1 Chapter 11 Colander Perfect Competition The perfectly competitive model is the economist’s equivalent of the vacuum model that is used in physics. It purposely has a set of highly restrictive assumptions and provides us with a reference point for thinking about various market structures and competitive processes like monopoly and oligopoly. Necessary conditions for an industry to be classified as purely competitive. 238 1. The number of firms is large. 2. Firms products are identical (homogeneous) 3. Both buyers and sellers are price takers. 4. There are no barriers of entry. 5. Both buyers and sellers have complete information. 6. Selling firms are profit-maximizing entrepreneurial firms. People who make the decisions must receive only profits and no other income from the firm. Purely competitive firms are price takers because they are so small in relation to market size that no matter how much they supply it has no discernible affect on market supply and hence market price. Also, they cannot influence the demand for their product via advertising, etc. Q- Why is this so? Barriers to entry are social, political, or economic impediments that prevent firms from entering a market. Examples; farming (maybe), some securities markets Recent technological developments have reduced the number of seller-set posted price markets (ex- retail stores) and replaced them with auction markets. 2 Price takers ask “How much should I supply, given the market price?” Price makers ask “Given the demand curve, how much should I produce and what price should I charge?” If the conditions for PC are not met, then we can’t use our formal concepts of supply and how it relates to cost as we did when we studied S & D earlier in the semester; we can, however, still talk informally about the supply of produced goods and cost conditions. Demand Curves for the Firm and the Industry in PC. 241 Fig. 11-1 241 Short-run Profit Maximization for a Purely Competitive Firm Marginal Cost – the increase in TC associated with production of an additional unit of output. Marginal Revenue – the increase in TR associated with the sale of an additional unit of output. The Golden Rule – A firm will maximize profits by producing to the point where MR = MC = P Fig. 11-2 242 Determining the profit maximizing level of output from a graph. Fig. 11-5 247 NOTE: Profit maximization is not the same as: a. Maximizing sales b. Maximizing profit per unit 3 SR Profit Maximization Rule: To maximize profits or minimize losses, a purely competitive firm should produce to the point where MR = MC as long as P>AVC. In the SR if a firm can shuts down it loses only its fixed costs. Therefore they will stay open in the SR as long as P>AVC because in doing so they will cover their variable costs while earning some revenue to apply to their fixed costs, and thus they’ll lose less money than if they shut down. Q - In the examples below, calculate the profit/loss by A: Staying open, B: By shutting down. Then decide what the proper business decision would be in each example. Firm #1: TR = $20,000 FC = $10,000 VC = $18,000 Decision is to . Firm #2: TR = $20,000 FC = $2,000 VC = $22,000 Decision is to . SR Supply Curve of a Firm in Pure Competition – The SR supply curve is that section of a firm’s MC curve that lies above its AVC. 4 The Logic -- If D intersects the MC in this section, it determines both P and Q. By definition any curve that does this is a supply curve. In the long-run however, the firms’ supply curve is that portion of its MC curve that lies above its ATC because the firm must earn a normal profit (which is included in ATC) to stay in business. Fig. 11-6 (a) 250 As always, the shape of the firm’s supply curve is determined by costs of production (wages, rent, utilities, etc.) and by expectations about future prices. Long Run Competitive Equilibrium In the SR an increase in industry demand leads to economic profits for existing firms. However, in the LR this leads to expansion of existing firms and entry by others into the industry which increases market supply and thus erases economic profits. Firms return to normal profits. Fig. 11-7 253 Thus, in the LR is it safe to say than an increase in D caused an increase (shift) in supply. In the SR, an increase in D leads to an increase in the quantity supplied (a movement along the supply curve) because supply cannot change. Whether the new industry price is above, equal to, or below the original price depends upon whether the industry was an increasing, constant, or decreasing cost industry. (254) The perfectly competitive model and the reasoning underlying it are extremely powerful. With them you have a simple model to use as a first approach to predict the effect of an event, or to explain why an event occurred. Q - Why is a decreasing cost industry incompatible with a purely competitive market structure? Hint: what will other firms do when they find that larger firms are more efficient?
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