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Firms in Perfectly Competitive Markets

May 5, 2025

Microeconomics: Firms in Perfectly Competitive Markets

Chapter Outline

  • 12.1 Perfectly Competitive Markets
  • 12.2 How a Firm Maximizes Profit in a Perfectly Competitive Market
  • 12.3 Illustrating Profit or Loss on the Cost Curve Graph
  • 12.4 Deciding Whether to Produce or to Shut Down in the Short Run
  • 12.5 Entry and Exit of Firms in the Long Run
  • 12.6 Perfect Competition and Efficiency

Perfectly Competitive Markets

  • Characteristics:
    • Many buyers and sellers.
    • Identical products.
    • No barriers to entry.
  • Firms are price takers due to identical products.
  • Demand curve for individual firms is horizontal.
  • Example: Agricultural markets like wheat.

Profit Maximization in a Perfectly Competitive Market

  • Profit Calculation: Profit = Total Revenue (TR) - Total Cost (TC)
  • Revenue Characteristics:
    • Price = Average Revenue (AR) = Marginal Revenue (MR)
  • Profit Maximization Rule:
    • Produce where Marginal Revenue (MR) = Marginal Cost (MC)
  • Graphical Illustration:
    • Profit is the area between TR and TC curves.
    • Profit is maximized where MR = MC.

Cost Curve and Profit/Loss

  • Profit/Loss depicted on cost curve graph:
    • If Price (P) > Average Total Cost (ATC), profit exists.
    • If P < ATC, loss occurs.
    • Profit = (P - ATC) x Quantity (Q)
  • MC = MR rule applies for loss minimization if no profit is possible.

Production Decision in Short Run

  • Firms face decision to produce or shut down:
    • Shut Down Rule: If Price < Average Variable Cost (AVC), shut down.
    • Firm’s supply curve is the MC curve for P >= AVC.

Entry and Exit in the Long Run

  • Economic Profit: Attracts new firms, increasing supply, driving prices down.
  • Economic Loss: Causes firms to exit, decreasing supply, driving prices up.
  • Long-Run Equilibrium: Firms earn zero economic profit; price equals ATC.

Efficiency in Perfect Competition

  • Productive Efficiency: Goods produced at lowest cost.
  • Allocative Efficiency: Production aligns with consumer preferences; last unit’s marginal benefit equals its marginal cost.
  • Perfect competition achieves both productive and allocative efficiency.

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