This chapter discusses perfect competition and profit maximization in competitive markets. It contains the following key points: 1. Under perfect competition, there are many small firms and buyers/sellers, homogeneous products, free entry and exit, and perfect information. Firms are price takers and maximize profits by producing where marginal revenue equals marginal cost. 2. In the short run, firms will shut down if price falls below average variable cost or operate at a loss if price is between average variable and average total cost. In the long run, zero economic profits are achieved through free entry and exit of firms. 3. External changes like shifting demand curves or new technology can impact market equilibrium price and quantity in both the

1. CHAPTER 5 MARKET STRUCTURE: PERFECT COMPETITION

6. Firm Industry 100 Figure: Market Equilibrium and Firm’s Demand Curve Price taker d $4 Output (bushels) Price $ per bushel D $4 S Price $ per bushel Output (millions of bushels)

12. Total Revenue, Average Revenue and Marginal Revenue for a competitive firm Quantity sold Price (RM) TR (RM) AR (RM) MR (RM) 0 20 0 20 20 1 20 20 20 20 2 20 40 20 20 3 20 60 20 20 4 20 80 20 20 5 20 100 20 20 6 20 120 20 20 7 20 140 20 20 8 20 160 20 20

13. Graphical Illustration of TR, AR and MR for a Competitive Firm TR AR = MR=D 1 2 3 4 5 6 7 8 9 10 160 140 120 100 80 60 40 20 0 Price and revenue Quantity Demanded (sold)

14. Profit maximization – Numerical example Quantity TR (RM) TC (RM) PROFIT (RM) MR (RM) MC (RM) 0 0 10 -10 - - 1 20 14 6 20 4 2 40 22 18 20 8 3 60 34 26 20 12 4 80 50 30 20 16 5 100 70 30 20 20 6 120 94 26 20 24 7 140 122 18 20 28 8 160 154 6 20 32

15. 160 140 120 100 80 60 40 20 0 Total revenue and total cost Total Revenue Total Cost Maximum Economic Profits RM30 Break-Even Point (Normal Profit) Break-Even Point (Normal Profit) 1 2 3 4 5 6 7 8 1. TOTAL REVENUE-TOTAL COST APPROACH

17. 2. MARGINAL REVENUE- MARGINAL COST APPROACH A q 1 : MR > MC; ↑ output q 2 : MR < MC; ↓ output q * : MR = MC Profit is maximized where MR = MC Profit increases until it is maxed at q* q 2 10 20 30 40 Price 50 MC 0 1 2 3 4 5 6 7 8 9 10 11 Output q * AR=MR=P q 1 Lost Profit for q 2 > q* Lost Profit for q 1 < q*

22. Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR=P ATC Economic Profit RM5 RM3 Supernormal Profit/ Economic Profit Minimum point of ATC

24. Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR ATC RM5 Breakeven/ Normal Profit Minimum point of ATC

26. Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR ATC Economic Loss RM5 RM7 Economic losses/ Subnormal profit

28. Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR AVC ATC Economic Loss P ATC Subnormal Profit (ATC>P>AVC)): (i) Keep Operating AVC

29. Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR AVC ATC Economic Loss P ATC Subnormal Profits (ATC>P<AVC): (ii) Shutdown AVC

33. Cost and Revenue, (dollars) MC AVC ATC Quantity Supplied P 1 P 2 P 3 P 4 P 5 Q 2 Q 3 Q 4 Q 5 Marginal Cost & Short-Run Supply Do not Produce Below AVC(< P 2 ) Normal Profit Shut down point Subnormal profit Supernormal profit

34. Cost and Revenue, (dollars) MR 1 Quantity Supplied MR 2 MR 3 MR 4 MR 5 P 1 P 2 P 3 P 4 P 5 Q 2 Q 3 Q 4 Q 5 Marginal Cost & Short-Run Supply Short-Run Supply Curve Supply No Production Below AVC

38. Try this!!

40. Try this!!

42. (1) Changing Preference Increase in demand Firm Industry

44. S 1 MC ATC MR D 1 Before Increase in Demand P Q q1 P Q Q1 Industry Firm (price taker) P1 P1

45. DD increases – DD curve shift left – P ↑ - Q ↑ - supernormal profit – new firms enter MR D 1 MC ATC D 2 Economic Profits S 1 MR 1 P Q q1 q2 P Q Q1 Q2 Industry Firm (price taker) P2 P1 P2 P1

46. New entry – SS ↑ - Q↑ - P↓ - (P = ATC) normal profit MR D 1 MC ATC D 2 Zero Economic Profits S 1 S 2 q2 Q1Q2Q3 IMPORTANT!! P Q q1 P Q Industry Firm (price taker) P2 P1 P2 P1

47. Changing Preference : Decrease in demand Industry Firm

49. Before decrease in demand: S 1 MC ATC D 1 MR P Q q1 P Q Q1 Industry Firm (price taker) P1 P1

50. MR D 1 MC ATC D 2 Economic Losses S 1 q2 DD decreases – DD curve shift right – P ↓ - Q ↓ - subnormal profit – existing firms exit P Q q1 P Q Q2Q1 Industry Firm (price taker) P1 P2 P1 P2

51. MR D 1 MC ATC D 2 Zero Economic Profits S 1 S 3 Q3 q2 Existing firms exit – SS ↓ - Q↓ - P↑: (P = ATC) normal profit IMPORTANT!! P Q q1 P Q Q2 Q1 Industry Firm (price taker) $60 50 40 $60 50 40

52. (2) Advancing Technology: Technology Improvements (a) Adopt new technology (b) Old technology firm Economic loss Positive economic profit New firms entry SS up, P down Profit reducing Produce at lower cost Exit Adopt new technology SS down, P up Zero economic profit

58. LETS DO IT

59. Output (unit) Total cost (RM) Variable cost (RM) 1 15 10 2 21 16 3 28 23 4 37 32 5 50 45 6 68 63

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