Econ 101 - Chapter 9

Price taker

A firm that can alter is rate of production and sales without affecting the market price of its product.

Perfect competition

A market structure in which all firms in an industry are price takers and in which there is freedom of entry into and exit from the industry

For a price taking firm, the price is equal to

AR = MR = Price

Market Structure

All features of a market that affect behaviour and performance of firms in that market, such as the number and size of sellers, the extent of knowledge about on another's actions, the degree of freedom of entry and the degree of product differentiation.

Assumptions of perfect competition

All firms sell an identical product, what economists call homogeneous products Consumers know the nature of the product being sold and the prices charged by each firm The level of each firm's output at which its long-run average cost reaches a minimum is small relative to the industry's total output. (This is a precise way of saying that each firm is small relative to the size of the industry.) The industry is characterized by freedom of entry and exit; new firm is free to enter the industry and start producing if it so wishes, any existing firms free to leave industry. Existing firms cannot block entry of new firms, no legal prohibitions or other barriers to entering or exiting industry

Conditions for long-run equilibrium in a competitive industry

Existing firms must be maximizing their profits, given their existing capital. Thus, short-run marginal costs of production must be equal to market price Existing Firms must not be suffering losses. If they are suffering losses, they will not replace their capital and the size of the industry will decline over time Existing firms must not be earning profits. If they are earning profits, then new firms will enter the industry and the size of the industry will increase over time. Existing firms must not be able to increase their profits by changing the size of their production facilities. Thus, each exiting firm must be at the minimum point of its LRAC curve.

Short-run equilibrium

For a competitive industry, the price and output at which industry demand equals short-run industry supply, and all firms are maximizing their profits. Either profits or losses for individual firms are possible.

Maximum profit is when

MR = MC

Market Power

The ability of a firm to influence the price of a product or the terms under which it is sold.

Marginal Revenue

The change in a firm's total revenue resulting from a change in its sale by one unit.

Two different ways of viewing the same profit maximization problem:

The level that shows the largest positive gap between total revenues and total costs (where TC and TR have same tangent or slope) Level at which price (marginal revenue) equals marginal costs.

Break-even price

The price at which a firm is just able to cover all of its costs, including the OC of capital

Shut-down price

The price at which the firm can just cover its average variable cost, and so is indifferent between producing and not producing

Total Revenue

Total receipts from the sale of a product; price times quantity P * Q

Average revenue

Total revenue divided by quantity sold; this is the market price when all units are sold at the same price TR/Q

If revenue is less than its variable cost at every level of output, the firm will

actually lose more by producing than by not producing at all.

Both new firms and old firms will have to adjust their output to this new price. New firms will continue to enter, and EqP will continue to fall, until

all firms in the industry are just covering their total costs. The industry has now reached what is called a zero-profit equilibrium.

The perfectly competitive firm adjusts its level of output in response to

changes in the market-determined price.

In industries with continuous technological improvement, low-cost firms will exist side by side with older high-cost firms. The older firms will

continue operating as long as their revenues cover their variable costs.

The profit maximizing response to a steadily declining demand is to

continue to operate with existing equipment as long as its variable costs of production can be covered

When a firm decides how much output to produce in order to maximize profit, it needs to know the

dmeand for its product and also its costs of production.

The long-run equilibrium of a competitive industry occurs when firms are

earning zero profits.

As long as the firm's own level of output cannot affect the price of the product it sells, then the firm's marginal revenue is

equal to its average revenue.

If a firm's MR > MC, than the firm should

expand its output.

The level of output at which LRAC reaches a minimum is known as the

firm's minimum efficient scale (MES)

Even though the demand curve for the entire industry is negatively sloped, each firm in a perfectly competitive market faces a

horizontal demand curve because variations in the firm's output have no significant effect on price.

If the market price is unaffected by variations in the firm's output, the firm's demand curve, its average revenue curve, and its marginal curve all coincide in the same

horizontal line.

Process of exit not always quick, sometimes slow for loss-making firms Rate at which firms leave unprofitable industries depend on

how quickly their capital becomes obsolete or becomes too costly to operate because of rising maintenance costs as it ages.

Homogeneous products

in the eyes of purchasers, every unit of the product is identical to every other unit.

If any unit of production adds more to revenue that it does to cost, producing and selling that unit will

increase profits.

The competitiveness of the market is the degree to which

individual firms lack such market power.

Supply curve is the section of

its marginal cost curve above the average variable cost curve

A competitive firm's supply curve is given by the portion of

its marginal cost curve that is above its average variable cost curve. The MC curve must be above the AVC to produce any output.

A profit-maximizing firm that is operating in a perfectly competitive market will produce the output that equates

its marginal cost of production with the market price of its product (as long as price exceeds average variable cost).

A market is said to have a competitive structure when its firms have little or no market power. The more market power the firms have, the

less competitive is the market structure.

In long-run competitive equilibrium, each firm's average cost of production is the

lowest attainable, given the limits of known technology and factor prices.

In perfect competition, the industry supply curve is the horizontal sum of the

marginal cost curves (above the level of average variable cost) of all firms in the industry.

If it is worthwhile for the firm to produce at all, the firm should produce the output at which

marginal revenue equals marginal cost

For a firm in perfect competition, price equals

marginal revenue.

Competitive industry that is subject to continuous technological improvement is that price is eventually governed by the

minimum ATC of the lowest-cost (newest) plants. Newer plants drive the price of the product down.

For a competitive firm to be maximizing its long-run profits, it must be producing at the

minimum point on its LRAC curve.

Another factor in speed of exit from industry is

nature of firms' fixed costs

As equipment become obsolete because firms cannot cover AVC, it will not be replaced unless

new equipment can cover its total costs

Perfectly competitive market structure

no need for individual firms to compete actively with one another because none has any power over the market. 0 market power

Firms will continue to exit, market price continue to rice, until

remaining firms can cover their total costs. Once again, market reaches a zero-profit equilibrium.

Response of gov't towards declining industries

propping up genuinely declining industries only delays their demise effective response is to provide retraining and income-support schemes that cushion the impacts of change.

Profits in a competitive industry are a signal for the entry of new firms; the industry will expand,

pushing price down until economic profits fall to zero.

When an industry is in short-run equilibrium,

quantity demanded equals quantity supplied, and each firm is maximizing its profits given the market price.

If the firms MR < MC, the firm should

reduce its output

With an unchanged market demand curve, this rightward shift in the industry supply curve will

reduce the equilibrium price

The longer it takes for firms' capital to become obsolete or too costly to operate, the longer firms will

remain in the industry while they are earning economic losses.

Entry of new firms into an industry causes a

rightward shift in the industry supply curve

Old plants and equipment will not be replaced, as a result, the industry's supply curve eventually

shifts letward, and the market price rises.

As a result, the capacity of the industry will

shrink.

If firm's fixed costs are mostly sunk costs, the process of exit in loss-making industry will be

slow If firms' fixed costs are mostly non-sunk costs, the process of exit will be faster

If a firm must pay fixed costs in any event, it will be worthwhile for the firm to produce as long as it can find

some level of output for which revenue exceeds variable costs

If firms are making losses but the market price is above the shut-down point, there will

still be exit from the industry, but it will be gradual.

Firm's fixed costs are divided into

sunk costs- cost could never be recovered non-sunk costs - costs that could be recovered by firm by such means as selling its capital or terminating its rental agreement.

Although the firms are just covering the variable costs, return on their capital is less than

the OC of capital. They are not covering their total costs. This is a signal for the gradual exit of firms.

The antiquated equipment in a declining industry is typically the effect rather than

the cause of the industry's decline.

Competitive behaviour

the degree to which individual firms actively vie with one another for business

details of market structure determine how we get from

the industry demand curve to the demand curve facing any individual firms.

An extra unit of production will reduce profits if

the marginal revenue is less than the marginal cost.

A unit of production raises profits if

the marginal revenue obtained from selling it exceeds the marginal cost of producing it.

Old capital is economically obsolete when

the market price of output does not even cover its average variable cost of production.

Losses in competitive industry are a signal for the exit of firms; the industry will contract, driving

the market price up until the remaining firms are just covering their total costs.

The industry supply curve is

the sum of what each firm will supply.

A firm should not produce at all if, for all levels of output,

the total variable costs of producing that output exceeds the total revenue form selling it. equivalently, the firm should not produce at all if, for all levels of output, the average variable cost of producing the output exceeds the market price.

Any feasible variations in production will leave price unchanged because

their effect on total industry output will be negligible.