Perfect Competition

Production and Profit

•Optimal output rule for price taking firms▫Price equals marginal cost at the price-

taking firm’s optimal quantity of output.▫Marginal revenue is equal to marginal

price. A price taking firm cannot influence the

market price by its actions. This is only true in a perfect competition

market.

▫Marginal curve is horizontal line at market price. The firm can sell as much as it like at the

market price. Regardless if it sells more or less, market

price is unaffected.

•When is production profitable?▫Firms make their production decisions with

the goal of maximizing economic profit. A firm’s decision of how much to produce,

and whether or not to stay in business, should be based on economic profit, not accounting profit.

•What determines whether a firm earns a profit or loss?▫Look at market price. Is it more or less

than a firm’s minimum average total cost?▫You can use the average total cost curve

and marginal cost curve to show graphically the short run options for a firm.

These curves can be use to decide whether is profitable or unprofitable. Shows 1 of 3 options

▫If the firm produces a quantity at which total revenue is great than total cost, the firm is profitable.

▫If the firm produces a quantity at which total revenue equals total cost, the firm breaks even.

▫If the firm produces a quantity at which total revenue is less than total cost, the firm incurs a loss.

This can be expressed in terms of revenue and cost per unit of output.▫Profit/Q= TR/Q- TC/Q▫TR/Q = is the market price▫TC/Q = is average total cost

▫A firm is profitable if market price for its products is more than the average total cost of the quantity the firm produces. If the firm produces a quantity at which P is

greater than ATC, the firm is profitable If the firm produces a quantity at which P =

ATC, the firm breaks even If the firm produces a quantity at which P is

less than ATC, THE FIRM INCURES A LOSS.

•GRAPHING PERFECT COMPETITION▫PROFIT: TR-TC= (TR/Q – TC/Q) X Q OR

THE EQUIVALENT PROFIT= (P-ATC) X Q

▫HOW DOES A PRODUCER KNOW WHETHER OR NOT ITS BUSINESS WILL BE PROFITABLE? YOU MUST COMPARE MARKET PRICE TO A

FIRM’S MINIMUM AVERAGE TOTAL COST A PRODUCER WILL MAXIMIZE HIS PROFIT

OR ACHIEVE ITS HIGHEST POSSIBLE PROFIT WHEN THEY FIND THE QUANTITY WHERE MARGINAL COST EQUALS PRICE.

REQUIRES MARKET PRICE TO BE HIGHER THAN MINIMUM AVERAGE TOTAL COST.

IF MARKET PRICE IS LOWER THAN AVERAGE TOTAL COST THERE IS NO OUTPUT AT WHICH THE FIRM WILL BE PROFITABLE

▫THE MINIMUM AVERAGE TOTAL COST OF A PRICE-TAKING FIRM IS CALLED ITS BREAK-EVEN PRICE. THIS IS THE PRICE WHERE IT EARNS

ZERO ECONOMIC PROFIT (NORMAL PROFIT)

THREE THINGS TO REMEMBER WHENEVER MARKET PRICE EXCEEDS

THE MINIMUM AVERAGE TOTAL COST, THE PRODUCER IS PROFITABLE

WHENEVER MARKET PRICE EQUALS THE MINIMUM AVERAGE TOTAL COST, THE PRODUCER BREAKS EVEN

WHENEVER THE MARKET PRICE IS LESS THAN THE MINIMUM AVERAGE TOTAL COST, THE PRODUCER IS UNPROFITABLE

• SHORT-RUN PRODUCTION▫SOMETIMES THE FIRM SHOULD PRODUCE

EVEN IF PRICE FALLS BELOW MINIMUM AVERAGE TOTAL COST. TOTAL COST INCLUDES FIXED COST AND CAN

ONLY BE ALTERED IN THE LONG RUN. ALSO FIXED COST DOES NOT DEPEND ON THE

AMOUNT PRODUCED.• SINCE IT CANNOT BE CHANGED IN THE SHORT

RUN, FIXED COST IS IRRELEVANT TO A FIRM’S DECISION TO PRODUCE OR SHUT DOWN IN THE SHORT RUN.

•THE SHUT DOWN PRICE▫WHEN THE MARKET PRICE IS BELOW

THE MINIMUM AVERAGE VARIABLE COST THE PRICE THE FIRM RECEIVES PER UNIT

IS NOT COVERING ITS VARIABLE COST PER UNIT

FIRM SHOULD CEASE PRODUCTION IMMEDIATELY BECAUSE THERE IS NO LEVEL OF OUTPUT AT WHICH THE FIRM’S TOTAL REVENUE COVERS VARIABLE COST

IN THIS CASE THE FIRM STILL MAXIMIZES ITS PROFIT BY NOT PRODUCING IT STILL HAS A FIXED COST IN THE SHORT

RUN, BUT WILL NO LONGER HAVE VARIABLE COST.

THIS MEANS THAT THE MINIMUM AVERAGE VARIABLE COST DETERMINES THE SHUT DOWN PRICE.▫THE PRICE AT WHICH A FIRM CEASES

PRODUCTION IN THE SHORT RUN.

▫WHEN THE MARKET PRICE IS GREATER THAN OR EQUAL TO THE MINIMUM AVERAGE VARIABLE COST THE FIRM MAXIMIZES PROFIT OR

MINIMIZES LOSS BY CHOOSING THE OUTPUT LEVEL AT WHICH ITS MARGINAL COST IS EQUAL TO MARKET PRICE.

•SHORT RUN INDIVIDUAL CURVE▫SHOWS HOW AN INDIVIDUAL FIRM’S

PROFIT- MAXIMIZING LEVEL OF OUTPUT DEPENDS ON THE MARKET PRICE, TAKING FIXED COST AS GIVEN.