PERFECTLY COMPETITIVE MARKETS Definition of a Perfectly Competitive Market • Very Large Number of Sellers and Buyers • Identical (Homogeneous) Product • Easy Entry/Easy Exit • Perfect Information Definition of a Perfectly Competitive Market A. Very Large Number of Sellers – Each firm produces an extremely small percent of total market supply. B. Identical Product – The product sold by one firm is identical to that sold by another firm. Definition of a Perfectly Competitive Market Cont’ C. Easy Entry and Easy Exit - Easy to enter this industry because costs are low. - Also easy to quit this industry because of the low costs. D. Buyers and Sellers Have Perfect Information - All the buyers and sellers know all of the relevant information. Consequences of a Competitive Market for the Firm A. The Competitive Firm Is A Price Taker - The firm must take the market price as given. B. The Competitive Firm Has No Market Power - The firm is so small that it has no power to shape the market in any way. Consequences of a Competitive Market for the Firm Cont’ C. The Competitive Firm Has A Horizontal Demand Curve – The firm must take the market price as given, and then decide how much it can produce. – It can sell any level of output, but only at the market price. – Whatever levels of output it sells at, the price will stay the same. The Profit Maximizing Rate of Output • We wish to answer the question: – At what rate of output will a competitive firm maximize its profits? There Are Two Approaches to Answer This Question A. Total Revenue/Total Cost B. Marginal Revenue/Marginal Cost Total Revenue • Total Revenue = - Price times Sales or - Price times Output Average Revenue • Average Revenue = – Same as price for the competitive firm. Marginal Revenue • Marginal Revenue= - The change in total revenue that comes from selling one more unit of output. Total Revenue/Total Cost Approach • Total Profits = Total Revenue - Total Costs • Total Revenue = Price * Output = Price * Sales • Total Costs = Fixed Costs + Variable Costs Total Revenue/Total Cost Approach • Firms maximize profits where total revenues are larger than total costs by the largest amount. The Marginal Cost/ Marginal Revenue Approach • More important than the total cost total revenue approach • This is because firms use the approach to determine exactly what level to produce at. Recall That: • Marginal Revenue = - Change in total revenue from one more sale. Marginal Cost • Marginal cost will be defined as: - Change in total cost from one more sale. The Marginal Cost-Marginal Revenue Approach Cont’ • The approach is to examine each sale to determine whether the costs of production is less than, equal to, or greater than, the revenues generated from the sale of that unit. Profit Maximization, Marginal Cost/Marginal Revenue Approach • If a new sale from a new level of production generates more revenues than costs, the firm should produce at the new level. • In this case marginal revenue is greater than marginal cost. Profit Maximization, Marginal Cost/Marginal Revenue Approach • If a new sale from a new level of production generates more costs than revenues, the firm should not produce at the new level. • In this case marginal cost is greater than marginal revenue. Profit Maximization for the Competitive Firm Cont’ • Firms will expand output as long as: MR>MC • Firms will cut back output as long as: MC>MR • Firms will maximize profits at the output: Where MC=MR SHORT RUN PROFITS AND LOSSES Short Run Profits and Losses A. As long as price is greater than the minimum average total cost, the firm has profits. P > MIN ATC Short Run Profits and Losses B. The break-even price is the price that is equal to the minimum ATC curve. P = MIN ATC Short Run Profits and Losses Cont’ C. If price falls below minimum ATC, it will suffer losses. P < MIN ATC THE SHUT DOWN DECISION Short Run Profits and Losses: The Shut Down Price A. If a firm shuts down, it will suffer a loss equal to its fixed costs. Investors lose all of their money. B. As long as the firm can pay for some of its fixed costs, it should continue to produce. Short Run Profits and Losses: The Shut Down Price C. The shut down price is the price that is just equal to the minimum average variable cost. P = MIN AVC Short Run Profits and Losses: The Shut Down Price Cont’ D. At any price above the minimum average variable cost, the firm will lose money, but less money than if it shuts down. • At any price below the minimum average variable cost, the firm should shut down. Summary of Price Decisions • If P > MIN ATC, there will be profits. • Produce where MR=MC • If P = MIN ATC, the firm will break even. • Produce where MR=MC Summary of Price Decisions Cont’ • If P < MIN ATC, but P > MIN AVC there will be losses. • Produce where MR = MC • If P < MIN ATC, and P < MIN AVC then shut down. LONG RUN SUPPLY Constant-Cost Industries • An industry in which expansion or contraction will not affect resource prices. Therefore production costs will stay the same. Increasing-Cost Industry • An industry in which expansion will lead to a rise in resource prices and production costs; and contraction leads to a fall in resource prices and production costs Decreasing-Cost Industry • An industry in which expansion will lead to a fall in resource prices and production costs; and contraction leads to a rise in resource prices and production costs. TOTAL FIXED VARIABLE TOTAL MARGINAL AVG. AVG. AVG. PRODUCT COSTS COSTS COSTS COSTS FIXED VARIABLE TOTAL COSTS COSTS COSTS 0 150 1 350 2 510 3 630 4 710 5 750 6 930 7 1130 8 1350 9 1590 10 1850 1) Compute all costs 2) If price is $186, compute revenues and profit max. level of output. 2) If price is $136, compute revenues and profit max. level of output. 2) If price is $106, compute revenues and profit max. level of output.