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UW-Madison ECON 101 - Perfect Competition

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Perfect CompetitionA. Perfect competition- the ideal or perfect market 1. characteristicsa. Many buyers and sellers- no one of them can influence the market price b. everyone in the market is producing homogeneous product: identical productc. free entry or exit into the market in the long run d. Perfect knowledge and perfect mobility of resources 2. Goal of the firma. Profit maximization (cost minimization)3. **start by analyzing Perfect competition in the short runa. Firm is a price taker- firm must accept the market priceb. For the firm, demand is a horizontal line= they can sell whatever quantity they want atthis price4. For a perfect competition firm, MR= D= Price a. Given this price from the market, what quantity of output should the firm produce? orgiven that the firm's goal is to max. profit and given that the firm is a price taker- what quantity will profitmaximize or loss minimizeb. Profit maximizing rule: the firm should produce that quantity when MR= MC1. MC < MR- produce more2. MC> MR- produce less3.MC= MR- Profit max. output **MC is supply curve for the firm and the location of MC determines thequantity the firm will producec. Calculation Profit maximization a. Market determines P1 and Q1- intersection of D and Sb. Firm views P1 as its MR curvec. Firm max profit by equating MR= MC= Qad. calculating TR: TR= P1 x Q1e. Calculate TC: at Q1 go to ATC to get ATC1, TC= ATC1 x Q11. Economic profit= 0= firm breaks even f. Firm's profit: profit= TR - TC, profit= P1Q1 - ATC1Q1, but P1= ATC so profit is 0g. Firm earns 0 economic profit= firm breaks even 1. break even pt.- min. pt. of the ATC when MR= P goes through this point the firm earns zero econ profit (accounting profit > 0 when econ profit =0)d. Shutdown point- min. point of AVC. When P= MR, goes through this point the firm earns just enough revenue to cover its VC. Profit=-FC. In the short run the firm is stuck w/ its fixed input therefore its FC. Firm should produce ONLY if cover VC.***remember that the market supply is the horizontal summation of all the individual firm supply curves** 3 profit possibilities: 1. Profit > 0= firm earning more than its Opportunity cost of production2. profit < 0= firm earning less than its opportunity cost of production3. profit= 0= firm is covering its opportunity cost of production NOT BADa. firm is covering all of owner's cost including compensation for any forgone investmentincome, or forgone salary1. Zero economic profit does NOT equal zero accounting profit *Now, let's go to the long run1. In the short runa. profit in the short run > 0, but in the long run more firms will enter the marketb. profit in the short run< 0, but in the long run firms will exit the marketc. lowest profit is when profit= -fixed costs**In these examples we are implicitly assuming constant cost industry A. Long run equilibrium1. Perfect competition is a standard for comparisona. in LR equilibrium, resources are optimally allocated among competing uses1. P= ATC= MC= min ATCb. P=MC- allocatively efficient1. Price is the value the consumer places on the output2. MC is the addition to TC from producing one more unit of the good a. P> MC= not enough resources b. P< MC= producing too many units 3. P= ATC- firms are earning a normal economic profit a. no incentive for entry or exit of firms 4. MC= min ATC- firm is producing level of output where its cost/unit is


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