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Week 5-1

Perfect Competition in the


Short Run

McGraw-Hill/Irwin

Copyright 2012 by The McGraw-Hill Companies, Inc. All rights reserved.

Objectives
After studying this chapter, you will able to
Define perfect competition
Explain characteristic of perfect competition
Explain how price and output are determined
in perfect competition
Profit Maximization in the short run
Explain why perfect competition is efficient

Four Market Models

Perfect competition
monopoly
Monopolistic competition
Oligopoly
Perfect
Competition

Monopolistic
Competition

Oligopoly

Monopoly

Market Structure Continuum


LO1

Four Market Models


Characteristics of the Four Basic Market Models
Perfect
Characteristic Competition

Monopolistic
Competition

Oligopoly

Monopoly

Number of firms

A very large
number

Many

Few

One

Type of product

Standardized

Differentiated

Standardized or
differentiated

Unique; no
close subs.

Control over
price

None

Some, but within rather


narrow limits

Limited by mutual
inter-dependence;
considerable with
collusion

Considerable

Conditions of
entry

Very easy, no
restriction

Relatively easy

Significant
obstacles

Blocked

Nonprice
Competition

None

Considerable emphasis
on advertising, brand
names, trademarks

Typically a great
deal, particularly
with product
differentiation

Mostly public
relation
advertising

Examples

Agriculture

Retail trade, dresses,


shoes

Steel, auto

Local utilities

LO1

Competition and the Market


Structure

Price Control and the Market


Structure
Least control over price

Most control over price

Characteristics of Market Structures

Very
Many

Agric. products
Fishery

Some

Fair
Amount

Extensive
Fair amount

with
differentiated

Extensive

oligopolies

Cable TV
Water

Characteristics #1

Very large numbers of buyers and


sellers (firms)
How many?
Number must be so large that no
individual decision maker can
significantly affect price of the product
by changing quantity it buys or sells
Each buys or sells only a tiny fraction of
the total quantity in the market
LO2

Characteristics #2

Firms have no market power


and are price takers
Each firm supplies a small
amount of the overall market
supply
Firms cannot influence the market
price by altering its output.
Only able to sell their good at the
price determined in the market
LO2

Characteristics #3

Standardized product

a product for which all other

products in the market are


identical and thus are perfect
substitutes.
The consequence of this is that
buyers are indifferent as to whom
they buy from.
Buyers do not perceive significant
differences between products of one seller
and another
For instance, buyers of wheat do not prefer one
farmers wheat over another
LO2

Characteristics #4

Easy (No Barriers) to entry or exit from


the market

LO2

there are no obstacles/restriction to entry or to exit the


industry.
Entry into a market is rarely freea new seller must always
incur some costs to set up shop, begin production, and establish
contacts with customers
But perfectly competitive market has no significant barriers to
discourage new entrants
Any firm wishing to enter can do business on the same terms
as firms that are already there
In many markets there are significant barriers to entry
Legal barriers
Existing sellers have an important advantage that new
entrants can not duplicate
Brand loyalty enjoyed by existing producers would
require a new entrant to wrest customers away from
existing firms
Significant economies of scale may give existing firms a cost
advantage over new entrants

Characteristics #5

Output is homogenous
Product is identical to that produced
by other firms
Goods produced in the perfectly
competitive market are the same.
This means that the goods produced
among the firms is replaceable (from
the aspect of price, quality of goods
and shape).
LO2

Characteristics #6

Resources are perfectly mobile

LO2

Characteristics #7

Buyers and firms have perfect


knowledge of the market
Economic agents (buyers and sellers)
have perfect knowledge about market
situations such as price, quality of the
goods and so on.

LO2

Characteristics #8
Perfectly elastic demand

LO2

Firm has no power to influence price


the firm merely chooses to produce a
certain level of output at the price that
is given.
The demand curve is not perfectly
elastic for the industry; it only appears
that way to the individual firm, since
they must take the market price no
matter what quantity they produce.
The firm faces a perfectly elastic
demand because each individual firm
makes up such a small part of the total

Characteristics #9

This perfectly elastic


demand curve is a
horizontal line at the price.

LO2

Perfect Competition
Deriving the demand curve
1. The intersection of the market supply
and the market demand curve
Price per
Ounce

Market

3. The typical firm can sell all it


wants at the market price

Price per
Ounce

$400

$400
D

Ounces of Gold per Day


2. determine the equilibrium
market price

Firm

Demand
Curve Facing
the Firm

Ounces of Gold per Day


4. so it faces a horizontal
demand curve

Because the perfectly competitive firm is a price-taker it faces a horizontal


demand curve. The price is determined by demand and supply in the market.

Average, Total, and Marginal


Revenue
Average Revenue
Revenue per unit
AR = TR/Q = P
Total Revenue
TR = P X Q
Marginal Revenue
Extra revenue from 1 more unit
MR = TR/Q
LO3

Average, Total, and Marginal


Revenue
Firms
Demand
Schedule
(Average
Revenue)

QD

Firms
Revenue
Data

TR

MR

0 $131
$0
] $131
1 131 131
] 131
2 131 262
] 131
3 131 393
] 131
4 131 524
] 131
5 131 655
] 131
6 131 786
] 131
7 131 917
] 131
8 131 1048
131
9 131 1179 ]
131
10 131 1310 ]

LO3

TR

D = MR = AR

Profit Maximization: TR-TC


Approach

Three questions:
Should the firm produce?
If so, what amount?
What economic profit (loss) will be
realized?

LO3

Profit Maximization: TR-TC


Approach

The Profit-Maximizing Output for a Purely Competitive Firm: Total Revenue


Total Cost Approach (Price = $131)
(1)
Total Product
(Output) (Q)

(2)
Total Fixed Cost
(TFC)

(3)
Total Variable
Costs (TVC)

(4)
Total Cost
(TC)

(5)
Total Revenue
(TR)

(6)
Profit (+)
or Loss (-)

$100

$0

$100

$0

$-100

100

90

190

131

-59

100

170

270

262

-8

100

240

340

393

+53

100

300

400

524

+124

100

370

470

655

+185

100

450

550

786

+236

100

540

640

917

+277

100

650

750

1048

+298

100

780

880

1179

+299

10

100

930

1030

1310

+280

LO3

Profit Maximization: TRTC


Approach

Total Economic
Profit

Total Revenue and Total Cost

$1800
1700
1600
1500
1400
1300
1200
1100
1000
900
800
700
600
500
400
300
200
100

LO3

$500
400
300
200
100

Break-Even Point
(Normal Profit)
Total Revenue, (TR)
Maximum
Economic
Profit
$299

Total Cost,
(TC)

P=$131
Break-Even Point
(Normal Profit)
0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity Demanded (Sold)

Total Economic
Profit

$299

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14
Quantity Demanded (Sold)

Profit Maximization: MR-MC


Approach

The Profit-Maximizing Output for a Purely Competitive Firm: Marginal


Revenue Marginal Cost Approach (Price = $131)

(1)
Total
Product
(Output)

(2)
Average
Fixed Cost
(AFC) =
TFC/Q

(3)
Average
Variable
Costs
(AVC)=
TVC/Q

(4)
Average
Total Cost
(ATC)= TC/Q

(5)
Marginal
Cost
(MC)=
TC/Q

(5)
Price =
Marginal
Revenue
(MR) =
TR/Q

LO3

(6)
Total
Economic
Profit (+)
or Loss (-)
$-100

$100.00

$90.00

$190

$90

$131

-59

50.00

85.00

135

80

131

-8

33.33

80.00

113.33

70

131

+53

25.00

75.00

100.00

60

131

+124

20.00

74.00

94.00

70

131

+185

16.67

75.00

91.67

80

131

+236

14.29

77.14

91.43

90

131

+277

12.50

81.25

93.75

110

131

+298

11.11

86.67

97.78

130

131

+299

10

10.00

93.00

103.00

150

131

+280

Profit Maximization: MR-MC


Approach

Cost and Revenue

$200

MR = MC

150
P=$131

MC
MR = P
ATC

Economic Profit

100

AVC
A=$97.78

50

LO3

Output

10

Loss-Minimizing Case

Loss minimization
Still produce because P > minAVC
Losses at a minimum where
MR=MC

LO3

Loss-Minimizing Case

Cost and Revenue

$200

Loss

A=$91.67

ATC
AVC

100
P=$81

50

LO3

MC

150

MR = P
V = $75

Output

10

Shutdown Case
(2)
Average
Fixed
Cost
(AFC) =
TFC/Q

(3)
Average
Variable
Costs
(AVC)=
TVC/Q

$100.00

$90.00

50.00

85.00

33.33

80.00

25.00

75.00

20.00

74.00

16.67

75.00

14.29

77.14

12.50

81.25

11.11

86.67

10

10.00

93.00

(1)
Total
Product
(Output
)
0

LO3

Marginal Cost and Short-Run


Supply
The Supply Schedule of a Competitive Firm Confronted with the Cost
Data in the table in Figure 11.3

LO4

Price

Quantity
Supplied

Maximum Profit (+)


Minimum Loss (-)

$151

10

$+480

131

+299

111

+138

91

-3

81

-64

71

-100

61

-100

Cost and Revenues (Dollars)

Marginal Cost and Short-Run


Supply

P5

P4
P3
P2
P1

AVC

Q4

Quantity Supplied

LO4

MR4

MR3
MR2
MR1

Q3

MR5
ATC

Q2

MC

Q5

Cost and Revenues (Dollars)

Marginal Cost and Short-Run


Supply

S
e

P5

P4
P3
P2
P1

MR5
ATC

AVC

Q2

MR4

MR3
MR2
MR1

Shut-Down Point
(If P is Below)
0

Q3

Q4

Quantity Supplied

LO4

MC

Q5

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