Perfect Competition
Perfect Competition - In competitive markets there
are:
1.
Many buyers and
sellers - individual firms have little effect on the price.
2.
Goods offered are
very similar - demand is very elastic for individual firms.
3.
Firms can freely
enter or exit the industry - no substantial barriers to entry.
Competitive
firms have no market power. Recall that businesses are trying to maximize
profits, and Profit = Total Revenue (TR) - Total Cost (TC).
Revenue in a Competitive Business
Businesses
in competitive markets take the market price (P) as given (price takers). How
much does the business receive for a typical unit is known as the "average
revenue" (AR) and is equal to TR/Q = (P x Q)/Q = Price. So average revenue
is equal to price, and is constant. How much additional revenue does the firm
get if it sells one additional unit? To answer this question, we take a look at
"marginal revenue" (MR) which is equal to the change in TR divided by
the change in quantity. Note that this too is equal to price, so the marginal
revenue is constant as well, and is equal to average revenue.
Profit Maximization
To
maximize profit, we need to know the revenue and costs of the business. Profit
is maximized when marginal revenue = marginal cost and marginal cost is
rising. To see why recall that marginal revenue is the additional revenue from
1 additional unit. Marginal cost is the additional cost from 1 additional unit.
When
MR > MC, revenue is increasing faster than costs and the firm should
increase production. When MR < MC, revenue from the additional unit is less
than the additional cost, and the firm should decrease production. As such, A firm
maximizes profits when MR = MC.
So
what happens to output at various prices? Since MC is upward sloping, as price
increases, quantity produced will increase too. As price falls, quantity
produced falls. In each case, the marginal cost curve determines how much the
firm is willing to produce at each price, so it translates into the supply
curve.
Shutting Down a Company (temporary)
A
company is considered to have shut down if it temporarily ceases production but
keeps fixed capital. A company has to exit the industry when it has made a
permanent decision to leave the industry. The decision to temporarily shut down
a business depends on a few factors. Recall that ATC = AVC + AFC. So average
fixed cost is the vertical distance between average variable cost and average
total cost.
Now
if a business shuts down, its total revenue becomes zero, and its total cost
equals the fixed cost. So the company should continue producing its product, as
long as it covers its variable costs. This way, total revenue is greater than
total variable cost, because losses are then less than TFC. Basically, shut
down when P (AR = MR) < AVC, to minimize the losses and so the company's
short-run supply curve = MC curve above AVC. The firm, therefore, produces where
profit equals marginal cost.
Another
way to put this is that sunk costs are sunk. Fixed costs are sunk, and
therefore cannot be recovered by shutting down in the short run. The decision
to continue producing depends on revenues and variable costs. If average
revenue is greater than average variable cost, then the business should
continue to produce. It is rational to continue producing, so long as AVC <
P < ATC.
When to Leave An Industry (permanent)
A
business should leave the industry when revenue is less than the cost of operating
in the long run. In other words, exit if total revenue is less than total cost
(P < ATC). In competitive markets, a company will make zero economic profits
in the long run. If companies are making more than zero economic profits, it
will encourage other firms to enter the industry to share in these profits. In
other words, enter if total revenue is greater than total cost (P > AC). If
companies are making zero economic profits, there is no entry and no exit,
which is a long-run condition.
(Perfect Competition, aspropendo.org)
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