1. Perfect Competition

2. Plan • Conditions for perfect competition • Profit maximization • In the short run • Choice of the optimal output • The shutdown condition • The industry supply • Market equilibrium • In the long run with free entry • Market supply, market equilibrium

3. Conditions for Perfect Competition • Firms Sell a Standardized Product • Firms are price takers • Factors of Production are Perfectly mobile in the long run • Firms and consumers have perfect information

4. Economic Profit • Economic profit is the difference between the total revenue and total cost • Note that the total cost includes ALL the costs. It may differ from the accounting costs. • Economic costs include alternative costs (say, a rental cost of capital) • Example: farms in New Jersey

5. How should a producer choose the output? • Assume he knows the cost function, • what is the smallest cost of producing Q units of output given the • technology • prices of the inputs • Producer’s objective is to maximize the profits, • Revenue-Cost, • What is the profit maximizing level of output?

6. Profit Maximization in the Short Run • Marginal revenue of producing another unit should equal to the marginal cost of its production • Marginal revenue in a competitive market is the market price. • Is it optimal to produce the quantity at which this condition is satisfied but the marginal cost is decreasing? • No.

7. Shut-down conditions • Should a firm produce if the price falls below AVC? • NO • Should a firm shut down if the price falls below ATC but above the AVC? • YES, in the short run

8. Supply • Firm supply is the relationship between market price and the quantity produced by a firm at that price. • Market supply is the relationship between market price and the quantity produced by all the firms in the industry at that price.

9. Example • Assume N firms in the industry are producing a toothpaste of identical quality. • Assume that the individual firm supply is identical across firms: • What is the industry supply of toothpaste?

10. Short Run Competitive Equilibrium • SR Equilibrium is a price and quantity such that demand is equal to the SR supply. • In the short run a firm can earn economic profit in a competitive market. • Example: • What is the optimal output for this firm if the price is 24? What is its profit if FC=1? • At what level of fixed cost will the firm earn zero economic profit?

11. Efficiency of SR Competitive Equilibrium • Allocation is efficient if there is no additional allocation that will make somebody in the economy strictly better off without worsening the well-being of the other. • Say, a SR competitive market equilibrium is (P*,Q*) • Take money from a consumer in the amount that he is willing to give up for an additional unit of output (less than P* ), give it the producer. He will not be willing to produce another unit (he will be worse off if he does). • Similarly, producing less will hurt both consumers and producers.

12. Competitive Markets in the Long Run • In the long run all inputs can be adjusted, • Firms that were operating below the minimum ATC will leave (shut down). • New firms can enter the competitive industry • New firms will enter as long as economic profits can be earned

13. Competitive Markets in the Long Run • In the LR firms do not earn economic profits! • Only the low cost firms stay in the industry! • What is the LR competitive market supply?

14. Competitive Equilibrium in the Long Run • The price equals to the minimum of the LAC • The quantity produced is determined by the demand • How many firms will enter the industry?

15. Can Long Run supply be upward sloping? • Yes • if some of the inputs are in limited supply • if some of the inputs’ prices increase as the production is expanded

16. Applications • Price supports for family farms