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Theory of Perfect Competition

Digression: Recall Rational (maximizing) Decision-Making Rule. Take action up to Marginal Benefit (MB) = MC Firm chooses output (action) to max. profit (objective)Must understand MB

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Theory of Perfect Competition

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    1. Theory of Perfect Competition Characteristics: Many sellers/buyers Firms sell identical product (perfect substitutes) Perfect information for buying/selling decisions No Barriers to Entry/Exit of firms

    3. Competitive Firms are Price Takers Change price/output, no impact on market Sees perfectly elastic demand for its good at market price. Why? Implications: Firms can sell all they desire at market price Price increase--Buyers substitute to other sellers Price decrease--Firm loses profits

    4. MR = extra revenue of selling another unit = (DTR) / (DQ) Firm takes price, decides how much to sell. So firms MR = demand for its product = Market Price Price Quantity Total Revenue Marginal Revenue (P) x (Q) (DTR) / (DQ) $5 1 $5 $5 5 2 10 5 5 3 15 5 Firms Demand = Marginal Revenue (MR)

    5. Firms demand = MR = Market Price

    6. Perfect Competition (Short Run) Firms Profit Maximizing Output Produce as long as MR > MC Firm earns marginal profit (on last unit, not all units) Why not stop producing where MR > MC? Profits maximized by producing up to: MR ( = P) = MC

    7. Graph: Firms Profit-Maximizing Output

    8. Graphing Firms Profits (example) Profits = Revenue - Total Cost = (P - ATC) x (q) = (15 - 10) x (100) = 500 Profits (shaded area)

    9. Graphing Firms Losses Losses = Total Revenue - Total Cost = 720 - 800 = -80 Losses (shaded area)

    10. A Word on Market Supply Curve Firm's MC as its Supply Curve Market Supply = Horizontal sum of firms short-run supply (MC) curves Why Market Supply Curve Slopes Up?

    11. Perfect Competition (Long Run) Firms Enter/Exit Industry (Inputs Variable) Long-Run Equilibrium Conditions: Firms max profits producing at P (=MR) = MC Zero Econ Profit: P = ATC No incentive for firms enter/exit industry. Why not? No incentive to change plant size Firms Produce at Minimum ATC

    12. Long Run Competitive Equilibrium P = MC = Minimum ATC

    13. Industry Adjustment to Increase Demand Market Demand rises, Price rises Raises firms demand/MR Firm raises output (new P = MR = MC) P > ATC, short-run profits attract firms. New firms increase market supply, reducing P This lowers firms demand/MR Firms enter & P falls until 0 econ profit earned Long-run equilibrium achieved Firms profit-seeking drives adjustment process

    14. Long Run Adjustment Process (Increased Market Demand)

    15. Do higher costs to firm mean higher prices? Do competitive firms advertise? Does competitive industry advertise? Does single industry price mean collusion or competition? Questions

    16. Efficiency Criterion & Perfectly Competitive Markets (1) Resource Allocative Efficiency Explained Any firm produces at MR = MC Since MR = P for competitive firm, then P = MC Meaning: Marginal Benefit (demanders) = Marginal Cost (suppliers of using societys resources) Societys marginal value of resources = its opportunity costs of using resources Allocative Efficiency satisfied

    17. Competitive Markets and Allocative Efficiency Consumer Surplus = area ABPE Supplier Surplus = area CBPE Market Surplus = area ABC Competitive Equilibrium maximizes market surplus What about Q1?

    18. (2) Productive Efficiency Firms produce at Minimum ATC in long-run Firms economizing on resource use If not, competing firm would undercut its price and capture extra profits Efficiency Criterion & Perfectly Competitive Markets (cont.)

    19. Competition Provides Incentives to: Profit Maximize Minimize costs Innovate Final Thoughts

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