© 2003 mcgraw-hill ryerson limited. perfect competition chapter 11
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© 2003 McGraw-Hill Ryerson Limited.
Perfect CompetitionPerfect Competition
Chapter 11Chapter 11
© 2003 McGraw-Hill Ryerson Limited.
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Perfect CompetitionPerfect Competition
The concept of competition is used in two ways in economics. Competition as a process is a rivalry
among firms. Competition as a market structure.
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Competition as a Competition as a ProcessProcess Competition involves one firm trying to
take away market share from another firm.
As a process, competition pervades the economy.
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A Perfectly Competitive A Perfectly Competitive MarketMarket A perfectly competitive market is one
which has highly restrictive assumptions, but which provides us with a reference point we can use in comparing different markets.
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A Perfectly Competitive A Perfectly Competitive MarketMarket In a perfectly competitive market:
The number of firms is large. The firms' products are identical. There is free entry and exit, that is,
there are no barriers to entry. There is complete information. Firms are profit maximizers. Both buyers and sellers are price
takers.
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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition The number of firms is large.
Large number of firms means that any one firm's output is very small when compared with the total market.
What one firm does has no bearing on market quantity or market price.
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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition Firms' products are identical.
This requirement means that each firm's output is indistinguishable from any other firm’s output.
Firms sell homogeneous product.
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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition There is free entry and free exit.
Firms are free to enter a market in response to market signals such as price and profit.
Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market.
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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition There is free entry and free exit.
Technology may prevent some firms from entering the market.
There must also be free exit, without incurring a loss.
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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition There is complete information.
Firms and consumers know all there is to know about the market – prices, products, and available technology.
Any technological advancement would be instantly known to all in the market.
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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition Firms are profit maximizers.
The goal of all firms in a perfectly competitive market is profit and only profit.
There is no non-price competition (based on quality, brand name, or the like).
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The Necessary The Necessary Conditions for Perfect Conditions for Perfect CompetitionCompetition Both buyers and sellers are price
takers. A price taker is a firm or individual
who takes the market price as given. Neither supplier nor buyer possesses
market power.
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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition Supply is a schedule of quantities of
goods that will be offered to the market at various prices.
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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition This definition of supply requires the
supplier to be a price taker.
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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition Because of the definition of supply, if
any of the conditions required for perfect competition are not met, the formal definition of supply disappears.
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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition That the number of suppliers be large
means that they do not have the ability to collude (act together with other firms to control price or market share).
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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition Other conditions make it impossible for
any firm to forget about the hundreds of other firms waiting to replace their supply.
A firm's goal is specified by the condition of profit maximization.
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The Definition of The Definition of Supply and Perfect Supply and Perfect CompetitionCompetition Even if the conditions for a perfectly
competitive market are not met, supply forces are still strong and many of the insights of the competitive model can be applied to firm behavior in other market structures.
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Demand Curves for the Demand Curves for the Firm and the IndustryFirm and the Industry The demand curve facing the firm is
different from the industry demand curve.
A perfectly competitive firm’s demand is horizontal (perfectly elastic), even though the demand curve for the industry is downward sloping.
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Demand Curves for the Demand Curves for the Firm and the IndustryFirm and the Industry Each firm in a competitive industry is so
small that it does not need to lower its price in order to sell additional output.
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Market supply
Marketdemand
1,000 3,000
Price$10
8
6
4
2
0Quantity
Market Firm
Individual firm demand
Market Demand Curve Market Demand Curve Versus Individual Firm Versus Individual Firm Demand Curve, Demand Curve, Fig 11-1(a and b), p Fig 11-1(a and b), p 236236
10 20 30
Price$10
8
6
4
2
0Quantity
A B C
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The Profit-Maximizing The Profit-Maximizing Level of OutputLevel of Output The goal of the firm is to maximize
profits. When it decides what quantity to
produce it continually asks how changes in quantity would affect its profit.
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Profit-Maximizing Level Profit-Maximizing Level of Outputof Output Since profit is the difference between
total revenue and total cost, what happens to profit in response to a change in output is determined by marginal revenue (MR) and marginal cost (MC).
A firm maximizes profit when MC = MR.
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Profit-Maximizing Level Profit-Maximizing Level of Outputof Output Marginal revenue (MR) is the change
in total revenue associated with a change in quantity.
Marginal cost (MC) is the change in total cost associated with a one unit change in quantity.
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Marginal RevenueMarginal Revenue
Since a perfect competitor accepts the market price as given, for a perfectly competitive firm marginal revenue is equal to price (MR = P).
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Marginal CostMarginal Cost
Initially, marginal cost falls and then begins to rise.
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How to Maximize ProfitHow to Maximize Profit
To maximize profits, a firm should produce where marginal cost equals marginal revenue.
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How to Maximize ProfitHow to Maximize Profit
If marginal revenue does not equal marginal cost, a firm can increase profit by changing output.
The supplier will continue to produce as long as marginal cost is less than marginal revenue.
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How to Maximize ProfitHow to Maximize Profit
The supplier will cut back on production if marginal cost is greater than marginal revenue.
Thus, the profit-maximizing condition of a competitive firm is MC = MR = P.
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Marginal Cost, Marginal Marginal Cost, Marginal Revenue, and PriceRevenue, and Price Fig. 11- Fig. 11-
2a, p. 2372a, p. 237Price = MR Quantity Total Cost Marginal Cost
35 0 40 28
35 1 68 20
35 2 88 16
35 3 104 14
35 4 118 12
35 5 130 17
35 6 147 22
35 7 169 30
35 8 199 40
35 9 239 54
35 10 293
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BC
Area1
P = D = MR
Costs
1 2 3 4 5 6 7 8 9 10 Quantity
60
50
40
30
20
10
0
A
MC
Marginal Cost, Marginal Marginal Cost, Marginal Revenue, and Price,Revenue, and Price, Fig. 11- Fig. 11-
2b, p. 2372b, p. 237
Area 2
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The Marginal Cost The Marginal Cost Curve Is the Supply Curve Is the Supply CurveCurve The marginal cost curve, above the
point where price exceeds average variable cost, is the firm's supply curve
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The Marginal Cost The Marginal Cost Curve Is the Supply Curve Is the Supply CurveCurve The MC curve tells the competitive firm
how much it should produce at a given price.
The firm can do no better than producing the quantity at which marginal cost equals price which in turn equals marginal revenue.
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The Marginal Cost Curve The Marginal Cost Curve Is the Firm’s Supply Is the Firm’s Supply Curve,Curve, Fig. 11-3, p. 239Fig. 11-3, p. 239
A
CMarginal cost$70
60
50
40
30
20
10
0 1 Quantity2 3 4 5 6 7 8 9 10
B
Cost, Price
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Firms Maximize Total Firms Maximize Total ProfitProfit Firms maximize total profit, not profit per
unit. As long as an increase in output yields
even a small amount of additional profit, a profit-maximizing firm will increase output.
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Profit Maximization Profit Maximization Using Total Revenue Using Total Revenue and Total Costand Total Cost Profit is maximized where the vertical
distance between total revenue and total cost is greatest.
At that output, MR (the slope of the total revenue curve) and MC (the slope of the total cost curve) are equal.
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TC TR
0
$385350315280245210175140105
7035
Quantity1 2 3 4 5 6 7 8 9
Profit Determination by Profit Determination by Total Cost and Revenue Total Cost and Revenue Curves, Curves, Fig. 11-4b, p 240Fig. 11-4b, p 240
Maximum profit =$81
$130
Loss
Loss
Profit
Total cost, revenue
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Total Profit at the Total Profit at the Profit-Maximizing Level Profit-Maximizing Level of Outputof Output While the P = MR = MC condition tells
us how much output a competitive firm should produce to maximize profit, it does not tell us the profit the firm makes.
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Determining Profit and Determining Profit and Loss From a Table of Loss From a Table of CostsCosts Profit can be calculated from a table of
costs and revenues. Profit is determined by total revenue
minus total cost.
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Determining Profit and Determining Profit and Loss From a Table of Loss From a Table of CostsCosts The profit-maximizing output choice is
not necessarily a position that minimizes either average variable cost or average total cost.
It is only the choice that maximizes total profit.
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Costs Relevant to a Firm, Costs Relevant to a Firm, Table 11-1, p 241Table 11-1, p 241
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Costs Relevant to a Firm, Costs Relevant to a Firm, Table 11-1, p 241Table 11-1, p 241
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Determining Profit and Determining Profit and Loss From a GraphLoss From a Graph Find output where MC = MR. The intersection of MC = MR (P)
determines the quantity the firm will produce if it wishes to maximize profits.
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Determining Profit and Determining Profit and Loss From a GraphLoss From a Graph Find profit per unit where MC = MR. To determine maximum profit, you must
first determine what output the firm will choose to produce.
See where MC equals MR, and then draw a line down to the ATC curve.
This is the profit per unit.
(a) Positive economic profit (b) Zero economic profit (c) Economic loss
Determining Profits Determining Profits Graphically,Graphically, Fig. 11-5, p 243 Fig. 11-5, p 243
Quantity Quantity Quantity
Price65 60 55 50 45 40 35 30 25 20 15 10
5 0
65 60 55 50 45 40 35 30 25 20 15 10
5 01 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 9 10 12
D
MC
A P = MR
B ATCAVC
E
Profit
C
MC
ATC
AVC
MC
ATC
AVC
Loss
65 60 55 50 45 40 35 30 25 20 15 10
5 0 1 2 3 4 5 6 7 8 910 12
P = MRP = MR
Price Price
© The McGraw-Hill Companies, Inc., 2000
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Zero Profit or Loss Zero Profit or Loss Where MC=MRWhere MC=MR Firms can also earn zero profit or even
a loss where MC = MR. Even though economic profit is zero, all
resources, including entrepreneurs, are being paid their opportunity costs.
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Zero Profit or Loss Zero Profit or Loss Where MC=MRWhere MC=MR In all three cases (profit, loss, zero
profit), determining the profit-maximizing output level does not depend on fixed cost or average total cost, but only where marginal cost equals price.
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The Role of Profits as The Role of Profits as Market Signals,Market Signals, Table 11-2, p 243 Table 11-2, p 243
Profit Calculation
Type of Profit Market Signal
> 0 Positive economic profit, or
Economic profit
Entry. Resources are drawn into the industry.
= 0 Zero economic profit,
Zero profit, or
Normal profit
Static. The industry is in long run equilibrium.
< 0 Economic loss Exit. Resources leave the industry.
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The Shutdown PointThe Shutdown Point
The firm will shut down if it cannot cover variable costs. A firm should continue to produce as
long as price is greater than average variable cost.
Once price falls below that point it will be cheaper to shut down temporarily and save the variable costs.
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The Shutdown PointThe Shutdown Point
The shutdown point is the point at which the firm will be better off by shutting down than it will if it stays in business.
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The Shutdown PointThe Shutdown Point
As long as total revenue is more than total variable cost, temporarily producing at a loss is the firm’s best strategy since it is taking less of a loss than it would by shutting down (loss minimization).
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MC
P = MR
2 4 6 8 Quantity
Price
60
50
40
30
20
10
0
ATC
AVC
Loss
A$17.80
The Shutdown The Shutdown Decision, Decision, Fig.11-6a, p 245Fig.11-6a, p 245
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Long-Run Competitive Long-Run Competitive Equilibrium, Equilibrium, Fig.11-6b, p 245Fig.11-6b, p 245
MC
P = MR
0
60
50
40
30
20
10
Price
2 4 6 8 Quantity
SRATC LRATC
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Short-Run Market Short-Run Market Supply and DemandSupply and Demand While the firm's demand curve is
perfectly elastic, the industry demand is downward sloping.
Industry supply is the sum of all firms’ supply curves.
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Short-Run Market Short-Run Market Supply and DemandSupply and Demand In the short run when the number of
firms in the market is fixed, the market supply curve is just the horizontal sum of all the firms' marginal cost curves.
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Short-Run Market Short-Run Market Supply and DemandSupply and Demand Since all firms have identical marginal
cost curves, a quick way of summing the quantities is to multiply the quantities from the marginal cost curve of a representative firm by the number of firms in the market.
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The market supplyThe market supply In the long run, the number of firms may
change in response to market signals, such as price and profit.
As firms enter the market in response to economic profits being made, the market supply shifts to the right.
As economic losses force some firms to exit, the market supply shifts to the left.
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Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium Profits and losses are inconsistent with
long-run equilibrium. Profits create incentives for new firms to
enter, output will increase, and the price will fall until zero economic profits are made.
Only zero economic profit will stop entry.
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Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium The existence of losses will cause some
firms to leave the industry. In a long run equilibrium firms make no
economic profit (the zero profit condition).
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Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium Zero profit does not mean that the
entrepreneur does not get anything for his efforts.
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Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium In order to stay in business the
entrepreneur must receive his opportunity cost or normal profits (the amount the owners of business would have received in the next-best alternative).
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Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium Normal profits are included as a cost.
Economic profits are profits above normal profits.
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Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium Even if some firm has super efficient
workers or machines that produce rent, it will not take long for competitors to match these efficiencies and drive down the price, until all economic profits are eliminated.
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Long-Run Competitive Long-Run Competitive EquilibriumEquilibrium The zero profit condition is enormously
powerful. As long as there is free entry and exit,
price will be pushed down to the average total cost of production.
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Adjustment from the Adjustment from the Short Run to the Long Short Run to the Long RunRun Industry supply and demand curves
come together to lead to long-run equilibrium.
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An Increase in DemandAn Increase in Demand
An increase in demand leads to higher prices and higher profits.
Existing firms increase output and new firms will enter the market, increasing industry output still more, price will fall until all profit is competed away.
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An Increase in DemandAn Increase in Demand
If the the market is a constant-cost industry, the new equilibrium will be at the original price but with a higher market output.
A market is a constant-cost industry if the long-run industry supply curve is perfectly elastic (horizontal).
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An Increase in DemandAn Increase in Demand
The original firms return to their original output but since there are more firms in the market, the total market output increases.
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An Increase in DemandAn Increase in Demand
In the short run, the price does more of the adjusting.
In the long run, more of the adjustment is done by quantity.
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Profit$9
10120
FirmPrice
Quantity
B
A
Market Response to an Market Response to an Increase in Demand,Increase in Demand,Fig. 11-Fig. 11-
7, p 2487, p 248
Market
Quantity
Price
0
B
A
C
MC
AC
SLR
S0SR
D0
7
700
$9
8401,200
D1
S1SR
7
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Long-Run Market Long-Run Market SupplySupply Two other possibilities exist:
Increasing-cost industry – factor prices rise as new firms enter the market and existing firms expand capacity.
Decreasing-cost industry – factor prices fall as industry output expands.
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An Increasing-Cost An Increasing-Cost IndustryIndustry If inputs are specialized, factor prices
are likely to rise when the increase in the industry-wide demand for inputs to production increases.
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An Increasing-Cost An Increasing-Cost IndustryIndustry This rise in factor costs would raise
costs for each firm in the industry and increase the price at which firms earn zero profit (break even).
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An Increasing-Cost An Increasing-Cost IndustryIndustry Therefore, in increasing-cost industries,
the long-run supply curve is upward sloping.
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A Decreasing-Cost A Decreasing-Cost IndustryIndustry If input prices decline when industry
output expands, individual firms' cost curves shift down.
The price at which firms break even now decreases, and the long-run market supply curve is downward sloping.
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An Example: Canadian An Example: Canadian Retail IndustryRetail Industry During the 1990s the Canadian retail
industry illustrated how a competitive market adjusts to changing market conditions.
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An Example: Canadian An Example: Canadian Retail IndustryRetail Industry Many retailers were lost or absorbed by
competitors: Eaton’s, Bretton’s, Pascal’s, Robinson’s, K-Mart and many others.
Initially, these firms saw their losses as the temporary result of reduced demand in a slowing economy.
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An Example: Canadian An Example: Canadian Retail IndustryRetail Industry As prices fell, P=MR fell below their
ATC. But since price remained above the
AVC, many firms closed their less profitable locations and continued to operate.
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An Example: Canadian An Example: Canadian Retail IndustryRetail Industry When demand did not recover, firms ran
out of options. Many firms realized as they moved into
the long run that they have to exit the Canadian retail industry.
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Price
Quantity
MC
ATC
AVC
P = MR
Loss
An Example: A An Example: A Shutdown Decision, Shutdown Decision, Fig. 11-Fig. 11-
8, p 2508, p 250
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Perfect CompetitionPerfect Competition
End of Chapter 11End of Chapter 11
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