ECON107Principles of

MicroeconomicsWeek 13

DECEMBER 2013

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Chapter-12

12PERFECT

COMPETITION

Lesson Objectives Define perfect competition

How perfect competition arises

Explain how a firm makes its output decision

Explain how price and output are determined in perfect competition

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Perfect Competition Perfect competition is a market in

which Many firms sell identical products to

many buyers (Standardized Product). There are no restrictions to entry into

the industry (Free Entry and Exit). Established firms have no advantages

over new ones (Price Takers). Sellers and buyers are well informed

about prices.

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How Perfect Competition Arises

Perfect competition arises when: the firm’s minimum efficient scale is

small relative to market demand so there is room for many firms in the market.

each firm is perceived to produce a good or service that has no unique characteristics, so consumers don’t care which firm’s good they buy.

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Perfect CompetitionA price taker is a firm that cannot influence the price of a good or service.No single firm can influence the price—it must “take” the equilibrium market price.Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.

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Goals of Perfectly Competitive firm

The goal of each competitive firm is to maximize economic profit, which equals total revenue minus total cost.

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SHORT RUN PROFIT MAXIMIZATION

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Two Approaches...First: Total-Revenue -Total Cost Approach

The Decision Rule:Produce in the short-run if it can realize

1- A profit (or)2- A loss less than its fixed costs

The Decision Process:•Should the firm produce (Whether to enter or exit a market)?•What quantity should be produced?•What profit or loss will be realized (How to produce at

minimum cost)?

Second: Marginal-Revenue -Marginal Cost Approach

DEMAND AS SEEN BY A PURELY COMPETITIVE SELLER

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$131 131

131131131131131131131131131

0 1 2

3456789

10

$ 0131262393524655786917

104811791310

$131131131131131131131131131131

Product Price (P)(Average Revenue)

TotalRevenue (TR)

MarginalRevenue (MR)

QuantityDemanded (Q)

]]]]]]]]]]

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TR

D = MR

1 2 3 4 5 6 7 8 9 10

1179

1048

917

786

655

524

393

262

131

0

Pri

ce

an

d r

ev

enu

e

Quantity Demanded (sold)

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TotalCost

0 1 2

3456789

10

TotalProduct

TotalFixedCost

TotalVariable

CostTotal

Revenue Profit $ 100

100 100

100100100100100100100100

$ 090

170240300370450540650780930

$ 100190270340400470550640750880

1030

Price: $131

- $100- 59

- 8+ 53

+ 124+ 185+ 236+ 277+ 298+ 299+ 280

TOTAL REVENUE-TOTAL COST APPROACH

$ 0131262393524655786917

104811791310

Can you see the

profit maxim

ization?

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$1,8001,7001,6001,5001,4001,3001,2001,1001,000 900 800 700 600 500 400 300 200 100 0

To

tal r

eve

nu

e a

nd

to

tal c

ost

TotalRevenue

TotalCost

MaximumEconomic

Profits$299

Break-Even Point(Normal Profit)

Break-Even Point(Normal Profit)

1 2 3 4 5 6 7 8 9 10 11 12 13 14

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Second: Marginal-Revenue -Marginal Cost Approach

Profit is maximized by producing the output at which marginal revenue (MR), equals marginal cost (MC).

MR = MC Rule

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AverageTotalCost

0 1 23456789

10

TotalProduct

AverageFixedCost

AverageVariable

Cost

Price =MarginalRevenue

TotalEconomicProfit/Loss

$100.00

50.00 33.3325.0020.0016.6714.2912.5011.1110.00

$90.0085.0080.0075.0074.0075.0077.1481.2586.6793.00

$190.00135.00113.33100.00

94.0091.6791.4393.7597.78

103.00

- $100- 59

- 8+ 53

+ 124+ 185+ 236+ 277+ 298+ 299+ 280

$ 131131131131131131131131131131

MarginalCost

90807060708090

110130150

Graphically

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If MR > MC, economic profit increases if output increases.

If MR < MC, economic profit decreases if output increases.

If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.

$200

150

100

50

0

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

MR

Economic Profit

$131.00

$97.78AVC

ATC

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Second: Marginal-Revenue -Marginal Cost Approach

A firm’s shutdown point is the point at which it is indifferent between producing and shutting down.

This point is where AVC is at its minimum.

It is also the point at which the MC curve crosses the AVC curve.

17 Figure shows the shutdown point.

Minimum AVC is $17 a sweater.

If the price is $17, the profit-maximizing output is 7 sweaters a day.

The firm incurs a loss equal to the red rectangle. If the price of a sweater is between $17 and $20.14, the firm produces the quantity at which marginal cost equals price.

The firm covers all its variable cost and at least part of its fixed cost.

It incurs a loss that is less than TFC.

18Output, Price, and Profit in the Short Run

Market Supply in the Short RunThe short-run market supply curve shows the quantity supplied by all firms in the market at each price when each firm’s plant and the number of firms remain the same.

19Output, Price, and Profit in the Short Run

Co

st a

nd

Rev

enu

e, (

do

llar

s)

MC

MR1

AVC

ATC

Quantity Supplied

MR2

MR3

MR4

MR5

P1

P2

P3

P4

P5

Q2 Q3 Q4 Q5

Do notProduce –Below AVC

Break-even(Normal Profit)Point

20Output, Price, and Profit in the Short Run

Co

st a

nd

Rev

enu

e, (

do

llar

s)

MC

MR1

MR2

MR3

MR4

MR5

P1

P2

P3

P4

P5

Q2 Q3 Q4 Q5

Yields theShort-Run

Supply Curve

Supply

NoProductionBelow AVC

21 At a price equal to minimum AVC, the shutdown price, some firms will produce the shutdown quantity and others will produces zero.

The market supply curve is perfectly elastic.

Short-Run Equilibrium

Short-run market supply and market demand determine the market price and output.

Figure shows a short-run equilibrium.

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Now it’s over for today. Do Now it’s over for today. Do you have any question? you have any question?

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