IV. The perfectly competitive (PC) market

    Recall: firm must do 2 things to max profit:
    1. Minimize cost of whatever amount is produced
        --we've just finished looking at this
    2. Decide how much to produce
        --we turn to that now

    Deciding how much to produce brings consumers and producers together in the market
        Consumers: part II: the demand side of the market
        Producers: part III: the supply side of the market

    We consider this interaction now in the context of a perfectly competitive market

    Assumptions and basic concepts

    (1) identical (homogeneous) products for all producers:
restricts all competition to a single dimension--price

    (2) many "small" sellers--each one too small to influence price of output  (zero measure)
    => firms are "price takers"
    regardless of industry demand, firm's D is horiz.

    (3) easy entry and exit
    => LR profits = 0

     (4) perfect information
    rules out miscalculations

    Relevance of PC--why study such an extreme case?

    (1) about 1/2 of economy is PC

    (2) provides a benchmark, a standard of comparison when looking at what goes wrong with markets

    (3) helps us understand firm behavior
    --competitive pressures
    --collusion
    --rent-seeking, etc.

    A. Equilibrium in the short run

    1. Choosing output

    Recall: firms try to maximize profits: TR - TC

    We've been looking at costs for some time now.
    For now, note just that TC = TC(Q)
        MC = DTC/DQ

    TR is also a function of Q

    For each PC firm  => TR = P^.Q, with P a constant = the going market price

    Marginal revenue (MR): the change in TR associated with the sale of an extra unit of output:

        MR = DTR/DQ

        For a PC firm, MR = P

        Anytime a PC firm sells another unit, TR rises by P

    Using marginal analysis to maximize profit

    Recall goal: max TR-TC.
    Note: selling extra output raises profits if and only if TR rises by more than TC:
    DTR > DTC => Dp > 0
   MR > MC =>  Dp > 0 => produce more

    Stop when MR<=MC.
    That will maximize your profits, with one possible exception:
    If p<0, check shutdown condition.

    Overall: 2-step process to choosing profit-maximizing output:
    Step 1: Expand production as long as MR >= MC (the upward-sloping portion of MC).
    Step 2: If profits are < 0, check to be sure that TR >= TVC (=> P >= AVC). If not, shut down.

    Review worksheet on profit maximization.

    The shutdown option:
    Q=0 => TR = 0, TC = TFC, p = -TFC

    => better to operate at Q* if
    p > -TFC =>
    TR - TC  > -TFC =>
    TR > TC - TFC =>
    TR > TVC =>
    TR/Q* > TVC/Q* =>
    P > AVC at Q*

    Note: there are only 4 possible situations at MR=MC:
    (1) P>ATC => positive economic profits => operate at P=MC
    (2) P=ATC => breakeven situation => operate at P=MC
    (3) P<ATC, but >=AVC => operate at P=MC for now since you're covering TVC and part of TFC (ex: dot.com firms)
    (4) P<AVC => shut down => losses = TFC; you're making your situation worse by operating since TR doesn't even cover TVC. Exit unless you expect things to improve.

    Rule: if you choose to be an industry, as long as P>minAVC, operate where P=MC for maximum profits

    Industry supply in the short run:

    Industry supply (S) =horizontal summation of individual firms' supply curves (MC curves above minAVC).
    That's why we say that marginal costs underlie supply curves.

    2. Calculating and illustrating profits

        p = TR - TC
            = P^.Q* - ATC^.Q*
            = (P - ATC)Q*

            = a rectangle:
            base = Q*
            height=P-ATC at Q*

    See profits geometry worksheet

    B. equilibrium in the long run

    Guest lecturer on steel industry cycle at a steel conference:
    Profits > 0 => entry until profits = 0 again
    Profits < 0 =>exit until profits = 0 again

    Example: coffee after WWII
    1. D1: 1945: equilibrium w/ European market closed off since 1941 (40% of market)
    2. D2: 1950: Brazil out of stocks demand stable after (e_I = 0)
    3. S2: 1955-1970s: 4-5 years to get first crop, yields rise 'til tree is 10-15 years old =>
        overplanting (e = 0.3 => foreign exchange falls)
    4. S3: 1970s: Brazilian frost brought market into line

Industry	Firm

    Key simplification here: ATC remained the same as industry output changed.
    Not always true.

    Effects of entry due to profits>0 (the reasoning works in reverse for exit):
    (1) P falls: always true
    (2) ATC curves shift if industry size afftecs input prices.
    (No single firm affects input prices. But all firms together might)

    Possible impact of entry on unit costs--3 possibilities:

    Why does this matter? It determines whether industry prices remain stable, rise or fall as industry size changes over time

    Example of an increasing cost industry:

Industry	Firm

    1: D shifts right --> profits > 0
    --> Entry -->
    2a: S shifts right --> -P
    2b: Input prices rise --> +ATC
    Entry stops when 2a + 2b --> 0 profits

Next topic