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Chapter 06 _Perfect Competition_

Chapter 06 _Perfect Competition_ - Chapter 6 A Firm in a...

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1 Chapter 6 A Firm in a Perfectly Competitive Market Introduction and Review In a free market system the demand and supply for a good determine the equilibrium price and quantity for that good. The question is whether these quantities of goods and services produced are allocatively efficient. To answer this question we started by looking into the determinants of demand and supply. Demand for a good comes from consumers. A consumer maximizes her satisfaction by consuming up to the point where the marginal benefit from consuming any good equals its marginal cost, which is the price of the good. The consumer is constrained by her limited income and faces the market prices of different goods, which she cannot control. The result is a consumer demand function for each good. The market demand curve is the sum of all the consumers’ demand functions at giv en prices. Therefore, at any price it tells us how much consumers as a whole are willing and able to buy of that good. Similarly, at any given quantity the market price equals to the willingness to pay of some people for that marginal unit. The consumer surplus is a measure of gains from trade for the consumers. It is the excess of what they are willing to pay to buy a particular quantity over and above what they actually pay to get it. The total expenditure by the consumers on the good equals the total revenue received by the producers. Supply comes from business firms. A firm’s objective is to maximize profits by producing output up to the point where the marginal benefit from that unit just equals its marginal cost. The marginal benefit is the revenue that the firm receives from the consumers for the sale of that unit. The marginal cost is the payments that it has to make to the providers of production inputs for producing that unit. In the last chapter we studied the cost of production. We determined that the marginal cost of production equals the price of the variable input times the amount of the variable input it takes to produce one unit of output. Cost of production depends on input prices and the internal organization of the firm. The firm’s marginal revenue, on the other hand, depend s on the structure of the output market. There are several types of market structures. In one extreme, called perfect competition , there are a very large number of small firms producing an identical product. The product of a firm is perfect substitute for those of all the other firms. In the other extreme we have the case of a monopoly , in which only one firm produces a product for which there are no close substitutes. There are also cases in between. Monopolistic competition is a combination of the above two cases where a large number of firms produce products that are slightly differentiated. Each good is a substitute for the other, but not a perfect substitute. Finally, in oligopoly a handful of firms produce products that are either identical or somewhat different. This chapter looks at the case of perfect competition.
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2 What is Perfect Competition?
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