Perfect Competition

Only available on StudyMode
  • Download(s) : 145
  • Published : May 13, 2013
Open Document
Text Preview
Perfect competition:
For a market to be perfectly competitive, one of the main criteria is that all firms (and consumers) are price takers.

The following conditions are also necessary:

1. There must be many buyers and sellers in the market for an identical product. 2. Firms' products are identical.
3. Buyers and sellers must be fully informed about prices, products, and technology. 4. There are no barriers to entry (or exit).
5. Selling firms are profit-maximizing entrepreneurial firms.

The scenario about the ice cream industry depicts a perfectly competitive market. Buyers view vanilla ice cream from different stores as identical products, new stores can enter the industry, and each store has no influence on the going market price.

In perfect competition, many firms sell identical products to many buyers. Therefore, if Falero charges even slightly more for a box than other firms charge, it will lose all its customers because every other firm in the industry is offering a lower price. In other words, one of Falero's boxes is a perfect substitute for boxes from the factory next door or from any other factory. So, a perfectly competitive firm faces a perfectly elastic demand for its output at the current market price.

In this case, the equilibrium market price is $5 per box, so Falero faces a perfectly elastic demand curve for its boxes at $5.

Since a perfectly competitive firm faces a perfectly elastic demand curve at the market price, it can sell any quantity it chooses at this price. Therefore, the change in total revenue that results from a one-unit increase in the quantity sold is equal to the market price, so the marginal revenue curve is a horizontal line at the market price of $5 per box. Since the demand curve is also a horizontal line at the market price, the demand curve and the marginal revenue curve are the same.

Economic profit equals total revenue minus total cost, so profit is at its maximum when the difference between total revenue and total cost is at its greatest

Economic profit is defined as the difference between total cost and total revenue. At a price of $12,000, a profit-maximizing firm in a perfectly competitive market will produce 4,000 hybrid vehicles per year, since this is the quantity where marginal cost equals the market price (which equals a competitive firm's marginal revenue).

Since profit is the difference between total revenue (TR) and total cost (TC), we can rewrite this expression as:

Profit = TR - TC

Profit = (P x Q) - (ATC x Q)

Profit = (P - ATC) x Q

In this case, profit = ($12,000 per vehicle - $16,000 per vehicle) x 4,000 per vehicle= -$4,000 x 4,000 = -$16,000,000, which is an economic loss. This is the blue shaded area (labeled A) in the graph above.

The firm will produce as long as the market price is above the shutdown price of 10 cents, so the firm's supply curve corresponds to the portion of the marginal cost curve for prices above 10 cents. For example, at 10 cents, the firm will produce 150,000 pairs of socks, so (150, 10) is a point on the firm's supply curve; at 15 cents, the firm will produce 200,000 pairs of socks, so (200, 15) is another point.

For prices below 10 cents, the firm will not produce at all.

The shutdown price of $2 marks the point at which average variable cost is at its minimum. In the short run, when price is below $2, a firm's variable costs exceed its total revenue, so the firm would maximize profits (minimize losses) by shutting down. The break-even price of $4 marks the point at which average total cost is at its minimum. In the long run, when price is below $4, a firm's total costs exceed its total revenue, so the firm would maximize profits (minimize losses) by exiting the market.

In the short run, the individual supply curve for a firm is the portion of the marginal cost curve that corresponds to prices greater than and equal to the shutdown price of $2. In perfect...
tracking img