Chapter 9: [ 10 Questions on Final] Perfect/Pure Competition, Firm Behaviour, and Efficient Outcomes

1. The next several chapters look at the amount of market power individual firms have within an industry. Perfectly competitive firms (pure competition) have no market power and have to take market prices as given. At the other end, monopolistic firms have maximum market power and only have to take the demand curve as given (and select a price and quantity along that demand curve)
2. The “market properties” of perfect competition are:
   1. Many firms, each too small to individually impact on market price
   2. All firms produce a standardized product – no product differentiation
   3. Buyers have full information about the product (features, quality, etc.)
   4. There are many buyers, so no one buyer has power in the market
   5. Firms are free to enter or exit the market (no obstacles)

                                                               i.      This is challenged by patents, by firms “too big to fail” (banks, auto industry), government policy (agriculture, energy)

The purpose of these assumptions is to produce dynamic market behaviour where firms compete for profits based on the efficient production of a desired product.

3.      IMPORTANT POINT:(to know, not for exam): The politically conservative normative preference for “free enterprise” is not always for competitive markets, it is frequently in support of market power for firms (monopoly, oligopoly), and is different from the economist’s positive preference for perfect/pure competition based on the efficiency of purely competitive outcomes.

Competitive firm’s demand curve (plan and simple) is horizontal at the going market price as determined by the intersection of the industry supply and demand curves. The firm’s production and profit maximizing decision take price as given.

5.      The firm’s short-run supply decision (focus on Figure 9.2, p 164):     A little math (-:

a.      Profits = Total Revenue – Total Costs = TR - TC

b.      Marginal Profits = Marginal Revenue – Marginal Costs = MR - MC

c.      With price given by the industry, MR = Price (under pure competition)

d.      Thus: Marginal Profits = P – MC

                                                               i.      Profits rise so long as P > MC

                                                             ii.      Expand production so long as MC < P

6.      TC = FC + VC = FC + AVC(Q) (Chapter 8)

a.      Consider where P = AVC: at output (q₁ )

                                                               i.      Profits = PQ – [ FC – AVC(Q) ]  = -FC

                                                             ii.      Produce or not produce and Profits still –FC

                                                            iii.      P = AVC (shutdown/break even price)

b.      Consider P between AVC and ATC: output between q₁ and q₃ (e.g. q₂)

                                                               i.      When Price > AVC so some of FC are covered

                                                             ii.      Profits > -FC (loses smaller) so produce

                                                            iii.      At q₃ profits are Zero (PQ = TC + VC) –or- P = ATC

c.      Consider P > ATC: output beyond q₃

                                                               i.      When P > ATC Profits are positive, so produce

                                                             ii.      Firm’s supply curve is MC curve above minimum AVC

Table 9.1 is Table 8.2 broken out into its various profit levels as indicated here

7.      Industry supply curve is horizontal sum of individual firm MC curves above their minimum AVC shutdown/break even price. <- Correction

8.      Profits act as both an incentive and an entry/exit signal (Section 9.4 in text)

a.      The cost curves include both a competitive return on invested capital and the opportunity costs of the entrepreneur, so and profits from P > ATC produces economic profits and signals to new firms to enter.

b.      While loses (P < ATC) may keep the firm producing in the short run (so long as P > AVC), they will prompt old firms to exit in the long run.

c.      The textbook calls “economic profits” supernormal profits

9.      In the longer run (Section 9.5)

a.      Firm entry/exit shift the industry supply curve and change market price.

b.      FC become VC and the shutdown/breakeven point moves to minATC.

10. Increasing and Decreasing Cost Industries
    1. Economies of scale reflect decreasing cost industries where long run ATC curves slope downward, producing a downward sloping supply curve (but may support the growth of large scale non-competitive industry)
    2. Diseconomies of scale reflect increasing cost industries where long run ATC curves slope upward, producing upward sloping supply curves  (and may inhibit the growth of large scale non-competitive industry)
    3. Constant returns to scale produce a relatively flat long run supply curve
11. Globalization and Technological Change
    1. Trade Agreements expand the scope of integrated markets
    2. Technology extends the global scope for command and control by the firm

12.  Efficient Resource Allocation under Perfect/Pure Competition

a.      Each purely competitive firm produces where P = MC

b.      Each consumer buys products where P_x/P_y  =  MU_x/MU_y  (from eq 6.1 p 106)

c.      So:    Consumers’ MU_x/MU_y   =   P_x/P_y   =   firms’ MC_x/MC_y

The subjective rate at which consumers substitute goods on the margin (given P_x/P_y ) is the same as the marginal costs of switching between producing the goods by producers. This efficient production-consumption outcome is the positive basis of economists’ support for pure competition.

13. Review the Key Terms (p. 173)