Economics 2010 Lecture 12 Perfect Competition. Competition Perfect Competition Firms Choices in Perfect Competition The Firm’s Short-Run Decision

Economics 2010Economics 2010

Lecture 12

Perfect Competition

CompetitionCompetition

Perfect CompetitionFirms Choices in Perfect CompetitionThe Firm’s Short-Run DecisionThe Firm’s Supply CurveThe Industry Supply Curve

Perfect CompetitionPerfect CompetitionPerfect 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 CompetitionPerfect Competition

In perfect competition, each firm is a price taker

Examples of firms in perfect competition: Wheat farms Fisheries Paper

Firms Choices in Perfect Firms Choices in Perfect CompetitionCompetition

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 Firms Choices in Perfect CompetitionCompetition

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 The Firm’s Short-Run DecisionDecision

All decisions are about profit--which action makes the maximum profit

Economic profit =

total revenue - total costTotal revenue = Price x Quantity [Remember, total cost includes normal

profit, an opportunity cost]

Normal profitNormal 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 CompetitionRevenue in Perfect Competition

First, market’s or industry’s demand and market supply determine the price that the firm takes as given


The firm can sell any quantity it chooses at this price


The demand curve the firm faces is perfectly elastic

Average revenue (AR) = marginal revenue (MR)


The firm’s total revenue curve is linear

An increase in the quantity sold brings a proportional increase in total revenue (TR)


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 DecisionThe 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?


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?


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


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


Now we show profit maximizing output by using marginal analysis

Marginal revenue equals marginal cost


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 following figures show the three possible outcomes: economic profit break even economic loss


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


Here, the firm incurs an economic loss

The price is $17 and the profit-maximizing quantity is 7

ATC exceeds AR


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


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


Let us show the shutdown decision and the shutdown point


The Firm’s Supply CurveThe 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)


For prices above minimum AVC, a change in price brings a change in the quantity supplied along the MC curve


At minimum AVC, the firm is indifferent between supplying 7 and supplying zero

Both are points on 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


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


And at prices above minimum AVC, the quantity supplied is traced by the MC curve


The Industry Supply CurveThe Industry Supply Curve

The short-run industry supply curveThe 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 CurveThe Industry Supply Curve

Industry equilibrium in the short run and

the long run

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Economics 2010 Lecture 12 Perfect Competition. Competition Perfect Competition Firms Choices in Perfect Competition The Firm’s Short-Run Decision