1Perfect CompetitionPerfect CompetitionPlanPlanbb Conditions for perfect competitionConditions for perfect competitionbb Profit maximizationProfit maximization•• In the short runIn the short run–– Choice of the optimal outputChoice of the optimal output–– The shutdown conditionThe shutdown condition–– The industry supplyThe industry supply–– Market equilibriumMarket equilibrium•• In the long run with free entryIn the long run with free entry–– Market supply, market equilibriumMarket supply, market equilibriumConditions for Perfect CompetitionConditions for Perfect Competitionbb Firms Sell a Standardized ProductFirms Sell a Standardized Productbb Firms are price takersFirms are price takersbb Factors of Production are Perfectly mobile in Factors of Production are Perfectly mobile in the long runthe long runbb Firms and consumers have perfect Firms and consumers have perfect informationinformation2Economic ProfitEconomic Profitbb Economic profit is the difference between Economic profit is the difference between the total revenue and total costthe total revenue and total costbb Note that the total cost includes ALL the Note that the total cost includes ALL the costs. It may differ from the accounting costs. It may differ from the accounting costs.costs.bb Economic costs include alternative costs Economic costs include alternative costs (say, a rental cost of capital)(say, a rental cost of capital)bb Example: Example: farms in New Jerseyfarms in New JerseyHow should a producer choose How should a producer choose the output? the output? bb Assume he knows the cost function,Assume he knows the cost function,•• what is the smallest cost of producing what is the smallest cost of producing QQ units of units of output given the output given the –– technologytechnology–– prices of the inputsprices of the inputsbb Producer’s objective is to maximize the Producer’s objective is to maximize the profits, profits, •• RevenueRevenue--Cost, Cost, bb What is the profit maximizing level of output?What is the profit maximizing level of output?()QCPQ−Profit Maximization in the Short RunProfit Maximization in the Short Runbb Marginal revenueMarginal revenue of producing another unit of producing another unit should equal to the should equal to the marginal costmarginal costof its of its productionproduction•• Marginal revenue Marginal revenue in a competitive market is the in a competitive market is the market price.market price.bb Is it optimal to produce the quantity at which Is it optimal to produce the quantity at which this condition is satisfied but the marginal this condition is satisfied but the marginal cost is decreasing?cost is decreasing?•• No.No.3ShutShut--down conditionsdown conditionsbb Should a firm produce if the price falls Should a firm produce if the price falls below AVC?below AVC?•• NONObb Should a firm shut down if the price falls Should a firm shut down if the price falls below ATC but above the AVC?below ATC but above the AVC?•• YES, in the short runYES, in the short runSupplySupplybb Firm supplyFirm supply is the relationship between is the relationship between market price and the quantity produced by market price and the quantity produced by a firm at that price.a firm at that price.bb Market supplyMarket supply is the relationship between is the relationship between market price and the quantity produced by market price and the quantity produced by allall the firms in the industry at that price.the firms in the industry at that price.ExampleExamplebb Assume Assume NN firms in the industry are firms in the industry are producing a toothpaste of identical quality.producing a toothpaste of identical quality.bb Assume that the individual firm supply is Assume that the individual firm supply is identical across firms:identical across firms:bb What is the industry supply of toothpaste? What is the industry supply of toothpaste? 20,320>+=QQPQNP320+=4Short Run Competitive Short Run Competitive EquilibriumEquilibriumbb SR EquilibriumSR Equilibrium is a price and quantity such is a price and quantity such that demand is equal to the SR supply.that demand is equal to the SR supply.bb In the short run a firm can earn economic In the short run a firm can earn economic profit in a competitive market.profit in a competitive market.bb Example: Example: •• What is the optimal output for this firm if the What is the optimal output for this firm if the price is 24? What is its profit if FC=1?price is 24? What is its profit if FC=1?•• At what level of fixed cost will the firm earn At what level of fixed cost will the firm earn zero economic profit?zero economic profit?()32QQVC=Efficiency of SR Competitive Efficiency of SR Competitive EquilibriumEquilibriumbb Allocation is efficient if there is no additional Allocation is efficient if there is no additional allocation that will make somebody in the allocation that will make somebody in the economy strictly better off without worsening economy strictly better off without worsening the wellthe well --being of the other.being of the other.•• Say, a SR competitive market equilibrium is Say, a SR competitive market equilibrium is (P*,Q*)(P*,Q*)–– Take money from a consumer in the amount that he is Take money from a consumer in the amount that he is willing to give up for an additional unit of output (less willing to give up for an additional unit of output (less than than P*P* ), give it the producer. He will not be willing to ), give it the producer. He will not be willing to produce another unit (he will be worse off if he does). produce another unit (he will be worse off if he does). –– Similarly, producing less will hurt both consumers and Similarly, producing less will hurt both consumers and producers.producers.Competitive Markets in the Long Competitive Markets in the Long RunRunbb In the long run all inputs can be adjusted,In the long run all inputs can be adjusted,bb Firms that were operating below the Firms that were operating below the minimum ATC will leave (shut down).minimum ATC will leave (shut down).bb New firms can enter the competitive New firms can enter the competitive industryindustrybb New firms will enter as long as economic New firms will enter as long as economic profits can be earned profits can be earned5Competitive Markets in the Long Competitive Markets in the Long RunRunbb In the LR firms do not earn economic In