Perfectly Competitive Market

• A perfectly competitive market exhibits several key properties.
  • The goods or services exchanged are homogeneous.
  • There are a large number of potential buyers and sellers.
  • Buyers and sellers act independently.
  • Price information is easily accessible.
  • Transactions occur at a single price, following the Law of One Price.
  • Free entry and exit exist.
  • All participants act as price-takers.
  • All potential gains from trade are realized.
• The assumption that information is complete, symmetric, and freely available to all underpins the perfect competition model.
• Private and social costs/benefits align.
• There is no uncertainty, free-riding, or state intervention
• Firms and consumers act rationally to maximize profits and utility
• There are no long term rents
• Advertising is limited
• Three characteristics are central to the unit.
  • Price-taking behavior
  • Free entry and exit
  • Product homogeneity

Price Taking Firms

• Each individual company is too small to influence market price.
• Many individual firms are price takers
• They regard the price as given, facing a perfectly elastic demand function at the market price level.

Free entry and exit

• No special costs hinder firms from entering or exiting the industry.
• Buyers easily switch suppliers, and suppliers can easily enter or exit the market.

Product Homogeneity

• The goods are perfectly substitutable.
• Firms cannot raise prices above competitors without losing business.
• This ensures one market price.

Revenue of competitive firms

• Total revenue is calculated by multiplying selling price by quantity sold.
  • TRi = (P x qi) where qi is the decision variable for firm “i”.
• Total revenue is directly proportional to output.
• Firms perceive demand as infinitely elastic at the market clearing price.

Profit maximization: Key concepts

• A firm seeks to determine the production level and whether to even produce at all.
• Firms might pursue other objectives besides pure profit maximization, such as reinvesting operations surpluses.
• Profit maximization remains a plausible goal.
• A firm seeks to find the "q" that maximizes profits across various prices, thereby determining its supply function in perfect competition.
• The goal is to maximize the difference between total revenue and total cost.
• Profit maximization occurs when marginal revenue (MR) equals marginal cost (MC).
• Increase production if MR > MC to boost profit
• Decrease production if MR < MC to boost profit
• Profit is maximized when MR = MC.

Marginal Revenue,Marginal Cost and Profit Maximization

• Profit is the difference between total revenue (TR) and total cost (TC).
• Marginal revenue (MR) is the change in revenue from a one-unit increase in output or the slope of TR.
• Marginal revenue, average revenue, and price are all equal along the horizontal demand curve.

Short Run Firm Decisions

• Firms select output "q**" where marginal cost (MC) equals the price (P), or marginal revenue (MR).
• Output Rule: produce at the level where marginal revenue equals marginal cost if producing at all.

Profit Maximization Conditions

• First Order Condition: dπ/dq = MR(q*) – MC(q*) = 0, or p = MC(q*).
• Second order condition requires rising marginal cost.
• Firms in the short run can tolerate losses up to a limit.
• Firms will produce if TR – VC – FC > -FC else shut down when P ≥ min AVC.
• In the long run, firms must cover all costs: p q – FC – VC(q) ≥ 0.

Marginal Cost Curve

• The marginal cost curve of the Competitive Firm is equivalent to the Supply Curve
• Normal profit = total revenue minus total cost.
  • Economists include opportunity costs in total cost.
  • Zero profit means revenue compensates owners for their time and money.
• Normal profit maintains the factors of production in current use.
• Abnormal profit exceeds normal profit.

Shutdown vs Exit

• A shutdown is a short-run decision not to produce due to current market conditions.

• Exit is a long-run decision to leave the market.

• Firms should shutdown if TR<VC, TR/Q<VC/Q, P

Firm Exit and Entry: Long Run Perspective

• Accounting profit equals revenues (R) minus labor cost (wL).
• Economic rent is amount firms will pay for less the minimum to obtain it
• Entering a market occurs when a firm can achieve a positive long-run profit.
• Exiting a market occurs when a firm anticipates a long-run loss.

Producer Surplus

• Measured by area under market price and above the marginal curve between 0 and profit maximizing outputs
• PS = R - VC
• Profit = R - VC- FC

Long Run Equilibrium

• Firms maximize profit where supplied quantity equals demanded quantity.
• No incentive to enter or exit.
• Three conditions hold:
• All firms maximize profit.
• No incentive to enter or exit.
• Quantity supplied equals quantity demanded.

Constant Cost Industry

• Exhibit horizontal long-run supply.

Increasing Cost Industry

• Exhibit upward sloping supply

Impact of Elasticity of Supply

• Long-run elasticity of industry supply mirrors short-run elasticity.
• Percentage change in output (∆Q/Q) results from percentage change in price (∆P/P).
• Constant-cost industries have infinitely elastic supply
• Long-run elasticities of supply are generally larger than short-run elasticities, due to industries adjusting in the long run.

Firms and Market Failure

• Some resources have limited quantities.
• Firms operate with differing costs, with the marginal firm exiting at a lower price.
• This leads the industry’s long-run supply curve to slope upward.

Taxes & Supply

• A tax on output raises the firm’s marginal cost curve.
• It reduces the firm’s output and increases the product’s market price
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Summary of Key Ideas

• Firms maximize profit by equating marginal revenue (MR) and marginal cost (MC).
• The marginal cost curve is the firm’s supply curve
• Free entry and exit drives long-run profits to zero.
• Demand shifts affect profits over different time horizons.
• Long-run firm numbers adjust to drive the market to a zero-profit equilibrium.
• In the short run, firms shut down if price falls below average variable cost (AVC).
• In the long run, firms exit if price falls below average total cost (ATC)
• Firm production costs drive the production process.
• Typical firms diminish marginal product
• Total costs are split between fixed and variable costs.
• Average total cost is total cost divided by quantity
• Marginal cost equals the rise of total cost if output was increased by one unit

Welfare economics

• The study of how resources are allocated and how it affects economic well being
• Allocative efficiency is a resource allocation where values of outputs by sellers equals buyers
• Subjective well being refers to way people evaluate their own happiness
• Objective well being refers to measures of the quality of life and uses indicators developed by researchers

Efficiency & Waste

• Efficiency refers to the relationship between resources used and economic waste generated.
• Efficiency entails maximizing the total surplus received by all members of society.
• Efficiency implies maximizing the total surplus between supply and demand
• None can get better without making one worse off

Impact of Taxes & Subsidies

• It depends on the elasticity