Lecture 14
PERFECT COMPETITION

1. Market structure of an industry

A. Perfect competition
Many sellers; same product (corn)
B. Monopolistic competition
Many sellers; differentiated products (gas stations)
C. Oligopoly
Few firms; identical or differentiated products(automobiles)
D. Monopoly
Single firm, unique product (local telephone service)

2. Perfect competition

• An individual seller cannot affect market price
• Each firm is a "price taker"

• Consumers buy the good only on the basis of price

• If profits are to be made, firms can enter the market freely
• If losses are incurred, firms can exit the industry freely

• All consumers (and firms) knows the price charged by each firm

3. Market price

• Obtained at the intersection of the market (or industry)supply and demand curves
• The market supply curve is the "sum" of the individual supply curves of all firms
  

4. Demand for the individual firm's output

• For an individual firm, the demand curve is horizontal
  • What is the elasticity of demand?
• The firm takes the market price as given

5. Objective of the firm

To maximize profits

Big Question: What is the optimal output level for an individual firm?

Big Answer: The output level at which Price = Marginal Cost

6. Graphical analysis

• Demand for the firm's output
  Demand curve (DD), Marginal revenue (MR) and Average Revenue (AR)
• The firm's cost function
  Marginal cost (MC), Average Cost (AC)

Step 1: Obtain the point at which P equals MC

Step 2: Indicate the corresponding output level (this is Q*)

Step 3: What is the average cost of producing Q* units?

Step 4: Indicate the revenue (TR) earned by the firm

Step 5: Indicate the cost (TC) incurred by the firm (Recall: TC = ACxQ)

Step 6: Indicate the profit made by the firm

Note: It is the AC curve, and not the MC curve, that is used in figuring out the total cost of producing a certain level of output.

7. Shut-Down Point

• If firm shuts down: Loss = Fixed costs
• If firm continues to operate: Loss = TC-TR
• Shut-down point: P = minimum AVC
• In the short run:
  • If P < minimum AVC:
    Firm should quit production (shut down)
  • If P > minimum AVC:
    Firm should continue to produce output using the P=MC criterion