Chapter 13 - Perfect competition. After studying this chapter you will be able to understand: What the characteristics of a perfectly competitive market are? How to calculate average, marginal, and total revenue? How to find a firm’s optimal quantity of output? How to differentiate between a firm’s shut down and market exit decisions?...
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Chapter 13
Perfect Competition
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What will you learn in this chapter?
exit decisions
competitive market
market, and what its implications are for profit-seeking firms
equilibrium
A competitive market
production decisions in a competitive
market.
– Full information exists.
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A competitive market
one has the ability to affect market prices Thus, all are
price takers.
– The only seller of food on a plane can charge a very high price,
knowing that some people would be hungry enough to pay it.
– The only buyer of food at a market at the end of the day could
offer a very low price, knowing that some seller would be willing
to sell.
price, although they may have some ability to set prices.
constraints on a firm’s ability to maximize profits.
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Revenues in a perfectly competitive market
In a perfectly competitive market, producers are able to sell
as much as they want without affecting the market price
• Average revenue is total revenue divided by quantity.
• Marginal revenue is the change in revenue.
) 5 ( )
4 ( )
3 ( )
2
(
)
1
(
Quantity
of plantains
(bunches)
Price
(CFA Francs)
Total revenue Average revenue
(CFA Francs/bunch
of plantains)
Marginal revenue
(CFA Francs)
0 , 1 0
, 1 0
, 1 0
,
1
1
0 , 1 0
, 1 0
, 2 0
,
1
2
0 , 1 0
, 1 0
, 3 0
,
1
3
0 , 1 0
, 1 0
, 4 0
,
1
4
0 , 1 0
, 1 0
, 5 0
,
1
5
(CFA Francs)
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Active Learning: Revenue of a firm in a
competitive market
Fill in the table for a price taking firm in a
competitive market.
Quantity Price
($)
Total revenue
($)
Average revenue
($)
Marginal revenue
($)
95
1
2
3
4
5
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Profits and production decisions
• Firms seek to maximize profits.
• In a competitive market, the only choice that a
price-taking firm can make to affect profits is
the quantity of output to produce.
• The profit-maximizing quantity corresponds to
the quantity at which marginal revenue is
equal to the marginal cost.
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Profits and production decisions
Profit maximization occurs where MR = MC for a
perfectly competitive firm.
Quantity of
plantains
(bunches)
Total revenue
(CFA Francs)
Total cost Profit Marginal
revenue
(CFA Francs)
Marginal cost
(CFA Francs)
Marginal profit
(CFA Francs
1
2
3
4
5
(CFA Francs) (CFA Francs)
1,000
2,000
3,000
4,000
5,000
1,200 1,800 2,600
3,600
4,800
-200 200 400
400
200
1,000 1,000 1,000
1,000
1,000
500 600 800
1,000
1,200
500 400 200
0
-200
Profits and production decisions
MR from the next unit is greater than the MC
quantity is at MR = MC (B).
quantity causes a loss as the
production as long as MR >
MC , as total profit increases as another unit is produced.
The profit maximizing point can be identified graphically
0
200
400
600
800
1,000
1,200
1,400
1,600
1,800
MC
Price (CFA Francs)
Profit at point C is
lower than at point B,
because MC is higher
than MR.
B
A
C
MR
Profit at point A is lower than at point B because
marginal profit (marginal revenue
-positive Marginal profit stays positive up to point B.
marginal cost) is
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Deciding when to operate
Producing the quantity where MR = MC may not
always be to the firm’s advantage.
Quantity
of plantains Total revenue Total cost Profit
Marginal revenue Marginal cost Marginal profit
– Optimal to produce zero output.
• If P < ATC, then profits will be negative.
(bunches) (CFA Francs) (CFA Francs) (CFA Francs)
(CFA Francs (CFA Francs) (CFA Francs)
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Deciding when to operate
• When deciding the quantity to produce, a firm
additionally must decide whether to:
–Produce
–Shut-down in the short-run
–Exit the market in the long-run
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Deciding when to operate
• When a firm shuts down production, it avoids
incurring variable costs.
deciding whether to shut down in the short-run
• The short-run decision to produce depends on
variable costs, not fixed costs.
• The long-run decision to produce depends on
total cost , since all costs are variable in the
long-run.
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The short-run supply curve and the
shutdown rule
The short-run shutdown rule is to produce if
price is higher than AVC.
1,000
600
MC
AVC
Plantains (bunches)
Price (CFA Francs)
1 Whenever P > AVC the firm
will produce along the point
supply curve, because revenue
exceeds variable cost.
Shutdown point
P Above
Short-run supply curve
P Shutdown
2 However, once the price
is below the minimum of the AVC, the firm will not produce because doing so would generate a negative profit
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The long-run supply curve and the
shutdown rule
Since all costs are variable in the long-run, the long-run
ATC
1,000
860
MC
AVC
Plantains (bunches)
Price (CFA Francs)
PAbove
Long-run supplycurve Exit point
In the long
run, firms will
price is above
ATC.
When prices
are below
ATC, the firm
will exit the
market.
PExit
ATC
Active Learning: Supply curves and
operation decisions
Identify the shutdown point, the exit point, and
the SR and LR supply curves.
0
MC
AVC
Quantity Price
ATC
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Firm and market supply curves
supply curve
Firm supply: one firm
0
200
400
600
1,000
1,200
1,400
Plantains (bunches)
Price (CFA Francs)
Market supply: 100 firms
Market supply
300 200
Firm supply Price (CFA Francs)
Plantains (bunches)
800
200 400 600 1,000 1,200 1,400
800
Below a price of
620, each firm
will shut down,
resulting in no
production.
market supply curve is established.
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Long-run supply
market in the long run
• If positiveeconomic profits exist:
–P > ATC
• If negativeeconomic profits exist:
–P < ATC
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Long-run supply
• The process of market entry and exit causes
firms in a perfectly competitive market to earn
them for their opportunity cost
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Long-run supply
Because all firms operate at the point where
price = min(ATC), firms in a competitive market
operate at an efficient scale.
0
MC
ATC
Plantains (bunches)
Price (CFA Francs)
MR
e
Pe
Q
A firm’s efficient scale is at the quantity where ATC=P=MC.
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Long-run supply
Given that P = min(ATC), price is the same at any
quantity in the long run.
Pe
0 Plantains (bunches)
Price (CFA Francs)
Supply
• If anything causes the market equilibrium to move away from this price, the resulting positive or negative profits will cause firms to enter or exit the market until zero economic profits are restored.
• The long-run supply curve is horizontal, or perfectly elastic.
Why the long-run market supply curve
shouldn’t slope upward, but does
elastic
sloping
same cost structure
firms, price must rise sufficiently to entice new
firms to enter the market
sloping
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Long-run economic profits
• The competitive market theory suggests that
all firms should earn zero economic profit in
the long-run.
• In reality, price = min(ATC) for only the
least-efficient firms in the market.
economic profit in the long-run
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2 … and
average total
cost of
production
1 Changing
variable costs
decrease marginal
cost of production.
Market entry due to changing production
costs
Improved technology and production capabilities
lowers MC and ATC.
Pe
MC1 ATC1
Plantains (bunches)
Price (CFA Francs)
MR
3 Minimum ATC drops below
the market price, and there is
room for firm entry, because
whenever ATC < MR, profit is
possible
MC2 ATC2
better production processes and new technologiesthat enable them to produce goods at lower cost
- Lowers MC and ATC
entrants
costs
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Responding to shifts in demand
Suppose the demand for a perfectly competitive
good increases; what happens in the short and long
run?
0
Plantains (bunches)
0
Plantains (bunches)
D2 S1 SL
1 New firms enter, shifting the supply curve right.
S2
2 Equilibrium quantity increases; price returns to long-run equilibrium.
Pe
0
D1
S1
SL
Plantains (bunches)
D2
S1 SL
1 Increase in demand shifts the demand curve right.
2 Equilibrium price and quantity increase.
Market is in long-run
equilibrium. Higher price causes short-run profits.
D1
Market has new long-run equilibrium.
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Summary
• Perfectly competitive markets are defined by:
• Firms maximize profit by producing at the
point where MR = MC.
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Summary
and the supply shifts outward until profits are zero
and the supply shifts outward until profits are zero
Summary
• If firms have different costs of production, the
long-run supply curve will be upward sloping.
• If firms innovate, the cost of production
decreases and price decreases as well.
• If the demand for a perfectly competitive good
increases, then short-run positive profits
induce entry of new firms and the supply shifts
out, causing a higher quantity of goods to be
produced at the same price.