Perfect Competition Economics for Today by Irvin Tucker

What will I learn in this chapter? This chapter discusses how competitive markets determine prices, output, and profits 2

What economic puzzles will I learn to solve? • Why is the demand curve horizontal for a firm in a perfectly competitive market? • Why would a firm stay in business while losing money? • In the short run, can alligator farms earn an economic profit? 3

Who was Adam Smith? The father of modern economics who wrote The Wealth of Nations, published in 1776 4

What did Adam Smith say about competitive forces? They are like an “invisible hand” that leads people who pursue their own interests to serve the interests of society 5

What is market structure? A classification system for the key traits of a market, including the number of firms, the similarity of the products they sell, and the ease of entry and exit 6

What is perfect competition? 1. many small firms 2. homogeneous product 3. very easy entry and exit 4. price taker 7

What is meant by a large number of firms? A large number of sellers condition is met when each firm is so small relative to the total market that no single firm can influence the market price 8

What does homogeneous mean? Goods that cannot be distinguished from one another; for example, one potato cannot be distinguished from another potato 9

What conclusion can we make? If a product is homogeneous, buyers are indifferent as to which seller’s product they buy 10

What does easy entry mean? Perfect competition requires that resources be completely mobile to freely enter a market 11

What is a price taker? A seller that has no control over the price of the product 12

What determines price? Supply and Demand 13

P $140 $130 Market Supply and Demand S $120 $100 $80 $60 $40 D $20 5 10 15 20 25 30 35 40 45 Q 14

What determines the individual firm’s demand curve? A horizontal line at the market price 15

$140 $130 $120 $100 $80 $60 $40 Individual firm demand D $20 5 10 15 20 25 30 35 40 45 16

Why is this horizontal line the firm’s demand curve? If the firm charges more than this price, it will not sell anything, and it has no incentive to charge less than this price 17

Why does the firm have no incentive to charge less than the market price? It can sell everything it brings to market at the market price 18

What does the perfectly competitive firm control? The only thing it controls is how many units it produces 19

How many units should this firm produce? The number of units whereby it will maximize its profits, or at least minimize its losses 20

What are the two methods to determine how many units to produce? • TR and TC • MR and MC 21

Using the total revenue - total cost method, where should a firm produce? Where the distance between TR and TC is the greatest 22

P $500 TR TC Maximize Profit $400 $300 $200 Loss $100 Quantity of Output 1 2 3 4 5 Q 23

P t tpu u t. O i $150 $100 ize im rof P ax M TR fit ro P $50 0 ss Lo -$50 1 2 3 4 5 Q 24

What is marginal revenue? MR = TR / 1 output 25

What is marginal cost? MC = TC / 1 output 26

Using the marginal revenue and marginal cost method, where should a firm produce? MR = MC 27

Why should a firm continue to produce as long as MR > MC? As long as MR is > than MC, money is being made on that last unit 28

Why will a firm not produce that unit where MR < MC? At the unit of output where MR < MC, money is being lost on that last unit 29

Why does P = AR in perfect competition? Each additional unit sold is adding the market price to TR and TR divided by P = AR 30

Why does P = MR in perfect competition? Because each unit sells for the same price, therefore each unit sold adds the price to total revenue 31

What conclusion can we make? Price equals marginal revenue equals average revenue equals the firm’s short run demand curve 32

Why is the firm’s demand curve horizontal at the market price? Because the firm can sell all it produces at the market price 33

$60 $50 $40 $30 $20 $10 Price & Cost per unit $80 $70 1 MC ATC P = MR = AR MR=MC D Profit AVC 2 3 4 5 6 7 8 9 34

$70 $60 $50 $40 $30 $20 $10 Price & Cost per unit P 1 MR=MC MC ATC AVC Loss 2 3 P=MR=AR 4 5 6 7 8 9 D Q 35

$70 $60 $50 $40 $30 $20 $10 Shutdown Point Price & Cost per unit P 1 MC ATC AVC Loss P=MR=AR D MR=MC 2 3 4 5 6 7 8 9 Q 36

Firm will shut down Price (MR) is below minimum average variable cost 37

What is the perfectly competitive firm’s shortrun supply curve? The firm’s marginal cost curve above the minimum point on its average variable cost curve 38

P Firm’s Short-Run Supply Curve MC $70 $60 $50 $40 $30 $20 ATC MR 3 AVC MR 2 MR 1 $10 1 2 3 4 5 6 7 8 9 Q 39

What is the industry’s supply curve? The summation of the individual firm’s MC curves that lie above their minimum AVC points 40

P $130 $120 $100 $80 $60 $40 Industry Equilibrium S = MC D $20 Q 5 10 15 20 25 30 35 40 45 41

What is a normal profit? The minimum profit necessary to keep a firm in operation 42

In the long-run, what happens when economic profits are made? When firms make more than a normal profit, firms enter the industry, as supply increases, a downward pressure is put on prices 43

In the long-run, what happens when losses are made? When firms make less than a normal profit, firms leave the industry, as supply decreases, an upward pressure is put on prices 44

In the long-run, where is equilibrium? At the market price that enables firms to make a normal profit 45

What exists at long-run perfectly competitive equilibrium? P = MR = SRMC = SRATC = LRAC 46

P $70 $60 $50 $40 $30 $20 Long-Run Competitive Equilibrium SRMC Equilibrium SATC LRAC MR $10 1 2 3 4 5 6 7 8 9 Q 47

END 48