Microeconomics Notes Perfect Competition

University:
Minnesota State University Moorhead
Course:
ECON-202 | Principles of Economics I: Micro
Academic year:

2020
Views:

162

Pages:

8
Author:

kundgetanufv

Perfect Competition: Assumptions of the Model: 1. There are many small firms, each of which acts independently and cannot influence the price of its product. 2. There is freedom of entry and exit so that any firm can freely enter and exit the industry without restrictions of any kind. 3. All firms sell a homogenous (or identical) product, making it impossible to distinguish between products or different producers. 4. Perfect information exists so that all firms and consumers have all the necessary information on price and output to make decisions. 5. Perfect resource mobility means that resources (factors of production) can be moved freely and without cost from one firm to another. The Perfectly Competitive firm as a price taker: Price taker: A firm that sells all the output it wants at a price determined in the market. The firm cannot influence P because of its small size and because it sells a homogenous product. Therefore, the demand curve facing the firm is perfectly elastic at Pe, determined by demand and supply. In the market (industry), demand (D) and supply (S) determine an equilibrium price Pe. Each firm in the industry accepts this price. If a firm tries to increase its price, it will lose all customers to other firms since the products they sell are identical. While the firms could lower their price below Pe, it would be foolish to do so since they can sell all they want at Pe. The total revenue curve is linear. Short-run profit maximization in perfect competition (MR=MC method): In the short run, the perfectly competitive firm may make an abnormal profit, normal profit, or loss. How to find the profit-maximizing (or loss-minimizing) equilibrium and the amount of profit or loss of the firm: 1. Find Q where MR=MC: This is Q1 if the firm earns an abnormal profit or normal profit, and Qloss if it makes a loss. 2. Draw a line upward to P or ATC (whichever is higher). 3. Compare P with ATC to find which is larger: P>ATC (abnormal profit), P = ATC (Normal profit), and PAC, the firm makes an abnormal profit. The amount of profit earned at the profit-maximizing level of output is (P1-ATC) *Q1. Loss (negative economic profit): Therefore, the firm makes a loss at MR = MC AC>P. The amount of loss at the loss-minimizing level of output is equal to (AC-P1)*Q1 Normal profit (zero economic profit): At MR=MC, P=AC, and therefore, the firm makes normal profit. The amount of profit at the profit-maximizing level is zero. The cost curves are identical in each of the three cases. What differs is the P, which is determined in the market and which the firm “takes.” Shutting down in the short run: break-even price and shut down price: Break-even price: The price at which the firm earns normal profit. P = minimum AC, meaning that the revenue per unit equals the cost per unit. Selling at this price, the business is just able to keep running. Shut down price: The price at which the firm will shut down. In the short run, it is where P=Minimum AVC. In the short run, a loss-making firm tries to minimize its losses. Since it is in the short run, it has at least one fixed input and, therefore, fixed costs. If it shuts down, its losses will equal its fixed costs. If it can make losses smaller than its fixed costs by continuing to produce, it should continue to produce. The difference between AC and AVC is AFC. In the diagram above, P1 (break-even price where the firm earns normal profit) is sufficient to cover all of AVC and AFC (so all of AC). At P2 (where the firm is making a loss), P is sufficient to cover all of the AVC and a portion of the AFC. The firm will continue to produce because of loss fixed costs. The firm should shut down at any price below P3 because it cannot cover its fixed and variable costs. The perfectly competitive firm’s short-run supply curve is its MC curve up to the minimum AVC (Shut-down price). In long-run equilibrium, all firms earn a normal profit (zero economic profit): The firms in the industry initially accept the price P1 determined in the marker and earn abnormal profits in the short run. When the industry goes into the long run, all production factors are variable, and as there are no barriers to entry, firms can freely enter and exit the market. These abnormal profits attract outsiders and enter the industry, causing the market supply curve to shift to the right and the price to fall. Market supply increases until the new supply S2 gives a price of P2, where the abnormal profits are eliminated. All firms in the industry earn a normal profit, where P = minimum ATC in the long run. The firms in the industry initially accept the price P1 determined in the market, making losses in the short run. When the industry goes into the long run (all variable inputs and no barriers to entry), some loss-making firms leave the industry, causing the market supply to shift to the left and the price to increase. Market supply decreases until the new supply curve S2 gives a price of P2, where the losses have been eliminated among the remaining firms in the industry; all remaining firms earn normal profit, where P = minimum ATC. Note the difference between the shut–down price in the short run and the long run: Short–run shut–down price: Where P = minimum AVC. If P falls below this level, the firm will incur larger losses than its fixed costs and is better off stopping production and closing down. Long–run shut-down price: where P = minimum ATC. If P falls below this level, the firm has no reason to continue producing as, in the long run, all its inputs are variable, and it can leave the industry. The break-even price, where P = minimum AC and the firm makes normal profit, is the same in the short and long run. Productive and allocative efficiency in perfect competition: Productive efficiency: Producing at the lowest possible cost. This occurs when production takes place at a minimum ATC. Allocative efficiency: Producing the combination of goods and services that consumers mostly want and the resources being used optimally with no deadweight loss to society. Occurs when P = MC or MB = MC. In long-run equilibrium, the firm warns of normal profit since P = AC. This equilibrium allows the firm to achieve productive efficiencies since output Qe is where AC is minimum and allocative efficiency is P = MC and MC=MB. In the perfectly competitive market, equilibrium occurs where MB = MC and social surplus is maximum, indicating allocative efficiency. These efficiency conditions are significant because there is no resource waste. Productive and allocative efficiency in the short–run: The perfectly competitive firm always achieves allocative efficiency, both in the short run and long run, because since P = MR, profit maximization occurring at MR = MC means that P (MB) = MC where profit is maximum. However, the firm earning abnormal profit in the short run does not achieve productive efficiency since production occurs at Q, where AC is not the minimum. Evaluation of Perfect Competition: Pros: 1. The achievement of productive efficiency (in the long run) means no resource waste in production. 2. Achievement of allocative efficiency means there is no resource waste due to producing goods not wanted or valued by society. 3. Because of the above efficiencies, perfect competition becomes a standard for assessing the extent of inefficiencies in other market structures. 4. Competition leads to firms lowering their cost of production, and higher-cost firms are forced out of the market. 5. Consumers benefit from low prices arising from competition and lack of abnormal profits in the long run. 6. Consumers decide what and how much will be produced because the market responds immediately to changes in consumer tastes and preferences. Firms have no power to influence consumers through advertising, as all goods are homogenous. Cons: 1. The model is based on unrealistic assumptions, and there are few real-world markets that it accurately describes. 2. Because of the small size of firms, they cannot grow large enough to enjoy economies of scale. 3. As firms open and close continuously, there may be a waste of resources involved as factors of production move from one firm/industry to another (this is assumed away in the model). 4. Homogenous products mean that consumers cannot enjoy product variety. 5. Since firms do not earn abnormal profits in the long run, they are unlikely to engage in research for new product development. 6. The model cannot guarantee that there will be no externalities of consumption or production. If these occur (they are likely to), allocative efficiency will no longer be achieved.

Microeconomics Notes Perfect Competition

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