Perfect Competition Review for AP Economics (page 2)
Review questions for this study guide can be found at:
Main Topics: Structural Characteristics, Demand, Profit Maximization, Short-Run Profits, Decision to Shut Down, Long-Run Adjustment
Structural Characteristics of Perfect Competition
Each market structure is defined by structural characteristics. These characteristics determine, among other things, how the profit maximizing price and quantity are set in the short run, as well as how profits might be maintained in the long run. Perfect competition is typically described by four characteristics:
- Many small independent producers and consumers. Not small like Mini-Me small, but small like each firm is too small to have an impact on market price. No one firm can drive up the price by restricting supply, or drive down the price by flooding the market with output. No one consumer can, by changing the amount of the good that he consumes, impact the price.
- Firms produce a standardized product. There exist no real differences between one firm's output and the next.
- No barriers to entry or exit. There exist no significant obstacles to the entry of new firms into, or the exit of existing firms out of this industry. Profitability or lack thereof determines whether the industry is expanding or contracting.
- Firms are "price takers." This characteristic is actually a result of the first three. Because all firms are too small to affect the price, they must accept the market price and produce as much as they wish at that price. Even if they couldchange the price, they would not do so. To see this, suppose that the market determined competitive price of barley is $5. If farmer Katie increased the price to $5.01, she would now be the high price supplier of barley with thousands of competitors producing an identical product at a lower price; Katie is likely to lose all of her customers. If she lowers her price to $4.99, she would seemingly clean up her competition. But remember, the price-taking characteristic tells us that Katie can sell all she wants at the market price of $5. If you can sell all you want at $5, why would Katie sell even one unit at $4.99?
All four of the characteristics of perfect competition are rarely found in today's industries, but agricultural commodities are usually regarded as approximately perfectly competitive.
Demand for the Firm
Each perfectly competitive firm produces a standardized, or homogenous, product. Because each firm's output is such a small share of the total market supply, the demand for each firm's output is perfectly elastic. Perfectly competitive firms have no effect on the market price; they simply produce as much as they can at the going price. This implies a horizontal demand curve for their product. This does NOT imply that the market demand curve is horizontal. If the market price of barley falls, quantity demanded rises. Figure 9.1 illustrates the difference between market demand (D) and the demand for one firm's product (d).
Let's get one thing straight. When we say firms maximizeeconomic profit, this means they are not going to settle for anything less than the highest possible difference between total revenue and total economic cost. If an additional dollar of profit is to be earned, they take that opportunity. If the maximum profit possible is actually zero, or even negative dollars, they accept this short-run outcome. There are two equivalent ways to maximize economic profit.
The Method of "Totals''
The perfectly competitive firm cannot change the price; it can only adjust output. To maximize profit the firm selects the output to maximize:
Economic Profit (π) = Total Revenue – Total Economic Cost
An example should help to illustrate how a firm goes about maximizing profit.
A carrot farmer operates in a perfectly competitive market. The going price for a bushel of carrots is $11. Table 9.1 summarizes how total revenue, total cost, and profit differ at various levels of output. Because it is the short run, there exist $16 of fixed costs. All costs reflect the explicit and implicit costs of hiring a resource.
Because the firm is a price taker, the level of output does not affect the going price. Total costs rise as production increases, a concept seen in the previous chapter. As a profit maximizer, our carrot farmer would choose to produce five bushels per day and earn $2 in daily economic profit. This method of profit maximization is much like "trial and error" and is a bit cumbersome. Let's explore an equivalent, and easier way.
The Method of "Marginals"
Throughout this book we have seen illustrations of marginal analysis and this situation is no different. You'll recall that rational decision making implies:
Since the only decision to be made by the perfectly competitive firm is to choose the optimal level of output, the firm's rule is:
- Choose the level of output where MR = MC.
Table 9.2 can be modified to show the marginal revenue and marginal cost of selling additional bushels of carrots.
Notice that in perfect competition, the price is equal to marginal revenue. This is fairly simple if you recall the assumptions of the model. Farmers can sell as much as they want at the market price. If a farmer sells one more bushel, total revenue increases by the price of the bushel; $11 in this case. Sell another bushel; earn another marginal revenue of $11. Price is also equivalent to average revenue (AR), or total revenue per unit. These relationships can be seen in Figure 9.2
- MR = ΔTR/ΔQ= P × ΔQ/ΔQ= P
- AR = TR/Q= P × Q/Q= P
- P = MR = AR = demand for the firm's product
Short-Run Profit and Loss
To maximize profit, the firm must choose the level of output (qe) where MR = MC. But how can we use Figure 9.2 to identify these profits? A little algebra goes a long way.
Π = TR – TC = P × qe – TC. If you divide both terms by quantity and remember that TC/q= Average Total Cost, you have:
Π = qe × (P– ATC)
The term (P– ATC) is the per unit difference between what the firm receives from the sale of each unit and the average cost of producing it, or profit per unit. When you multiply this per unit profit by the number of units (qe) produced, you have total profit. Table 9.3 and Figure 9.3 incorporate the ATC into our carrot farmer's table profit maximizing decision.
Profit Rectangles and Flying Monkeys
Everyone remembers The Wizard of Ozand the critical instructions that the people of Munchkinland gave Dorothy and Toto as they set off to find the Wizard: "Follow the yellow brick road." And when Dorothy, Toto, and friends stayed on the yellow brick road, they were fine. Whenever they ignored these cautionary words and left the yellow brick road, bad things happened—the scariest being the arrival of the flying monkeys. The flying monkeys tore the Scarecrow limb from limb and set the Scarecrow's straw innards on fire. Talk about a Rolaids moment! Very bad things happen when you leave the yellow brick road.
When you find the profit maximizing level of production, qe, you are locating the yellow brick road for this firm. Neverleave this level of output, or bad things happen. Finding qe is the first step in calculating profit with a "profit rectangle." The area of the shaded rectangle is 5 bushels wide, multiplied by 40 cents high. In our case, the price $11 is in Figure 9.3 above the average total cost $10.60 so we have positive economic profits of $2. This does not always occur in the short run. Another look at our per unit equation tells us:
While firms would love to maintain the above scenario where P> ATC and positive economic profits are made, it might not always turn out that way. Due to a failure of the Bugs Bunny diet fad, the market for carrots suffers a dramatic decrease in demand. Plummeting demand decreases the market price to $6.50 per bushel and firms must readjust their profit maximizing output decision.
At the much lower price of $6.50, the firm now finds that MR = MC at an output of three bushels per day. Not surprisingly, the opportunity for positive economic profit has been eliminated. The profit maximizing, or loss minimizing, output of three bushels provides the best possible scenario for the firm; but that scenario involves economic losses of $14.50. The rectangle can still be seen in Figure 9.4, where average total cost is $11.33 per bushel.
- Many AP students lose points because they incorrectly locate and label profit. When finding the profit/loss rectangle, it is important to remember the following.
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