Ch 8 profit max under perfect competition
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Ch 8: Profit Max Under Perfect Competition. Three assumptions in p.c. model: 1) Price-taking : many small firms, none can affect mkt P by ing Q  no mkt power; 2 ) Product homogeneity : each firm produces nearly identical product

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Ch 8 profit max under perfect competition
Ch 8: Profit Max Under Perfect Competition

  • Three assumptions in p.c. model:

  • 1) Price-taking: many small firms, none can affect mkt P by ing Q  no mkt power;

  • 2) Product homogeneity: each firm produces nearly identical product

  • 3) Free entry and exit: assures big number of firms in industry.


More on perfect competition
More on Perfect Competition

  • Real-life examples:

    • Agricultural products

    • Oil.

  • P.C. is an ideal; useful starting point.

  • Also assume:


Profit maximization
Profit Maximization

  • Profit-max extends beyond just p.c. mkt structure.

  • Define profit = TR – TC

  • (q) = R(q) – C(q), or

  •  = R – C.

  • So firm picks q* where difference between TR and TC is greatest.

  • With graphs of TR and TC:


Three curves in figure 8 1
Three Curves in Figure 8.1

  • TR: slope is MR

  • TC: slope is MC.

  •  function: see inverse U-shape:

  • Max  where:

    • 1)

    • 2)

    • 3) Rule:

      • pick -max q* where MR = MC.


Review implications of perfect competition
Review Implications of Perfect Competition

  • First: keep terms straight:

    • Q =

    • D =

    • q =

    • d =

  • Market D is downward sloping but demand curve faced by individual firm is perfectly elastic (horizontal).

  • So: firm demand curve is same is its MR curve.


Further implications
Further Implications

  • Recall: firm’s demand curve is its MR curve.

  • This means that P = MR.

  • So profit-max rule: pick -max q* where MC = MR = P.

  • Also, since P = MR for each q, then P = MR = AR.


Further details
FURTHER Details

  • Revise rule: pick -max q* where MR = MC AND MC is rising.

  • Note:

  • Short Run profit for p.c. firm:

  • P - ATC at q* = avg profit per unit of q.

  • Explain:

  • Total  at q* = q*  avg. .


Firm s sr shutdown decision
Firm’s SR Shutdown Decision

  • Situation: What if the SR -max q* results in losses?

  • Firm must choose (1) vs (2):

  • 1) Continue producing at q*:

  • 2) Shutdown in SR:


Sr shutdown rule
SR Shutdown Rule

  • Firm must know: at q*, what is:

    • P,

    • ATC, and

    • AVC.

  • Rule: If   0 in SR:

    • continuing producing q* as long as P  AVC.

  • In LR:


Competitive firm s sr supply curve
Competitive Firm’s SR Supply Curve

  • Supply Curve: shows q produced at each possible price.

  • SR supply curve: the firm’s MC curve for all points where MC  AVC

    • I.e., -max q* is where P  AVC.

  • Remember “trigger” for shutdown in SR  implies that MC curve has an irrelevant part (where MC  P).


Firm s response to price of input
Firm’s Response to  Price of Input

  • Consider:  price input  causes  MC at each q  shift up to left of MC curve.

  • See Figure 8.7:

    • Start at P = $5 with MC1; so q* = q1.

    • Now: price input causes  MC:

    • Shifts MC up to left.

    • Causes  q*.


Sr market supply curve
SR Market Supply Curve

  • Shows: amount of Q the industry will produce in SR at each possible price.

  • Sum SR supply curves for firms using horizontal summation.

  • That is: at each possible price, sum up total quantity supplied by each firm.

  • See Figure 8.9.

  • (Note: for each firm: as q es, individual MC curves no .).


Price elasticity of market supply
Price Elasticity of Market Supply

  • ES = %Qs/1%P =

  • (Q/Q) / (P/P).

  • ES  0 always because SMC slopes upward.

  • If MC  a lot in response to Q, then ES is low.

  • Extreme cases:

    • Perfectly inelastic S:

    • Perfect elastic S:


Producer surplus in sr
Producer Surplus in SR

  • Concept analogous to CS.

  • For rising MC: P  MC for every unit of q except last one produced.

  • For a firm (see Figure 8.11):

    • For all units produced (up to q*):

    • Measures area above MC schedule (S curve) and below mkt price.


Lr competitive equilibrium
LR Competitive Equilibrium

  • If each firm earns zero economic , each firm is in LR equilibrium.

  • Three conditions:

    • 1. All firms in industry are profit-maximizing.

    • 2. No firm has incentive to enter or leave industry (due to  = 0).

    • 3. P is that which equates QS = QD in market.


Adjustment from sr to lr equilibrium
Adjustment from SR to LR Equilibrium

  • Firm starts in SR equilibrium.

  • Positive profits induce new firms to entire industry.

  • This causes market P to fall.

  • This causes firm’s MR line to fall, until profits = 0 again.

    • Key: firms enter as long as P  AVC

  • Note: in this case, MC no shift due to constant cost assumption.

  • LR choice of q*:

    • where LMC = P = MR = LAC.

    • Key is LMC=LAC.


Economic rent
Economic Rent

  • Economic Rent:

  • For an industry: economic rent same as LR producer surplus.

  • For a fairly fixed factor (like land):

  • In LR in a competitive mkt:


Industry s lr supply curve
Industry’s LR Supply Curve

  • Cannot just sum horizontally because as price es, # firms in industry es. Must connect the zero-profit points.

  • Shape of LR supply curve: depends on whether (and in what direction) the es in each firm’s q causes es in input prices.

  • Constant cost industry: As q and Q , input prices no  so firm’s MC, AVC, and ATC NO shift as q changes.

  • SO: LR industry supply curve is flat (perfectly horizontal).


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