microeconomics final exam help
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econperfect.pdf
PERFECT COMPETITION ECONOMICS 101-PROFESSOR WALLACE
SPRING 2020
ASSUMPTIONS - PERFECT COMPETITION
• Many small firms. No firm is large enough to affect market price. Firms are price takers.
• Firms produce identical product.
• There are no barriers to market entry and exit in the industry in the long run. Barriers such as patents and ownership of a scarce resource are not present. Free (unrestricted) entry and exit.
• Perfect information about market.
CHARACTERISTICS OF IMPERFECT COMPETITION
• Firms produce a differentiated product.
• Actions of a firm affect market price of the good.
• Types of imperfect competition • Monopolistic Competition – many small firms selling differentiated products.
Free entry and exit in the long run. Barber shops, restaurants.
• Oligopoly – few large firms with average costs declining at high levels of output. Thus restricted entry and exit in the long run. Cell phones
• Monopoly – One firm in the industry. Good has no close substitutes. Barriers prevent long run entry. Electric utility, oil company in many places.
PERFECT VS. IMPERFECT COMPETITION
• Key distinguishing feature is the demand schedule of the firm.
• Perfect competition – firms are price takers so the firm’s demand is horizontal line at the market price of the good.
• Imperfect competition – actions of a firm affect market price so the firm’s demand schedule has a negative slope.
REVENUE
• Revenue concepts • Total revenue (TR) is price of the good times quantity sold, 𝑃×𝑞 • Marginal revenue (MR) is the change in TR caused by the change in output,
MR = ∆"# ∆$
PERFECT COMPETITION AND SHORT-RUN PROFIT MAXIMIZATION
• In the short run there is no entry or exit because quantity of a firm’s capital is fixed. The firm cannot obtain the capital needed to enter the market. Cannot reduce capital to exit a market.
• Rule to maximize profits • All firms (perfect and imperfect competition) produce where MR = MC • Only perfectly competitive firms - produce where P* = MC because P* = MR
in perfect competition since the firm is a price taker.
• Exception: if P* < AVC, the firm will shutdown.
P = 8 KD. Since the firm is a price taker, the level of output does not affect P. Thus TR = P ✕ q = 8 ✕ q . What are total fixed costs in this example?
Output Total Cost Marginal Cost
0 7 --
1 12 5
2 18 6
3 26 8
4 36 10
HOW MUCH SHOULD THE FIRM PRODUCE?
• Should the firm produce the first unit of output? YES Since P* > MC (8 > 5), producing this unit will add more to TR than it adds to TC, thus profits rise (loss falls).
• Should the firm produce the second unit of output? YES Since P* > MC (8 > 6), TR increases more than TC, thus profits rise (loss falls).
• Should the firm produce the fourth unit of output? NO Since P* < MC (8 < 10), TR increases less than TC, thus profits fall (loss increases).
• Firm should produce 3 units of output where P* (MR) = MC.
KD Perfect Competition in the Short Run P Firm is a Price Taker. Assume P > AVC
q* q
MC
P* MR=d
D S
Q*
If P* > MC Produce more
If P* < MC Produce less
Condensed Perfect Competition
ANALYSIS WITH THE GRAPHICAL MODEL
• We have seen that a perfectly competitive firm will produce where P* = MC, provided P > AVC.
• Now we will look at four cases. In the first three the firm produces where P* = MC. In the fourth, the firm shuts down because P* < AVC.
• We will include the AC, AVC curves in the graph.
CASE 1-FIRM MAKES ECONOMIC PROFIT IN THE SHORT RUN
• Total revenue is P* ✕ q*
• Total cost is AC ✕ q*
• Economic profit is TR – TC = (P* – AC) ✕ q* > 0
• Note that P* = MC > AC
KD Perfect Competition-Short Run Economic Profit. P* > AC
q* q
MC AC
AVC P*
AC Area of economic profits
MR = d
0
KD Perfect Competition-Short Run Economic Profit. P* > AC
q* q
P*
TR MR = d
0
KD Perfect Competition-Short Run Economic Profit. P* > AC
q* q
P*
AC
TCTR MR = d
0
KD Perfect Competition-Short Run Economic Profit. P* > AC
q* q
P*
AC Area of economic profits
0
CASE 2-FIRM MAKES ZERO PROFIT IN THE SHORT RUN
• Total revenue is P* ✕ q*
• Total cost is AC ✕ q*
• 0 = TR – TC = (P* – AC) ✕ q*
• Note that P* = MC = AC
KD Perfect Competition-Short Run Zero Economic Profit P* = MC = AC
q* q
MC AC
AVC
P* MR = d
CASE 3-FIRM HAS AN ECONOMIC LOSS IN THE SHORT RUN
• Total revenue is P* ✕ q*
• Total cost is AC ✕ q*
• TR – TC = (P* – AC) ✕ q* < 0
• Note that P* = MC < AC
KD Perfect Competition-Short Run Economic Losses-Firm Continues to Produce. AVC < P* < AC
q* q
MC AC
AVC
P* AC
Area of economic losses
WHY DOES THE FIRM PRODUCE IF IT HAS A LOSS?
• Note that AVC < P* < AC
• TR – TC = (P* - AC) ✕ q* = (P* - AVC - AFC) ✕ q*
• Price is high enough that it can cover the AVC of the output and pay part of AFC.
• Numerical example: Let q* = 50, P* = 6 KD, AC = 10 KD, and
AVC = 4 KD. TR = 300, TC = 500 profit (loss) = -200.
• AFC = 10 – 4 = 6, TFC = 300. Shutdown loss would be -300.
CASE 4: P < AVC FIRM HAS A SMALLER ECONOMIC LOSS IF IT SHUTS DOWN
• Note that P* < AVC < AC
• TR – TC = (P* - AC) ✕ q* = (P* - AVC - AFC) ✕ q*
• Price is not high enough to cover the AVC.
• Firm shuts down production in the short run if P* falls below the minimum AVC (shutdown point).
CASE 4 CONTINUED: P < AVC NUMERICAL EXAMPLE
• Price is not high enough to pay the AVC,
• Numerical example: Let q* = 50, P* = 6 KD, AC = 10 KD, and
AVC = 7 KD. TR = 300, TC = 500 profit = -200.
• AFC = 10 – 7 = 3, TFC = 150. Shutdown loss would be -150, smaller than if the firm produces where P* = MC. Remember TVC is 0 if q = 0.
KD Perfect Competition-Short Run Economic Losses-Firm Shuts Down
P < AVC
q
MC AC
AVC
P*
0 = q*
Shutdown Point
MR = d
NUMERICAL EXAMPLE – ECONOMIC PROFIT
• P* = 10, AC = 7, q* = 50
• TR = 10 ✕ 50 = 500
• TC = 7 ✕ 50 = 350
• Economic profit = TR – TC = 150 or (10 – 7) ✕ 50
KD Perfect Competition-Short Run Economic Profit. P* > AC
50 q
MC AC
AVC 10
7 Area of economic profits
NUMERICAL EXAMPLE – ECONOMIC LOSS, P* > AC
• P* = 10, AC = 12, q* = 50
• TR = 10 ✕ 50 = 500
• TC = 12 ✕ 50 = 600
• Economic loss = TR – TC = -100 or (10 – 12) ✕ 50
• Suppose AVC = 9 then AFC = 3 and TFC = 3 ✕ 50 = -150, economic loss if the firm produced nothing.
KD Perfect Competition-Short Run Economic Losses-Firm Continues to Produce. AVC < P* < AC
50 q
MC AC
AVC
10 12 Area of economic losses
SAMPLE QUESTIONS
• Look at the graph in the next slide.
• How much does the firm produce?
• What is total revenue?
• What is total cost?
• How much is the firm’s economic profit or loss (which is it)?
• Price would have to fall to ___ or less for the firm to shut down.
$ Short Run Costs, Demand of a Wheat Farm
6 9 12 16 17 q
MC AC
AVC
15
7
d=MR 13 11
4
MARKET ENTRY IN THE LONG RUN
• Long run is a period of time sufficient for firms to change the amount of capital (fixed in the short run).
• In the long run, market entrants (new firms) can acquire the capital needed to compete in a perfectly competitive market.
• What attracts market entrants? Economic profits.
• New entrants cause the market supply to shift right and price falls.
• When price falls to minimum of the long run average costs, economic profits are zero and entry stops.
KD Perfect Competition-Long Run P P* > LRAC New firms enter market
q** q* q
LRAC
P*
P**
D S S´
Q* Q**
LRMC
MARKET EXIT IN THE LONG RUN
• Long run is a period of time sufficient for firms to change the amount of capital (fixed in the short run).
• In the long run, existing firms can dispose of capital and leave the market.
• What drives firms out of a market? Economic losses.
• Market exit causes the market supply to shift left and price rises.
• When price rises to minimum of the long run average costs, economic losses are zero and exit stops.
KD Perfect Competition-Long Run P Existing firms leave market
q* q** q
LRAC
P** P*
D S´ S
Q** Q*
Market Entry and Exit in the Long Run
