Chapter 8 Analysis of Perfectly competitive Markets Assumptions: firm maximizes profits Perfect competition is a world of atomistic firms who

are price-takers. Profits = total revenues total costs are like the net earnings or take-home pay of a business represent the amount a firm can pay in dividends to the owners, reinvest in new plant and equipment, or employ to make financial investments.

Perfect Competition

world of price-takers sells a homogenous product it is so small relative to its market that it cannot affect the market price; it

simply takes the price as given firms segment in the demand curve is only a tiny segment of industrys curve the extra revenue gained from each extra unit sold is therefore market price *Demand curve is completely elastic for a perfectly competitive firm *The maximum profit output comes at that output where marginal cost equals price

o The reason underlying this proposition is that the competitive firm

can always make additional profit as long as the price is greater than the marginal cost of the last unit o Total profit reaches its peakis maximizedwhen there is no longer any extra profit to be earned by selling extra output. * extra revenue price per unit * extra cost- marginal cost Rule for a firms supply under perfect competition: A firm will maximize profits when it produces at that level where marginal cost equals price: MC = P * The firms marginal cost curve can be used to find its optimal production schedule: the profit- maximizing output will come where the price intersects the marginal cost curve. Zero-profit point- the production level at which the firm makes zero economic profits; price equals average cost, so revenues just cover costs.

General Rule: A profit-maximizing firm will set its output at that level where marginal cost equals price. Diagrammatically, this means that a firms marginal cost curve is also its supply curve. possibility: the price will be so low that the firms will want to shut down In general , a firm will want to shut down in the short run when it can no longer cover its variable cost.

Shutdown point: critically low market price at which revenues just equal cariable costs. (loss exactly equal fixed costs)

o For prices above the shutdown point, the firm will produce along its

marginal cost curve because even though the firm might be losing money, it would lose more money by shutting down. o For prices below the shutdown point, the firm will produce nothing at all because by shutting down the firm will lose only its fixed cost. Shutdown rule: The shutdown point comes where revenues just cover variable costs or where losses are equal to fixed costs. When the price falls below average variable costs, the firm will maximize profits (minimize its losses) by shutting down. SUPPLY BEHAVIOR IN COMPETITIVE INDUSTRIES The total quantity brought to market at a given price will be the sum of the individual quantities that all firms supply at that price. In the short run, demand shifts produce greater price adjustments and smaller quantity adjustments than they do in the long run.

Short-run equilibrium: when any change in output must use the same fixed amount of capital Long-run equilibrium: when capital and all other factors are variable and there is free entry and exit of firms from the industry. o In the long run, the price as a competitive industry will tend toward the critical point where identical firms just cover their full competitive costs. o The long-run equilibrium in a perfectly competitive industry is therefore one with no economic profits. Zero-profit long run equilibrium: IN a competitive industry populated by identical firms with free entry and exit, the long-run equilibrium condition is that price equals marginal cost equals the minimum long run average cost for each identical firms: P=MC=minimum king-run AC=zero-profit price

GENERAL RULES Demand Rule: an increase in demand for a commodity (the supply curve being unchanged) will raise the price of the commodity. For most commodities, an increase in demand will also increase the quantity demanded. A decrease in demand will have the opposite effects. Supply rule: An increase in supply of a commodity (the demand curve being constant) will generally lower the price and increase the quantity bought and sold. A decrease in supply has the opposite effects. Pure economic rent: When the quantity supplied is constant at every price, the payment for the use of such a factor of production Backward-Bending Supply As improved technology raises real wages, people feel that they want to take part of their leisure and early retirement.

Shifts in Supply An increased supply will decrease P most when demand is inelastic An increased supply will increase Q least when demand is inelastic

The concept of Efficiency An economy is efficient when it provides its consumers with the most desired set of goods and services given the resources and technology of the economy. Allocative efficiency occurs when no possible reorganization of production can make anyone better off without making someone else worse off. At minimum, an efficient economy is on its PPF. But efficiency goes further and requires not only that the right mix of goods be produced but also that these goods be allocated among consumers to maximize consumer satisfactions. Economic surplus: rust area between supply and demand curves at the equilibrium; sum of the consumer surplus, which is the area between the demand curve and the price line and the Producer surplus, which is the area between price line and the SS curve. The producer surplus includes the rent and profits to firms and owners of specialized inputs in the industry and indicates the excess of revenues over cost of production. o Is the welfare or net utility gain from production and consumption of a good; it is equal to the consumer surplus plus the producer surplus.

Many goods Condition: Utility-maximizing consumers spread their dollars among different goods until the marginal utility of the last dollar is equalized for each good consumed. A perfectly competitive economy is efficient when marginal private cost equals marginal social costs and when both equal marginal utility.

Competition guarantees efficiency, in which no consumers utility can be raised without lowering another consumers utility. Central role of marginal cost: Only when prices are equal to marginal costs is the economy squeezing the maximum output and satisfaction from its scarce resources of land, labor and capital. MARKET FAILURES Imperfect Competition: When a firm has a market power in a particular market. Externalities: arise when some of the side effects of production or consumption are not included in market prices. Imperfect information: * Read Summary