Run Competitive Equilibrium
At long run equilibrium, economic profits are zero
Profits create incentives for new firms to enter, market supply will increase, and the price will fall until zero profits are made
The existence of losses will cause firms to leave the industry, market supply will decrease, and the price will increase until losses are zero

41. Long-Run Competitive Equilibrium
Zero profit does not mean that the entrepreneur does not get anything for his efforts
Normal profit is the amount the owners would have received in their next best alternative
Economic profits are profits above normal profits

42. Long-Run Competitive Equilibrium Graph
At long-run equilibrium, economic profits are zero MC
SRATC
LRATC
P = D = MR Q

43. Long-Run Market Supply
If the long-run industry supply curve is perfectly elastic, the market is a constant-cost industry
If the long-run industry supply curve is upward sloping, the market is an increasing-cost industry
If the long-run industry supply curve is downward sloping, the market is a decreasing-cost industry
In the short run, the price does more of the adjusting, and in the long run, more of the adjustment is done by quantity

44. The Long-Run Competitive Industry Supply Curve
Constant cost Industries: long-run supply curve is a horizontal line at the minimum value of the LAC curve.
Increasing cost industries: long-run supply curve is upward sloping.
Decreasing cost industries: long-run supply curve is downward-sloping.
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45. Long-Run Supply Curve for an Increasing Cost Industry
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