ECON2010 Perfect Competition PDF

ECON2010 – Business Economics Topic 5 – Chapter 12 Perfect Competition ECON 2010 BUSINESS ECONOMICS Topic ‐ 5 Perfect Competition Chapter 12 After studying this chapter, you will be able to: 1. Explain Perfect Competition 2. Illustrate the firm’s Output, Price and Profit under Perfect Competition Wh...

ECON2010 – Business Economics Topic 5 – Chapter 12 Perfect Competition ECON 2010 BUSINESS ECONOMICS Topic ‐ 5 Perfect Competition Chapter 12 After studying this chapter, you will be able to: 1. Explain Perfect Competition 2. Illustrate the firm’s Output, Price and Profit under Perfect Competition What is Perfect Competition? © 2019 Pearson Education Ltd. 1 ECON2010 – Business Economics Topic 5 – Chapter 12 Perfect Competition What Is Perfect Competition? Perfect competition takes place when a market has:  Many firms selling identical products to many buyers.  There are no restrictions to enter or exit the market.  Existing firms have no advantages over firms that newly opened up.  Buyers and seller are well informed as the market information on prices and quantities available is transparent and accessible. © 2019 Pearson Education Ltd. How Perfect Competition Arises? Perfect competition happens when:  The firm’s minimum efficient scale is small relative to market demand, so there is room for many firms in the market.  All firms appear to produce a product or service with no unique characteristics. So, consumers don’t mind buying from any firm. © 2019 Pearson Education Ltd. In Perfect Competition firms are: Price Takers In perfect competition, each firm is a price taker. A price taker is a firm that has no influence over the price of a good or service. No single firm can influence the price and must “take” the market equilibrium price. Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic. © 2019 Pearson Education Ltd. 2 ECON2010 – Business Economics Topic 5 – Chapter 12 Perfect Competition Perfect Competition: Economic Profit and Revenue The goal of each firm is to maximize economic profit, which equals total revenue minus total cost. Total cost is the opportunity cost of production, and includes normal profit. A firm’s total revenue equals price, P, multiplied by quantity sold, Q, or P  Q. A firm’s marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold. © 2019 Pearson Education Ltd. Perfect Competition: Market Price, Total & Marginal Revenue The Figure below illustrates a firm’s revenue concepts. Figure (a) shows that market demand and market supply determine the market price that the firm must take. With the market price of $25 a sweater, the firm sells 9 sweater and makes total revenue of $225. Figure (b) shows the firm’s total revenue curve (TR) Figure (c) shows the marginal revenue curve (MR), which is the demand curve for the firm’s product. © 2019 Pearson Education Ltd. How are price output decisions made? © 2019 Pearson Education Ltd. 3 ECON2010 – Business Economics Topic 5 – Chapter 12 Perfect Competition What Is Perfect Competition? The Firm’s Decisions A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces. Firm’s need to answer and decide about these questions: 1. How to produce at a minimum cost? 2. What quantity to produce? 3. Should it enter or exit a market? Let’s start by looking at the firm’s output decision. © 2019 Pearson Education Ltd. The Firm’s Output Decision: Using Total Revenue & Total Cost One way to find the profit maximizing output in perfect competition is by looking at Total Cost & Total Revenue curves Figure (a) shows the total revenue, TR, curve and the total cost curve, TC. Total revenue minus total cost is economic profit (or loss), shown by the curve EP in Figure (b). © 2019 Pearson Education Ltd. The Firm’s Output Decision: Using Total Revenue & Total Cost At low output levels, the firm incurs an economic loss - it can’t cover its fixed costs. At intermediate output levels, the firm makes an economic profit. © 2019 Pearson Education Ltd. 4 ECON2010 – Business Economics Topic 5 – Chapter 12 Perfect Competition The Firm’s Output Decision: Using Total Revenue & Total Cost At high output levels, the firm again incurs an economic loss - now the firm faces steeply rising costs because of diminishing returns. The firm maximizes its economic profit when it produces 9 sweaters a day. © 2019 Pearson Education Ltd. The Firm’s Output Decision: Using Marginal Revenue & Marginal Cost The firm can use marginal analysis to determine the profit-maximizing output. Because marginal revenue is constant and marginal cost eventually increases as output increases, profit is maximized by producing the output at which marginal revenue, MR, equals marginal cost, MC. Profit is maximized when MR=MC The Figure on the next slide shows the marginal analysis that determines the profit-maximizing output. © 2019 Pearson Education Ltd. The Firm’s Output Decision: Using Marginal Revenue & Marginal Cost If MR > MC, economic profit increases if output increases. If MR < MC, economic profit decreases if output increases. If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized. © 2019 Pearson Education Ltd. 5 ECON2010 – Business Economics Topic 5 – Chapter 12 Perfect Competition Breakeven & Shutdown © 2019 Pearson Education Ltd. The Firm’s Output Decision: Temporary Shutdown Decision If the firm makes an economic loss, it must decide whether to exit the market or to stay in the market. If the firm decides to stay in the market, it must decide whether to produce something or to shut down temporarily. The decision will be the one that minimizes the firm’s loss. © 2019 Pearson Education Ltd. The Firm’s Output Decision: Temporary Shutdown Decision Loss Comparisons The firm’s loss equals total fixed cost (TFC) plus total variable cost (TVC) minus total revenue (TR). Economic loss = TFC + TVC  TR = TFC + (AVC  P) x Q If the firm shuts down, Q is 0 and the firm still has to pay its TFC. So the firm incurs an economic loss equal to TFC. This economic loss is the largest that the firm must bear. © 2019 Pearson Education Ltd. 6 ECON2010 – Business Economics Topic 5 – Chapter 12 Perfect Competition The Firm’s Output Decision: Shutdown Point A firm’s shutdown point is the price and quantity at which it is indifferent between producing the profit-maximizing quantity and shutting down. The shutdown point is at minimum AVC (only variable costs are being covered). This is also the point where MC curve crosses AVC curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily (it is minimizing its loss). At the shutdown point, the firm incurs a loss equal to total fixed cost (TFC). © 2019 Pearson Education Ltd. The Firm’s Output Decision The Figure shows the shutdown point. Minimum AVC is $17 a sweater. At $17 a sweater, the profitmaximizing output is 7 sweaters a day. The firm incurs a loss equal to the red rectangle. The SHUTDOWN POINT is where MC curve equals AVC curve. At the SHUTDOWN POINT the only loss is the Fixed Cost. © 2019 Pearson Education Ltd. Class Activity Do All Problems & Theory Questions in Topic 5 Worksheet & © 2019 Pearson Education Ltd. 7 ECON2010 – Business Economics Topic 5 – Chapter 12 Perfect Competition Economic Profit & Loss © 2019 Pearson Education Ltd. Profits and Losses in the Short Run Maximum profit is not always a positive economic profit. To see if a firm is making a profit or incurring a loss we compare the firm’s ATC at the profit-maximizing output with the market price. In Figure (a) price equals average total cost and the firm makes zero economic profit (breaks even). In Figure (b), price exceeds average total cost and the firm makes a positive economic profit. In Figure (c), price is less than average total cost and the firm incurs an economic loss economic profit is negative. © 2019 Pearson Education Ltd. Firms Entry & Exit in Perfect Competition © 2019 Pearson Education Ltd. 8 ECON2010 – Business Economics Topic 5 – Chapter 12 Perfect Competition Output, Price, and Profit in the Long Run In short-run equilibrium, a firm can make an economic profit, break even, or incur an economic loss. In long-run equilibrium, firms break even because firms can enter or exit the market. Firms can also change their plants size, and change their costs in the long run. Entry and Exit New firms enter an industry in which existing firms make an economic profit so supply increases and prices fall and every firm makes normal profit. Firms exit an industry when they incur an economic loss, so supply decreases and price rises and every firm makes normal profit. © 2019 Pearson Education Ltd. 9