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Perfect Competition I. Assumptions: 1. Product homogeneity. 2. Large number of buyers and sellers. 3. Free entry and exit of firms. 4. Perfect knowledge. 5. Factor mobility. II. Market vs. Firm demand III. Short Run Equilibrium 1. The Total Approach: Numerical Ex. 2. The Marginal Approach. a. Profits b. Losses c. Shut-down d. Short-run Supply Curve e. Calc. Approach d∏/dQ = 0 IV. Long-run equilibrium. 1. Super-normal profits Entry 2. Losses Exit. V. Industry SS Curve: Horizontal Summation of firm SS curves. 107 Perfect Competition Assumptions behind Perfect Competition: 1. Product Homogeneity All firms sell an identical product. There is no way the buyer can differentiate among different firms' products. 2. Large number of buyers and sellers. No individual firm or buyer, no matter how large their sales or purchases, can influence market quantity. 3. Free entry and exit of firms. No barriers either cost or legal barriers to entry Promotes competition. 4. Perfect knowledge Sellers and buyers have complete knowledge of the market. 5. Factor Mobility: Factors of production are free to move from one firm to another. 108 Market and Firm Demand: Although market demand may slope downwards, firm demand is always perfectly elastic. Given the large number of sellers and perfect knowledge if a firm tries to raise its price above the market price, it will lose all its business. Review: 1. What are F.C.? 2. How do you get TVC from these figures? 3. How do you calculate MC? 4. Why is price fixed at $25? MC TC 2000 800 1200 12 Q 100 0 100 109 Short-run equilibrium: 1. The Total Approach: Maximize ∏ = TR - TC Profits (∏) Total Revenue (TR) = Price (P) * Quantity (Q) Numerical example: See handout Note:(1) ∏ = ∏ max when the gap between TR and TC is largest. (2) ∏ = ∏ max when MR = MC. MR TR Q (TR from each additional unit sold) AR TR Q (TR per unit sold) Note: P = AR = MR under Perfect Competition. 110 2. (A) The Marginal Approach. a. Profit MR = P > MC b. Loss MR = P < MC c. Normal Profits MR = P = MC d. Shut-down P < AVC min. (minimizes firm's losses) e. Short-run Supply Curve Profit: TR = OPx x Qxfirm TC = OACYQxfirm ∏ = TR - TC = shaded area Qxf determined by MR = MC and MC must be rising. MC < MR ≥ ∏ by Q MC > MR ≥ ∏ by Q ∏ (Q) = TR (Q) -TCCQ) d dTR dTC =0 dQ dQ dQ d 2 <0 dQ 2 111 (b) Loss: TC = OAXY TR = OPxYQf ∏ = TR - TC = -(PxAXY) MR = MC ≥ o xf is produced. (c) Break-even TR OP x XQ xf TC OP x XQ xf ∏=0 112 (d) Shut-down. Idea max ∏ or min losses. Px < AVC min Shut down because you minimize your losses by only paying fiscal costs Since you can't cover any variable costs producing output only increases losses Esc: If you cannot even cover the paychecks of employees it is better to shut-down and pay only the rent on land and machinery rather than also have to pay employees out of your own pocket. 113 (e) Short-run Supply Curve 114 Long-run equilibrium: 1. Super-normal profits exist. Firms enter the industry to reap those profits Industry SS shifts S.E. Market equilibrium price falls. Profits are completed away (by higher input costs) Long-run equilibrium is achieved. Price falls till P = LMC = AC min 2. Firms are making losses. Some firms exit the industry to avoid losses greater than Total Fixed Costs. Industry SS shifts N.W. Market equilibrium price rises till P = LMC = AC min Shifts in Cost Curves: SR: (Better tech. or more of a fiscal input). Change in FC shifts ATC but not AVC Change in VC shiftws AVC and ATC. LR: All costs are variable.