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Perfect Competition Perfectly Competitive Industries have the following features 1 2 3 4 5 There are many firms and each one is small relative to the size of the market There are no entry or exit barriers Each firm produces an identical product no differences in appearance location brand names or other attributes Everyone in the economy knows the production technology and market price All firms are price takers The Firm s Problem Each firm in the market chooses its output to maximize its profit taking the market price as given maxq pq c q f p is the market price c q is the firm s variable cost function f is the firm s fixed cost At the optimal output choice price equals the marginal cost of production p c q mc Equilibrium Equilibrium in perfectly competitive markets occurs through entry and exit In equilibrium 0 If 0 entry occurs if 0 exit occurs If the industry is initially in equilibrium and a shock occurs entry and exit occur instantly to restore the zero profit condition Entry and exit occur instantly because there are no entry or exit barriers Examples of shocks The demand curve shifts The variable cost function changes Fixed costs change No real world industry satisfies all of the conditions of the perfect competition model All models are simplified representations of reality designed to provide us with intuition If the five conditions are close to being satisfied the model has important implications for analyzing industries particularly in the long run 1 Economic profits above or below zero do not persist for long Entry and exit occurs to eliminate non zero profits 2 Positive demand shocks lead to entry while negative demand shocks lead to exit Long run effects on market price and firm size are negligible 3 If fixed costs fall market price and firm size fall while market quantity and the number of firms rise 4 If the marginal cost curve shifts down market price falls while firm size and the market quantity rise The effect on the number of firms is ambiguous



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