Perfect Competition (Unit 3)
If P = ATC, the firm is...
breaking even.
If there is not a quantity where MR=MC, then...
choose the HIGHEST QUANTITY where MR > MC.
For a supplier to determine their price, they will ALWAYS...
choose the equilibrium market price. (Price where S = D)
*** If a firm shuts down in the SR, then...
its loss = FC. (Loss is equal to fixed cost.)
If P = ATC, then the firm should...
keep producing.
If P > ATC, then the firm should...
keep producing.
If P < ATC, the firm is...
making a NEGATIVE profit / losing money.
As long as P > ATC, the firm is...
making a profit.
Step 1 of graphing.
- Draw ATC, AVC, and MC curves. (Make sure MC intersects ATC and AVC at their minimums.) - We are missing marginal revenue. (We need to know where MR = MC)
Step 2 of graphing.
- Draw marginal revenue, MR. (Or D = MR).
The P.C. firm's short run supply curve.
- For any price on the short run supply curve that is below AVC, - For any price on the short run supply curve that is above the AVC,
LR Exit Rules
- If P > ATC, then KEEP PRODUCING. - If P = ATC, then KEEP PRODUCING. _ If P < ATC, then EXIT THE MARKET.
Recall: P* = ATC* when ATC is at its minimum. Therefore...
- If P* is lower than the min. ATC, the firm will exit in the LR.
Things to check:
- MC must intersect the MINIMUM of ATC (and AVC if we need to draw AVC). - q* must be directly below the point where MR = MC. (UNLESS the firm is going to shut down / P < AVC). - Check if P < AVC, because then q* = 0, and you do not draw a point for q* on the graph. - ATC* must be drawn directly above q*.
In the LR, the continual process of entry and exit...
- Results in a LR equilibrium where the typical firm is breaking even. - When Profit = 0, there is no further incentive for firms to enter or exit the market. (LR equilibrium is essentially where P = ATC).
Graphing Profit: A little trick for graphing a firm's profit.
- The profit area is ALMOST ALWAYS a RECTANGULAR area on a graph. - Length is on the y-axis, while width is on the x-axis. Finding TR - The rectangle for which we need to find the area is between the origin (0,0) of the graph and the point where MC = MR (this point is known as q*). - TR = P x q. If we can find a rectangle whose length is P and whose width is q, then its area MUST be TOTAL REVENUE. Finding TC - The rectangle for which we need to find the area is between the origin (0,0) of the graph and the point where ATC and q* intersect. - TC = ATC x q. If we can find a rectangle whose length is ATC* and whose width is q*, then its area is TC. Finding Profit - Subtracting the area for TC from TR. - TR - TC.
Interpretation of point where D = MR intersects MC.
- When the D = MR graph intersects MC above ATC, the firm is making a profit. The firm should definitely keep producing. (P > ATC) - When the D = MR graph intersects MC on ATC, the firm is breaking even at economic profit / making zero economic profit. (P = ATC) - When the D = MR graph intersects MC below ATC, the firm is making a NEGATIVE economic profit, or losing money. (P < ATC) However, the firm is still making operating profit IF the point is above the AVC. This means that the firm should keep producing to minimize debt. - When the D = MR graph intersects MC on AVC, their operating profit is zero / there is NEGATIVE economic profit. They are also making zero operating profit. The firm could keep producing or stop producing, because their loss will be the same either way. - When the D = MR graph intersects MC below AVC, the operating profit is NEGATIVE. The firm would shut down.
Order of events in PC:
1) The market sets the price. 2) The firm chooses what quantity it wants to produce in order to maximize profit at the market price. Thus, the firm does not get to choose the price, but it DOES get to choose the quantity. *MR = MC* *MR = MC* *MR = MC*
When TR < VC, - if the firm continued producing, it would in cur an 1.___. - the firm is not bringing in enough revenue to pay for the 2.___, so it is better off shutting down.
1. "Operating Loss" 2. VC
In a perfectly competitive market...
1. A firm will find the market equilibrium price (PE) from the market. 2. The firm charges the market equilibrium price (PE) for its product. 3. The firm can sell all that it can produce at that price - firm's demand curve is HORIZONTAL.
Assumptions of Perfect Competition
1. A large number of firms, and each firm is small relative to the total market demand such that NO ON FIRM HAS ANY INFLUENCE ON THE MARKET PRICE. 2. All firms sell an identical product. 3. There are no barriers to entry or exit in the industry 4. Each FIRM'S demand curve is perfectly elastic. +However, the MARKET demand curve is still downward sloping.
In the SR... - The firm will incur 1.___ whether or not it is producing. - But, the firm will only incur 2.___ if it iis producing. - If it shuts down, 3.___ = 0. - VC is also known as 4.___. When TR > VC, the firm is... - Making an 5.___. - Making more than enough revenue to pay for its VC --> can use the excess revenue to pay for at least part of its 6.___.
1. FC 2. VC 3. VC 4. "Operating Cost" 5. "Operating Profit" 6. FC
Step 3 of graphing.
Plot all the points where D = MR intersect MC. These will represent all the different price points.
- Recall profit = TR - TC = (P - ATC) x q. - If P* > ATC*, then 1.___. - If P* < ATC*, then 2.___.
1. Profit > 0 2. Profit < 0
When TR = VC... - The firm is only making enough revenue to pay for its 1.___, and it does not have any revenue left over to put towards the 2.___. - It is okay for the firm to keep producing since it makes enough revenue to pay for its 3.___, but it can also decide to shut down.
1. VC 2. FC 3. operating costs
In perfect competition, MR is a __________ at the level of the __________. MR is the same line as the firm's __________.
1. horizontal line 2. price 3. demand curve
PC Summary
4 Assumptions: - Many Firms - Sell an identical product. - No barriers to entry or exit. - Each firm's demand curve is PERFECTLY ELASTIC. Additional SR Assumptions: - Fixed Number of Firms - Fixed Plant Size for Each Firm Profit in the SR can be GREATER THAN, LESS THAN, or EQUAL TO ZERO. Additional LR Assumption: - ALL inputs are VARIABLE. - Profit at the LR equilibrium must be EQUAL TO ZERO. - In *Perfect Competition*, all firms are called PRICE-TAKERS because they take the MARKET PRICE as given.
SR in Perfect Competition
Additional Assumptions: - Fixed Number of Firms - Fixed Plant Size for Each Firm
When the equilibrium price increases, the profit on the graph will be...
Between the PE2 line and the horizontal line that passes where q*2 intersects ATC. Also to the left of q*2.
What three values are equal?
D=MR=AR
The Entry and Exit of Firms in the LR
Due to profit incentives: - When Profit > 0 (P > ATC)... - New firms enter the market. - Existing firms may expand. +Market supply increases. - When Profit < 0 (P < ATC)... - Some firms downsize. - Some firms exit the market. +Market supply decreases. +LR Exit Point: P < min of ATC - When Profit = 0 (P = ATC)... - No incentive for firms to enter or exit the market.
SR Shutdown Rules:
If P > AVC: The firm should keep producing. If P = AVC The firm could keep producing or shut down, because the loss is the same either way. If P < AVC The firm should shut down in the SR.
Consider the following: - TR = PxQ - VC = AVC x Q The shut down rules can also apply to TR and VC. The SR shutdown rules are as follows:
If TR > VC, then the firm should keep producing. If TR = VC, then the firm could keep producing or shut down. The loss is the same eiither way. If TR < VC, then the firm should shut down in the SR.
If you find that Profit < 0 in the SR, you MUST check the SR shutdown rules to see if the firm is better off shutting down or if it should keep producing.
If the firm shuts down in the SR, q* = 0 and loss = FC. *PROFITS ARE MAXIMIZED WHERE MR = MC.* If you cannot find a point where MR = MC, choose the LARGEST QUANTITY where *MR > MC*
Perfect Competition in the LR
In the LR... - The *number of firms* and *plant size* will vary. - All costs are variable. (There are NO fixed costs. This means that TC = VC and ATC = AVC.) - Firms will exit the market if TR < TC.
SR Effects
Mkt D increases: - Price Increase - The firm's D = MR curve shifts UPWARDS - The typical firm's profit > 0.
The MR Curve for the PC Firm
P-----QD-----TR-----MR 5-----0-------0----------- 5-----10------50------5 5-----20------100-----5 5-----30------150-----5 5-----40------200----5
The perfectly competitive firm is said to be a __________, because it takes the market price as given and has no control over the price.
Price-Taker
SR Shutdown Point
The MINIMUM / LOWEST point / peak on the AVC curve.
If P = AVC...
The firm could keep producing or shut down, because the loss is the same either way.
If P > AVC...
The firm should keep producing.
If P < AVC...
The firm should shut down in the SR.
What if profit = 0 or if profit < 0? Is it better for the firm to keep producing or to shut down?
The firm should shut down.
D = MR Graph
The line for D=MR is a FLAT, HORIZONTAL line that is located at the MARKET PRICE.
What is the profit-maximizing quantity?
The output level where MR = MC.
On a graph, q* (the profit-maximizing quantity) is where...
The point where the line for D=MR and the MC curve INTERSECT.
Unfortunately for Jack, he will not enjoy his profits for long. This happens because:
There is a profit incentive: - For new farmers to enter the market. - For existing farmers to expand production. LR Effects: - Since P > ATC, new firms will enter the market and existing firms will expand production. - Mkt S will increase. - P will decrease until the typical firm is breaking even once again.
Optimal Output Level
To maximize profit, the firm will produce at the output level where MR = MC. We refer to this as the profit-maximizing quantity, q*.
If P < ATC, then the firm should...
indeterminate. We need to know if P >, =, or < AVC.
In perfect competition, MR is equal to...
price.
The profit area is ALWAYS...
the area between P* and ATC multiplied by q*.