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Chapter 8 Analysis of Perfectly competitive Markets

Assumptions: firm maximizes profits

Perfect competition is a world of atomistic firms who are price-takers.

Profits = total revenues

total costs

are like the net earnings or take-home pay of a business represent the amount a firm can pay in dividends to the owners,

reinvest in new plant and equipment, or employ to make financial

investments.

Perfect Competition

world of price-takers sells a homogenous product it is so small relative to its market that it cannot affect the market price; itsimply takes the price as given firms segment in the demand curve is only a tiny segment of industrys

curve

the extra revenue gained from each extra unit sold is therefore market price*Demand curve is completely elastic for a perfectly competitive firm

*The maximum profit output comes at that output where marginal cost equals

price

oThe reason underlying this proposition is that the competitive firmcan always make additional profit as long as the price is greater than

the marginal cost of the last unit

o Total profit reaches its peakis maximizedwhen there is no longerany extra profit to be earned by selling extra output.

* extra revenue price per unit

* extra cost- marginal cost

Rule for a firms supply under perfect competition: A firm will maximize profits

when it produces at that level where marginal cost equals price: MC = P

* The firms marginal cost curve can be used to find its optimal production

schedule: the profit- maximizing output will come where the price intersects the

marginal cost curve.

Zero-profit point-the production level at which the firm makes zero economic

profits; price equals average cost, so revenues just cover costs.

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General Rule: A profit-maximizing firm will set its output at that level where

marginal cost equals price. Diagrammatically, this means that a firms marginal cost

curve is also its supply curve.

possibility: the price will be so low that the firms will want to shut down

In general , a firm will want to shut down in the short run when it can no longercover its variable cost.

Shutdown point:critically low market price at which revenues just equal cariable

costs. (loss exactly equal fixed costs)

o For prices above the shutdown point, the firm will produce along itsmarginal cost curve because even though the firm might be losing

money, it would lose more money by shutting down.

o For prices below the shutdown point, the firm will produce nothing atall because by shutting down the firm will lose only its fixed cost.

Shutdown rule: The shutdown point comes where revenues just cover variablecosts or where losses are equal to fixed costs. When the price falls below average

variable costs, the firm will maximize profits (minimize its losses) by shutting down.

SUPPLY BEHAVIOR IN COMPETITIVE INDUSTRIES

The total quantity brought to market at a given price will be the sum of theindividual quantities that all firms supply at that price.

In the short run, demand shifts produce greater price adjustments andsmaller quantity adjustments than they do in the long run.

Short-run equilibrium: when any change in output must use the same fixed

amount of capital

Long-run equilibrium: when capital and all other factors are variable and there is

free entry and exit of firms from the industry.

o In the long run, the price as a competitive industry will tend toward thecritical point where identical firms just cover their full competitive costs.

o The long-run equilibrium in a perfectly competitive industry is thereforeone with no economic profits.

Zero-profit long run equilibrium: IN a competitive industry populated by

identical firms with free entry and exit, the long-run equilibrium condition is thatprice equals marginal cost equals the minimum long run average cost for each

identical firms:

P=MC=minimum king-run AC=zero-profit price

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GENERAL RULES

Demand Rule: an increase in demand for a commodity (the supply curve being

unchanged) will raise the price of the commodity. For most commodities, an

increase in demand will also increase the quantity demanded. A decrease in demand

will have the opposite effects.

Supply rule: An increase in supply of a commodity (the demand curve being

constant) will generally lower the price and increase the quantity bought and sold. A

decrease in supply has the opposite effects.

Pure economic rent: When the quantity supplied is constant at every price, the

payment for the use of such a factor of production

Backward-Bending Supply

As improved technology raises real wages, people feel that they want to takepart of their leisure and early retirement.

Shifts in Supply

An increased supply will decrease P most when demand is inelastic An increased supply will increase Q least when demand is inelastic

The concept of Efficiency

An economy is efficient when it provides its consumers with the most desiredset of goods and services given the resources and technology of the economy.

Allocative efficiencyoccurs when no possible reorganization of production canmake anyone better off without making someone else worse off.

At minimum, an efficient economy is on its PPF. But efficiency goes further andrequires not only that the right mix of goods be produced but also that these

goods be allocated among consumers to maximize consumer satisfactions.

Economic surplus:rust area between supply and demand curves at theequilibrium; sum of the consumer surplus, which is the area between the

demand curve and the price line and the Producer surplus, which is the area

between price line and the SS curve. The producer surplus includes the rent and

profits to firms and owners of specialized inputs in the industry and indicates

the excess of revenues over cost of production.

o Is the welfare or net utility gain from production and consumption ofa good; it is equal to the consumer surplus plus the producer surplus.

Many goods

Condition:Utility-maximizing consumers spread their dollars among different goods

until the marginal utility of the last dollar is equalized for each good consumed.

A perfectly competitive economy is efficient when marginal private cost equals

marginal social costs and when both equal marginal utility.

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Competition guarantees efficiency, in which no consumers utility can be raised

without lowering another consumers utility.

Central role of marginal cost: Only when prices are equal to marginal costs is the

economy squeezing the maximum output and satisfaction from its scarce resources

of land, labor and capital.

MARKET FAILURES

Imperfect Competition: When a firm has a market power in a particular market.

Externalities:arise when some of the side effects of production or consumption are

not included in market prices.

Imperfect information:

* Read Summary