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Perfect Competition 101

Noa Bendit-Shtull What do the cost curves look like for an individual firm? To draw an individual firm in perfect competition, draw a marginal cost curve (MC), an average total cost curve (ATC), and an average variable cost curve (AVC). The marginal cost curve is decreasing at first because of the benefits of specialization (see Parkin 258). As output continues to increase, MC increases because of the law of diminishing marginal returns. Both the ATC and AVC are decreasing and then increasing. They intersect the MC at their minima. Why is this? Think of grades as an analogy. Your GPA is your average grade (comparable to the ATC or AVC), and the next grade you get is your marginal grade (comparable to MC). If your next grade is higher than your GPAif the marginal is above the averageit will pull the average up. Conversely, if your next grade is lower than your GPAif the marginal is below the averageit will pull your GPA down. Therefore, when MC is above AVC, AVC is increasing. When MC is below AVC, it is decreasing. The same goes for ATC (because the portion of ATC that is related to marginal costs is just the AVC; average fixed costs are not related to MC). Why does the gap between ATC and AVC become narrower as output increases? The gap between ATC and AVC is AFC, average fixed cost (because ATC = AVC + AFC, so ATC AVC = AFC). That gap, AFC, is decreasing because FC is a lump sum that doesnt change with output. As you produce more units, FC remains the same, but AFC gets smaller and smaller, as you spread out the FC over more and more units of output. How does the firm know what quantity to produce? In perfect competition, no individual firm has market power to determine the price. Each firm is a price taker, with the price determined by the market as a whole. To see this visually, draw a graph of the market to the side of a graph of the individual firm. The market graph should show market supply and demand. The quantity produced by the market is denoted by a capital Q to differentiate it from the quantity produced by each firm, q. The intersection of supply and demand determines the market price. Draw a horizontal line at the market price running straight through the graph for the individual firm, illustrating that the price determined by the market is also the price that each individual firm faces. This price curve is also each individual firms marginal revenue (MR) curve, because the marginal revenue that the firm receives from each unit sold is exactly the price they sell it for.

In order to maximize profit, the firm will produce at the quantity where MC intersects MR. Why? The MR curve is constant, and the MC curve is increasing. To the left of the intersection, MR > MC. It makes sense for the firm to produce every single unit for which the marginal revenue is greater than the marginal cost. However, to the right of the intersection, MR < MC. If the revenue of producing an additional unit of output is greater than the marginal cost of producing it, the firm should choose not to produce that unit. Therefore, the firm only produces up to where MC = MR. In the image below, the firm produces at quantity q*.

Note: take care to differentiate between the conditions for profit maximization (MC=MR) and efficiency (MC=MB). How can you tell if a firm is making a profit? The equation for profit is = TR TC. If total revenue is greater than total cost, then profit is positive. If TR = TC then profit is zero and the firm just breaks even. If TC is greater than TR, then profit is negative, so the firm makes a loss. To show this graphically, first identify the areas that correspond to TR and TC, then see if the two squares are the same size, or if one is greater than the other. Ill use the example above. We know that TR = (P)*(q). Total revenue will be a rectangle with the quantity produced as the base and the price per unit as the height. The area shaded in light green is the total revenue.

To find TC, remember that TC = (ATC)*(q). The total cost will be a rectangle with the quantity produced (q*) as the base and ATC as the height. To find ATC, move directly upward at quantity q* until you hit the ATC curve, then trace over to the vertical axis to find the average total cost per unit at the quantity q*. Below, TC is shaded in pink.

Visually, its clear that the TC rectangle is larger than the TR rectangle. Therefore, this firm is incurring a loss. The loss is the area by which TC is greater than TR. The graph below shows both TC and TR, as well as the loss (or negative profit) outlined in a thick purple line.

If the price were higher, the loss would be smaller. The image below shows a scenario where the price set by the market is high enough so that the firm makes a profit. As always, the firm chooses the quantity q* at the point where MC = MR.

Next, TR is shown in green:

TC is shown in pink:

This final graph shows TC and TR together. It is clear that TR is greater than TC. Profit is positive, outline in red.

In equilibrium, firms in a perfectly competition market, TR = TC, so firms make no profit. There is zero profit when the market price is exactly at the minimum of ATC, as shown below.

In the short run, how does a firm decide whether to produce? The short run is defined in Parkin as the time frame in which the quantity of at least one factor of production is fixed (Parkin 252). It takes time to sell your fixed factors of production, like land, factories, or machines. The time frame in which you cant get rid of your fixed inputs is called the short run. In the short run, you can either produce or not produce. If you decide not to produce, your fixed costs are still sunk; youve already paid for your fixed inputs. Assume that if you do choose to produce, youll incur a loss. But if you dont produce, youll also incur a loss; youll lose your fixed costs, since that money is down the drain. Therefore, you need to compare the loss that you would incur if you choose to produce to the total fixed cost.

The image above illustrates a firm producing at q* but making a loss. Should this firm produce or not? We need to compare this loss to the TFC (total fixed cost). TFC = (AFC)*(q), so the area should be a rectangle with a base of q* and a height of AFC. AFC is the distance between ATC and AVC. The next graph shows the TFC shaded in yellow. The height of the box, which is the distance between ATC and AVC, is the AFC. The length of the box is q*. The TFC is greater than the loss shown in the graph above. Therefore, the firm would incur a greater loss if they chose not to produce (and just sat on their factory).

Under what general conditions will the firm decide to produce in the short run, even if they are making a loss? In the short run, if the price is above the minimum of the AVC, then the TFC will be greater than the losses the firm would incur if they chose to produce. Therefore, its better for the firm to produce in the short run. If the price is below the minimum of the AVC, then the TFC will be smaller than the losses from production. Graph both of these scenarios to convince yourself. What about in the long run? In the long run, the firm has the option to sell fixed inputs and leave the market. If a firm sells all of its fixed inputs and leaves the market, its profits are zero. In the short run, we compared the losses the firm would incur if it chose to produce with the which is the loss it would incur if it didnt produce, which is TFC. In the long run, we need to compare the losses the firm would incur if it chose to produce with the loss it would incur if it left the industry entirely, which is zero. Therefore, if a firm is making any loss at all, in the long run it will leave the market.