Perfect Competition

Perfect Competition • Market structure in the output market. • Number of firms • Type of product • Ease of entry/exit • Market info and knowledge • Price and output are strongly related to market structure.

Perfect Competition • Homogeneous or standardized product • Enough firms so that each firm is small relative to the market. Thus, no control over price. • No obstacles to entry and exit. • Perfect info about product and market. Best method of production & market price. Also potential entrants know whether existing firms earn economic profits.

Firm’s Demand and Perfect Competition • Since each firm is a price-taker, its demand curve is horizontal at the market price. It can also said to be perfectly elastic at the market price. P S P D P P D Q Q Firm Market

Firm’s Demand • The firm’s demand curve in perfect competition is also the • MR curve – since each additional unit adds a constant amount (Price) to Total revenue(TR) • Average Revenue curve – since AR is TR/Q

Profit Maximization in the Short Run MC $ D=MR=P MR=MC Q* Q Remember FC is irrelevant in the Short Run. Old MB=MC Rule for Unconstrained Max from Chap. 4

Short Run Equilibrium for the Perfectly Competitive Firm • There are actually two basic cases to be considered • Revenues (TR) covers variable costs(TVC). In this case the firm produces where MR=MC • If P>ATC, operate at economic profit • If min AVC >P<ATC operate at a loss(but will minimize loss) • Revenues(TR) is not able to cover variable cost(TVC) at any level of output(Q). In this case the firm should shut down (Q=0). This occurs when P< min AVC.

Graphics for Previous Slide • Refer to Figure 12.4, 12.5, and 12.6 in text plus lecture drawings. • Note Figure 12.6 covers all possibilities by assuming 3 different market prices(P1, P2, P3)

Short Run Supply in Perfect Competition • The short run supply curve for the firm is that part of the MC curve above AVC. (Figure 12.7) MC $ AVC Q

Long Run Equilibrium in Perfect Competition • In the LR, firms can freely enter and exit the industry in response to market incentives. • Thus, if economic profits exist new firms will be attracted into the industry. As the number of firms increase, market Supply increases and market price falls. As market price falls so goes each firm’s demand curve (since price takers) and the process continues til all economic profit is eliminated.

Long Run Equilibrium in Perfect Competition • See graphics in lecture and Figures 12.8 and 12.9. • LR equilibrium occurs when P= LMC=LAC

Rent and Long Run Supply • Economic rent is the payment to the owner of a resource in excess of the resource’s opportunity cost. • Firm’s that employ such productive resources earn only normal profits in the LR because the excess is paid to the owner of the resource. • Shaq receives huge rents since his income is far in excess of his opportunity costs.

Profit Maximizing Input Usage • So far have focused on profit max in terms of the output to produce. • Need to also develop profit max in terms of input usage. • Again this is an application of unconstrained maximizing theory in which the solution is MB = MC. We just change names to fit the application. • MB = increase in revenue generated by hiring an additional unit of “labor” (will call MRP) • MC = increase in cost due to hiring an additional unit of “labor” (is the wage rate)

Marginal Revenue Product • The marginal revenue product (MRP) is the additional revenue earned when the firm hires an additional unit of labor. I = units of the input MR = marginal revenue MP = marginal product

#14, page 472 MRP = MR(MP) MC = w/MP FC=50

Perfect Competition