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ECON:3350:INDUSTRY ANALYSIS: BROOK

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Chapter

Competitive Firm and Market
Behavior
Perfect Competition
Perfectly competitive market structure contains the following characteristics. First, many
firms exist in the market, with no firm being able to influence the industry price. Another
way to think about this is that economies of scale are small relative to the size of the
market. Consequently, the size of the market is large with each consumer demanding a small
percentage of total demand. Second, the perfectly competitive industry produces a
homogenous or standardized product. The interpretation of homogeneous output is that
consumers cannot distinguish between products produced by different firms. Third, the
perfectly competitive market has complete information, so all firms are fully informed about
production techniques, and consumers are fully aware of substitutes. As a corollary to this
characteristic, I will state that each firm has identical production costs. This just makes some
of the analysis easier, although the results are basically the same, even if each firms cost are
different. Fourth, the market contains no barriers to entry or barriers to exit.
As a result of the first three characteristics, firms in a perfectly competitive market act or
behave as price-takers. What this means is that firm believe that no matter how much they
sell or buy, they do so without affecting the market price.
Can you think of an example of a market that exhibit the four characteristics listed out
above? Let me know what you have come up with: stacey-brook@uiowa.edu. I will give
you a few suggestions later, but I want you to think about this. Let's see what we come up
with, and see if the suggestions meet all of the perfectly competitive characteristics.
Benefits of the Perfectly Competitive Model
Given the few examples of perfectly competitive markets, why spend any time at all on this
type of market structure? Good question. The answer lies in that perfect competition is the
easiest of the market structure models to start out with. In perfect competition, we can look
at the principles and ideas that cover most aspects of market structure, without adding too
much initial complexity. Then we will determine how much output the firm produces,

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In other words. "No offense Dr. we will start with the competitive model first. (reading from left to right). and then friction is added. Why not? Well a downward-sloping curve. With that in mind. as starting in physics with the analysis of a world with no friction. So downward-sloping from left to right is eliminated. and was equal to average revenue. we said that perfectly competitive firms act as price takers. About now you might be thinking. Why? Well let's think about it. For our analysis. If the firm behaves as selling the output for the same price. Demand as faced by the Perfectly Competitive Firm In the characteristics given above. with price (P) on the vertical axis and quantity (Q) on the horizontal axis? Would it be downward-sloping? No. the firm has no ability to charge a price other than the current market price. In the same way. or the demand curve as faced by the perfectly competitive firm is perfectly elastic. to make the model much more representative to the world in which we live in. then charting this out results in the following hypothetical table: Price (P) Quantity (Q) $10 0 $10 1 $10 2 $10 3 $10 4 Thus on a graph. refers to a relationship between price and quantity that is negatively related. or perfectly elastic. regardless of how much the firm sells. and therefore we concluded that the demand curve was equal to price. But starting from this point. parallel to the horizontal axis. But our characteristic of the perfectly competitive market says that price is the same from the viewpoint of the perfectly competitive firm no matter how much output the firm produces. reading from left to right. and equal to marginal revenue. The demand curve as faced by the perfectly competitive firm is a relationship between the amount of output that is demanded by consumers (Q). Brook. with price (P) on the vertical axis and quantity (Q) on the horizontal axis. what do you think the demand curve as faced by the perfectly competitive firm would look like on a graph. much of the principle ideas in physics are easier to see. I like to liken starting with the competitive model in economics. and then add some friction (price setting) behavior to make our market models more realistic. Do we exist in a world with no friction? No. no matter what amount of output it produces. and the price that it sells the output (P). 2 .ECON:3350:INDUSTRY ANALYSIS: BROOK whether the firm should produce that amount of output and whether the firm makes a profit or a loss. the demand curve as faced by a perfectly competitive firm is horizontal. demand curves are not upward-sloping. The demand curve as faced by a perfectly competitive firm is perfectly elastic. the demand curve as faced by the perfectly competitive firm is horizontal. On a graph.

knowing that the firm must equate its MR and its MC to maximize its profits we can start answering each of the four questions above. How much should the firm produce in order to maximize profits? (i. So with these definitions in hand. that price and marginal revenue are the same. let's try an example to work us through the story of why price = average revenue = marginal revenue in the perfectly competitive market. let's suppose that the perfectly competitive price is $10. or did the firm break-even? The good news is that we will have simple rules to determine the answers to these questions.ECON:3350:INDUSTRY ANALYSIS: BROOK but I do not believe you. and let's calculate Total Revenue. I can substitute 3 . Did the firm make a profit or a loss. Average Revenue. Since profit maximization is where MR = MC. so TR = P*Q. such as the perfectly competitive model. or MR = TR / Q.e. Price (P) $10 $10 $10 $10 $10 Quantity (Q) 0 1 2 3 4 Total (TR) Revenue Average (AR) $0 $10 $20 $30 $40 Revenue Marginal (MR) $10 $10 $10 $10 $10 Revenue ----$10 $10 $10 $10 The relationship of price equaling marginal revenue is very helpful. Thus P = MR. let's just think of the additional output as equal to 1." What? OK. but only occurs in models that uses price taking behavior. we are trying to figure out Q*) 2. Finally marginal revenue (MR) is the additional revenue from producing additional output. Average revenue (AR) is then total revenue divided by quantity. or AR = TR / Q.e. Should the firm produce Q* or should the firm shut down? 4. so that marginal revenue is just the change in total revenue. What is the profit-maximizing price? (i. For this class. Short-Run Profit Maximization or Loss Minimization Now. Solving for the profit maximizing level of output (Q*) Question #1 I just showed you that for the perfectly competitive firm. and Marginal Revenue. we are trying to figure out P*) 3. The Four Key Questions The key questions are: 1. Total revenue (TR) is defined as the amount you sell (Q) times the price at which you sell it (P).

P* is where the perfectly elastic demand curve crosses the vertical axis. so multiplying ATC by Q yields TC. and draw a dashed line directly down to the horizontal axis. in fact we have one unique Q. Since. which is denoted as Q*. I do this for a reason. So armed with our perfectly competitive firm information we can run through three (3) scenarios. I skipped question #3. or I will just type it out as P = MC. which leaves us with  = [P . actually. but in perfect competition. The profit maximizing price is the market given price. which is what we started with. thus if P > ATC.TC. ATC. yes!. Now we have an equation that we can use. if P = ATC then firm is making zero profit. if P < ATC then firm is making a loss. which we solved for in question #1. yes! once we draw the curve on the graph of the form talked about in the last chapter and Q. Q* cannot be negative). that the firm cannot produce a negative output (i. As an equation.ATC] * Q. P* is given.  = [P * Q] . This is the profit maximizing level of output. the firm is making zero economic profits. this is easy.[ATC * Q].[ATC * Q]. Notice. and ATC = TC / Q. I am just too impatient and cannot wait to find out whether this firm is making a profit or a loss. the profit maximizing level of output (Q*) is the point where price and marginal cost cross each other. In the perfectly competitive case. which may or may not be apparent when we get to the third question. yes! (it is the demand curve). On a graph. In summary the rule in regard to profit is: if P > ATC then firm is making a profit.ECON:3350:INDUSTRY ANALYSIS: BROOK price for marginal revenue (MR) in the previous equation to end up with P = MC. Neat eh? Our rule to determine Q* is.  = TR . since total revenue = P * Q. the demand curve as faced by a perfectly competitive firm as perfectly elastic (horizontal). is the difference between total revenue (TR) and total cost (TC). (accounting profit = opportunity cost). They are: firm makes a profit. and if P = ATC. since all of the information in the profit equation in bold. Find the point on your graph. is found on our graph. we can factor out a Q from the right hand side of the equation. which I denote as . We can also write this equation as:  = [P * Q] . with price (P) on the vertical axis and quantity (Q) on the horizontal axis. On a graph. firm makes a loss. This is referred to as marginal cost pricing. Let's check: P. 4 . Profits. Thus our rule to determine if the firm is making a profit is to compare price and ATC. the demand curve as faced by a perfectly competitive firm is perfectly elastic (horizontal) and the marginal cost shaped as discussed in chapter one. with price (P) on the vertical axis and quantity (Q) on the horizontal axis. the firm is making an economic profit.e. Solving for the profit maximizing price (P*) (Question #2) OK. No. For later market structures. if P < ATC. in perfect competition: Set price equal to marginal cost. and the firm makes zero economic profit. we will have to solve for P*. Solving for the profit/loss (Question #4) I know. the firm is making a loss.

If the firms per unit total costs (ATC) are always greater than price. and the ATC curve is U shaped. Suppose that the firm knows that if it produces. with price (P) on the vertical axis and quantity (Q) on the horizontal axis. our equation for profit is  = [P . and since the minimum of the ATC is "resting" on the demand curve. so the term in brackets is average profit. The loss by the firm will look on a graph as the distance between ATC(Q*) and price. with price (P) on the vertical axis and quantity (Q) on the horizontal axis. which is negative. So at Q* (where P = MC). and only for perfect competition. it will incur a loss. Since P = ATC. the demand curve as faced by a perfectly competitive firm is perfectly elastic (horizontal). assuming it is maximizing its profits. the marginal cost curve is shaped like a check-mark. which would read in words. times the amount demanded (Q*). times the amount produced (Q*). let's look at the perfectly competitive firm making a loss. the marginal cost curve is shaped like a check-mark. then the firm is making an economic profit. In order for the firm to make a profit. To draw the firm making a loss. price must be greater than ATC(Q*). On a graph. How? I knew you would want to know. then at the profit maximizing level of output. at the profitmaximizing level of output (Q*) that we solved for in Question #1. if the ATC curve is below the demand curve. Thus the firm is making a profit. The next two will not be as trivial. On your graph.ATC] * Q. then the firm will make a profit. We again have three scenarios. economic profits must be equal to zero. Q = 0) if it will make a loss? Well since we still have two scenarios. the demand curve as faced by a perfectly competitive firm is perfectly elastic (horizontal). Should a firm always shut-down (i. All of the cost curves are in reference to the level of output at Q*!! So. The first scenario is quite simple to analyze. and the ATC curve is U-shaped. It is again a rectangle solved exactly like at the end of the previous paragraph. the demand curve as faced by a perfectly competitive firm would make zero economic profits if at its profit maximizing level of output (Q*) the price set in the market is just equal to the firms ATC. the ATC curve must be above the demand curve at every point. price also equals the minimum of ATC. the average total cost of producing the profit maximizing level of output. Remember that the marginal cost curve crosses the minimum of the ATC. then the firm will be spending more to produce the product than it will receive in selling the product. This would happen if the ATC just rested on the demand curve. with price (P) on the vertical axis and quantity (Q) on the horizontal axis. Our last scenario is the firm making zero economic profit. ATC(Q*) is less than P*. If P > ATC. (Think of it as a bowl placed on a flat surface). An easy way to remember this on a graph for perfect competition. is if the ATC curve is below the demand curve at any point. This is where the MC curve crosses the demand or price line. Solving for shut-down case (Question #3) OK. On a graph. the 5 . so the firm should produce Q*. Now let's look at whether the firm should produce Q* or whether the firm should shut-down. the first thing (always) that you solve for is Q*.ECON:3350:INDUSTRY ANALYSIS: BROOK Let's start out with the firm making a profit. and remember that the marginal cost curve crosses the minimum of the ATC curve. On a graph. it is equal to the demand curve. Next. How much? Well.ATC] on the graph.e. Thus profit is equal to the rectangle of length (Q*) times the height [P .

It is the rectangle of length Q*. Thus the AFC and therefore the total fixed cost are greater than the average loss and therefore the total loss to the firm. even though it is making a loss. If by producing the firm loses less money than by shutting down. and below the ATC curve. P > AVC. we need to compare the loss of producing with the loss of not producing. the marginal cost curve is shaped like a check-mark. because its loss of producing is less than its loss of not producing. with price (P) on the vertical axis and quantity (Q) on the horizontal axis.ATC(Q*)]. since AFC is the difference between the ATC curve and the AVC curve. and remember that the marginal cost curve crosses the minimum of the ATC curve. Remember that ATC = AVC + AFC (average fixed cost).yes. Thus the firm loses less money by producing than by shutting down. But we can figure it out. Scenario 3 is when the AVC curve is above the demand curve at every point. since the firm cannot cover their per unit production costs (i. and the ATC curve is Ushaped. the firm should produce.e. You could interpret that as that AFC is less than the average loss of producing. OK. fixed cost and variable cost? Great! The underlying idea if that a firm should continue to produce its output if the firm losses are less than its total fixed costs. then the firm should produce. Our next two scenarios can be referred to as loss minimizing scenarios. So the vertical difference between the ATC and AVC curve is the AFC. At Q*. So what is the dividing line to determine whether the firm shuts down or produces? Remember that a firms total cost is divided up into two main components. the demand curve as faced by a perfectly competitive firm is perfectly elastic (horizontal). is the vertical distance between ATC and AVC greater than the vertical distance between ATC and Price. and Multiplying [P ATC(Q*)] by Q* equals the loss of producing. For this to be true. The loss of not producing is just the firm’s total fixed costs. and this will be a negative number. the AVC curve which is also U shaped. Unfortunately we do not have total fixed costs on our graph. Why? First let's calculate the firm's loss of producing Q*. When the AVC curve is above the demand 6 . This is the way we will look at the firm. the firm is making a loss of the rectangle [P . the firm should shut down. the firm is covering its variable costs of production. Under this scenario . But in order to determine with confidence why the firm should still produce. In other words. Why? If the AVC curve is below the demand curve.ATC] *Q. then at AVC(Q*). and some of its fixed costs. How do you show that on a graph? Well first solve for the profit maximizing level of output (Q*). Multiplying AFC by Q* equals Total Fixed Costs. Another way of thinking about this is if the firm can make enough in total revenue to cover its production costs. notice on the graph that the distance between ATC and AVC is less than the distance between ATC and P. the ATC curve is always above the demand curve! Scenario 2 is when the AVC curve is below the demand curve at any point. P < AVC). and now finally. by producing if the firm can cover its per unit production costs (AVC) then the firm should produce. Under these two scenarios that follow. even if it is going to make a loss. and height [P . If the AVC curve is above the demand curve. On a graph. If the AVC curve is below the demand curve. At Q*.ECON:3350:INDUSTRY ANALYSIS: BROOK answer must me no! In fact there are times when it is rational for a firm which forecasts a loss to continue its operations in the short-run.

the firm incurs a greater loss by producing than by shutting down.e. and the math rules in order to come up with a solution for the four questions listed out above. 2. In summary: If P ≥ AVC. firm earns zero economic profit (break-even) if P = ATC. if P > AVC. What is the profit-maximizing price? will have to solve for this in the future. 1. what is the answer to each of the four questions above? I will give the solution to the above problem in class. but I want you to use the material in this chapter. 4. and the price = $20. (i. produce Q*. 7 . Thus if P < AVC. We 3. I think this summary will be very helpful. Key Questions and Solutions Let's put our rules developed so far together with the four questions listed out above. shut-down. Should the firm produce Q* or should the firm shut down? Yes. How much should the firm produce in order to maximize profits? (i. No. we are trying to figure out Q*) Rule: Set Price = Marginal Cost (only in perfect competition. firm makes an economic loss if P < ATC. especially with the monopoly market structure to follow. if P < AVC. we are trying to figure out P*) Given. and if P < AVC. Numerical Example Suppose you were given the following information: the firms cost equation is C(Q) = 5 + Q2. Did the firm make an economic profit or a loss.ECON:3350:INDUSTRY ANALYSIS: BROOK curve at every point. otherwise set marginal revenue = marginal cost).e. or did the firm break-even? Firm makes an economic profit if P > ATC. we conclude that the firm should rationally shut-down.