Chapter 12 notes Perfect competition Perfect competition is a market in which Many firms sell identical products to many buyers no brand names There are no restrictions on entry into the market Established firms have no advantage over new ones Sellers and buyers are well informed about prices FFCR 0 HHI 100 Examples of perfect competition farming fishing plumbing painting etc Perfect competition arises if the minimum efficient scale of a single producer is small relative to the market demand for the good or service A firm s minimum efficient scale is the smallest output at which long run average cost reaches its lowest level Price taker a firm that cannot influence the market price because its production is an insignificant part of the total market A firm s goal is to maximize economic profit Economic profit equals total revenue minus total cost Total cost the opportunity cost of production which includes normal profit Total revenue equals the price of its output multiplied by the number of units of output sold upward sloping straight line Marginal revenue the change in total revenue that results from a one unit increase in the quantity sold calculated by dividing the change in total revenue by the change in the quantity sold in perfect competition the firm s marginal revenue equals the market price The demand for the firm s product is perfectly elastic and is a straight horizontal line Market demand for product is not perfectly elastic elasticity depends on the substitutability of product In order to maximize economic profit a firm must decide How to produce at minimum cost What quantity to produce Whether to enter or exit a market A firm s cost curves total cost average cost and marginal cost describe the relationship between its output and costs A firm s revenue curves total revenue and marginal revenue describe the relationship between its output and revenue From the firm s cost curves and revenue curves we can find the output that maximizes the firm s economic profit Economic profit total revenue total cost Break even point when the firm make s zero economic profit Marginal analysis compares marginal revenue MR and marginal cost MC As output increases the firm s marginal revenue is constant but its marginal cost eventually increases If marginal revenue exceeds marginal cost MR MC then the revenue from selling one more unit exceeds the cost of producing it and an increase in output increases economic profit If marginal revenue is less than marginal cost MR MC then the revenue from selling one more unit is less than the cost of producing that unit and a decrease in output increases economic profit If marginal revenue equals marginal cost MR MC then the revenue from selling one more unit equals the cost incurred to produce that unit Firm will maximize economic profit when marginal revenue equals marginal cost Law of supply other things remaining the same the higher the market price of a good the greater is the quantity supplied of that good Temporary Shutdown Decision A firm must decide to temporarily shut down or continue producing To make this decision the firm compares the loss from shutting down with the loss from producing and takes the action that minimizes its loss Loss Comparisons A firm s economic loss equals total fixed cost TFC plus total variable cost TVC minus total revenue o Total variable cost equals average variable cost AVC multiplied by quantity produced Q o Total revenue equals price P multiplied by the quantity Q Economic loss TFC AVC P Q If the firm shuts down Q 0 Must pay fixed costs so economic loss TFC The shutdown point Shutdown point the price and quantity at which it is indifferent between producing and shutting down average variable cost is a minimum The firm s supply curve When the price exceeds minimum average variable cost the firm maximizes profit by producing the output at which marginal cost equals price When the price is less than minimum average variable cost the firm maximizes profit by temporarily shutting down and producing no output o The firm produces zero output at all prices below the minimum average variable cost When the price equals minimum average variable cost the firm maximizes profit either by temporarily shutting down and producing no output or by producing the output at which average variable cost is a minimum Market supply in the short run Changes in Demand Short run market supply curve show the quantity supplied by all the firms in the market at each price when each firm s plant and the number of firms remain the same Market demand and short run market supply determine the market price and market output If demand increases and the demand curve shifts rightward the price rises firms increase production If demand decreases and the demand curve shifts leftward the price falls and firms decrease production Profits and Losses in the Short Run Although the firm produces the profit maximizing output it does not necessarily end up making an economic profit Economic profit P ATC Q o If price equals average total cost a firm breaks even o If price exceeds average total cost a firm makes economic profit o If price is less than average total cost a firm incurs economic loss Output Price and Profit in the Long Run Entry and exit change the market supply which influences the market price the quantity produced by each firm and its economic profit or loss New firms enter a market in which existing firms are making an economic profit As new firms enter a market the market price falls and the economic profit of each firm decreases Firms exit a market in which they are incurring an economic loss As firms leave a market the market price rises and the economic loss incurred by the remaining firms decreases Entry and exit stop when firms make zero economic profit Long run equilibrium when economic profit and economic loss have been eliminated and entry and exit have stopped Changing tastes and Advancing Technology A permanent decrease in demand has decreased the number of firms A permanent increase in demand increases the number of firms o Ex demand for computers increased permanently with the introduction of the internet In the process of moving from the initial equilibrium to the new one firms incur economic losses External economies factors beyond the control of an individual firm that lower the firm s costs as the market output increases External diseconomies factors outside the control of a firm that raise the firm s costs as the market