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Economics 2010 Lecture 12 Perfect Competition Competition Perfect Competition Firms Choices in Perfect Competition The Firm’s Short-Run Decision The Firm’s Supply Curve The Industry Supply Curve Perfect Competition Perfect competition occurs in a market where: There are many firms, each selling an identical product There are many buyers Firms in the industry have no advantage over potential new entrants (no barriers to entry) Firms and buyers are well informed about the prices of the products of each firm in the industry Perfect Competition In perfect competition, each firm is a price taker Examples of firms in perfect competition: Wheat farms Fisheries Paper Firms Choices in Perfect Competition In a perfectly competitive market, a firm must make four key decisions: Whether to enter the industry If enter, whether to stay in the industry or leave it If stay, whether to produce or to temporarily shut down If produce, how much to produce (and how to produce it) Firms Choices in Perfect Competition In the short run we can only choose: whether to produce or to temporarily shut down If we do produce, how much to produce The Firm’s Short-Run Decision All decisions are about profit--which action makes the maximum profit Economic profit = total revenue - total cost Total revenue = Price x Quantity [Remember, total cost includes normal profit, an opportunity cost] Normal profit The entrepreneurial ability and time of the entrepreneur needs to be rewarded by the normal profit in an industry Risky industries, or industries which demand high entrepreneurial skills are probably paying off higher profits Also remember that any money you invest has a opportunity cost because you could have invested it in your next best option instead Revenue in Perfect Competition The revenue curves in perfect competition are: Average revenue Marginal revenue Total revenue The following figure shows the revenue curves of a firm in perfect competition Revenue in Perfect Competition First, market’s or industry’s demand and market supply determine the price that the firm takes as given Revenue in Perfect Competition The firm can sell any quantity it chooses at this price Revenue in Perfect Competition The demand curve the firm faces is perfectly elastic Average revenue (AR) = marginal revenue (MR) Revenue in Perfect Competition The firm’s total revenue curve is linear An increase in the quantity sold brings a proportional increase in total revenue (TR) The Firm’s Short-Run Decision The firm’s short-run problem is to choose the output that maximizes profit. We can solve this problem by looking at either: total cost and total revenue, or marginal cost and marginal revenue The Firm’s Short-Run Decision This figure shows the firm’s profit maximizing output by using total cost and total revenue At low output rates, the firm incurs an economic loss The reason is that it has some fixed costs, remember? The Firm’s Short-Run Decision At an output rate of 4 sweaters a day, the firm breaks even At output rates above 12 sweaters a day, the firm again incurs an economic loss This time, the reason is now diminishing returns, remember? The Firm’s Short-Run Decision At 12 sweaters a day, the firm breaks even Between 4 and 12 sweaters a day, the firm makes an economic profit The maximum profit occurs at 9 sweaters a day Here, total revenue is $225, total cost is $183, and economic profit is $42 The Firm’s Short-Run Decision Here we derive the firm’s profit maximizing output by using the profit curve The profit curve reaches its maximum at 9 sweaters a day The Firm’s Short-Run Decision Now we show profit maximizing output by using marginal analysis Marginal revenue equals marginal cost The Firm’s Short-Run Decision Profit maximization does not guarantee a profit When price equals marginal cost, average total cost, ATC, can be greater than, equal to, or less than price Profit maximization can mean loss minimization The Firm’s Short-Run Decision The following figures show the three possible outcomes: economic profit break even economic loss ATC is less than AR (price) The Firm’s Short-Run Decision Here, the firm breaks even The price is $20 and the profitmaximizing quantity is 8 ATC equals AR The Firm’s Short-Run Decision Here, the firm incurs an economic loss The price is $17 and the profitmaximizing quantity is 7 ATC exceeds AR The Firm’s Short-Run Decision The shutdown point is the point at which the firm's maximized profit is the same regardless of whether the firm produces or temporarily shuts down The shutdown point is the point of minimum average variable cost The Firm’s Short-Run Decision If price equals minimum AVC, the profit is the same from producing as from shutting down temporarily and paying the fixed costs Either way, the firm incurs a loss equal to total fixed cost If the firm produced with AVC greater than price, its loss would exceed total fixed cost The Firm’s Short-Run Decision Let us show the shutdown decision and the shutdown point The Firm’s Supply Curve A perfectly competitive firm's supply curve shows how the firm's profit maximizing output varies as the market price varies A perfectly competitive firm's supply curve is the firm's marginal cost curve above the point of minimum average variable cost The Firm’s Supply Curve This shows the firm’s supply curve We begin with the firm’s cost curves in part (a) The Firm’s Supply Curve For prices above minimum AVC, a change in price brings a change in the quantity supplied along the MC curve The Firm’s Supply Curve At minimum AVC, the firm is indifferent between supplying 7 and supplying zero Both are points on the firm’s supply curve The Firm’s Supply Curve But nothing in between 7 and zero is on the supply curve The firm will never supply 1,…,6 sweaters a day At prices below minimum AVC, the quantity supplied is zero Let’s look at the supply curve The Firm’s Supply Curve At prices below minimum AVC, the quantity supplied is zero along the price axis. Then there is a jump from zero to the shutdown point The Firm’s Supply Curve And at prices above minimum AVC, the quantity supplied is traced by the MC curve The Industry Supply Curve The short-run industry supply curve The horizontal sum of the firm’s supply curves The Industry Supply Curve This figure shows the industry supply curve It is like the firm’s curve except it has no break at the shutdown price Next Industry equilibrium in the short run and the long run