Chapter 9: Limited Decision-Making in Perfect Competition

Section C-TTh (2:30 PM-4:00 PM)

Reporters:
Noay, Lizette Claire
Pandac, Amanda Yvette
Pebida, Daverly
Perfect Competition

The least competitive business environment there is. In perfect competition, you can’t
set your product’s price and you have no incentive to advertise or innovate.

Perfect competition has four primary characteristics:

● A large number of firms: Your firm is one of a large number of firms, so it produces
a negligible amount of the total quantity of the commodity provided in the market.
● Standardized commodity: All firms produce a standardized or homogeneous
commodity, which means the commodity produced by your firm is no different from
the commodity produced by any other firm.
● Easy entry and exit: There are no barriers to entry in perfect competition.
● Perfect information: The good’s price and quality are known to all buyers and
sellers.

Price taker

The firm can’t set price; rather, the firm “takes” the price established by the market’s
supply and demand.

Making an Offer the Firm Can’t Refuse: Market Price

The market price of an asset or service is determined by the forces of supply and
demand. If an individual firm attempts to charge a price that's higher than the market price,
consumers will buy the product from a rival firm who sells the product at the lower market
price.

Competing with Advertising

In a perfectly competitive market, advertising is a waste of money. Advertising

doesn't allow the perfectly competitive firm to charge a higher price because it is a price
taker. Since it can already sell any amount of its products, there is no need for advertising to
increase sales.

Sprinting to Maximum Short-Run Profit

The firm simply determines the quantity of output to produce in order to maximize
profits. The firm can’t determine the product’s price; hence, the idea of limited
decision-making. In addition, the firm can’t change its fixed cost in the short run.
Determining price is out of your control

Markets always move toward equilibrium, so the market-determined price ultimately

is the price that makes quantity demanded equal to quantity supplied.

Qd is the market quantity demanded and P is the market price in dollars. Qs is the market
quantity supplied.

In order to determine the equilibrium price, you take the following steps:

1. Set quantity demanded equal to quantity supplied.

2. Combine similar terms.
3. Divide both sides of the equation by 35,000 to solve for P.

Maximizing profit with total revenue and total cost

Total revenue equals price multiplied by the quantity sold, or

TR= P x q

P represents the commodity’s price as determined by supply and demand in the market.

Total cost has two components — total fixed cost and total variable cost. Total
fixed cost is a constant, so even if your firm shuts down and produces zero units of output, it
still incurs total fixed cost.

Total profit equals total revenue minus total cost, or

(Profit) π =TR — TC

Economists use the terms profit and economic profit interchangeably. Economic profit
is defined as the difference between total revenue and the explicit plus implicit costs of
production.

As an equation:

Economic Profit= Total Revenue-(Explicit Costs + Implicit Costs)

The explicit costs plus implicit costs include every cost associated with production,
including the opportunity cost of your time and financial investment. Therefore, if economic
profit equals zero, you stay in business.

Remember:
Zero economic profit is okay. Positive economic profit is even
better. Negative economic profit is always bad.

Profit Maximization — process business firms undergo, to ensure the best output and price
levels are achieved in order to maximise its returns.
Marginal Revenue — change in total revenue that occurs when one additional unit of
output is produced. (slope of the total revenue function)
Marginal Cost — change in total cost that occurs when one additional unit of output is
produced. (slope of the total cost equation)

Profit Maximization Rule — states that if a firm chooses to maximize its profits, it must
choose that level of output where Marginal Cost (MC) is equal to Marginal Revenue (MR).
MR = MC

MR>MC — an additional unit of output adds more to your firm’s revenue than it adds to
your firm’s cost, and the additional unit earns you more profit.
MR<MC — an additional unit adds less to your revenue than it adds to your cost, and your
profit decreases.
P=MR=d
● Marginal revenue does not change as the firm produces more output because the
price is already determined by supply and demand. The increase in total revenue
from producing one additional unit will equal the price.
● Marginal revenue curve is a horizontal line, or perfectly elastic.
● Since price is constant in perfect competition, demand will always be equal to
both price and marginal revenue.

Marginal Cost Curve at first declines as production increases which represents the
area of increasing marginal returns that is common at low levels of production. But then
marginal costs start to increase, displaying the typical pattern of diminishing marginal
returns.

Profit-Maximizing Quantity of Output — the output level where marginal revenue

and marginal cost intersect. Profit is maximized at the output level.

Firms who shut down in the short run still have production costs — total fixed cost
can’t be changed. Thus, if a firm loses less money than total fixed cost by producing in
the short run, the firm should continue production in order to minimize losses.

Giving up and shutting down

There is a point where you should immediately give up and shut down. But first
remember that going out of a business in the short run doesn't mean that your losses go to
zero.
Disappearing profit in the long run
The long run is a period of time in which all inputs you employ are variable.
Therefore, the perfectly competitive firm operating in the long run can change the quantity
employed of any input-fixed inputs don't exist.

Perfect competition has two important characteristics that influence the long-run equilibrium:
● Easy entry and exit — firms have no difficulty moving into or out of a competitive
market.
● Price taker — individual firm's can't set price, but they can sell everything they
produce at the price established by the market.

Key points
➔ When economic profit reaches zero, no incentive for entry or exit.
➔ The long-run equilibrium requires both average total cost is minimized and price
equals average total cost (zero economic profit is earned).
➔ Similarly, if initial economic losses- negative economic profit - exist, firms leave the
market to this long-run equilibrium
➔ So no matter where you start, in perfect competition your economic profit
ultimately becomes zero.