Perfect Competition

Perfect Competition Costs and Unit 3 – Theory of the Firm

This lecture is interactive. Before beginning make sure students are paired with a partner with a whiteboard, marker & eraser. Move your seat together beside your partner’s to where you can comfortably take your own notes & write on the white board together. You don’t need to take notes until you see this sign.

4 market structures in which firms compete: #1 – perfect competition #2 – monopoly #3 – monopolistic competition #4 - oligopoly 3 of 34

Perfect Competition 1. Many buyers and sellers 2. All the products are homogeneous. 3. All buyers & sellers are price takers. 4. There are NO barriers to entry. 5. There is perfect information. 6. There is no chance of long-run profits.

Hello Kitty Purses P In Unit 2 we learned about this graph. What does this graph tell us? S P D Q Q The industry/market graph is simple supply and demand. The price charged in the market and the quantity produced are where supply and demand meet.

In this unit on costs we’re adding to our analysis the individual firm. firm cost On your whiteboard draw the graph for an individual firm correctly labeling the 2 axes & title of graph. quantity 6 of 34

On your graph correctly diagram & label the ATC & AVC curves. firm cost ATC AVC quantity

On your graph correctly diagram & label the MC curve. MC firm cost ATC AVC ensure that MC intersects ATC & AVC at lowest points. quantity

Indicate where the law of diminishing returns sets in. MC firm cost ATC AVC diminishing returns sets in here b/c…explain quantity

MC firm cost ATC AVC In this segment as more inputs were added, the cost of each next unit was rising. quantity In this segment as more inputs were added to production, the cost of each next unit (marginal) was decreasing. 10 of 34

P firm P industry S P D Q Q Q The industry/market P and Q are printed with capital letters “P” and “Q” The individual firm’s graph is going to be a little more difficult.

dollars firm P industry S MC ATC P mr A d p (P = MR) B C D mc MR>MC Q Q q q2 q1 Rate of output It’s a bit involved, no? You are a farmer in this market. How many units or bushels of corn should you produce? Small q1? Small q? Don’t copy notes yet! or Small q2?

dollars P S MC ATC P mr A d p (P = MR) B C D mc MR>MC Q Q q q2 Rate of output q1 And the answer is-- Small “q” Why? MR = MC Because that’s the “q” where

Draw the firm & market graphs below. cost market firm P S MC MR=D=AR=P p D Q Q q quantity

cost P S MC P d p (P = MR) D Q Q q output Let’s look at each line individually so that you understand more about how individual firms make decisions. Individual firms are price takers and will take the market price.

dollars P S MC P d p (P = MR) D Q Q q Rate of output Notice that P = MR = D and they are also equal to AR. The questions is— Why are they all equal to each other? P -- Price MR – Marginal Revenue D -- Demand AR – Average Revenue 15 of 34

dollars P S $2 P d $2 p (P = MR) D Q Q Rate of output Since the firm is a price taker, it must take the market price. Say that the market price for a bushel of corn is $2 per bushel.

dollars P S $2 P d $2 p (P = MR) D 1 2 3 4 Q Q Rate of output For how much does each firm sell each unit (bushel)? q x P = TR x 1 $2 2 $2 x 2 $2 4 What do you get when you multiply P x q? 3 x $2 6 4 $2 8 x TR The Farmer!! Who do we appreciate?

dollars P S P = MR $2 P $2 p D Q Q Rate of output q x P = TR MR What MR? x 1 $2 2 $2 > MR is the additional revenue earned from selling 1 more of the good x 2 $2 4 > $2 3 x $2 6 > $2 4 $2 8 x P = MR

cost P S D = P = MR $2 P $2 p D 1 Q Q At a price of $2 the demand is infinitely elastic. Buyers can buy one unit (bushel) to an infinite amount of units (bushels) for $2 per bushel. So, now D = P = MR. 20 of 34

dollars P S D = P = MR = AR $2 P $2 p D Q Q Rate of output How would you figure out average revenue? q x P = TR AR MR x 1 $2 2 2 2 AR = TR / q x 2 $2 4 2 2 3 x $2 6 2 2 4 $2 8 x 2 P = AR = MR

MR DARP dollars P S MR = D = AR = P D = P = MR = AR $2 P $2 p D Q Q Rate of output Are there any questions on why D = P = MR = AR? When I grew up on the farm, we just so happened to live next to another farmer who everyone called, “Mr. Darp.” I never realized until I started teaching economics that people in the community called him that because he knew so much about perfect competition.

dollars P S MC P p MR=D=AR=P D q Q Q Rate of output When labeling the demand curve for the individual firm, make sure it is labeled—MR=D=AR=P All firms maximize profits by producing where MR = MC.

dollars P S MC P p MR=D=AR=P D q Q Q Rate of output All firms maximize profits by producing where MR = MC. How do we know this from our previous discussion where we said firms and individuals make decisions “on the margin?” because a firm would say to itself, “Can I get more for the next unit, than I would have to pay to produce it?”

cost P S firm market MC ATC p MR=D=AR=P D Q Q q quantity Note: MC touches ATC at its lowest point. Now we add the ATC curve to the graph to determine if this firm is earning an economic profit, an economic loss, or breaking even. 25 of 34

cost P S MC ATC p MR=D=AR=P ATC D Q Q q Rate of output Whenever the P is above ATC at the profit- maximizing quantity (q), then the firm is earning an economic profit. In this situation the P is above ATC at profit- maximizing quantity (q).

cost P S Economic profit MC ATC A A p p MR=D=AR=P B C D Q Q x 0 0 q q Rate of output Since the P is above ATC at the profit-maximizing output q, the firm is earning an economic profit. P x q What is the formula for total revenue? Then P x q will give you the total revenue of: TR = 0, P, A, q

dollars P S Economic profit MC ATC A p MR=D=AR=P B B C C D Q Q 0 q q x 0 Rate of output ATC x q What is the formula for total costs? Then P x ATC will give you the total costs of: TC = 0, B, C, q The TR (0, P, A, q) is larger than the TC (0, B, C, q). Since TR > TC, the firm is earning economic profit. Economic Profit = B, P, A, C

Practice on a white board Write both team members’ names on the whiteboard. Draw a correctly labeled diagram showing both the industry and the individual firm where the firm is suffering an economic loss. Draw as large as possible still being easily legible. 29 of 34

Let’s check the market graph first. P market S P & Q axes labeled? 1 point each P D market labeled? 1 point Q Q dotted lines drawn from equilibrium to axes? 1 point each S & D labeled? 1 point each equilibrium P & Q labeled? 1 point each

cost firm P market MC ATC S MR=D=AR=P p P D Q Q q quantity 2 axes labeled? firm labeled? MC curve Nike swoosh & labeled? ATC curve smiley face & labeled?

cost firm P market MC ATC S MR=D=AR=P p P D Q Q q quantity MC intersect ATC lowest point? firm’s quantity correctly determined from MR = MC, drawn dotted line & labeled small q? firm’s price line drawn from market, solid line & labeled? was firm’s Mr. DARP line drawn below ATC? firm’s price labeled on axis with small p?

Erase your white board. Write both team members’ names on the whiteboard. Draw a correctly labeled diagram showing both the industry and the individual firm where the firm is at zero economic profit. Draw as large as possible still being easily legible.

cost firm P market MC ATC S MR=D=AR=P p P D Q Q q quantity 34 of 34

Perfect Competition