Download Perfectly competitive market

Chapter 6
Production Decisions
in a
Perfectly Competitive
Market
Chapter 6
Production
 Cost
 Production decisions in a perfectly
competitive market

Production decisions
in other market structures
Monopoly
 Monopolistic Competition
 Oligopoly

Perfect Competition





Perfectly competitive market: all
participants are price-takers
Perfectly competitive industry: all
producers are price-takers
Price-taker: whose action has no effect on
market price
Price-taking producer: market price does
not change because of the quantity he sells.
Price-taking consumer: market price does
not change because of the amount he buys.
Perfect Competition: Characteristics

Many buyers and sellers
and each is so small that no one can affect
price individually (for sellers, no one has large
enough market share)
 All firms produce a homogeneous product
(identical / standardized)
at least consumers think so
 Free entry and exit
each firm has complete knowledge about
production and cost；no regulation limit
Producer Decision-Making:
Goal: Maximize Profit
= TR – TC
–TC = TFC + TVC = wL + rK
–ATC = TC / Q
–MC = Δ(TC)/ΔQ
Recall: Short-Run Costs - Summary
at Q=0, VC=0, but FC>0
 when MC is declining, ATC and AVC
both decline at an increasing rate
 when MC starts increasing, ATC and
AVC may both be decreasing but at a
decreasing rate
 MC intersects AVC and ATC at their
minimum, respectively

The Relationship Between the Average
Total Cost and the Marginal Cost Curves
the four curves together:
More Realistic Cost Curves
Total Revenue: TR
TR = PQ
 AR = PQ/Q = P
 MR = Δ(PQ)/ΔQ
= (ΔP*Q)/ΔQ + (P*ΔQ)/ΔQ
= (ΔP /ΔQ ) Q + P(ΔQ/ΔQ )
= (ΔP /ΔQ ) Q + P
Perfect competition:
MR = P = AR (ΔP =0)

Short-Run optimal output level
in a perfectly competitive market

Goal: maximize profit
– Demand facing the industry: downward
sloping
– Demand facing the firm: horizontal at P
(all are price takers, and no one is large
enough to affect market price)

Optimal output level determined by
D=P=MR=MC
Profit-Maximizing Output

Decision rule:
is maximized when MR = MC
(think: why?)
profit is maximized at the quantity of
output where the marginal revenue of
the last unit produced is equal to its
marginal cost.
Short-Run Costs for Jennifer and Jason’s
Farm
Questions to consider:
How much is fixed cost?
 Is marginal cost calculated based on
total cost or variable cost?
 Why is marginal revenue constant at
$18?
 What is net gain?
 Is the goal to maximize net gain?

Again: under perfect competition

MR = Δ(PQ)/ΔQ
= (ΔP*Q)/ΔQ + (P*ΔQ)/ΔQ
= (ΔP /ΔQ ) Q + P(ΔQ/ΔQ )
When ΔP=0 (price taking)
 MR =P
Decision rule:
is maximized when MR=P=MC
The Price-Taking Firm’s
Profit-Maximizing Quantity of Output
The profit-maximizing point is where the marginal cost curve
crosses the marginal revenue curve (which is a horizontal line at
the market price).
Profitability and Market Price
Costs and Production in the Short-Run
Profitability and Market Price
The Short-Run Production Decision
A firm will cease production in the short-run if the market price falls
below the shut-down price, which is equal to minimum average
variable cost.
Short-Run optimal output level: various
profit situations

Rule: produce at MR=P=MC.
– Positive Economic Profit:
when D=MR=P>ATC at MR=P=MC
– Operating at a loss:
when AVC<D=MR=P<ATC at MR=P=MC
– Shut Down:
when D=MR=P<AVC at MR=P=MC

The break-even price:
the market price at which the firm earns zero
profit (P=ATC).
Profit Maximization：MR=MC

MR>MC, expand
 MR<MC, reduce
 MR=MC, optimal
P
P1
MC
ATC
AVC
D=MR=P
P2
Q
Principles:
MC tells how much to produce (produce
up to the amount where MR=P=MC)
 ATC tells how much profit or loss is
made if the firm decides to produce
(profit = (P - ATC) * Q).
 AVC tells whether to keep producing
(keep producing only when P>AVC at
P=MC)

Summary
Also example: AVC and ATC
Table 6.4, P.176
Employees
per day
Bottles
per day
Variable
cost
($/day)
Average
variable cost
($/unit of
output)
Total
cost
($/day)
Average
total cost
($/unit of
output)
0
0
0
40
1
80
12
0.150
52
0.650
2
200
24
0.120
64
0.320
3
260
36
0.138
76
0.292
4
300
48
0.160
88
0.293
5
330
60
0.182
100
0.303
6
350
72
0.206
112
0.320
7
362
84
0.232
124
0.343
Marginal
cost
($/bottle)
0.15
0.10
0.20
0.30
0.40
0.60
1.00
The Marginal, Average Variable, and Average
Total cost Curves for a Bottle Manufacturer
Price = Marginal Cost: The Perfectly
Competitive Firm’s Profit-Maximizing Supply
Rule
Measuring Profit Graphically
Figure 6.7, P.178
A Negative Profit
Figure 6.8, P.179
The Short-Run Supply
A firm will cease production in the short-run if the market price falls below the
shut-down price, which is equal to minimum average variable cost.
Short-Run Supply
for the firm: supply curve is upward
sloping because of the law of increasing
cost (S=MC).
 for the industry: the supply curve is
upward sloping, flatter than single firm
supply curve, and steeper than the
horizontal summation firm supplies.

The Short-Run Market Equilibrium
There is a short-run market equilibrium when the quantity supplied equals
the quantity demanded, taking the number of producers as given.
The Effect of an Increase in Demand in
the Short-Run and the Long-Run
D↑  P↑  non-zero profits  entry  S↑  P↓  back to zero profit
(on LRS curve)
Comparing the Short-Run and Long-Run
Industry Supply Curves
The long-run industry supply curve is always flatter—more elastic—than the
short-run industry supply curve. This is because of entry and exit:
Long-Run optimal output level:
All firms will be producing where
P=LMC=LAC and economic profit will
be zero because of free entry and exit.
 Firms enjoy big economic rent if they
own the resources that have higher
productivity than similar resources
owned by others.

Long-Run Equilibrium
LMC
P
LAC
E
N
AR=MR
O
M
Q
The Long-Run Market Equilibrium
A market is in long-run market equilibrium when the quantity supplied
equals the quantity demanded, given that sufficient time has elapsed for entry
into and exit from the industry to occur.
Conclusions:

In a perfectly competitive industry in
equilibrium, the value of marginal cost is the
same for all firms.
 In a perfectly competitive industry with free
entry and exit, each firm will have zero
economic profits in long- run.
 The long-run market equilibrium of a perfectly
competitive industry is efficient: no mutually
beneficial transactions go unexploited.
Long-Run Supply:
For the firm: produce where
P=LMC=min LAC.
 For a constant-cost industry: long-run
supply is horizontal.
 For an increasing-cost industry: longrun supply is upward sloping.
