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Outline
What is a competitive market? Short-run profit maximization
Minimizing short-run losses
The competitive firms supply curve andindustry short-run supply curves
Perfect competition in long-run
Perfect competition and efficiency
Summary
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Market structure
Many of firms decisions depend on the structure of themarket in which it operates.
Market structure describes the important features of a
market such as: number of suppliers/producers product degree of uniformity do firms in the market
produce identical products or differentiated products?
Ease of entry into marketcan new firms enter easily orare they blocked by barriers?
forms of competition among firms do firms competeonly through prices or use advertising & product differences?
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Market equilibrium & Firms Demand Curve
in Perfect Competition
Market price of wheat =$5 is determined by intersection of the market DDand SS curve.
Once market P is established , producers can sell all they wants at themarket P
Perfectly competitive firm so smallhow much the firm produce has noeffect on the market price
Market equilibrium Firms demandPricePrice
Q of wheat Q of wheat
$5 $5
S
D
d
1,0000 5 10 15
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Short-run Profit Maximization
Profit = Total revenue (TR)Total cost
(TC) Total revenue for a firm is the selling price
times the quantity sold.
TR = (P Q) Total revenue is proportional to the
amount of output.
Average revenue (AR) tells how much revenuea firm receives for the typical unit sold.
AR = TR / Q
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The Revenue of a Competitive Firm
In perfect competition, AR= Price
Average Revenue =Total revenue
Quantity
Price Quantity
Quantity
Price
AR
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The Revenue of a Competitive Firm
Marginal revenue is the change in total
revenue from an additional unit sold.
MR = TR/ Q For competitive firms, MR=Price
Thus in perfect competition,P=AR=MR
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Table 1 Total, Average, and Marginal Revenue for a
Competitive Firm
Q Price TR =(PXQ)
AR =TR/Q
MR=TR/ Q
1 gallon $6 $6 $6
2 6 12 6 6
3 6 18 6 6
4 6 24 6 6
5 6 30 6 6
6 6 36 6 67 6 42 6 6
8 6 48 6 6
Price = Average Revenue = Marginal Revenue
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PROFIT MAXIMIZATION AND THE
COMPETITIVE FIRMS SUPPLY CURVE
The goal of a competitive firm is to
maximize profit.
This means that the firm will want toproduce the quantity that maximizes the
difference between total revenue and total
cost. Firm maximizes economic profit when TR
> TC by the greatest amount
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The Marginal Cost-Curve and the Firms Supply
Decision
Golden rule of profit maximization:
MR = MC
which holds for all market structure
For perfectly competitive firm,demand curve = P = MR = AR
Firm will expand output as long as MR > MC & stopexpanding output before MC > MR
When MR > MC, increase Q
When MR < MC, decrease Q
When MR = MC, profit is maximized.
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Profit Maximization: A Numerical Example (Price = $6)
Q TR =(PXQ)
TC Profit
(TR-TC)
MR
( TR/ Q)
MC
( TC/ Q)
Change inProfit
(MR-MC)
0gallon
$0 $3 -$3
1 6 5 1 $6 $2 $4
2 12 8 4 6 3 3
3 18 12 6 6 4 2
4 24 17 7 6 5 1
5 30 23 7 6 6 0
6 36 30 6 6 7 -1
7 42 38 4 6 8 -2
8 48 47 1 6 9 -3
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Short-Run Profit Maximization (TRTC)
TC TR
Q
Total dollars
5
$30
$23
Maximum economicprofit = $7
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Short-Run Profit Maximization (MR= MC)
Q
Dollars per unit
5
$6
$5
A
B
MC
ATC
d=MR=ARPROFIT
1. MC curve intersection
with MR at point A whereQ=5
2. Output < 5, MR > MC, socan increase profit byincreasing output
3. Output beyond 5, MC >MR, firm can increaseprofit by reducingoutput
4. Economic profit =rectangle = TR ($6 X 5 )ATC ($5 X 5) = $5
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Profit Maximization for a Competitive Firm
Quantity0
Costs
andRevenue
MC
ATC
AVC
MC
1
Q1
MC2
Q2
The firm maximizesprofit by producingthe quantity at whichmarginal cost equalsmarginal revenue.
QMAX
P= MR1= MR
2 P= AR= MR
If the firm
produces Q1,marginal cost isMC1.
If the firm producesQ2, marginal cost isMC
2
.
Suppose the market price is P.
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Minimizing Short-Run Losses
Sometimes the price that the firm is required totake will be so low that no rate of output will givesprofit
Faced with losses, firm has 2 options:
1. It can produce at a loss or
2. Temporarily shut down In SR firm faces 2 types of cost : FC & VC
A firm that shut down in the SR must still pay FC
The decision to shut down or proceed depends onwhether revenue could cover VC
As long firms revenue cover VC (or price coversAVC) & some portion of FC a firm will produce
and not shut down
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The firm shuts down if the revenue it
gets from producing is less than thevariable cost of production.
Shut down if TR < VC
Shut down if TR/Q < VC/Q Shut down if P < AVC
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Minimizing LossesQ MR or P TR TC MC ATC AVC Profit or
loss
0 - $0 $15.0 - - - -$15
1 $3 3 19.75 $4.75 $19.75 $4.75 -16.75
2 $3 6 23.50 3.75 11.75 4.25 -17.50
3 $3 9 26.50 3.00 8.83 3.83 -17.50
4 $3 12 29.00 2.50 7.25 3.50 -17.00
5 $3 15 31.00 2.00 6.20 3.20 -16.00
6 $3 18 32.50 1.50 5.42 2.92 -14.50
7 $3 21 33.75 1.25 4.82 2.68 -12.75
8 $3 24 35.25 1.50 4.41 2.53 -11.25
9 $3 27 37.25 2.00 4.14 2.47 -10.25
10 $3 30 40.00 2.75 4.00 2.50 -10.0011 $3 33 43.25 3.25 3.93 2.57 -10.25
12 $3 36 48.00 4.75 4.00 2.75 -12.00
13 $3 39 54.50 6.50 4.19 3.04 -15.50
14 $3 42 64.00 9.50 4.57 3.50 -22.00
15 $3 45 77.50 13.50 5.17 4.17 -32.50
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Minimizing Short-Run Losses
TC
TR
Q
Total dollars
10
$40
$30
Q
Dollars per unit
10
$3
$2.50
A
MC
ATC
d=MR=ARLOSSminimumeconomic
loss=$10
AVC$ 4
1. TR lies below TC
2. Vertical distance measures theloss
3. Loss minimized at Q=10
1. P > AVC (MC=MR) .
2. Firm will produce rather thanshut-down even though firm
experiencing loss. Q=10.
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The Firm and Industry Short-Run Supply Curves
As long as P covers AVC, firm will supplythe quantity resulting from the intersectionof its upward-sloping MC curve and its MRor demand curve
The portion of the firms MC curve thatintersects and rises above the lowest pointon its AVC curve becomes short-run firm
SS curve The quantity supplied is determined by theintersection of the firms MC curve and itsdemand or MR curve.
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Figure 2 Marginal Cost as the Competitive Firms Supply
Curve
Quantity0
Price
MC
ATC
AVCP1
Q1
P2
Q2
So, this section of thefirms MCcurve isalso the firms supplycurve.
As P increases, the firm willselect its level of output along
the MC curve.
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Figure 3 The Competitive Firms Short-Run Supply Curve
MC
Quantity
ATC
AVC
0
Costs
Firmshutsdown ifP AVC, firmwill continue toproduce in theshort run.
If P> ATC, thefirm willcontinue toproduce at a
profit.
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Aggregating individual supply to form market supply
P P P P
P P P P
10 20
Sa Sb Sc Sa + Sb +Sc = S
10 1020 20 30 60
1. At price < P, no output supplied
2. At P, each firm supplies 10 units: market supply = 30 units
3. At P, each firm supplies 20 units: market supply = 60 units
4. SR industry supply curve is horizontal sum of all firms SR supplycurves : horizontal summation of the firm level MC curves
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Relationship between SR profit maximization &
Market equilibrium
Q12
$5
$4
A
B
MC=sATC
dPROFIT
Firm
AVC$5
12,000
MC=s
Industry or market
D
1. Market P=$5 and assume there are 1,000 producers, market supply= 12,000. At this price each firm produce 12 unit
2. Each producer earns an economic profit of $12 (TR-TC= $60 - $48)
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Profit as the Area between Price and Average Total Cost
(a) A Firm with Profits
Quantity0
Price
P= AR=MR
ATCMC
P
ATC
Q(profit-maximizing quantity)
Profit
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Profit as the Area between Price and Average Total Cost
(b) A Firm with Losses
Quantity0
Price
ATCMC
(loss-minimizing quantity)
P= AR=MRP
ATC
Q
Loss
3 P ibl P fit O t i th Sh t R
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3 Possible Profit Outcomes in the Short Run
P and Cost
Q
$20
8
MC
ATC
AR=MR
a. Normal profit (P=ATC)
P and Cost
Q
$20
9
MC
ATCAR=MR
b. Economic Profit (P>ATC)
$25profit
P and Cost
Q
$17
7
MC
ATC
AR=MR
c. Economic loss (P
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Perfect Competition in Long Run
In the long run:
Firms have time to enter & exit
Can adjust their scale of operations
No distinction between FC and VC because all inputs arevariable in the LR
SR economic profit will encourage new firmsto enter the
market in the LR May encourage some existing firms to expand their scale of
operations
Industry supply curve shifts rightward in the LR driving
down the price This process continues as long as economic profit is greaterthan zero
There is zero economic profit in the LR
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In the long run, the firm exits if the revenue itwould get from producing is less than its total
cost. Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC
A firm will enter the industry if such an actionwould be profitable.
Enter if TR > TC
Enter if TR/Q > TC/Q
Enter if P > ATC
Long run equilibrium for the firm and the industry
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Long run equilibrium for the firm and the industry
p
MC
ATC
d
Firm
p
Q
S
Industry or market
D
1. In the LR market SS adjust as firms enter or leave
2. This continues until market SS intersect the market DD at aP=lowest point on each firms LRAC at point E. (P=ATC) efficient
scale
3. At point E, MC, SRAC and LRAC are all equal.
LRAC
E
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Figure 4 The Competitive Firms Long-Run Supply
Curve
MC = long-run S
Firm
exits ifP< ATC
Quantity
ATC
0
Costs Firms long-runsupply curve
Firmenters if
P> ATC
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Figure 7 Long-Run Market Supply
(a) Firms Zero-Profit Condition
Quantity (firm)0
Price
(b) Market Supply
Quantity (market)
Price
0
P= minimumATC
SS
MC
ATC
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The Long Run: Market Supply with Entryand Exit
At the end of the process of entry and exit,firms that remain must be making zero
economic profit.
The process of entry and exit ends only whenprice and average total cost are driven to
equality.
Long-run equilibrium must have firmsoperating at their efficient scale.
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A Shift in Demand in the Short Run andLong Run
An increase in demand raises price andquantity in the short run.
Firms earn profits because price now
exceeds average total cost.
Figure 8 An Increase in Demand in the Short Run
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Figure 8 An Increase in Demand in the Short Run
and Long Run
Firm
(a) Initial Condition
Quantity (firm)0
Price Market
Quantity (market)
Price
0
P1
ATC
P1
1Q
MC
A market begins in longrun equilibrium.
With firms earn zeroprofit.
D1
Short run supply, S1
Long runsupply
A
Long run adjustment to an increase demand
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Long run adjustment to an increase demand
p
MC
ATC
d
Firm
p
Q2
S
Industry or market
D
1. Initial market equilibrium at a : firms supplies q & earns normalprofit2. Suppose DD (D to D1), in short run market P to p ; firms output
(q)3. Economic profit attract new , supply (S to S1) .4. New equilibrium at point c & price return to initial level
5. Firms demand curve shift back down from d to d.
LRACE
Q1
pd
P
a
b
c
S1
D1
q
profit
Q3
Long run adjustment to an decrease demand
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Long run adjustment to an decrease demand
p
MC
ATC
d
Firm
p
Q2
S1
Industry or market
D1
1. Initial LR market equilibrium at a and firms equilibrium at E2. Suppose DD (D to D1), in short run market P to p ; firms demandfall from d to d ; output to q. Market output falls to Q2.
3. Economic loss many firms exit - supply (S to S1) .4. P back to p, new equilibrium at point c5. Market output reduced to Q3 & firms only earns normal profit as
demand shift back to d.
LRACE
Q3
p d P
c
ba
S
D
q
loss
Q1
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Perfect Competition and Efficiency
There are two concepts of efficiency used
to judge market performance- productive efficiency (producer surplus)
- allocative efficiency (consumer surplus)
Perfect competition guarantees bothallocative and productive efficiency in thelong run
Efficiency allocation of resources wheremarginal benefit = marginal cost(MB=MC)
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Productive efficiency
Productivity efficiency occurs when thefirm produces at the minimum point onits long-run average cost curve (LRAC)the market price equals the
minimum average total cost (P=ATC)
The entry & exit of firms and any
adjustment in the scale of each firmensure that each firm produces at theminimum point on its LRAC curve
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Allocative Efficiency
Occurs when firms produce the output
that is most valued by consumers The demand curve reflects the marginal
value that consumers attach to each unit.
-the market price is the amount of money thatpeople are willing & able to pay for the final unitthey consume
In both the SR & LR, the equilibrium
price in perfect competition = marginalcost of supplying the last unit sold(P=MC)
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Consumer surplus (the connection between demand
and marginal benefit) Marginal benefit is the value
of one more unit of a good
MB = the maximum price thatconsumer are willing to payfor another unit of good
DD curve = MB curve
Consumer surplus =difference between value of agood & market price
When consumer buy lessthan it is worth they receive
consumer surplus Represented by area below
DD curve but above marketclearing price
DD= MB
$1
$5
$4
$3
$2
Consumersurplus
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Producer surplus (the connection between supply
and marginal cost)
When firms sells somethingmore than it costs toproduce the firms obtainsa producer surplus
Represented by areaabove supply curve andbelow market clearing price
SS = MC
5
$15
10
Producersurplus
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Consumer surplus and Producer surplus
When marketequilibrium reached atpoint E, productiveefficiency & allocativeefficiency occurs.
the combination of P*and Q* maximizes thesum of consumersurplus & producer
surplus.DD= MB
Consumer
surplusP*
SS= MC
Producersurplus
QQ*
Dollars per unit
E
Maximizing
The social welfare
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Because a competitive firm is a price taker, itsrevenue is proportional to the amount of outputit produces.
The price of the good equalsboth the firms
average revenue and its marginal revenue.
To maximize profit, a firm chooses the quantityof output such that MR=MC
This is also the quantity at which P=MC Therefore, the firms marginal cost curve is its
supply curve.
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In the short run, when a firm cannot recover itsfixed costs, the firm will choose to shut down
temporarily if the P < AVC.
In the long run, when the firm can recover bothfixed and variable costs, it will choose to exit if
the P < ATC.
In a market with free entry and exit, profits are
driven to zero in the long run and all firms
produce at the efficient scale.
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