Perfect Competition: Firm Profits and Market Equilibrium, Study notes of Accounting

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Chapter 1 0

Perfect Competition

Introduction:

To an economist, a competitive firm is a firmthat does not determine its market price. Thistype of firm is free to sell as many units of itsgood as it wishes without affecting the marketprice. Consequently, the challenge in thiscircumstance is not deciding what price tocharge consumers, but rather what

quantity

to produce at the prevailing market price. Wewill explore these decisions in the short andlong-runs with the assumption that the firmpursues the goal of profit maximization.

Price

Price

Demand

Supply

Pm

P^ m

demand

Quantity

quantity

Market Demand and Supply

Demand Function for the firm.

Perfect Competition

• Conditions for Perfectly competitive markets

 Product firms are perfect substitutes ( homogeneous product)  Firms are price takers Reasonable with many firms, all with very small market share  Perfect and symmetric information  Long run: Perfect factor mobility  Capital and labor flow freely all firms face same factor prices  Free entry and exit of firms ( no barriers to entry)

• This Chapter

 How do firms in perfectly competitive market choose?  What forces drive the market price and quantity?  Long run vs short-run  Welfare properties of perfectly competitive markets

ch11: Perfect Competition 2

Definition of Profits

• Economic profit:

 is defined as the difference between total revenue and total cost, where total cost

includes fixed cost (implicit cost/opportunity cost) and variable cost (explicit cost)

• Accounting profit:

 is defined as the difference between total revenue and all explicit costs incurred.

• Here we consider economic profit.

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Competitive markets: the short run

11.3 Competitive markets in the short run

Short run (in this context)

 # firms is fixed (no entry or exit)

(a) The short-run quantity decision

• Firms take price as given
• Firms face short-run cost curves (as capital is fixed) Problem of the competitive firm:
• In words, choose q so as to maximize profits given the price of output (and

input prices)

• Necessary condition: marginal benefit (MB) = marginal cost (MC).
• , that is p=MC(q) (with price taking behavior)
• Here, necessary condition p=MC(q), to get optimum q

max pq C ( Q ) q

p C ' ( q ) 0

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Competitive market in the short run

ch11: Perfect Competition 7

The Short-Run Supply Function of A Competitive Firm In the short-run, the supply function of a competitive firmshows the quantity supplied at each price when one factor ofproduction is fixed. Assumption:

The firm attempts to maximize profit by

constantly adopting cost saving technologies in order to:

survive ¾

avoid a takeover

When the firm decides to shut down production, [q=0], thefirm loses (-F). That is, profit is equal to minus fixed cost.In the short run, the firm will only engage in production iftotal revenue is equal or greater than total variable cost.

Pq

V(q) ≥

In the short run, the fixed cost is a sunk cost, and therefore thequantity produced does not depend on the size of fixed cost.

Deriving The Output That Maximizes Total Short-RunProfits In the short run, we will assume that capital is fixed. Tomaximize short run profits, the firm selects a level of outputwhere marginal revenue, MR, equals short-run marginal cost.

MR= P = MCs(q)

“A competitive firm produces a quantity where price equals

short-run marginal cost, and marginal cost is rising.”

The Short-Run Supply Function of A Competitive Firm By applying the MR=P=MCs rule, we have derived one pointon the firm’s short-run supply function. I.e. At price P

, the 1

firm should supply q

1

units.

The quantity the firm supplies at any price can also be foundby using this rule for profit maximization.Consequently, the firm’s short-run marginal cost function isthe firm’s short-run supply function where total revenueequals or is greater than total variable cost.

The firm’s short-run marginal cost function is the firm’sshort-run supply function as long as total revenue

≥

total

variable cost. Note:

You need to know the position of the SAC curve in orderto determine whether the firm’s is making a profit or aloss in the short-run. But the firm can determine its short-run profit maximizing output without knowing whether itis earning a profit or a loss. If a firm sets output whereprice equals short-run marginal cost, it is operating as wellas it can at the given price level.

Competitive market in the short run

(b) Short-run supply curve of the individual firm

• Supply curve: curve relating price and quantity supplied
• Supply curve coincides with MC curve, but…
• Only if price exceeds average variable costs p>AVC(q).
• This way at least the variable costs are covered, other wise the firm will shut down.
• Condition to stay in business: p>=AVC

ch11: Perfect Competition 8

Competitive market in the short run

ch11: Perfect Competition 9