The Model of Perfect Competition

1. The Model of Perfect Competition Microeconomics - Dr. D. Foster

2. Perfect Competition - An Ideal • Firms are primarily distinguished from each other by the degree of competition they face: Perfect Competition Monopolistic Competition Monopoly Oligopoly • Profit maximization. • The Model of Perfect Competition. • Allocative and Productive efficiencies. • Long-run costs and adjustments

3. Profit Maximizing Rule • No matter what kind of firm we are talking about, they will max. profit when:Marginal Revenue = Marginal Cost (MR) (MC) • If MR > MC, you are foregoing profit. • If MR < MC, you are foregoing profit.

4. Perfect Competition • All goods are identical.--One cannot be (usefully) distinguished from another. • Many buyers and sellers.--No one can affect price through their actions. • There are no barriers to entry/exit.--Firms cannot earn economic profit in the long run. • Buyers & sellers have perfect information.--A single price will prevail in the market.

5. P $ S MC Pe = MR = d Pe D q Q q* Qe q2 q1 A Firm The Market Perfect Competition • Market price = price to the firm = MR(This is the “demand” for the firm’s output & is perfectly elastic.)

6. $ MC ATC Pe MR = d q q* A Firm Perfect Competition How can we tell if a firm makes a profit? Calculate: Total Revenue = P•q*& Total Cost = ATC •q* Econ Profit = TR - TC

7. $ MC ATC Pe MR = d q q* A Firm Scenario #1 - Positive Profit The ATC must be less than the price, so that calculated profit is positive. What will happen in this industry in the long run?

8. $ MC ATC Pe MR = d q q* Scenario #2 - Zero Econ Profit The ATC must be equal to the price, so that calculated profit is zero. What will happen in this industry in the long run? A Firm

9. $ MC ATC AVC Pe MR = d q q* A Firm Scenario #3 - Negative Profit I The ATC must be more than the price, so that calculated profit is negative. Will this firm stay in business in the short run?It depends . . . What will happen in this industry in the long run?

10. ATC $ AVC MC Pe MR = d q q* A Firm Scenario #3 - Negative Profit II:The Shutdown Point The firm will shut down, right away, if the Price (MR) is less than the AVC…or, if the total loss > fixed costs What will happen in this industry in the long run? Fixed Costs Do worksheet on perfect competition.

11. Perfect Competition & Efficiency Allocative Efficiency (What to produce?) occurs when Price = Marginal Cost Why ? Productive Efficiency (How to produce?) occurs where output level is at the minimum ATC Why ?

12. $ MC ATC Pe MR = d q q* Perfect Competition & Efficiency Perfectly competitive firms are alwaysAllocatively Efficient Perfectly competitive firms always charge a price = MC. Why? In the LR, perfectly competitive firms produce at min. ATC. Why? In the LR, perfectly competitive firms are Productively Efficient

13. S* P P If econ profits are positive, entry occurs S S S* Pe Pe If econ profits are negative, exit occurs D D Q Q Qe Qe The Market The Market Perfect Competition in LR We know that in SR, firms can earn a positive, or negative, economic profit. What happens in the long run?

14. P S S* Pe Pe* MR* = d* D Q q* Qe The Market Perfect Competition in LR If a firm earns positive economic profit, in the long run that will be dissipated as firms enter. $ MC ATC Pe MR = d In the LR, this firm earns 0 econ profit. q q* A Firm

15. S* P S MR* = d* Pe* Pe D Q q* Qe The Market Perfect Competition in LR If a firm earns negative economic profit, in the long run that will be eliminated as firms exit. ATC $ MC Pe MR = d In the LR, this firm earns 0 econ profit. q q A Firm

16. S1 S2 P P S S LRS1 LRS2 S3 Pe Pe LRS3 D* D* D D Q Q Qe Qe The Market The Market Perfect Competition in LR If the market is in equilibrium . . . econ profits = 0.If demand increases (e.g., incomes rise), what happens in SR and LR in this market?

17. The Paradox of Taxing Economic Profit In the short run, there are no consequences! P $ MC S ATC MR* = d* P* Pe = MR = d Pe D* D q Q q Qe Q* q* A Firm The Market

18. The Paradox of Taxing Economic Profit In the short run, there are no consequences! But, what about the long run? Firms no longer earn an economic profit. No firms will enter into this market. The price will not fall; the output will not rise.

19. A Firm $ ATC1 ATC2 ATC3 LRAC q q* Economies of scale Diseconomies of scale Long Run Costs

20. q1 q2 Long Run CostsSpecial Case - The Flat Bottomed LRAC A Firm $ LRAC Firms of varying size survive together; q1 is the “minimum efficient scale.” q Constant Returns to scale

21. The Model of Perfect Competition Microeconomics - Dr. D. Foster