Chapter 7 Perfect Competition

1. Chapter 7 Perfect Competition Econ 1900 Laura Lamb

2. 7.1 Four market models • Perfect competition • Monopolistic competition • Oligopoly • Pure Monopoly

3. What are the major characteristics of each market model?

4. 7.2 Perfect competition • Large number of firms • Standardized products • Price takers • Easy entry & exit of firms

5. Rare in the real world • Then why do we study it? • helps analyze industries with characteristics similar to perfect competition. • provides a context in which to apply revenue and cost concepts developed in previous chapters. • provides a norm or standard against which to compare and evaluate the efficiency of the real world.

6. Demand in perfect competition • Demand is perfectly elastic for each firm • Not for the industry • Individual firms can sell as much as they want at the market price

7. Demand schedule for a firm

8. Average Revenue • Total Revenue • Marginal Revenue

9. 7.3 Profit Maximization in the Short –Run: two approaches • Compare total revenue & total cost • Compare marginal revenue & marginal cost

10. Consider the market for maple syrup

11. Break-even point • Where is the break-even point for the firm? • This is where a normal profit is made • No economic profit at this point

12. Method 2 MR = MC rule: in the short run, a firm will maximize profit by producing at the output level where MR = MC.

13. Use the MR=MC Rule

14. ***The MR=MC rule is applicable to all market models***

15. Note For perfectly competitive firms: MR = MC is equivalent to P= MC Why?

16. Questions 1. Suppose the price dropped from $8/can to $6/can, how would the profit maximizing level of output change? 3. Now suppose, the price drops to $4/can. How much should be produced?

17. At a price of $4/can:

18. A loss minimizing situation • If a loss is incurred, the firm should continue to produce as long as the price is greater than average variable cost (AVC). • Modified rule: MR = MC if P>minimum AVC

19. 7.4 Marginal cost and the short-run supply curve In the example of Dave’s Maple Syrup: • when P=$8, quantity supplied = 10 • when P=$4, quantity supplied = 8 • appears rational in light of the law of supply! • The short-run supply curve is the section of the MC curve starting at minimum AVC (and above).

20. The Supply curve can shift In what situations would the supply curve for the firm shift?

21. Equilibrium in the firm & the industry

22. Is the industry profitable at the equilibrium?

23. The firm should produce is P≥minimum AVC • The firm should produce the quantity at MR=MC

24. Firm versus the industry • Individual firms must take price as given, but the supply plans of all competitive producers as a group are a major determinant of product price.

25. 7.5 Profit maximization in the long- run Assumptions: • Entry and exit of firms are the only long‑run adjustments • Firms in the industry have identical cost curves. • The industry is a constant‑cost industry • the entry and exit of firms will not affect resource prices or location of unit‑cost schedules for individual firms.

26. **In the long run, product price = minimum ATC

27. Long-run adjustments • If P>minimum ATC →economic profits will attract new firms to the industry →increased supply of the product →price is driven down to minimum ATC. • If P<minimum ATC →economic losses will cause some firms to leave the industry →decreased supply of the product →price is driven up to minimum ATC.

28. Example 1 A change in consumer tastes increases the demand for product • trace the steps to a new long-run equilibrium • Illustrate with two graphs, one for the firm and one for the industry.

29. Example 2 Household income decreases causing a fall in demand for the product. • trace the steps to a new long-run equilibrium • Illustrate with two graphs, one for the firm and one for the industry.

30. **In the long run, equilibrium price & quantity always occur where ATC is at a minimum for a perfectly competitive firm.

31. Some conclusions about long-run equilibrium • The product price will be exactly equal to each firm’s point of minimum average total cost.

32. Long-run supply for a constant cost industry • Perfectly elastic • Level of output does not affect price in the long-run.

33. Long-run supply for an increasing cost industry • Upward sloping as industry expands output.

34. Long-run supply for a decreasing cost industry • Downward sloping as the industry expands output.

35. 7.6 Perfect competition & Efficiency In the long run: • Productive efficiency occurs where P = minimum ATC • Allocative efficiency occurs where P = MC • allocative efficiency implies maximum consumer and producer surplus.

36. Efficiency Gains from entry of new firms in the pharmaceutical industry • When a pharmaceutical company introduces a new drug, it typically owns the patent and can price and produce as a monopolist, earning economic profits. • When patent rights expire, firms pursuing economic profits enter the market for that drug. • Prices of these drugs typically drop 30-40 percent. • Those lower prices increase efficiency and consumer surplus.