Colander Micro Notes C 11 by gdDK26



                                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.

      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

                          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

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.

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
                 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

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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