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1.5.perfect Competition-2
1.5.perfect Competition-2
Perfect Competition
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consumers look to maximize their utility, and producers look to maximize
their profits (produce where MC = MR).
9. Firms can only make normal profits in the long run, although they can make
abnormal (super-normal) profits in the short run.
The single firm takes its price from the industry, and is, consequently, referred to
as a price taker. The industry is composed of all firms in the industry and the
market price is where market demand is equal to market supply. Each single firm
must charge this price and cannot diverge from it.
Questions
1: Explain why in a perfectly competitive market, the firm is a price taker. Why
cant the firm choose the price at which it sells its good?
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Perfect Competition and Profit Maximisation
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Profit maximization occurs at the quantity where marginal revenue equals
marginal cost.
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The firms decision regarding shut-down
The firm considers its sunk costs when deciding to exit, but ignores them when
deciding whether to shut down. Sunk costs are costs that have already been
committed and cannot be recovered.
The firm shuts down if the revenue it gets from producing is less than the
variable cost of production.
Shut down if TR < VC
Shut down if TR/Q < VC/Q
Shut down if P < AVC
The portion of the marginal-cost curve that lies above average variable cost is the
competitive firms short-run supply curve.
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The firms decision regarding exit
In the long run, the firm exits if the revenue it would get from producing is less
than its total cost.
Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC
The competitive firms long-run supply curve is the portion of its marginal-cost
curve that lies above average total cost.
Summary
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Questions
4: Tulip growing is a perfectly competitive industry, and all tulip growers have
the same cost curves. The market price of tulips is $25 (MR and AR) a bunch, and
each grower maximises profit by producing 2000 bunches a week. The average
total cost of producing tulips is $20 a bunch, and the average variable cost is $15
a bunch. Minimum average variable cost is $12 a bunch.
(a) What is the economic profit that each grower is making in the short run?
$5*2000= $10000
(b) What is the price at the growers shutdown point? <$12
(c) What is each growers profit at the shutdown point?
5: Cost figures for a hypothetical firm are given in the following table. Use them to
answer the questions below. The firm is selling in a perfectly competitive market.
6: Sarahs Salmon Farm produces 1000 fish a week. The marginal cost is $30 a
fish, average variable cost is $20 a fish, and the market price is $25 a fish. Is Sarah
maximising profit? Explain why or why not. If Sarah is not maximising profit, to
do so, will she increase or decrease the number of fish she produces in a week?
MR= $25, MC= $30 No profit maximizing
She should increase the number of fish produced to cover the fixed costs
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7: Suppose the industry equilibrium price of residential housing construction is
$100 per square foot and the minimum average variable cost for a residential
construction contractor is $110 per square foot. What would you advise the
owner of this firm to do? Explain.
The first thing is to assess the
8: Myrtle Beach, South Carolina, is lined with virtually identical motels.
Summertime rates run about $100 a night. During the winter, one can find rooms
for as little as $20 a night. Assume the average fixed cost of a room per night
including insurance, taxes and depreciation is $50. The average guest-related cost
for a room each night, including maid service and linens, is $15. Would these
motels be better off renting rooms for $20 in the off-season or shutting down
until summer?
9: You are considering building a Rent Your Own Storage Center. You are trying
to decide whether to build 50 storage units at a total economic cost of $200000,
100 storage units at a total economic cost of $300000, or 200 storage units at a
total economic cost of $700000. If you wish to survive in the long run, which size
will you choose?
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Profits and losses in perfect competition
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Short-run equilibrium under perfect competition
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In the long run
However, in the long run firms are attracted into the industry if the incumbent
firms are making supernormal profits. This is because there are no barriers to
entry and because there is perfect knowledge. The effect of this entry into the
industry is to shift the industry supply curve to the right, which drives down
price until the point where all super-normal profits are exhausted. If firms are
making losses, they will leave the market as there are no exit barriers, and this
will shift the industry supply to the left, which raises price and enables those left
in the market to derive normal profits.
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Example of an increase in demand in the short run
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An increase in demand raises price and quantity in the short run.
Firms earn profits because price now exceeds average total cost.
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Questions
10: What can you expect from an industry in perfect competition in the long run?
What will price be? What quantity will be produced? What will be the relation
between marginal cost, average cost and price?
11: Trout farming is a perfectly competitive industry, and all trout farms have the
same cost curves. The market price is $25 a fish. To maximise profit, each farm
produces 200 fish a week. Average total cost is $20 a fish, and average variable
cost is $15 a fish. Minimum average variable cost is $12 a fish.
(a) If the price falls to $20 a fish will trout farms continue to produce 200 fish a
week? Explain why or why not.
(b) If the price falls to $12 a fish, what will the trout farmer do?
12: 3M created Post-it Notes, also known as sticky notes. Soon many other firms
entered the sticky note market and started to produce sticky notes.
(a) What was the incentive for these firms to enter the sticky note market?
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(b) As time goes by, do you expect more firms to enter this market? Explain why
or why not?
(c) Can you think of any reason why any of these firms might exit the sticky note
market?
13: When Rod Laver completed his first grand slam in tennis in 1962, all rackets
were made of wood. Today, tennis players use graphite rackets. As the demand
for wooden tennis rackets decreased permanently, how did the profits of the
firms producing wooden tennis rackets change? As some of these firms switched
to producing graphite rackets, how did their economic profits change?
14: Consider this statement: When marginal revenue equals marginal cost, total
cost equals total revenue, and the firm makes zero profit. Do you agree or
disagree? Explain.
15: The perfectly competitive firm will sell all the quantity of output consumers
will buy at the prevailing market price. Do you agree or disagree? Explain your
answer.
Economists are concerned about the efficiency of markets, and ensuring that
resources are allocated efficiently.
Perfect competition is considered to be efficient because:
Supernormal profits are not made by any firm in perfect competition in the
long-run.
MC = price, so both parties, suppliers and customers, get exactly what they
want.
No wasteful advertising.
Firms are allocatively and productively efficient.
The major assumption behind this analysis and evaluation is that firms cannot
produce products cheaper if they were bigger. It assumes that there are no
economies of scale available in the market.
Allocative efficiency
Allocative efficiency occurs when the value consumers put on the good or
service equals the cost of producing the product or service. In other words,
when price = marginal cost.
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We can see from Figure 1 below that when it is in long-run equilibrium, perfect
competition achieves allocative and productive efficiency as MC = MR = AC = AR.
This means that they are maximizing profits (MC = MR) but only making normal
profit (AC = AR).
Productive efficiency
Look at economies of scale. Some are always likely to exist. Financial economies
apply - the better your reputation the cheaper the loans, bulk-buying economies
are there as well. Economies of scale are there, like gravity. It is up to the firm to
take advantage of them. Competition encourages their application and
exploitation.
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Perfect competition may well operate efficiently, as far as economists are
concerned. The consumer, however, may get an ordinary product or service at a
high price. Is it worth it?
Evaluation
The benefits
It can be argued that perfect competition will yield the following benefits:
1. Because there is perfect knowledge, there is no information failure and
knowledge is shared evenly between all participants.
2. There are no barriers to entry, so existing firms cannot derive
any monopoly power.
3. Only normal profits made, so producers just cover their opportunity cost.
4. There is no need to spend money on advertising, because there is perfect
knowledge and firms can sell all they can produce. In addition, selling
unbranded goods makes it hard to construct an effective advertising
campaign.
5. There is maximum possible:
o Consumer surplus
o Economic welfare
6. There is maximum allocative and productive efficiency:
o Equilibrium will occur where P = MC, hence allocative efficiency.
o In the long run equilibrium will occur at output where MC = ATC,
which is productive efficiency.
7. There is also maximum choice for consumers.
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How realistic is the model?
Very few markets or industries in the real world are perfectly competitive. For
example, how homogeneous is the output of real firms, given that even the
smallest of firms working in manufacturing or services try to differentiate their
product.
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which economists and regulators can evaluate levels of competition that exist in
real markets.
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