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CHAPTER 7 PERFECT COMPETITION

Part Two: Microeconomics of Product Markets. CHAPTER 7 PERFECT COMPETITION. In this chapter you will learn:. 7.1 The four basic market structures 7.2 The conditions required for perfectly competitive markets 7.3 How firms in perfect competition maximize profits or minimize losses

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CHAPTER 7 PERFECT COMPETITION

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  1. Part Two: Microeconomics of Product Markets CHAPTER 7PERFECT COMPETITION

  2. In this chapter you will learn: 7.1 The four basic market structures 7.2 The conditions required for perfectly competitive markets 7.3 How firms in perfect competition maximize profits or minimize losses 7.4 Why the marginal cost curve and supply curve of competitive firms are the same 7.5 About the firm’s profit maximization in the long run 7.6 About the efficiency of competitive markets Chapter 7

  3. Four Market Structures • Perfect Competition • Monopoly • Monopolistic Competition • Oligopoly Pure Monopoly Pure Competition Monopolistic Competition Oligopoly Market Structure Continuum Chapter 7.1

  4. Characteristics of Perfect Competition • Very Large Numbers • Standardized Product • Price-Takers • Easy Entry and Exit Pure Monopoly Pure Competition Monopolistic Competition Oligopoly Market Structure Continuum Chapter 7.2

  5. Demand for a Firm in Perfect Competition • Perfectly Elastic Demand • Average, Total, and Marginal Revenue • average revenue = price • marginal revenue = price • total revenue = price x quantity Illustrated… Chapter 7.2

  6. ] ] ] ] ] ] ] ] ] ] 131 131 131 131 131 131 131 131 131 131 x Chapter 7.2

  7. Figure 7-1 The Demand and Revenue Curves for a Firm in Perfect Competition 1179 1048 917 786 655 524 393 262 131 0 TR Demand is perfectly elastic since the firm can sell as much output as it wants at the market price Price and revenue D = MR = AR 2 4 6 8 10 12 Quantity Demanded Chapter 7.2

  8. Profit Maximization in the Short Run • Purely competitive firm can maximize its profit (minimize its loss) only by adjusting output Two Approaches: • total revenue-total cost approach • marginal revenue-marginal cost approach Chapter 7.3

  9. p=$131 Chapter 7.3

  10. Break-even point Break-even point (normal profit) Figure 7-2 Maximum economic profit $299 TR TR TC Chapter 7.3

  11. Total Revenue-Total Cost Approach • Profit = TR - TC • Profit is maximized where the vertical distance between TR and TC is maximized • Break-even points are where TR=TC • Now, the marginal revenue-marginal cost approach… Chapter 7.3

  12. Should the firm produce the 1st unit? What about the 2nd unit? What about the 9th unit? ] ] ] ] 9 units will maximize profits the same profit-maximizing result as with the TR-TC approach! ] ] ] ] ] Figure 7-3 Chapter 7.3

  13. Marginal Revenue-Marginal Cost Approach Short run profit maximization occurs where MR=MC: • Rule applies only if producing is preferable to shutting down • Rule is an accurate guide to profit maximization for ALL firms • Rule can be restated as P=MC for purely competitive firms, since MR=P Chapter 7.3

  14. 131 97.78 9 MC Profit = 9 X (131 - 97.78) = 299 ATC Find ATC AVC Find the quantity where MR=MC AFC Chapter 7.3

  15. Loss-Minimizing Case • Suppose price falls from $131 to $81… Chapter 7.3

  16. Firm should produce the first 6 units ] ] ] ] ] ] ] ] ] Figure 7-4 Chapter 7.3

  17. Loss = 6 X (81 - 91.67) = -64.02 < TFC 91.67 81 MC ATC AVC AFC Chapter 7

  18. Shutdown Case • Suppose the price falls even further, to $71… Chapter 7.3

  19. 94 71 MC ATC Loss = 5 X (71 - 94) = -115>TFC AVC AFC When price is below minimum AVC, the firm should shut down 5 Chapter 7.3

  20. Figure 7-6 Marginal Cost and Short-Run Supply ATC P MC Costs and revenues (dollars) AVC At every price, the MR = MC point indicates the quantity being produced... Q Chapter 7.4

  21. P3 MR3 Q3 Marginal Cost and Short-Run Supply ATC P MC Costs and revenues (dollars) AVC Record the quantity being supplied for each price Q Chapter 7.4

  22. Marginal Cost and Short-Run Supply ATC P MC Costs and revenues (dollars) AVC P3 MR3 P2 MR2 At a lower price a lower quantity will be supplied Q Q2 Q3 Chapter 7.4

  23. Marginal Cost and Short-Run Supply ATC P MC Costs and revenues (dollars) P4 AVC MR4 P3 MR3 P2 MR2 At a higher price a higher quantity will be supplied Q Q2 Q3 Q4 Chapter 7.4

  24. Marginal Cost and Short-Run Supply ATC MC P MR5 P5 Costs and revenues (dollars) P4 AVC MR4 P3 MR3 P2 MR2 MR1 P1 Firm should not produce below P2 Q Q2 Q3 Q4 Q5 Chapter 7.4

  25. Marginal Cost and Short-Run Supply ATC P Short-run supply curve (Above AVC) MC MR5 P5 Costs and revenues (dollars) P4 AVC MR4 P3 MR3 P2 MR2 MR1 P1 Q Q2 Q3 Q4 Q5 Chapter 7.4

  26. Marginal Cost and Short-run Supply • Firm’s short-run supply curve is the portion of its MC curve above minimum AVC • Diminishing Returns, Production Costs, and Product Supply • Supply curve shifts: • A wage increase shifts the supply curve upward and to the left (decreasing in supply) • Technological progress would shift the supply curve downward to the right (increasing in supply) Chapter 7.4

  27. Economic Profit P P Q Q Figure 7-7Competitive Equilibrium for a Firm and the Industry S=MCs ATC MC D $111 $111 AVC D 8 8000 Firm (price taker) Industry 1000 firms Chapter 7.4

  28. Table 7-4 Output Determination in Perfect Competition in the Short Run Chapter 7.4

  29. Profit Maximization in the Long Run • Assumptions: • Entry and Exit Only • Identical Costs • Constant-Cost Industry Chapter 7.5

  30. The Goal of Our Analysis • In the long run, p = minimum ATC • Because: • Firms seek profit and avoid losses • Firms are free to enter and exit the industry Chapter 7.5

  31. D2 Figure 7-8 Entry Eliminates Economic Profits If product demand increases... S1 P MC P ATC $60 $50 $40 $60 $50 $40 Economic Profits MR D1 Q Q 100 100,000 Firm (price taker) Industry 1000 firms Chapter 7.5

  32. S2 Entry Eliminates Economic Profits S1 ...new firms enter, S increases, P falls MC P P ATC $60 $50 $40 $60 $50 $40 MR D2 New Equilibrium with more firms D1 Q Q 100 100,000 110,000 Firm (price taker) Industry 110,000 firms Chapter 7.5

  33. D2 Figure 7-9 Exit Eliminates Losses If product demand decreases... S1 MC P P ATC $60 $50 $40 $60 $50 $40 MR Economic Loss D1 Q Q 100 100,000 Firm (price taker) Industry 1000 firms Chapter 7.5

  34. S3 90,000 Exit Eliminates Losses ...firms exit, S decreases, P increases S1 MC P P ATC $60 $50 $40 $60 $50 $40 MR D1 New equilibrium with fewer firms D2 Q Q 100 100,000 Firm (price taker) Industry 90,000 firms Chapter 7.5

  35. Long-Run Equilibrium • If price > min ATC • profits attract new firms • as S increases, price drops to min ATC • If price < min ATC • losses cause firms to exit • as S decreases, price rises to min ATC • So, in the long run, p = min ATC Chapter 7.5

  36. Long-run Supply • Crucial factor is whether the number of firms in the industry affects the costs of individual firms Chapter 7.5

  37. Figure 7-10 Long-run Supply for a Constant-Cost Industry Is Horizontal Demand increases P Profits attract new firms S1 P>$50 P=$50 D2 D2 D1 Price remains the same in the long run Q Q1 Q2 Q2 Chapter 7.5

  38. Figure 7-11 Long-run Supply for an Increasing-Cost Industry Is Upsloping Demand increases Profits attract new firms S1 P P>>$50 P=$50 D2 D1 In the long run, greater supply is offered at a higher price Q Q2 Q1 Chapter 7.5

  39. long-run S Long-run Supply for a Decreasing-Cost Industry Is Downsloping Demand increases S1 Profits attract new firms P P>$50 P=$50 P<$50 D1 D2 In the long run, greater supply is offered at a lower price Q Q2 Q1 Chapter 7.5

  40. Price = MC = Minimum ATC (normal profit) Figure 7-12 Pure Competition and Efficiency P MC ATC MR P Q Q Chapter 7.6

  41. Pure Competition and Efficiency • Productive Efficiency • P = Minimum ATC • Allocative Efficiency • P = MC Chapter 7.6

  42. Allocative Efficiency andConsumer and Producer Surplus • Consumer Surplus is the difference between what the consumer is willing to pay and the market price • Producer Surplus is the difference between the marginal cost of production and the market price • At equilibrium, consumer and producer surplus is maximized Chapter 7.6

  43. Figure 7-12 Long-Run Equilibrium:A Competitive Firm and Market P Consumer Surplus The sum of consumer and producer surplus is maximized Pe Producer Surplus Q Qe Chapter 7.6

  44. Pure Competition and Efficiency • Productive Efficiency • P = Minimum ATC • Allocative Efficiency • P = MC • Dynamic Adjustments • purely competitive markets adjust to restore efficiency when disrupted by changes in the economy Chapter 7.6

  45. The “Invisible Hand” Revisited • The efficient allocation of resources in perfect competition comes about because businesses and resource suppliers seek to further their self-interest • Both business profits and consumer satisfaction are maximized Chapter 7.6

  46. Chapter Summary • 7.1 Four Market Structures • 7.2 Characteristics of Pure Competition and the Firm’s Demand Curve • 7.3 Profit Maximization in the Short Run • MR ( = P) = MC ; TR – TC is the highest • 7.4 Marginal Cost and Short-Run Supply • Firm’s short-run MC that Lies above its AVC • 7.5 Profit Maximization in the Long Run • 7.6 Pure Competition and Efficiency • P = ATC = MC Chapter 7

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