THE PERFECTLY COMPETITIVE MARKET OUTLINE: I. Introduction to Market Structure II. Characteristics of Perfect Competition III.

Perfect Competition Graphically IV. Revenue for the Firm V. Short Run Equilibrium Profit Maximization VI. Graphically A. A Profit B. A Loss C. Breaking even VII. The Shutdown Rule VIII. The Firms Short Run Supply Curve IX. Long-Run Equilibrium in a Perfectly Competitive Market X. Permanent Changes in Market Demand 1) An Increase in Market Demand 2) A Decrease in Market Demand

Productivity

Product Curves Short run

Firms (Choice of Q)

Costs Long run

Customer Demand (Market Conditions) INTRODUCTION TO MARKET STRUCTURE Market Spectrum (Ch.11) Perfect Competition (Ch.13) Monopolistic Competition (Ch.13) Oligopoly

Market Structures (4)

(Ch.12) Pure Monopoly

I. Perfect Competition Characteristics:

(Market forces to operate unimpeded) 1) 2) 3) 4) all firms sell an identical (homogeneous) product So consumers are indifferent to different sellers Many sellers or firms (LRATC hits low point at relatively small level of output) Firms are price takers Their market share isnt large enough to affect the market price NO MARKET POWER Free entry and exit no barriers to entry or exit such as - exclusive control of a resource - unusually high start up costs Instantaneous entry and exit Complete information Firms maximize profits no firms operating charitably

5)

6) 7) 8)

II. Perfect Competition Graphically

Total revenue (dollars per day)

Demand, Price, and Revenue in Perfect Competition

Price (dollars per sweater) Price (dollars per sweater)

TR

50

S
Market demand curve

50

demand curve MR

25

25

225

D
0

9 20 Quantity (thousands of sweaters per day)

9 20 Quantity (sweaters per day)

10 20 Quantity (sweaters per day)

market
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Demand and marginal revenue

total revenue
Slide 12-10

Each firms demand curve is perfectly elastic A change in q of any firm is not significant enough to change the market demand, D, so one firm can not impact the market price. If a firm tries to increase its price, it will lose all of its customers

III. Revenue for the firm Total Revenue = TR = Pe q

Marginal Revenue: Revenue from selling one more unit of the good MR = Pe IV. Short-Run Equilibrium - Profit Maximizing Output levels Profit = TR TC

Total Revenue, Total Cost, and Economic Profit

Total revenue and total cost (dollars per day)

TC TR
300 225 183 100 Economic loss 0 4 9 12
Slide 12-15

Economic loss Economic profit = TR TC

Quantity (sweaters per day)

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Total Revenue, Total Cost, and Economic Profit

Total revenue and total cost (dollars per day)

TC
300 225 183 100 0 4 9 12

TR

Quantity (sweaters per day)

Profit/loss (dollars per day)

42 20 0 -20 -40
Economic loss Economic profit

12

Quantity (sweaters per day)

Profitmaximizing quantity

Profit/ loss
Slide 12-16

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MR=MC The Profit Maximizing Condition V. Graphically looking at profit A) A firm earning a positive economic profit As long as Pe > ATC where MR=MC, the firm is earning a positive economic profit

Economic Profit
Price and cost (dollars per sweater)
30.00

MC

ATC MR

25.00

Economic profit

20.33

15.00

0
Copyright 2000 Pearson Education Canada Inc.

9 10

Quantity (sweaters per day)

Slide 12-24

Profit = TR TC Profit = Pe*q (ATC)q

B) A firm earning zero economic profit (normal rate of return) may still be earning a positive accounting profit As long as Pe = ATC where MR=MC, the firm is earning zero economic profit

Normal Profit
Price and cost (dollars per sweater)
30.00 Break-even Breakpoint

MC

ATC

25.00

20.00

MR
15.00

0
Copyright 2000 Pearson Education Canada Inc.

10 Quantity (sweaters per day)

Slide 12-23

Profit = TR TC Profit = Pe*q (ATC)q Normal rate of Return C) A firm earning a negative economic profit (economic loss) If Pe < ATC where MR = MC, the firm is suffering an economic loss GRAPH Profit = TR TC Profit = Pe*q (ATC)q VI. The Shutdown Rule How do you know when to shut down and when to keep producing? When Pe < ATC (LOSS) If Pe > AVC the firm will keep operating Even though suffering a loss, still paying some fixed costs If Pe < AVC the firm will shut down The firm shuts down because it is not covering its fixed costs of production

Shut down is a temporary decision close down operation until market conditions look better If we expect P < ATC indefinitely we get out of business this is a long run decision getting out of business for good Maximizing profit also means minimizing loss VII. The firms short-run supply curve If D shifts in the market, Pe changes causing MR or d to shift. New output determined where MR1 = MC The part of MC curve above AVC is the firms short-run supply curve Shows relationship between P and q for the producer

A Firms Supply Curve

Price and cost (dollars per sweater)

MC 31 MR2

25

Shutdown point

MR1 AVC MR0

s 17

0
Copyright 2000 Pearson Education Canada Inc.

9 10
Slide 12-28

Quantity (sweaters per day)

The industry supply curve is the horizontal summation of the supply curves of individual firms. VIII. Review of the Perfect Competition and Long-Run Equilibrium in a Perfectly Competitive Market 1) QD = QS in the market no P 2) Firms are breaking even or earning a normal rate of return no # firms a) Existing firms cannot be suffering losses (This would include exit from the market) b) Existing firms cannot be earning an economic profit (This would induce new entry into the market) This is called the zero profit condition 3) Allocative efficiency: (Pe = MC) (this implies that the firm is putting their resources into best paying use)

for perfect competition this is also true in the short run no resource allocation 4) Productive efficiency: (Pe = min ATC) Must be at minimum of LRATC so that expansion of plant size will not lower costs Low point of LRATC is called minimum efficient scale So no incentive to change plant size. no plant size Economic or productive efficiency IX. Permanent changes in Market Demand 1) An increase in market demand

GRAPHS Suppose D shifts from D0 to D1. a) In the short-run (a to b) As demand increases, (D0 to D1), the firms demand curve increases due to the higher equilibrium price, (d0 to d1) or (MR0 to MR1). The profit maximizing output increases from q0 to q1 as existing firms increase output and respond to the higher price level and the ability to earn greater profits. (by running factories overtime) Existing firms increase output by moving along up their supply curve (i.e. the marginal cost curve). As existing firms increase production, this is a short run response. Market output increases as we move along S0 from point a to point b. Is point b a long run equilibrium? No P > min ATC b) In the short-run (a to c) In the long run the profits of existing firms send a signal to new firms to enter the market. As new firms enter what happens to the market supply curve? It shifts out to the right As S0 shifts to S1, the market price falls hence pushing the firms demand curve back to its original level. The lower price encourages firms to cut production back to q0. So now we have more firms, but all producing at the old equilibrium output level. Point c is along run equilibrium. The long run market supply curve connects the dots representing the long run equilibrium. In this case it is perfectly flat. This shows that the industry has constant costs. There are also industries where the cost of inputs change when firms enter and exit the markets, however, we will not focus on such cases.

2) A decrease in the market demand

Suppose D shifts from D0 to D1. c) In the short-run As demand decreases, (D0 to D1), the firms demand curve decreases due to the lower equilibrium price, (d0 to d1) or (MR0 to MR1). The profit maximizing output decreases from q0 to q1 as existing firms decrease output and respond to the lower price level and the ability to suffer greater losses. Existing firms decrease output by moving down their supply curve (i.e. the marginal cost curve). As existing firms decrease production, this is a short run response. Market output decreases as we move along S0 from point a to point b. Is point b a long run equilibrium? No P > min ATC d) In the long run the losses of existing firms send a signal to new firms to exit the market. As some firms exit the market supply curve shifts back to the left As S0 shifts to S1, the market price rises hence pushing the firms demand curve back to its original level. The higher price encourages firms to increase production back to q0. So now we have fewer firms, but all producing at the old equilibrium output level. Point c is a long run equilibrium. The long run market supply curve connects the dots representing the long run equilibrium. In this case it is perfectly flat. This shows that the industry has constant costs. There are also industries where the cost of inputs change when firms enter and exit the markets, however, we will not focus on such cases.