Perfect Competition: Profit Maximization and Revenue Analysis

Perfect Competition Assumptions

Perfect Competition CHAPTER 5; 7PERFECT COMPETITION Assumptions: . The market has many buyers and many sellers. · Homogeneity of output - firms produce identical products · The multiplicity of sellers of identical goods means that no one firm has power to determine the price - so firms are price takers. . No barriers to entry or exit · Perfect information and low transaction cost . Perfect competition is the benchmark of Efficiency.

Perfect Competition - The Short Run

PERFECT COMPETITION - THE SHORT RUN Assumptions: . The market has many buyers and many sellers. · Homogeneity of output - firms produce identical products · The multiplicity of sellers of identical goods means that no one firm has power to determine the price - so firms are price takers. . No barriers to entry or exit The short run: the amount of capital employed (and so also the number of firms) is fixed.

Profit Maximization in Short Run

Profit Maximization I = TR - TC π q q*

Revenue Concepts

Revenues . Total revenue = price x quantity sold TR = pq · Average revenue = total revenue / quantity sold = price AR = TR/q = p · A firm's marginal revenue is the additional revenue from selling one additional unit of output. · Marginal revenue = the rate of change of total revenue with respect to quantity sold MR = dTR dq

Revenue Example

Example: Suppose price is given at 20 so TR = 20q AR = 20 MR = aTR/aq which is the amount by which TR rises when there is a marginal increase in q. Clearly, therefore, MR = 20. Diagramatically: £ £ TR 60 20 AR=MR 20 1 3 q q

Profit Maximization Equation

Profit Maximization I = TR - TC

Profit Maximization in a Perfectly Competitive Market

In a perfectly competitive market, the profit maximising output level occurs where p=MC. £ MC AC MR=p q* * q Profit is maximised where marginal cost cuts marginal revenue from below. Below q*, adding units of output adds more to revenue than to cost. Above q* more is added to cost than to revenue.

Supernormal Profit

£ MC AC MR=p q* q The shaded area is supernormal profit: total revenue (AR x q*) minus total costs (AC x q*).

Profit Maximization Example

Example: Profit maximisation Profit maximisation in a perfectly competitive market. A firm operates in a perfectly competitive market. Suppose the firm's total cost curve is TC = 5 +2q2. Calculate the profit maximising quantity when price is 16.

Marginal Cost and Supply Curve

Marginal cost and the supply curve £ MC p FIRM

Marginal Cost and Supply Curve Diagram 2

Marginal cost and the supply curve £ MC I p FIRM

Marginal Cost and Supply Curve Diagram 3

Marginal cost and the supply curve £ MC p FIRM The marginal cost curve is the supply curve, but ...

Short-Run Shut Down Condition

Short-run shut down condition If operate: profit=TR-TC=TR-FC-VC If shutdown: profit=0-FC-0 As long as TR covers the VC (that is p ≥ AVC), the firm should keep operating. Shutdown if p < AVC £ MC AC AVC In the short run, a firm may continue production even if it is making a loss - so long as it is covering its variable costs. This has the effect of minimising the losses.

Firm Shut Down Decision Example

Example: Firms shut down decision A firm operates in a perfectly competitive market. Suppose the firm's total cost curve is TC = 3q3 - 18q2 +30q + 50. Calculate the price below which the firm will shut down.

Industry Supply Curve

Industry supply curve The industry supply curve is the horizontal sum of individual firms supply curves. £ S1 S2 Sindustry P1 91 92 91+ 92 Q

Short Run Market Equilibrium

Short run market equilibrium Suppose there are 8 identical firms in the perfectly competitive market of cardboard boxes. The firm's total cost function is given by TC = 5 + 2q2. Suppose the market demand is given by QD = 10 - 3p. Find the short run market equilibrium.

Short Run Market Equilibrium Diagram

S £ £ MC AC p* D q INDUSTRY FIRM Profit is maximised where marginal cost cuts marginal revenue from below. Below q*, adding units of output adds more to revenue than to cost. Above q* more is added to cost than to revenue. D=AR= MR q* q

Long Run Competitive Equilibrium

Long run competitive equilibrium · Free entry: The ability of a firm to enter an industry without encountering legal or technical barrier. . In the long run, all factors of production are variable; firms may enter (attracted by supernormal profits) or leave (owing to losses) the industry. · Long-run competitive equilibrium occurs at the point where the market price is equal to the minimum average total cost. · At the equilibrium, the firms earn zero economic profit (considering opportunity cost).

Equilibrium Under Perfect Competition: Long Run Diagram

Equilibrium under perfect competition: the long run S £ £ MC AC p* D=AR= MR D q INDUSTRY q* q FIRM The existence of supernormal profit attracts new entrants into the industry. Supply (at industry level) increases, pushing the price down - thus shifting the demand curve faced by individual firms down until ...

Long Run Equilibrium and Efficiency

Equilibrium under perfect competition: the long run S £ S' £ MC AC I p* D=AR= MR D q INDUSTRY q* q FIRM .. no further supernormal profits are made. At this point there is no incentive for further new entry, and so the industry is in long run equilibrium. Note that in this equilibrium each firm produces output at minimum average cost - and so we have allocative efficiency. This makes perfect competition a good benchmark.