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MARKETSTRUCTURE:PerfectCompetition
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Purpose of thischapter
To explain howcompetitive markets
determine prices,output, and profits
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Structure of the
MarketThe process by which price
and output are determinedin the real world is stronglyaffected by the structure ofthe market
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Market structureA classification system for
the key traits of a market,including the number offirms, the similarity of theproducts they sell, and theease of entry and exit
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Types of Market
Structure1.Perfect Competition
2.Monopoly
3.Monopolistic Competition4.Oligopoly
Types 2, 3 and 4 are referred to as imperfectcompetition
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Perfect competition
1. many small firms
2. homogeneous product
3. very easy entry and exit
4. price taker
5.economic agents haveperfect knowledge of market
conditions
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Homogeneous Product
Goods that cannot be
distinguished fromone another; for
example, one potatocannot bedistinguished from
another potato
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Seller is a Price taker
A seller that has nocontrol over the priceof the product it sells
He can not influence
the price
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Price determination inPC
Supply and Demand
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Market Supply and DemandP
Q
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What determines theindividual firmsdemand curve?A horizontal line atthe market price
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Individual firm demand
Q
P
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If the firm charges morethan this price, it will not
sell anything, and it hasno incentive to chargeless than this price
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Why does the firm
have no incentive tocharge less than the
market price?It can selleverything it bringsto market at themarket price
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What does theperfectly competitive
firm control?
The only thing it controlsis how many units itproduces.
It can not influence price.It has to sell at the
market-clearing price.
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How many units of theproduct should thisfirm produce?
The number of units
whereby it will maximizeits profits, or at leastminimize its losses
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There are two
methods todetermine how many
units to produce TR and TC
MR and MC
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The total revenue -total cost method
Where the distancebetween TR and TCis the greatest.Then profit can be
maximized
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Quantity of Output
TRMaximize Profit TC
TR,TC
QProfit Maximising Output
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Marginal Analysis to
determine the profit-
maximising level of output
By comparingMarginal Revenue and
Marginal Cost
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Marginal revenue
MR = TR / 1 outputChange in total revenue from
the sale of one additional unitof output
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Marginal cost
MC = TC / 1 outputChange in total cost from
producing one additional unitof output
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The marginal revenue and marginal costmethod to profit maximization
MR = MCThe firm maximizesprofit byproducing the output where
marginal revenueequalsmarginal cost
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Why should a firmcontinue to produce
as long as MR > MC?As long as MR is > than
MC, money is beingmade on that last unit
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Why will a firm notproduce that unitwhere MR < MC?
At the unit of output whereMR < MC, money is being
lost on that last unit
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ATC
AVC
MCP = MR = AR
Profit
Pric
e&
Co
stp
er
unit MR=MC
Profit maximising output
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ATCAVC
MC
P=MR=ARLoss
Pri
ce&
Co
stp
eru
ni t MR=MC
P
Q
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ATC
AVC
MC
P=MR=AR
Short-Run Shutdown
MR=MC
P
Q
Loss
Price&
Co
stp
er
unit
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Price (MR) is below
minimum averagevariable cost
Firm will shut down
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Shut down
If the price (average revenue)is below the minimum point on
the average variable costcurve, the MR = MC rule doesnot apply, and the firm shutsdown to minimize its losses.
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The perfectly competitive
firms short-run supply
curve
The perfectly competitive firmsshort-run supply curve is a
curve showing the relationship
between the price of a productand the quantity supplied in the
short run.
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The perfectly
competitive firms short-run supply curve
The firms marginal costcurve above the
minimum point on itsaverage variable costcurve
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AVC
MC
MR3
MR2MR1
Firms Short-Run Supply CurveP
Q
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The industrys supplycurve
The summation of theindividual firms MC
curves that lie abovetheir minimum AVCpoints
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The industrys
supply curveThe perfectly competitive
industrys short-run supply
curve is the horizontal
summation of the short-runsupply curves of all firms in
the industry
Industrys Supply Curve
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S = MCIndustrys Supply Curve
P
Q
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Normal profitThe minimum
profit necessary tokeep a firm in
operation
I th l
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In the long-run,what happens when
economic profitsare made?
When firms make morethan a normal profit, firmsenter the industry.Assupply increases, adownward pressure is
put on prices
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In the long-run, what
happens whenlosses are made?When firms make less thana normal profit, firms leavethe industry. As supply
decreases, an upwardpressure is put on prices
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In the long-run, whereis equilibrium?
At the market pricethat enables firms tomake anormal profit
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long-run perfectlycompetitiveequilibrium
P = MR = SRMC =
SRATC = LRAC
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SATC
LRAC
SRMC
MR
Equilibrium
Long-Run Competitive EquilibriumP
Q
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Three different typesof industries can
exist in the long-run
Constant-cost Decreasing-cost Increasing-cost
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Constant-cost industry
An industry in which theexpansion of industryoutput by the entry of
new firms has no effecton the firms cost curves
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The long-run supplycurve in a constant-
cost industry
It is perfectly elastic,which is horizontal
I i d d t
I i d d
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Increase in demand sets ahigher equilibrium price
Increase in demand sets ahigher equilibrium price
Entry of new firmsincreases supply
Entry of new firmsincreases supply
Initial equilibriumprice is restored
Initial equilibriumprice is restored
Perfectly elastic long-runsupply curve
Perfectly elastic long-runsupply curve
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A decreasing-costindustry
An industry in which the
expansion of industryoutput by the entry of
new firms decreasesthe firms cost curves
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The long-run supplycurve in a decreasing-cost industry
It is downward sloping
I i d d t
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Increase in demand sets ahigher equilibrium price
Increase in demand sets ahigher equilibrium price
Entry of new firmsincreases supply
Entry of new firmsincreases supply
Equilibrium priceand AC decreaseEquilibrium priceand AC decrease
Downward sloping long-runsupply curve
Downward sloping long-runsupply curve
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An increasing-costindustry
An industry in which theexpansion of industryoutput by the entry ofnew firms increases thefirms cost curves
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The long-run supplycurve in a increasing-cost industry
It is upward sloping
I i d d t
I i d d t
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Increase in demand sets ahigher equilibrium price
Increase in demand sets ahigher equilibrium price
Entry of new firmsincreases supply
Entry of new firmsincreases supply
Equilibrium priceand AC increaseEquilibrium priceand AC increase
Upward sloping long-runsupply curve
Upward sloping long-runsupply curve
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Summary
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Market structure consists of threemarket characteristics: (1) thenumber of sellers, (2) the nature
of the product, (3) the case ofentry into or exit from the market.
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Perfect competition is a marketstructure in which an individualfirm cannot affect the price of the
product it produces. Each firm inthe industry is very small relativeto the market as a whole, all thefirms sell a homogeneous
product, and firms are free toenter and exit the industry.
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A price-taker firm in perfect
competition faces a perfectlyelastic demand curve. It can sellall it wishes at the market-
determined price, but it will sellnothing above the given marketprice. This is because so many
competitive firms are willing tosell at the going market price.
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The total revenue-total costmethod is one way the firmdetermines the level of outputthat maximizes profit. Profit
reaches a maximum when thevertical difference between thetotal revenue and the total cost
curves is at a maximum.
P
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Quantity of Output
TRMaximize Profit TC
P
Q
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The marginal revenue equalsmarginal cost method is a secondapproach to finding where a firmmaximizes profits. Marginal
revenue is the change in totalrevenue from a one-unit changein output. Marginal revenue for a
perfectly competitive firm equalsthe market price.
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The MR = MC rule states that the
firm maximizes profit or minimizesloss by producing the outputwhere marginal revenue equals
marginal cost. If the price(average revenue) is below theminimum point on the averagevariable cost curve, the MR = MCrule does not apply, and the firmshuts down to minimize its losses.
ATC
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ATC
AVC
MC
P = MR = AR
Profit
Pr
ice&
Costp
er
unit MR=MC
tP
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ATCAVC
MC
P=MR=ARLoss
P
ric
e&
Co
stp e
runi t
MR=MCP
Q
Short Run ShutdownP t
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AVC
MC
P=MR=AR
Short-Run Shutdown
MR=MC
P
Q
Loss
P
ric
e&
Costp e
runit
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The perfectly competitive firmsshort-run supply curve is a curveshowing the relationship between
the price of a product and thequantity supplied in the short run.
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The individual firm always producesalong its marginal cost curve aboveits intersection with the averagevariable cost curve. The perfectly
competitive industrys short-runsupply curve is the horizontalsummation of the short-run supply
curves of all firms in the industry.
Industry EquilibriumP
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S = MCIndustry EquilibriumP
Q
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Long-run perfectly competitiveequilibrium occurs when the firmearns a normal profit byproducing where price equalsminimum long-run average costequals minimum short-runaverage total cost equals short-
run marginal cost.
Long-Run Competitive EquilibriumP
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SATC
LRAC
SRMC
MR
EquilibriumP
Q
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A constant-cost industry is anindustry whose total output canbe expanded without an increasein the firms average total cost.Because input prices remainconstant, the long-run supplycurve in a constant-cost industry
is perfectly elastic.
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A decreasing-cost industry is anindustry in which lower inputprices result in a downward-sloping long-run supply curve. As
industry output expands, thefirms average total cost curveshifts downward, and the long-run
equilibrium market price falls.
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An increasing-cost industry is anindustry in which input prices riseas industry output increases. As a
result, the firms average totalcost curve rises, and the long-runsupply curve for an increasing-cost industry is upward sloping.
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