Perfectly Competitive Theory of The Firm

Learning Objectives Describe using examples, the assumed characteristics of

the perfectly competitive market.Explain, using a diagram the shape of the PC’s AR, MR,

MC.Explain, using a diagram, that it is possible for PC markets

to make economic, normal and negative profit in the short-run based on MC and MR rule.

Distinguish between SR shut-down P and break-even PExplain, using a diagram, how a PC will move from SR

equilibrium to LR equilibrium, Allocative and productive efficiency

Types of Markets (degrees of competition)

3

One firm 2-12 firms many firms many, many firms

Monopoly Oligopoly Monopolistic Perfect

Competition Competition

Assumptions of the Perfectly Competitive Market• large number of firms• Selling homogeneous (identical) products • no barriers to entry or exit• no control over the market price (Price-taker)• Makes only normal profit in the long run (break-

even)

Example: There are hundreds of coffee shops in the city of

TorontoThey all pay the same wagesThey all sell identical products (coffee, muffins

and etc.)It is cheap and easy to open a coffee shop

Price TakersThis means that PC firms have no control over

the price as it’s determined by the marketThis is also true in the case of AR and MR as P is

constant Demand for the output is perfectly elastic

Profit MaximizationThis has already been discussed in in the

previous sectionProfit is maximized when MR=MC

SHORT-RUN

PRODUCTION COST CURVES:

REMEMBER

• Marginal Cost, which slopes upwards because of diminishing marginal returns

• Average variable cost, which is the per unit labor costs of production

• Average total cost, which is the average variable costs plus the average fixed costs (the per-unit costs of fixed capital resources)

• Recall also that MC must intersect the average cost curves at their lowest points.

Profit Max.- Profit Earning Firm:

when producing at its MC=MR pointWhen P>ATC, then the firm is making

ECONOMIC PROFIT This means the firm has covered all explicit and

implicit cost and earning revenue beyond its cost

GraphThe firm’s economic profits is the blue area (P-

ATC)xQThe firm is maximizing its profits by producing

where MR=MC.

Keep In MindDue to the absence of entry barriers, these

profits will not be sustained in the long-run, as new firms will enter the market.

Discuss Discuss with your partner the profit earning firm

Loss-minimization Firm when producing at its MC=MR pointAnd P<ATC , then the firm will be minimizing its

lossesEarning no economic profit at allloss minimizing firm will either exit the industry in

the long-runOr hope other firms exit until the supply decreases,This will cause the price to rise once again

Graph Since the market demand is low, the firm selling price is below

ATC

The firm’s economic losses are the colored area (ATC-P)xQ.

The firm is minimizing its losses by producing where MR=MC.

Due to the absence of entry barriers, these losses will be eliminated in the long-run as firms exit the industry to avoid further losses.

Discuss Discuss with your partner the econ loss earning

firm

The Breaking-even FirmThis is when a firm is producing at P=ATCBreaking even means a firm is covering all of its

explicit and implicit costs, but earning no additional profit

Normal Profit

GraphThe market’s price is set to be = to the ATCThe firm covering all its costs but no profitThere is no incentive for the firm to enter or exit

Test Your knowledgeWith your partner, answer the following question

in your note bookExplain, using a diagram, that it is possible for

PC markets to make economic, normal and negative profit in the short-run based on MC and MR rule.

Long-Run

Profit Maximization in the Long-run

The period of time over which firms can adjust all its variable factors

Entry and exit in the long-run: If econ profits are being earned, firms may want to

enter the market If econ losses are being earned, firms may want to

minimize losses by exiting the marketDue to entry and exit in PC, there are no Econ

profits in the LONG-RUNTherefore, all firms BREAK EVEN in the long-run

Entry Eliminates ProfitWhen individual firms are earning economic

profits in a PC market, new firms will be attracted to the market

leading to an increase in market supply and a fall in the price

Therefore Profit shall decrease

Example In the current market for pizza, Pe is $20 and

ATC is $16, $4 a pizza and total of $800 profitSince profits are to be made, more firms want to

enter the market. This will increase the supply and therefore reduces the price to a breakeven point

Example The price of pizza falls from $20 to $15MR falls to maintain profit max.,MR=MCProfits are eliminated as price falls to firm’s min.

ATC

Exit Eliminates LossesWhen individual firms are earning losses in a

perfectly competitive market,certain firms will choose to leave the market to

avoid losses and to seek profits elsewhere

Example $20 a pizza at $16 ATC, $4 a pizza in lossesThe shop shuts downThis will cause the S to decrease and therefore

price will rise again

ExampleThe price of pizza rises from $12 to $15MR rises, causing the firm to increase its output

to maintain its MR=MC levelLosses are eliminated, as the price rises to the

firm’s minimum ATC

DiscussionWhy in a PC market, firms always break-even in

the long-run?

Pop QuizHow will the existence of economic profits in a

purely competitive market affect the total supply in that market? 2 marks

How will the existence of economic losses among the firms in a purely competitive market affect the total supply in the market? 2 marks

AnswersBecause there are NO BARRIERS TO ENTRY, new

firms will enter a market where profits are being earned. As new firms enter, market supply will shift out, lowering the market price faced by firms, eliminating economic profits.

Because firms are loss averse, and there are NO BARRIERS TO EXIT, some firms will leave the industry, reducing market supply, increasing the price, eliminating losses for the remaining firms!

Shut-down Rule Which firms leave the market and which firms

stay?The cost of production varies from firm to firm This depends on the IMPLICT cost of the ownerSome owners value their skills and time higher

than othersTherefore this demines the period they are

willing to stay in the market

A firm facing econ losses have 2 choices: Continue to operate with hope of P=ATC, breakeven Shut-down and give up fixed costs (explicit cost = Fc and

VC)When to shutdown?

P>AVC or firms total losses continuing to operate >TFC If this is not the case, the firm should stay in the

market • Total losses if it continues to operate = (AR-ATC)xQ• Total losses if it shuts down= (ATC-AVC)xQ

Example • The demand for pizzas is so low that the price ($10) is lower than

the firm’s AVC ($11). The firm cannot even afford to pay its workers.

• The firm’s total losses (17-10)x160, are greater than its total fixed costs (17-11)x160. The firm would minimize its losses by shutting down

• This firm should exit the market

Test Your KnowledgeExplain the shut-down rule. Post your answers on edmodo

MC and “Supply” CurveAs we know, if the price of a good ever falls

below a firm’s AVC, the firm will no longer produce the good.

Reasoning • As price rises above AVC, the

firm will increases its quantity in direct relationship with the price

• As price decreases, but remains above AVC, the firm will reduce its output.

• In this regard, the firm’s MC above its AVC is similar to a firm’s supply curve. The quantity supplied by the firm reflects a direct relationship with the price of the good

P

Q

PC Firm

Q1 Q2 Q3 Q4

MR1

MR2

MR3

MR4

P1

P4

P3

P2

MC

AVC

Firm's Supply curve

• The MC increases as output increases because of diminishing marginal returns

• Since the MC increases at higher level of output, firms require a higher prices in order for them to increase output, so they can maintain the MR=MC level and maximize profits.

• In other words, the MC curve represents the relationship between price and quantity supplied. This is a direct relationship (demonstrating the law of supply!)

GraphP

Q

PC Firm MC

AVC

Firm's Supply curve

Test Your Knowledge How does MC curve is similar to the SUPPLY

curve? Explain using laws of supply.

Efficiency in PCIn long-run equilibrium, purely competitive firms

will produce the efficient level of output and price

Firms can be productively efficient and an industry can be allocatively efficient.

Productive efficiency Is achieved when firms produce at min ATC

This means that firms are producing output at lowest cost possible.

• If price is high enough that firms are earning profits, then the signal from buyers to sellers is WE WANT MORE

• If price is low enough that firms are earning losses, then the signal from buyers to sellers is WE WANT LESS

Graph• Price is higher than the firm’s ATC.

• The firm’s are earning economic profits

• The signal from buyers is “we want more”, so more firms will enter the market to satisfy demand.

• As new firms enter, price will fall to minimum ATC, and firms will be more productively efficient!

Allocative Efficiency is achieved if a market produces at the quantity

where marginal benefit equals marginal cost (where Price = Marginal Cost)

• It means: The right amount of output is being produced. There is neither under nor over-allocation of resources towards a good in a purely competitive industry.

If the price were higher than the MC, this is a signal that MB(demand) exceeds MC(supply) and more output is desired

If price were lower than MC, the signal from buyers to sellers is that MC exceeds MB and less output is desired.

Only when P = MC is the right amount of output being produced.

Explain the Following Graph in relation to allocative efficiency

Practice Questions

With your partner, answer the following questions:Describe the situation in the market below and firm

below:1.Show the firm's: i) MR, ii) Output, iii) Economic profit

or loss2.Assuming this is a PC market, describe and illustrate

the long run adjustments that will restore this market to Equilibrium. Show on the graphs, for both the industry and the firm, the price and output after long-run adjustments

P

Q

Sindustry

Dindustry

Industry

P

Q

Firm

MC ATCAVC

MR=D=AR=P1

Pe

P

Q

Sindustry

Dindustry

Industry

P

Q

FirmMC ATC

AVC

MR=D=AR=P1

Pe

P

Q

Sindustry

Dindustry

Industry P

Q

Firm MC ATCAVC

MR=D=AR=P1

Pe