1. Competitive firms and Markets
Perloff chapter 8

2. Competition Firms are price takers.
Firm’s demand curve is horizontal.
Reasons for a horizontal demand curve:
Identical products from different firms;
Freedom of entry and exit;
Perfect knowledge of prices;
Low transaction costs.
Where all conditions are satisfied: Perfect Competition.

3. Profit p = R – C Definition of R straightforward. Costs:
Business profit includes only explicit costs, e.g. workers wages and materials.
Owner doesn’t take a salary, what remains is profit.
Economic profit uses opportunity cost.
Suppose profit was £20000 but you could earn a salary of £25000, what should you do?

4. Profit maximisation p , Profit p * Profit D p < 0 D p > 0 1 1 qq *
Quantity, q
, Units
per day
Source: Perloff

5. Output decision
Produce where profit is maximised.

6. Profit maximisation p , Profit p * Profit D p < 0 D p > 0 1 1 qq *
Quantity, q
, Units
per day
Source: Perloff

7. Output decision Produce where profit is maximised.
Produce where marginal profit is zero.
Marginal cost equals marginal revenue.
p(q) = R(q) – C(q)
Marginal Profit(q) = MR(q) – MC(q) = 0
MR(q) = MC(q)

8. Shutdown rule Shutdown if it reduces its loss.
In the short-run, shutting down means revenue and variable costs are zero.
It must continue to cover fixed costs.
p=R-VC-F= =-2000
p=R-VC-F= =-3500
Shutdown if revenue is less than avoidable cost.
This rule is applicable in the long and short run.

9. Short-run output decision
Cost, revenue,
Thousand $
Short-run output decision
Cost, C
Revenue
4,800 MR = 8
2,272 1 p *
1,846
MC=MR
R=pq
MC=p
426 p ( q )
100 p
* = $426,000 –
100
140
284 q
, Thousand metric tons of li
me per year p
, $ per ton 10 MC AC e 8 p = MR p
* = $426,000
6.50 6
140
284 q
, Thousand metric tons of li
me per year

10. Short run shutdown decision
Shutdown if revenue less than avoidable cost.
In short run avoidable costs are variable costs.

11. Short run shutdown decisionp
, $ per ton MC AC b
6.12
AVC
6.00 A =
$62,000
5.50 p e B =
$36,000
5.14
5.00 a
=36
=62
TC=6.12*100000=612000
VC=514000
TR=550000
TR-TC=-62000
FC=( )*100000=98000 50
100
140 q
, Thousand metric tons of lime per year

12. Short run supply curve of the firm
, $ per ton S e 4 8 p 4 e 3 AC 7 p 3
AVC e 2 6 p 2 e 1 5 p 1 MC q
= 50 q =
140 q
= 215 q
= 285 1 2 3 4 q
, Thousand metric tons of lime per year

13. Industry SR supply curve with 5 identical firms
(a) Firm
(b) Market p
, $ per ton p
, $ per ton 7 7 1 2 S 3 S 1 S S S 4
6.47
6.47
AVC S 5 6 6 5 5 MC 50
140
175 50
150
250
700
100
200 q
, Thousand metric tons Q
, Thousand metric tons
of lime per year
of lime per year

14. Industry SR supply curve with 2 different firms
, $ per ton S 2 S 1 S 8 7 6 5 25 50
100
140
165
215
315
450 q , Q
, Thousand metric tons of lime per year

15. SR equilibrium in the market
(a) Firm
(b) Market p
, $ per ton p
, $ per ton 8 1 8 S S D 1 e 1 7 7 E
6.97 1 AC A B D 2
6.20 6
AVC 6 C 5 5 E e 2 2 q
= 50 q
= 215 Q
= 250 Q
= 1,075 2 1 2 1 q
, Thousand metric tons Q
, Thousand metric tons
of lime per year
of lime per year

16. Supply curve of the firm in the long-run
, $ per unit S SR S LR
LRAC
SRAC
SRAVC 35 p A B 28 25 24 20
LRMC
SRMC 50
110 q
, Units per year

17. Long run adjustment of the industry
All factors are variable.
Entry and exit are possible.
Entry occurs with positive long-run profits
Exit occurs with long-run losses
Identical firms:
All firms make a loss when P<min(LAC), industry supply is zero.
All firms make a profit if P>min(LAC), number of firms is indeterminate. Note that elasticity of the industry supply curve increases with the number of firms.

18. Long run industry supply curve
(a) Firm
(b) Market p
, $ per unit p
, $ per unit S 1
LRAC
Long-run market supply 10 10
LRMC
150 Q
, Hundred metric tons of oil per year q
, Hundred metric tons of oil per year

19. Upward sloping long run industry supply curve
Limited entry
New firms cannot enter because of legislative control.
New firms only enter when profits exceed the costs of entry.
Firms differ
Minimum LAC is lower for some firms than others.
Number of low LAC firms is limited.
Input prices vary with output
Increasing cost (firms in one industry account for much of the supply of a particular input).
Decreasing cost (economies of scale in the input supplier)

20. Differing firms: the LR supply curve for cotton
Price, $ per kg
Iran
1.71 S
United States
1.56
Nicaragua, Turkey
1.43
Brazil
1.27
Australia
1.15
Argentina
1.08
Pakistan
0.71 1 2 3 4 5 6
6.8
Cotton, billion kg per year

21. Increasing cost industry
(a) Firm
(b) Market p
, $ per unit p
, $ per unit MC 2 MC 1 AC 2 S AC 1 e E 2 2 p 2 e E 1 1 p 1 q q q
, Units per year Q = n q Q = n q Q
, Units per year 1 2 1 1 1 2 2 2

22. Decreasing cost industry
(a) Firm
(b) Market p
, $ per unit 1 p
, $ per unit MC MC 2 AC 1 AC 2 e 1 E p 1 1 e 2 E 2 p 2 S q q q
, Units per year Q = n q Q = n q Q
, Units per year 1 2 1 1 1 2 2 2

23. Long run competitive equilibrium
(a) Firm
(b) Market
, $ per ton p
, $ per ton D 1 2 MC D AC S SR f
AVC F 2 2 11 11 E 2 S LR 10 e 10 E f 1 F 1 1 7 7
100
150
165
1,500
2,000
3,300
3,600 q
, Hundred metric tons Q
, Hundred metric tons
of oil per year
of oil per year

24. Profit in the long run Free entry Restricted entry
Entry occurs to the point where profits are zero
No profit in long-run equilibrium
Economic profit is revenue minus opportunity cost.
Restricted entry
Entry is often limited because of a limited quantity of an input eg. land.
Profits become rent.

25. Economic Rent p , $ per bushel MC AC (including rent) AC
(excluding rent) p * p *
= Rent
begin by assuming that the land is not paid for. AC includes opportunity cost, owners of land could rent land to other potential farmers who want to produce tomatoes. q * q
, Bushels of tomatoes per year