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Microeconomics Chapter 8: Perfect Competition

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AN INTRODUCTION TO PERFECT COMPETITION
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a) Market Structure = important features of a market, such as the number of firms, product uniformity across firms, firm’s ease of entry and exit, and forms of competition – number of suppliers (many or few?) – product’s degree of uniformity (do firms supply identical products, or are there differences across firms?) – firm’s ease of entry and exit (can firms come and go easily or are entry and exit blocked?) – forms of competition (compete based on price? advertising? product differences?) b) INDUSTRY = consists of all firms that supply output to a particular MARKET *a firm’s decisions about how much to produce or what price to charge depend on the structure of the market 1) Perfectly Competitive Market Structure 2) Demand Under Perfect Competition
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1) Perfectly Competitive Market Structure
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a) Perfect Competition = a market structure with many fully informed buyers and sellers of a standardized product and no obstacles to entry or exit of firms in the long run b) Firms Sell a Commodity = a standardized product, a product that does not differ across producers, such as a bushel of wheat or an ounce of gold c) buyers and sellers are fully informed about the price and availability of all resources and products d) firms and resources are freely mobile (over time they can easily enter or leave the industry without facing obstacles like patents, licenses, and high capital costs) *a perfectly competitive firm is so small relative to the market that the firm’s supply decision does not affect the market price
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2) Demand Under Perfect Competition
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– each farm is so small relative to the market that each as no impact on the market price – once the market determines the price, any farmer can sell all he or she wants to at that market price – the demand curve facing an individual farmer is a horizontal line drawn at the market price (perfectly elastic) a) Price Taker = a firm that faces a given market price and whose quantity supplied has no effect on that price; a perfectly competitive firm that decides to produce must accept, or “take,” the market price – in a perfect competition, there is no competition
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SHORT RUN PROFIT MAXIMIZATION
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a) Economic Profit = Total Revenue – Total Cost (including both explicit and implicit costs) – each firm tries to maximize economic profit – economic profit is any profit above normal profit 1) Total Revenue Minus Total Cost 2) Marginal Revenue Equals Marginal Cost 3) Economic Profit in the Short Run
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1) Total Revenue Minus Total Cost
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the firm maximizes economic profit by finding the quantity at which total revenue exceeds total cost by the greatest amount – profit is maximized at the rate of output where total revenue exceeds total cost by the greatest amount
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2) Marginal Revenue Equals Marginal Cost
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a) Marginal Revenue (MR) = the firm’s change in total revenue from selling an additional unit; a perfectly competitive firm’s marginal revenue is also the market price – in perfect competition, marginal revenue is the market price b) Marginal Cost = change in total cost from producing another unit of output – marginal cost first declines, reflecting increasing marginal returns in the short run as more of the variable resource is employed, then marginal cost increases, reflecting diminishing marginal returns from adding more of the variable resource – the firm increases production as long as each additional unit of output adds more to total revenue than to total cost (that is, as long as marginal revenue exceeds marginal cost) b) Golden Rule of Profit Maximization = to maximize profit or minimize loss, a firm should produce the quantity at which marginal revenue equals marginal cost; this rule holds for all market structures
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3) Economic Profit in the Short Run
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a) Average Revenue (AR) = total revenue divided by quantity or AR = TR/Q – in all market structures: Market Price = Marginal Revenue = Average Revenue – at lower rates of output, marginal revenue exceeds marginal cost, so the firm could increase profit by expanding output – at higher rates of output, marginal cost exceeds marginal revenue, so the farm could increase profit by reducing output – total cost and total revenue curves measure economic profit by the vertical distance between the two curves
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MINIMIZING SHORT-RUN LOSSES
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the short run is a period too short to allow existing firms to leave the industry 1) Fixed Cost and Minimizing Losses 2) Marginal Revenue Equals Marginal Cost 3) Shutting Down in the Short Run
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1) Fixed Cost and Minimizing Losses
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firms face two types of costs in the short run: 1) fixed cost (property taxes and fire insurance) 2) variable cost (labor) – a firm produces rather than shuts down if total revenue exceeds the variable cost of production (excess covers at least a portion of fixed cost)
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2) Marginal Revenue Equals Marginal Cost
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the bottom line is that the firm produces rather than shuts down if there is some rate of output where the price at least covers average variable cost
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3) Shutting Down in the Short Run
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if total revenue exceeds variable costs, the farm produces in the short run – if average variable cost exceeds the price at all rates of output, the firm shuts down (because they’ll lose just fixed cost rather than lose both fixed cost plus some variable cost) – a firm that shuts down does not escape fixed cost; when demand picks up again, production resumes – fixed cost is sunk cost in the short run, whether the firm produces or shuts down
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THE FIRM AND INDUSTRY SHORT-RUN SUPPLY CURVES
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– if average variable cost exceeds price at all output rates, the firm shuts down in the short run – if price exceeds average variable cost, the firm produces the quantity at which marginal revenue equals marginal cost 1) The Short-Run Firm Supply Curve 2) The Short-Run Industry Supply Curve 3) Firm Supply and Market Equilibrium
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1) The Short-Run Firm Supply Curve
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a) Shutdown Point = price just equals average variable cost, so the firm is indifferent between producing and shutting down; either way the firm loses what it must pay to cover fixed cost b) Breakeven Point = price equals average total cost; the firm produces a certain amount to earn a normal profit c) Short-Run Firm Supply Curve = a curve that shows how much a firm supplies at each price in the short run – in perfect competition, the portion of a firm’s marginal cost curve that intersects and rises above the low point on its average variable cost curve
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2) The Short-Run Industry Supply Curve
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a curve that indicates the quantity supplied by the industry at each price in the short run – in perfect competition, the horizontal sum of each firm’s short-run supply curve
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3) Firm Supply and Market Equilibrium
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shows the relationship between the short-run profit-maximizing output of the individual firm and market equilibrium price and quantity
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PERFECT COMPETITION IN THE LONG RUN
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in the long run, a firm has time to enter and leave and to adjust its size – no distinction between fixed and variable cost because all resources under the firm’s control are variable – short-run economic profit attracts new entrants in the long run and may cause existing firms to expand; market supply thereby increases, driving down the market price until economic profit disappears 1) Zero Economic Profit in the Long Run 2) The Long-Run Adjustment to a Change of Demand
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1) Zero Economic Profit in the Long Run
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in the long run, firms in perfect competition earn just a normal profit, which means zero economic profit – long-run adjustment continues until the market supply curve intersects the market demand curve at a price that corresponds to the lowest point on each firm’s long-run average cost curve, or LRAC curve
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2) The Long-Run Adjustment to a Change of Demand
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a) consider how a firm and an industry respond to an increase in market demand b) consider how a firm and an industry respond to a decrease in market demand
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Effects of an Increase of Demand
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– new entry shifts out market supply, forcing the market price down until economic profit disappears *short-run economic profit attracts new firms to the industry in the long run
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Effects of a Decrease of Demand
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– as firms exit, market supply decreases, so the price increases along market demand curve *short-run loss forces some firms out of business in the long run – in the short-run, the decline in market demand forces the market price down, which causes the demand curve facing each individual firm to drop – since the lower market price is below average total cost, each firm operates at a loss
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THE LONG-RUN INDUSTRY SUPPLY CURVE
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in the short run, a firm alters quantity supplied by moving up or down its marginal cost curve (that portion at and above average variable cost) until marginal cost equals marginal revenue, or price – if the price is too low to cover minimum average variable cost, a firm shuts down in the short run – short run economic profit (or loss) prompts some firms in the long run to enter (or leave) the industry or to adjust firm size until remaining firms earn just a normal profit – price changed in the short-run but not the long-run a) Constant-Cost Industries b) Increasing-Cost Industries
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Long-Run Industry Supply Curve
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a curve that shows the relationship between price and quantity supplied by the industry once firms adjust in the long run to any change in market demand
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a) Constant-Cost Industries
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a) Constant-Cost Industry = an industry that can expand or contract without affecting the long-run per-unit cost of production; the long-run industry supply curve is horizontal – each firm’s per-unit costs are independent of the number of firms in the industry EX: output in the pencil industry can expand without bidding up the prices of wood, graphite, and rubber, because the pencil industry uses such a tiny share of the market supply of these resources
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b) Increasing-Cost Industries
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a) Increasing-Cost Industry = an industry that faces higher per-unit production costs as industry output expands in the long run; the long-run industry supply curve slopes upward – new firms enter the industry until the combination of a higher production cost and a lower price squeezes economic profit to zero EX: a market expansion of oil production could bid up the prices of drilling rigs and the wages of petroleum engineers and geologists, raising per-unit production costs for each oil producer
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REVIEW
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1) firms in perfect competition can earn an economic profit, a normal profit, or an economic loss in the SHORT RUN 2) the entry or exit of firms and adjustments in each firm’s size squeeze economic profit to zero in the LONG RUN 3) firms in a perfectly competitive industry earn only a normal profit in the LONG RUN 4) market supply curve is more elastic in the LONG RUN THAN THE SHORT RUN
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PERFECT COMPETITION AND EFFICIENCY
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1) Productive Efficiency: Making Stuff Right 2) Allocative Efficiency: Making the Right Stuff 3) What’s So Perfect About Perfect Competition
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1) Productive Efficiency: Making Stuff Right
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a) Productive Efficiency = the condition that exists when production uses the least-cost combination of inputs; minimum average cost in the long run
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2) Allocative Efficiency: Making the Right Stuff
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a) Allocative Efficiency = the condition that exists when firms produce the output most preferred by consumers; marginal benefit equals marginal cost – the marginal value, or the marginal benefit, that consumers attach to the final unit purchased, just equals the opportunity cost of the resources employed to produce that unit – when the marginal benefit that consumers derive from a good equals the marginal cost of producing that good, that market is said to be allocatively efficient
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3) What’s So Perfect About Perfect Competition
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a) Producer Surplus = a bonus for producers in the short run; the amount by which total revenue from production exceeds variable cost – the combination of consumer surplus and producer surplus shows the gains from voluntary exchange b) Social Welfare = the overall well-being of people in the economy; maximized when the marginal cost of production equals the marginal benefit to consumers