Firm In Competitive Market

Perfect competition
This is an extreme form of capitalism. No firm has the power to affect the price of the product. The price is determined by the interaction of demand and supply.

Assumptions
The model of perfect competition is built on 4 assumptions:

Many firms in an industry

Each firm produces only small proportion of total industry supply Firms have no power to affect price of product Price is determined by the interaction of demand and supply in the market

Existing firms cannot stop new firms to setting up in business

Freedom of entry is applied in the long run because setting up business take time

The product is all equal

No need to do branding or advertising

4. Producers and consumers have perfect knowledge of the market

Prices Producers aware of Costs Market opportunities

Prices
Consumers aware of Quality Availability

Profit Maximization and the Competitive Firms Supply Curve

As long as MR exceeds MC, increasing output will raise profit. If MR is less than MC, the firm can increase profit by decreasing output. Profit maximization occurs where MR is equal to MC

Analyze Cost Curve

The features of cost curves:
MC curve is upward slopping ATC curve is U-shaped The MC curve intersect the ATC curve at the minimum of ATC

MR and AR can be shown by a horizontal line at the market price

Short Run Equilibrium of the firm

The diagrams below can show the determination of price , output and profit in the short run under perfect competition.

P S

MC AC

Pe D O Q (millions)

AR AC

Qe Q (thousands)

 Price
Price is determined in the industry by the intersection of demand and supply. Firms are price taker. Changes in output of firm cannot affect market price. Thus, the demand curve is horizontal at this price.

 Output
The profit is maximize where MR = MC (Qe). MR is equal to price (output is not affected price). Since the price is not changing, the revenue earn for an extra unit is the price itself. In this situation, MR = AR.

 Profit
AC curve below the AR curve, the firm earns supernormal profit. supernormal profit per unit at Qe is the vertical difference between AR and AC Total supernormal profit is the shaded rectangle below of AR

 There is a difference between a temporary shutdown of a firm and an exit from the market.

 Temporarily shut down earn no revenue firm choose not to produce output still have to pay fixed cost. Exits from market long run decision of firm to leave the market.

 Shut down where TR<VC P<AVC. Firm will do to maximize profit

If P<AVC, firm will produce no output. If P>AVC, the firm will produce the level of output that MR=MC

 Firm decides to exit the market if the revenue earn is less than TC (TR<TC) Exit if P<ATC Enter if P>ATC

Short-Run Supply Curve

Firms SR supply curve will be its SR marginal cost curve. Why?
Under perfect competition P = MR, and MR = MC Thus, P = MC

MC = S

 At P1, profit would maximized at Q1 where P = MC. a is a point on supply curve. At P2, Q2 would be produced. b is a point on supply curve. Under perfect competition, firms supply entirely depends on production costs.

 Marginal costs rise as output rises. A higher price is necessary to induce the firm to increase its output.

Long Run Equilibrium of the Firm

New firms will be attracted into industry if the existing firms are making supernormal profits. Firms will increase the scale of operations if they can make supernormal profits. In the long run, all factors of production are variable.

S1

Se LRAC

P1
PL D

AR1
ARL

D1
DL

QL Industry Firm

Entry of new firms

Expansion of existing firms

Increase industry supply

At price P1, supernormal profits are earned. New firms enter the market Supply curve shift to the right

The point which demand curve touched the lowest point of LRAC curve

Price is falling to the point where they earn normal profits

The full long run equilibrium is the point where LRAC = AC = MC = MR = AR