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ECO20A- Tutor Session 4

27 September 2023

Simba Karadzandima
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PERFECTLY COMPETITIVE FIRMS-TERMS AND DEFINITIONS

• Price taker - firm that has no influence over market price and thus takes the price as given.
• Each firm in a competitive industry sells only a small fraction of the entire industry output.
• Product Homogeneity-products of all of the firms in a market are perfectly substitutable with one
another
• Freedom of entry and exit-condition under which there are no special costs that make it difficult
for a firm to enter (or exit) an industry.
• Firms and consumers have perfect information.
• How much output the firm decides to sell will have no effect on the market price of the product.
• Due to price taking, the demand curve facing an individual competitive firm is given by a horizontal
line. What is does this mean?
• Along this demand curve, MR=AR=P
• Output Rule (profit maximization) - produce at the level at which MR=MC.
• Shut-Down Rule- firm should shut down if P<AVC of production at the profit-maximizing output.
• Economic Profit – AR>AC; normal profit AR=AC; economic loss AR<AC
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Characteristic Perfect Competition Monopolistic Oligopoly Monopoly
Competition
Number of firms Many Many Few One
Type of product Homogenous or Differentiated, but May or may Unique product
standardised substitutable not be
differentiated
Entry and exit Completely free Free Barriers to entry: Completely blocked
• Natural factors
• Scale economies
• Patents
• Access to
technology
• Name recognition
Consumer Identical products Perspective of Follow No close substitutes for the
behaviour easily obtainable with differentiation advertising products
perfect information
Can easily substitute
products
Nature of demand Horizontal (perfectly Fairly elastic Depend on nature of Equals market demand curve –
curve elastic) market structure downward sloping
Profit Short run: Short run: Substantial Substantial
Economic profit Economic profit profits profits
Long run: Long run:
zero profit zero profit
Examples of Gold, oil Toothpaste Automobiles Arms manufacturing
products Steel
 CHOOSING OUTPUT IN THE SHORT RUN

The Short-Run Profit of a Competitive Firm

Figure 8.3
Chapter 8: Profit Maximization and Competitive Supply

A Competitive Firm Making a

Positive Profit
In the short run, the competitive
firm maximizes its profit by
choosing an output q* at which
its marginal cost MC is equal to
the price P (or marginal revenue
MR) of its product.

The profit of the firm is

measured by the rectangle
ABCD.

Any change in output, whether

lower at q1 or higher at q2, will
lead to lower profit.
Shut-Down Rule: The firm should shut
down if the price of the product is less
than the average variable cost of
production at the profit-maximizing
output. Less than 25

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 CHOOSING OUTPUT IN THE LONG RUN

Long-Run Competitive Equilibrium

Entry and Exit

Chapter 8: Profit Maximization and Competitive Supply

Figure 8.14

Long-Run Competitive Equilibrium

Initially the long-run equilibrium
price of a product is $40 per unit,
shown in (b) as the intersection of
demand curve D and supply curve
S1.
In (a) we see that firms earn
positive profits because long-run
average cost reaches a minimum
of $30 (at q2).
Positive profit encourages entry of
new firms and causes a shift to
the right in the supply curve to S2,
as shown in (b).
The long-run equilibrium occurs at
a price of $30, as shown in (a),
where each firm earns zero profit
and there is no incentive to enter
or exit the industry.
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EQUILIBRIUM IN THE SHORT RUN AND THE LONG RUN

Chapter 8: Profit Maximization and Competitive Supply

Because the firm is the only producer of its brand, it faces a downward-sloping demand curve.
In the short run the firm earns profits shown by the shaded rectangle. This encourages new firms to enter the
market.
This increases number of products, reduces demand faced by the incumbents (falls-shifts to the left) and
profits decline.
In the long run, these profits attract new firms with competing brands. The firm’s market share falls, and its
demand curve shifts downward.
Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 6 of 36
 MONOPOLY

• An Example
Figure 10.3

Example of Profit Maximization

Chapter 8: Profit Maximization and Competitive Supply

Part (a) shows total revenue R, total cost

C, and profit, the difference between the
two.
Part (b) shows average and marginal
revenue and average and marginal cost.
Marginal revenue is the slope of the total
revenue curve, and marginal cost is the
slope of the total cost curve.
The profit-maximizing output is Q* = 10,
the point where marginal revenue equals
marginal cost.
At this output level, the slope of the profit
curve is zero, and the slopes of the total
revenue and total cost curves are equal.
The profit per unit is $15, the difference
between average revenue and average
cost.
Because 10 units are produced, total profit
is $150.
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EXAMPLE
Chapter 8: Profit Maximization and Competitive Supply

.
• What is the firm’s supply curve.
Provide a reason for your answer.
• Explain the shutdown rule, and give
the price that illustrates this rule on
the graph.
• What is the price and corresponding
quantity at which the firm makes
normal profit?
• What is the price and corresponding
quantity at which the firm makes an
economic loss?

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 8 of 36
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SOLUTION
Chapter 8: Profit Maximization and Competitive Supply

• The rising portion of the firm’s marginal cost curve above the minimum of its
average variable cost curve at point b is the firm’s supply curve. This is
because if the price is P5, the firm will not produce at all.

• The firm should shut down if it unable to cover its variable costs, that is if price
is below the average variable costs. Any price below P4.

• P2 and Q2
• P3 and Q3. P4 and Q4 may also be correct

Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall • Microeconomics • Pindyck/Rubinfeld, 8e. 9 of 36
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