ECON2011- CHAPTER 8

Monday, 13 May, 2019 8:41 PM

Competitive Markets (Perfect Competition)

General aim of a firm: Firms minimize costs at every level of production or always choose to maximise profit. Quantity and price
depends on the market structure.

General characteristics of PC firms:

1. High number of firms
2. Homogenous products
3. Low/no barriers to entry or exit
4. Firms are price takers and they have no influence on the market prices

Summary of the four different types of market structure

Perfect competition is assumed to be the most efficient market structure from a welfare perspective.
Consumer surplus is maximised and firms produce at the lowest possible cost.

The demand curve under a PC firm is always horizontal because no matter the quantity produced, the price is still the same (s ince it
takes the market equilibrium price)

Profit Maximization under PC firms:

Interchanging market demand curve and firm's demand curve

A firm that wants to maximize profit will choose the output level at which the gap between its total revenue and its total co st is
largest.

Profit : Total Revenue - Total Cost

Find output that maximizes profit = set the derivative of profit = 0

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To find output that maximized profit

Marginal revenue: Additional revenue from selling one additional unit of output.

Deriving for marginal revenue

Marginal Revenue under Perfect competition: just market price in PC firm ( P = MR )

A PC firm maximized profit at the point where MC=MR (P). Because a firm in PC faces a constant market price, the total revenue
curve is a straight line from the origin with a slope equal to the marginal revenue, or the price. At the quantity Q*, the sl ope of the
total revenue curve (MR) equals the slope of the total cost curve (MC).

Showing the point where profit is maximized.

If MC < P , profit could be increased by producing additional units.

If MC > P, profit could be increased by reducing production because additional units will cost more to produce than you are selling
for.

*All based on the assumption that the marginal cost curve approaches the marginal revenue curve from below and that MC is ris ing
when output increases. There may be cases where the MC is actually falling where the

MC and MR in a PC firm

Profit: TR - TC

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Profit: TR - TC

a) Supernormal profit b) Normal profit c) Subnormal profit

Shut Down Conditions:

In short-run TR < VC or P < AVC (despite net profit is negative) which also means you can continue to operate as long as you can
cover your variable costs

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Decide whether to operate at a loss or shut down in the SR

*only the portion of the SRMC above the AVC will be the firm's supply curve because the firm won't produce and will shut down
if P < AVC. Below AVC the firm will shut down and supply of the firm is zero

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PC Firm's Short Run Supply Curve

Market Supply = horizontal sum of all individual firms' supply curves.

Industry/Market Supply curve when firms have the same costs

Industry/Market Supply Curve when firms have different costs (Just remember to find the min price at which each firms are wil ling to produce separately)

Producer Surplus in PC firms

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Producer Surplus for a Competitive Market/Industry

Long-run conditions:
Due to the free entry and exit in a PC market, firms will only be able to earn a normal profit in the long -run. This is because, when
firms in a certain industry are earning positive economic profit (supernormal profit), new firms will enter, shifting the sho rt-run
industry supply curve out, lowering the market price. Same works for the case where firms are sub -normal profit, firms will leave,
shifting the industry supply curve in, pushing up the market price.

*Long-run supply curve of market is a perfectly horizontal line.

Positive Long-Run Profit

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Deriving Long-Run supply curve

Long-run adjustments to increase in demand in a PC market

Long-run adjustments to a reduction in costs in a PC market

All long-run explanations above are based on the assumptions that the industry is facing constant cost. If the industry is facing
increasing cost as output increases, then the long run industry supply curve will be slightly upward sloping but not as steep as the
SR supply curve. If the industry is facing decreasing cost as output increases, the curve will be downward sloping instead.

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Firms with different long-run marginal costs

Economic Profit IS NOT Economic Rent

While a PC firm earns zero economic profits in the LR, it can still earn positive economic rents. A firm earns positive rents when it
costs are lower relative to those of other firms in the industry. In a PC market consisting of firms with different LRAC, the LR market
price equals the minimum average total cost of the highest cost firm in the industry. The highest cost firm makes zero profit and
zero producer surplus.

Market equilibrium (Qe) -> Qs = Qd

Equilibrium price (Pe)

Equilibrium price is the only price that can "clear" the market. Any changes in price will cause a shortage or surplus.
If P > Pe, there will be surplus, in order to sell off the products, this pushes the price downwards towards the equilibrium as Qd
increases and Qs decreases.

Graphical Explanation of excess supply

If P < Pe, there will be a shortage, which will induce buyers to bid up the price, quantity demanded will fall and supplied w ill rise
until the market reaches equilibrium at a higher price.

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Graphical explanation of excess demand

Relationship between market and firm demand in PC

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