Theory of Perfect Competition

• Characteristics:
– – – – Many sellers/buyers Firms sell identical product (perfect substitutes) Perfect information for buying/selling decisions No Barriers to Entry/Exit of firms

then looks at firm behavior in comp. profit (objective) – Must understand MB & MC to producing – Last chapter: About costs of producing – This chapter: Introduce MB (revenue).Digression: Recall Rational (maximizing) Decision-Making Rule – Take action up to Marginal Benefit (MB) = MC – Firm chooses output (action) to max. markets .

Competitive Firms are “Price Takers” • Change price/output. no impact on market • “Sees” perfectly elastic demand for its good at market price. Why? • Implications: – Firms can sell all they desire at market price – Price increase--Buyers substitute to other sellers – Price decrease--Firm loses profits .

– So firm’s MR = demand for its product = Market Price Price Quantity Total Revenue (P) x (Q) 1 $5 2 10 3 15 Marginal Revenue (DTR) / (DQ) $5 5 5 $5 5 5 . decides how much to sell.Firm’s Demand = Marginal Revenue (MR) – MR = extra revenue of selling another unit = (DTR) / (DQ) – Firm “takes” price.

Firm’s demand = MR = Market Price $ $ TYPICAL FIRM (sees perfectly elastic demand for its product) MARKET S 5 P=5 d = MR D q Market Q Q .

not all units) • Why not stop producing where MR > MC? – Profits maximized by producing up to: MR ( = P) = MC .Perfect Competition (Short Run) • Firm’s Profit Maximizing Output – Produce as long as MR > MC • Firm earns marginal profit (on last unit.

Graph: Firm’s Profit-Maximizing Output $ Marginal Cost •If MR > MC. profit of 70th is $3 5 •qMax maximizes profits: P = MR = MC d = MR •Never produce over qMax 3 2 70 71 qMax q . increase profit with more output •Marg.

Graphing Firm’s Profits (example) Profits = Revenue .10) x (100) = 500 $ Profits (shaded area) MC ATC 15 10 d = MR qMax = 100 q .ATC) x (q) = (15 .Total Cost = (P .

800 = -80 $ Losses (shaded area) MC ATC 10 9 d = MR 80 q .Total Cost = 720 .Graphing Firm’s Losses Losses = Total Revenue .

A Word on Market Supply Curve • Firm's MC as its Supply Curve • Market Supply = Horizontal sum of firms’ short-run supply (MC) curves • Why Market Supply Curve Slopes Up? .

Perfect Competition (Long Run) • Firms Enter/Exit Industry (Inputs Variable) • Long-Run Equilibrium Conditions: – Firms max profits producing at P (=MR) = MC – Zero Econ Profit: P = ATC • No incentive for firms enter/exit industry. Why not? • No incentive to change plant size – Firms Produce at Minimum ATC .

Long Run Competitive Equilibrium P = MC = Minimum ATC $ TYPICAL FIRM MC ATC $ MARKET S P1 d = MR P1 D q1 Q1 Q .

short-run profits attract firms. New firms increase market supply. Price rises Raises firm’s demand/MR Firm raises output (new P = MR = MC) P > ATC.Industry Adjustment to Increase Demand – – – – – – – – – Market Demand rises. reducing P This lowers firm’s demand/MR Firms enter & P falls until 0 econ profit earned Long-run equilibrium achieved Firms profit-seeking drives adjustment process .

Long Run Adjustment Process (Increased Market Demand) $ $ TYPICAL FIRM MC MARKET D1 D2 S1 P2 a d2 = MR2 P2 P1 A ATC d1 = MR1. P1 S2 q1 q2 Q . d3 = MR3.

Questions • • • • Do higher costs to firm mean higher prices? Do competitive firms advertise? Does competitive industry advertise? Does single industry price mean collusion or competition? .

Efficiency Criterion & Perfectly Competitive Markets • (1) Resource Allocative Efficiency Explained – Any firm produces at MR = MC – Since MR = P for competitive firm. then P = MC – Meaning: Marginal Benefit (demanders) = Marginal Cost (suppliers of using society’s resources) – Society’s marginal value of resources = its opportunity costs of using resources – Allocative Efficiency satisfied .

Competitive Markets and Allocative Efficiency • Consumer Surplus = area ABPE • Supplier Surplus = area CBPE • Market Surplus = area ABC • Competitive Equilibrium maximizes market surplus • What about Q1? A g d MARKET S PE B f C e Q1 QE D Q .

) • (2) Productive Efficiency – Firms produce at Minimum ATC in long-run – Firms economizing on resource use – If not.Efficiency Criterion & Perfectly Competitive Markets (cont. competing firm would undercut it’s price and capture extra profits .

Final Thoughts • Competition Provides Incentives to: – Profit Maximize – Minimize costs – Innovate .

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