ECO 101 (Module 8 - Perfect Competition)

Perfect Competition Conditions

1. The industry has many firms and many customers; 2. All firms produce identical products; 3. Sellers and buyers have all relevant information to make rational decisions about the product being bought and sold; and 4. Firms can enter and leave the market without any restrictions - in other words, there is free entry and exit into and out of the market.

Which of the following statements is consistent with perfect competition?

A market offering identical goods where information is shared equally among consumers and firms

Profit Margin

At any given quantity of output, the difference between price and average total cost; also known as average profit

Price < ATC

Firm earns a loss

Price > ATC

Firm earns an economic profit

Price = ATC

Firm earns zero economic profit

Price Taker

Firms in a perfectly competitive marker since no firm has any market power they must take the prevailing marker price as given

Break-Even Point (2)

Level of output where the marginal cost curve intersects the average cost curve at the minimum point of AC; if the price is at this point, the firm is earning zero economic profits

Shutdown Point

Level of output where the marginal cost curve intersects the average variable cost curve at the minimum point of AVC; if the price is below this point, the firm should shut down immediately

The firm's profit-maximizing level of output will occur where

MR = MC (or at a level close to that point)

Perfect Competition

Market Structure where each firm faces many competitors that sell identical products so that no firm has any market power

At a greater quantity, marginal costs of production will have increased so that

P < MC.

Profit-maximizing rule for a perfectly competitive firm

Produce the level of output where marginal revenue equals marginal cost

Profit formula

Profit = Total revenue - Total cost = (Price)(Quantity Produced) - (Average Cost)(Quantity Produced)

Marginal Revenue

The additional revenue gained from selling one more unit of output

Market Structure

The conditions in an industry, such as number of sellers, how easy or difficult it is for a new firm to enter, and the type of products that are sold

Profit

The difference between total revenues and total costs

Break-Even Point (1)

The level of output where price just equals average total cost, so profit is zero

Zero Economic Profits

a firm is covering all of its cost, including the opportunity costs of its capital; i.e. normal accounting profits

Constant Cost Industry

an industry whose technology is such that there is no advantage to size; a large firm faces the same average costs as a small firm does.

It's also allocatively efficient, meaning it's producing the optimal quantity of output (i.e. where price equals marginal cost),

because that quantity maximizes total economic surplus.

In the long run, perfectly competitive firms will react to profits; they will respond to losses by

by increasing production; reducing production or exiting the market.

Marginal Cost =

change in total cost / change in quantity

Marginal revenue =

change in total revenue / change in quantity

As long as there are still profits in the market,

entry will continue to shift supply to the right.

When perfectly competitive firms maximize their profits by producing the quantity where P = MC, they also assure that the benefits to consumers of what they are buying, as measured by the price they are willing to pay, is

equal to the costs to society of producing the marginal units, as measured by the marginal costs the firm must pay—and thus that allocative efficiency holds.

Marginal revenue received by a perfectly competitive firm is

equal to the price P

As long as MR > MC, a profit-seeking firm should keep

expanding production

in the short run,

firms cannot change the usage of fixed inputs,

Perfect competition is productively efficient, because in the long run

firms produce their products as cheaply as possible (i.e. at minimum average cost).

Productive Efficiency

given the available inputs and technology, it's impossible to produce more of one good without decreasing the quantity of another good that's produced

In that case, the marginal costs of producing additional flowers is

greater than the benefit to society as measured by what people are willing to pay.

In other words, the gains to society as a whole from producing additional marginal units will be

greater than the costs.

In that situation, the benefit to society as a whole of producing additional goods, as measured by the willingness of consumers to pay for marginal units of a good, would be

higher than the cost of the inputs of labor and physical capital needed to produce the marginal good.

Profits will be highest where marginal revenue, which is price for a perfectly competitive firm,

is equal to marginal cost

MR = MC

is the signal to stop expanding, so that is the level of output they should target

What this means is that

it's producing at the right point on the production possibilities frontier.

First consider the upper zone, where prices are above the level where

marginal cost (MC) crosses average cost (AC) at the zero profit point

The answer is that perfect competition shows

markets operating at their best.

If the price that a frim charges is lower than its average cost of production, the firm's profit margin is

negative and it is suffering an economic loss

long run equilibrium will be attained when

no new firms want to enter the market and existing firms do not want to leave the marker, as economic profits have been driven down to zero

If the price that a firm charges is higher than its average cost of production for that quantity produced, then the firm's profit margin is

positive and it is earning economic profits

For society as a whole, since the costs are outstripping the benefits, it will make sense to

produce a lower quantity of such goods.

In the short run, the perfectly competitive firm will seek the quantity of output where

profits are highest or, if profits are not possible, where losses are lowest

What this means in a larger context is that the economy is operating on its production possibilities frontier,.

rather than inside the frontier

Expanding production into the zone where MR < MC

reduced economic profits

Exit of many firms causes the market supply curve to

shift to the left.

At a lesser quantity, marginal costs will not yet have increased as much,

so that price will exceed marginal cost; that is, P > MC.

We call the point where the marginal cost curve crosses the average cost curve, at the minimum of the average cost curve,

the break-even point

while in the long run,

the firm can adjust all factors of production.

If a price falls into the zone between the break even point, where MC crosses AC, and the shutdown point, where MC crosses AVC,

the firm will be making losses in the short run - but since the firm is more than covering its variable costs, the losses are smaller than if the firm shut down immediately

At any price above that level,

the firm will earn profits in the short run

Finally, consider a price at or below the shutdown point where MC crosses AVC. At any price like this one,

the firm will shutdown immediately, because it cannot even cover its variable costs

Entry

the long-run process of firms entering an industry in response to industry profits

Exit

the long-run process of firms reducing production and shutting down in response to industry losses

For a perfectly competitive firm,

the marginal cost curve is identical to the firm's supply curve starting from the minimum point on the average variable cost curve.

In a perfectly competitive market, price will be equal to

the marginal cost of production.

This time, instead, demand decreases, and with that,

the market price starts falling.

As the supply curve shifts to the left,

the market price starts rising, and economic losses start to be lower.

In the long run in a perfectly competitive market, because of the process of entry and exit,

the price in the market is equal to the minimum of the long-run average cost curve

We call the point where the marginal cost curve crosses the average variable cost curve

the shutdown point

Price < minimum average variable cost,

then firm shuts down

Price > minimum average variable cost,

then firm stays in business

If P > AVC but P <ATC,

then the firm continues to produce in the short-run, making economic losses

If the price falls exactly on the break even point where the MC and AC curves cross,

then the firm earns zero profits

If the market price is below average cost at the profit-maximizing quantity of output,

then the firm is making losses

If the market price faced by a perfectly competitive firm is above average cost at the profit-maximizing quantity of output,

then the firm is making profits

If the market price is equal to average cost at the profit-maximizing level of output,

then the firm is making zero profits

If the market price that a perfectly competitive firm faces is above average variable cost, but below average cost,

then the firm should continue producing in the short run, but exit in the long run.

If the market price that a perfectly competitive firm face is below average variable cost at the profit-maximizing quantity of output,

then the firm should shut down operations immediately

If P < AVC,

then the firm stops producing and only incurs its fixed costs

Profits will be highest (or losses will be smallest) at the quantity of output where

total revenues exceed total costs by the greatest amount (or where total revenues fall short of total costs by the smallest amount)

Allocative Effciency

when the mix of goods being produced represents the mix that society most desires

Long-run Equilibrium

where all firms earn zero economic profits producing the output level where P = MR = MC and P = AC

This will stop whenever the market price is driven down to the zero-profit level,

where no firm is earning economic profits.