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Ch 8: Profit Max Under Perfect CompetitionPowerPoint Presentation

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

More on Perfect Competition

- Real-life examples:
- Agricultural products
- Oil.

- P.C. is an ideal; useful starting point.
- Also assume:

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

- 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

- 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

- 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

- 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:

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

- 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 .).

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

- 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

- 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

- 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:
- 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).

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