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Perfect Competition
After studying this chapter you will be able to: Define perfect competition Explain how firms make their supply decisions and why they sometimes shut down temporarily Explain how price and output are determined in a perfectly competitive market Explain why firms enter and leave a competitive market and the consequences of entry and exit Predict the effects of a change in demand and of a technological advance Explain why perfect competition is efficient
Pearson Education 2012
You might be relaxing over a cup of coffee, but coffee shops operate in a fiercely competitive market with lean pickings for most of its producers. How does competition in coffee and other markets influence prices and profits? We study a fiercely competitive market in this chapter. We explain the changes in price and output as the firms in perfect competition respond to changes in demand and technological advances.
that has no unique characteristics, so consumers dont care which firms good they buy.
No single firm can influence the price it must take the equilibrium market price.
Each firms output is a perfect substitute for the output of the other firms, so the demand for each firms output is perfectly elastic.
The goal of each firm is to maximize economic profit, which equals total revenue minus total cost.
Total cost is the opportunity cost of production, which includes normal profit. A firms total revenue equals price, P, multiplied by quantity sold, Q, or P Q. A firms marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.
Part (a) shows that market demand and market supply determine the market price that the firm must take.
The goal of the competitive firm is to maximize its economic profit, given the constraints it faces.
To achieve this goal, a firm must decide:
Figure 7.3 on the next slide shows the marginal analysis that determines the profit-maximizing output.
If the firm makes an economic loss, it must decide to exit the market or to stay in the market.
If the firm decides to stay in the market, it must decide whether to produce something or to shut down temporarily. The decision will be the one that minimizes the firms loss.
The firms loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR).
Economic loss = TFC + TVC TR
= TFC + (AVC P) x Q
If the firm shuts down, Q is 0 and the firm still has to pay its TFC.
If the firm were to produce just 1 unit of output at a price below minimum average variable cost, it would incur an additional (and avoidable) loss.
Figure 7.5 shows how the firms short-run supply curve is constructed. If price equals minimum average variable cost, 17, the firm is indifferent between producing nothing and producing at the shutdown point, T.
The short-run market supply curve shows the quantity supplied by all the firms in the market at each price when each firms plant and the number of firms remain constant.
At a price equal to minimum average variable cost the shutdown price the market supply curve is perfectly elastic because some firms will produce the shutdown quantity and others will produce zero.
Short-run market supply and market demand determine the market price and output.
Figure 7.7 shows a shortrun equilibrium.
An increase in demand bring a rightward shift of the market demand curve: the price rises and the quantity increases.
A decrease in demand bring a leftward shift of the market demand curve: the price falls and the quantity decreases.
Pearson Education 2012
In short-run equilibrium, a firm may make an economic profit, break even, or incur an economic loss.
Which of these outcomes occurs determines how the market adjusts in the long run. In the long run, firms can enter or exit the market.
A decrease in demand shifts the market demand curve leftward. The price falls and the quantity decreases.
Figure 7.10 illustrates the effects of a permanent decrease in demand when the market is in long-run equilibrium.
Economic profit induces entry, which increases short-run supply and shifts the short-run market supply curve rightward.
As market supply increases, the price falls and the market quantity continues to increase.
The main difference between the initial and new long-run equilibrium is the number of firms. In the new equilibrium, a larger number of firms produce the equilibrium quantity.
Pearson Education 2012
External diseconomies are factors beyond the control of a firm that raise the firms costs as the market output increases.
Pearson Education 2012
A new technology enables firms to produce at a lower average total cost and a lower marginal cost firms cost curves shift downward. Firms that adopt the new technology make an economic profit.
Resources are used efficiently when no one can be made better off without making someone else worse off.
This situation arises when marginal social benefit equals marginal social cost.
In competitive equilibrium, resources are used efficiently the quantity demanded equals the quantity supplied, so marginal social benefit equals marginal social cost. The gains from trade for consumers is measured by consumer surplus.
The gains from trade for producers is measured by producer surplus. Total gains from trade equal total surplus, and in long-run equilibrium total surplus is maximized.
Pearson Education 2012