ECON 202: Principles of Microeconomics. Chapter 11 Firms in Perfectly Competitive Markets

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1 ECON 202: Principles of Microeconomics Chapter 11 Firms in Perfectly Competitive Markets

2 Firms in Perfectly Competitive Markets 1. Market Structures. 2. Perfectly Competitive Markets. 3. Maximizing Profit in a Perfectly Competitive Market. 4. Profit and Loss on the Cost Curve. 5. Deciding Whether to Produce or to Shut Down in the Short Run. 6. Entry and Exit of Firms in the Long Run. 7. Perfect Competition and Efficiency. Firms in Perfectly Competitive Markets 2

3 1. Four Market Structures CHARACTERISTIC PERFECT COMPETITION MONOPOLISTIC COMPETITION OLIGOPOLY MONOPOLY Number of firms Many Many Few One Type of product Identical Differentiated Identical or differentiated Unique Ease of entry High High Low Entry blocked Examples of industries Wheat Apples Selling DVDs Restaurants Manufacturing computers Manufacturing automobiles First-class mail delivery Tap water Firms in Perfectly Competitive Markets 3

4 2. Perfectly Competitive Market Conditions for perfect competitive market: Many buyers and sellers, small relative to the market. Products are identical. No barriers to new firms entering the market. Prices are determined by the interaction of aggregate demand and aggregate supply. Firms are so small that cannot affect the price in the market. If raise prices, consumers switch to another firm. Price takers. Example: wheat farmers. Firms face perfectly elastic demand. Firms in Perfectly Competitive Markets 4

5 2. Perfectly Competitive Market Firms in Perfectly Competitive Markets 5

6 3. Maximizing Profit in a Perfectly Competitive Market Profit = Total Revenue Total Cost Firms maximize profits by producing the quantity of output where the difference between total revenue and total cost is as large as possible. QUANTITY (BUSHELS) (Q) TOTAL REVENUE (TR) TOTAL COSTS (TC) PROFIT (TR-TC) $ $ $ Firms in Perfectly Competitive Markets 6

7 3. Maximizing Profit in a PCM Marginalist approach: Starting from zero, to produce one more unit only if additional revenue is higher than additional cost. Marginal revenue: additional revenue from last unit sold. Marginal cost: additional cost from last unit produced. QUANTITY (BUSHELS) (Q) TOTAL REVENUE (TR) TOTAL COSTS (TC) PROFIT (TR-TC) MARGINAL REVENUE (MR) MARGINAL COST (MC) $ $ $ $ $ Firms in Perfectly Competitive Markets 7

8 3. Maximizing Profit in a PCM For firms in perfectly competitive markets, marginal revenue curve is the same as the demand curve. Firms in Perfectly Competitive Markets 8

9 3. Maximizing Profit in a PCM In order to maximize profits is equivalent: To produce where difference between total revenue and total cost is the greatest. To produce where marginal revenue is equal to marginal cost. In the case of firms in perfectly competitive markets, marginal revenue is equal to the price in the market. Condition for maximizing profit: Price = Marginal Revenue Firms in Perfectly Competitive Markets 9

10 4. Profit and Loss on the Cost Curve Remember that: Total Revenue = Price x Quantity Total Cost = Average Total Cost x Quantity Price and cost (dollars per bushel) Marginal Cost Average Total Cost P Profit Total Revenue Total Cost Q Profit Maximizing level of output Quantity Firms in Perfectly Competitive Markets 10

11 4. Profit and Loss on the Cost Curve Then, by comparing Price and ATC we can say: P > ATC, firm is making profit. P = ATC, firm is breaking even. P < ATC, firm is experiencing losses. Firms in Perfectly Competitive Markets 11

12 5. Deciding Whether to Produce or to Shut Down in the Short Run If the firm incurs in losses, should the firm stop production or continue operating? In the short-run, firms can not leave the market because an input is fixed. The decision will depend on its fixed cost. If firm stops production, it will have to pay fixed costs anyway. If by continue the production, the firm losses less than the fixed cost, the firm will decide to continue operating. Both situations are bad, but one is worse than the other. Since Total Cost = Fixed Cost + Variable Cost Firm will continue producing when revenue is greater than VC. Firms in Perfectly Competitive Markets 12

13 5. To Produce or to Shut Down in SR Total Revenue > Variable Cost Total Revenue Quantity > Variable Cost Quantity Price > Average Variable Cost Condition for keeping production in the short run. When Price = Average Variable Cost Shutdown point. Firms in Perfectly Competitive Markets 13

14 5. To Produce or to Shut Down in SR Price and cost (dollars per bushel) Supply Curve for the firm in the short run Marginal Cost Average Total Cost Average Variable Cost P 1 P 2 P MIN Q SD Q 2 Q 1 Quantity Firms in Perfectly Competitive Markets 14

15 5. To Produce or to Shut Down in SR Firms in Perfectly Competitive Markets 15

16 6. Entry and Exit of Firms in the Long Run When exist economic profit in a market, more firms are attracted to enter. Firms in Perfectly Competitive Markets 16

17 6. Entry and Exit of Firms in the Long Run With economic losses, some firms will leave. Firms in Perfectly Competitive Markets 17

18 6. Entry and Exit of Firms in the Long Run Firms in Perfectly Competitive Markets 18

19 6. Entry and Exit of Firms in the Long Run In the long-run With economic profit, entry of new firms make price decrease until firms are breaking even. With economic losses, exit of firms make price increase until firms are breaking even. Resulting situation is Long-run competitive equilibrium. Long run competitive equilibrium price is at minimum point of the Average Total Cost curve. Economic profits dissapear in the long run. Firms in Perfectly Competitive Markets 19

20 6. Entry and Exit of Firms in the Long Run Long Run Supply Curve in a Perfectly Competitive Market Firms in Perfectly Competitive Markets 20

21 6. Entry and Exit of Firms in the Long Run Industries with a horizontal long-run supply curve are called constant-cost industries. In some industries, the average cost of production can increase if scale of production increases: Input is available in limited amounts. (land in wine production) Long-run supply curve is upward sloping. Increasing-cost industry. In other cases industries, the average cost of production can fall if scale of production increases: An input is produced at lower cost because of a higher demand. (microchips for microwaves) Long-run supply curve is downward sloping. Decreasing-cost industry. Firms in Perfectly Competitive Markets 21

22 7. Perfect Competition and Efficiency In the long-run, firms in perfectly competitive markets will produce at the lowest point of their average cost curve. Minimizing their cost of production. In the long-run, perfect competition results in productive efficiency. Situation in which a good is produced at the lowest possible cost. Also, in perfectly competitive markets, firms will use the available resources to produce the goods that best satisfy consumer wants. Firms in Perfectly Competitive Markets 22

23 7. Perfect Competition and Efficiency In perfectly competitive markets: The price of a good represents the marginal benefit consumers receive from consuming the last unit of the good sold. Perfectly competitive firms produce up to the point where the price of the good equals the marginal cost of producing the last unit. Therefore, firms produce up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Perfect competition achieves allocative efficiency. A state of the economy in which production represents consumer preferences Every good is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Firms in Perfectly Competitive Markets 23

24 ECON 202: Principles of Microeconomics Chapter 11 Firms in Perfectly Competitive Markets

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