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Perfect Competition. Plan. Conditions for perfect competition Profit maximization In the short run Choice of the optimal output The shutdown condition The industry supply Market equilibrium In the long run with free entry Market supply, market equilibrium.
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Plan • Conditions for perfect competition • Profit maximization • In the short run • Choice of the optimal output • The shutdown condition • The industry supply • Market equilibrium • In the long run with free entry • Market supply, market equilibrium
Conditions for Perfect Competition • Firms Sell a Standardized Product • Firms are price takers • Factors of Production are Perfectly mobile in the long run • Firms and consumers have perfect information
Economic Profit • Economic profit is the difference between the total revenue and total cost • Note that the total cost includes ALL the costs. It may differ from the accounting costs. • Economic costs include alternative costs (say, a rental cost of capital) • Example: farms in New Jersey
How should a producer choose the output? • Assume he knows the cost function, • what is the smallest cost of producing Q units of output given the • technology • prices of the inputs • Producer’s objective is to maximize the profits, • Revenue-Cost, • What is the profit maximizing level of output?
Profit Maximization in the Short Run • Marginal revenue of producing another unit should equal to the marginal cost of its production • Marginal revenue in a competitive market is the market price. • Is it optimal to produce the quantity at which this condition is satisfied but the marginal cost is decreasing? • No.
Shut-down conditions • Should a firm produce if the price falls below AVC? • NO • Should a firm shut down if the price falls below ATC but above the AVC? • YES, in the short run
Supply • Firm supply is the relationship between market price and the quantity produced by a firm at that price. • Market supply is the relationship between market price and the quantity produced by all the firms in the industry at that price.
Example • Assume N firms in the industry are producing a toothpaste of identical quality. • Assume that the individual firm supply is identical across firms: • What is the industry supply of toothpaste?
Short Run Competitive Equilibrium • SR Equilibrium is a price and quantity such that demand is equal to the SR supply. • In the short run a firm can earn economic profit in a competitive market. • Example: • What is the optimal output for this firm if the price is 24? What is its profit if FC=1? • At what level of fixed cost will the firm earn zero economic profit?
Efficiency of SR Competitive Equilibrium • Allocation is efficient if there is no additional allocation that will make somebody in the economy strictly better off without worsening the well-being of the other. • Say, a SR competitive market equilibrium is (P*,Q*) • Take money from a consumer in the amount that he is willing to give up for an additional unit of output (less than P* ), give it the producer. He will not be willing to produce another unit (he will be worse off if he does). • Similarly, producing less will hurt both consumers and producers.
Competitive Markets in the Long Run • In the long run all inputs can be adjusted, • Firms that were operating below the minimum ATC will leave (shut down). • New firms can enter the competitive industry • New firms will enter as long as economic profits can be earned
Competitive Markets in the Long Run • In the LR firms do not earn economic profits! • Only the low cost firms stay in the industry! • What is the LR competitive market supply?
Competitive Equilibrium in the Long Run • The price equals to the minimum of the LAC • The quantity produced is determined by the demand • How many firms will enter the industry?
Can Long Run supply be upward sloping? • Yes • if some of the inputs are in limited supply • if some of the inputs’ prices increase as the production is expanded
Applications • Price supports for family farms
