chap011 mkt structure perfect competition
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Perfect Competition
Chapter 11
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Laugher Curve
Q. How many economists does it take toscrew in a light bulb?
A. Eight.
One to screw it in and seven to holdeverything else constant.
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Perfect Competition
The concept of competition is used in twoways in economics.
Competition as a process is a rivalry amongfirms.
Competition as the perfectly competitive
market structure.
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A Perfectly Competitive
Market A perfectly competitive marketis one in
which economic forces operate
unimpeded.
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A Perfectly Competitive
Market A perfectly competitive market must meet
the following requirements:
Both buyers and sellers are price takers. The number of firms is large.
There are no barriers to entry.
The firms products are identical. There is complete information.
Firms are profit maximizers.
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The Necessary Conditions for
Perfect Competition Both buyers and sellers are price takers.
Aprice takeris a firm or individual who takes
the market price as given. In most markets, households are price takers
they accept the price offered in stores.
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The Necessary Conditions for
Perfect Competition Both buyers and sellers are price takers.
The retailer is not perfectly competitive.
A retail store is not a price taker but a pricemaker.
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The Necessary Conditions for
Perfect Competition There are no barriers to entry.
Barriers to entry are social, political, or
economic impediments that prevent otherfirms from entering the market.
Barriers sometimes take the form of patentsgranted to produce a certain good.
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The Necessary Conditions for
Perfect Competition There are no barriers to entry.
Technology may prevent some firms from
entering the market. Social forces such as bankers only lending to
certain people may create barriers.
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The Necessary Conditions for
Perfect Competition The firms' products are identical.
This requirement means that each firm's
output is indistinguishable from anycompetitor's product.
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The Necessary Conditions for
Perfect Competition There is complete information.
Firms and consumers know all there is to
know about the market prices, products,and available technology.
Any technological breakthrough would beinstantly known to all in the market.
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The Necessary Conditions for
Perfect Competition Firms are profit maximizers.
The goal of all firms in a perfectly competitive
market is profit and only profit. The only compensation firm owners receive is
profit, not salaries.
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The Definition of Supply and
Perfect Competition If all the necessary conditions for perfect
competition exist, we can talk formally
about the supply of a produced good.
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The Definition of Supply and
Perfect Competition Supplyis a schedule of quantities of
goods that will be offered to the market at
various prices.
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The Definition of Supply and
Perfect Competition When a firm operates in a perfectly
competitive market, its supply curve is that
portion of its short-run marginal cost curveabove average variable cost.
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Demand Curves for the Firm
and the Industry The demand curves facing the firm is
different from the industry demand curve.
A perfectly competitive firms demandschedule is perfectly elastic even thoughthe demand curve for the market is
downward sloping.
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Demand Curves for the Firm
and the Industry Individual firms will increase their output in
response to an increase in demand even
though that will cause the price to fall thusmaking all firms collectively worse off.
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Market supply
Marketdemand1,000 3,000
Price
$108
6
4
2
0Quantity
Market Firm
Individual firmdemand
Market Demand Versus
Individual Firm Demand Curve
10 20 30
Price
$108
6
4
2
0Quantity
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Profit-Maximizing Level of
Output The goal of the firm is to maximize profits.
Profit is the difference between total
revenue and total cost.
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Profit-Maximizing Level of
Output 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 of
Output Marginal revenue(MR) the change in
total revenue associated with a change in
quantity. Marginal cost(MC) the change in total
cost associated with a change in quantity.
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Marginal Revenue
A perfect competitor accepts the marketprice as given.
As a result, marginal revenue equals price(MR = P).
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Marginal Cost
Initially, marginal cost falls and then beginsto rise.
Marginal concepts are best definedbetween the numbers.
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Profit Maximization:MC = MR
To maximize profits, a firm should producewhere marginal cost equals marginal
revenue.
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How to Maximize Profit
If marginal revenue does not equalmarginal 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 Profit
The supplier will cut back on production ifmarginal cost is greater than marginal
revenue. Thus, the profit-maximizing condition of a
competitive firm is MC = MR = P.
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C
A
P = D = MR
Costs
1 2 3 4 5 6 7 8 9 10 Quantity
60
5040
30
20
10
0
A
B
MC
Marginal Cost, Marginal
Revenue, and Price
0
123456789
10
$28.00
20.0016.0014.0012.0017.00
22.0030.0040.0054.0068.00
Price = MR QuantityProduced
MarginalCost
$35.00
35.0035.0035.0035.0035.0035.0035.0035.0035.0035.00
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The Marginal Cost Curve Is the
Supply Curve The marginal cost curve is the firm's supply
curve above the point where price exceeds
average variable cost.
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The Marginal Cost Curve Is the
Supply Curve The MC curve tells the competitive firm
how much it should produce at a given
price. The firm can do no better than produce the
quantity at which marginal cost equals
marginal revenue which in turn equalsprice.
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The Marginal Cost Curve Is the
Firms Supply Curve
A
B
CMarginal cost
Cost,Price
$70
60
5040
30
2010
0 1 Quantity2 3 4 5 6 7 8 9 10
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Firms Maximize Total Profit
Firms seek to maximize total profit, notprofit per unit.
Firms do not care about profit per unit. As long as increasing output increases total
profits, a profit-maximizing firm should
produce more.
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Profit Maximization Using
Total Revenue and 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
Totalcost,reve
nue
$385350
315280245210175140
1057035
Quantity1 2 3 4 5 6 7 8 9
Profit Determination Using Total
Cost and Revenue Curves
Maximum profit =$81
$130
Loss
Loss
Profit
Profit =$45
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Total Profit at the Profit-
Maximizing Level of Output The P = MR = MCcondition tells us how
much output a competitive firm should
produce to maximize profit. It does not tell us how much profit the firm
makes.
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Determining Profit and Loss
From a Table of Costs Profit can be calculated from a table of
costs and revenues.
Profit is determined by total revenue minustotal cost.
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P = MR Output Total CostMarginal
Cost
Average
Total Cost
Total
Revenue
Profit
TR-TC
0 40.00 0 40.00
35.00 1 68.00 28.00 68.00 35.00 33.00
35.00 2 88.00 20.00 44.00 70.00 18.00
35.00 3 104.00 16.00 34.67 105.00 1.00
35.00 4 118.00 14.00 29.50 140.00 22.0035.00 5 130.00 12.00 26.00 175.00 45.00
35.00 6 147.00 17.00 24.50 210.00 63.00
Costs Relevant to a Firm
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P = MR Output Total CostMarginal
CostAverageTotal Cost
TotalRevenue
ProfitTR-TC
35.00 4 118.00 14.00 29.50 140.00 22.00
35.00 5 130.00 12.00 26.00 175.00 45.00
35.00 6 147.00 17.00 24.50 210.00 63.00
35.00 7 169.00 22.00 24.14 245.00 76.00
35.00 8 199.00 30.00 24.88 280.00 81.0035.00 9 239.00 40.00 26.56 315.00 76.00
35.00 10 293.00 54.00 29.30 350.00 57.00
Costs Relevant to a Firm
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Determining Profit and Loss
From a Graph Find output where MC = MR.
The intersection ofMC = MR (P) determines
the quantity the firm will produce if it wishesto maximize profits.
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Determining Profit and Loss
From a Graph Find profit per unit where MC = MR.
Drop a line down from where MC equals MR,
and then to the ATC curve. This is the profit per unit.
Extend a line back to the vertical axis to
identify total profit.
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Determining Profit and Loss
From a Graph The firm makes a profit when the ATC
curve is below the MR curve.
The firm incurs a loss when the ATC curveis above the MR curve.
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Determining Profit and Loss From
a Graph Zero profit or loss where MC=MR.
Firms can earn zero profit or even a loss
where MC = MR. Even though economic profit is zero, all
resources, including entrepreneurs, are beingpaid their opportunity costs.
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(a) Profit case (b) Zero profit case (c) Loss case
Determining Profits Graphically
Quantity Quantity Quantity
Price65605550
454035302520
151050
65605550
454035302520
151050
1 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 ATC
AVCE
Profit
C
MC
ATC
AVC
MC
ATC
AVC
Loss
65605550
454035302520
151050
1 2 3 4 5 6 7 8 910 12
P = MR
P = MR
Price Price
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The Shutdown Point
The firm will shut down if it cannot coveraverage variable costs.
A firm should continue to produce as long asprice is greater than average variable cost.
If price falls below that point it makes sense toshut down temporarily and save the variablecosts.
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The Shutdown Point
The shutdown pointis the point at whichthe firm will be better off it it shuts down
than it will if it stays in business.
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The Shutdown Point
If total revenue is more than total variablecost, the firms best strategy is to
temporarily produce at a loss. It is taking less of a loss than it would by
shutting down.
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MC
P = MR
2 4 6 8 Quantity
Price
60
50
40
30
2010
0
ATC
AVC
Loss
A$17.80
The Shutdown Decision
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Short-Run Market Supply and
Demand While the firm's demand curve is perfectly
elastic, the industry's is downward sloping.
For the industry's supply curve we use amarket supply curve.
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Short-Run Market Supply and
Demand The market supply curve is the horizontal
sum of all the firms' marginal cost curves,
taking account of any changes in inputprices that might occur.
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Long-Run Competitive
Equilibrium Profits and losses are inconsistent with
long-run equilibrium.
Profits create incentives for new firms to enter,output will increase, and the price will falluntil zero profits are made.
The existence of losses will cause firms toleave the industry.
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Long-Run Competitive
Equilibrium Only at zero profit will entry and exit stop.
The zero profit condition defines the long-
run equilibrium of a competitive industry.
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Long-Run Competitive
Equilibrium MC
P = MR
0
60
5040
30
20
10
Price
2 4 6 8 Quantity
SRATC LRATC
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Long-Run Competitive
Equilibrium Zero profit does not mean that the
entrepreneur does not get anything for his
efforts. Normal profit the amount the owners of
business would have received in the next-
best alternative.
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Long-Run Competitive
Equilibrium Normal profits are included as a cost and
are not included in economic profit.
Economic profits are profits above normalprofits.
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Long-Run Competitive
Equilibrium Firms with super-efficient workers or
machines will find that the price of these
specialized inputs will rise. Rentis the income received by those
specialized factors of production.
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Long-Run Competitive
Equilibrium The zero profit condition makes the
analysis of competitive markets applicable
to the real world. To determine whether markets are
competitive, many economist focus on
whether barriers to entry exist.
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Adjustment from the Long Run
to the Short Run Industry supply and demand curves come
together to lead to long-run equilibrium.
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An Increase in Demand
An increase in demand leads to higherprices and higher profits.
Existing firms increase output. New firms enter the market, increasing output
still more.
Price falls until all profit is competed away.
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An Increase in Demand
If input prices remain constant, the newequilibrium will be at the original price but
with a higher output.
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An Increase in Demand
The original firms return to their originaloutput but since there are more firms in the
market, the total market output increases.
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An Increase in Demand
In the short run, the price does more of theadjusting.
In the long run, more of the adjustment isdone by quantity.
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Profit$9
10 120
FirmPrice
Quantity
B
A
Market Response to an Increase
in DemandMarket
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 Supply
In the long run firms earn zero profits.
If the long-run industry supply curve is
perfectly elastic, the market is a constant-cost industry.
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Long-Run Market Supply
Two other possibilities exist:
Increasing-cost industry factor prices rise
as new firms enter the market and existingfirms expand capacity.
Decreasing-cost industry factor prices fallas industry output expands.
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An Increasing-Cost Industry
If inputs are specialized, factor prices arelikely to rise when the increase in the
industry-wide demand for inputs toproduction increases.
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An Increasing-Cost Industry
This rise in factor costs would force costsup for each firm in the industry and
increases the price at which firms earnzero profit.
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An Increasing-Cost Industry
Therefore, in increasing-cost industries, thelong-run supply curve is upward sloping.
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A Decreasing-Cost Industry
If input prices decline when industry outputexpands, individual firms' marginal cost
curves shift down and the long-run supplycurve is downward sloping.
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A Decreasing-Cost Industry
Input prices may decline to the zero-profitcondition when output rises.
New entrants make it more cost-effectivefor other firms to provide services to allfirms in the market.
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An Example in the Real World
K-mart decided to close over 300 storesafter experiencing two years of losses (a
shutdown decision). K-mart thought its losses would be
temporary.
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An Example in the Real World
Price exceeded average variable cost, so itcontinued to keep some stores open even
though those stores were losing money.
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Price
Quantity
MC
ATC
AVC
P = MR
Loss
An Example in the Real World
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An Example in the Real World
After two years of losses, its prospectivechanged.
The company moved from the short run tothe long run.
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An Example in the Real World
They began to think that demand was nottemporarily low, but permanently low.
At that point they shut down those storesfor which P < AVC.
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Perfect Competition
End of Chapter 11
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