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# Ch 8: Profit Max Under Perfect Competition - PowerPoint PPT Presentation

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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• 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.

• Real-life examples:

• Agricultural products

• Oil.

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

• Also assume:

• 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

• 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.

• 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.

• 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.

• 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

• 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:

• 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

• 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

• 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

• 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 .).

• 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:

• 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.

• 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.

• 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:

• 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

• 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).