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Department of Economics University of California, Berkeley ECON 100A Spring 2010 - Section 12 GSI: Antonio Rosato Profit Maximization in a Competitive Market So far we have seen what are the components of the firm’s costs of production, and what is the cost minimizing choice of inputs for the firm given a certain production level. But how does the firm determine what is that level of production? We will first examine that question in the setting of perfect competition . This means we make three assumptions: (1) price taking, (2) homogenous products and (3) free entry and exit. 1. When many firms compete in the market, each one of them on its own does not have an effect on market price. When is it not so? When there is a small number of firms in the market. 2. Products are homogenous products when they are perfectly substitutable for each other. It is hard to think about a good example with everyday consumption goods, but usually agricultural products and raw materials are assumed to be homogenous. Homogenous products mean a single price in the market. 3. Free entry and exit exists when there are relatively low costs for a firm to enter or leave an industry. If a farmer thinks that it is a good idea to enter the wheat production industry, he should have no special cost associated with it except of course capital, labor... But these are “ordinary” costs of production. Although it is rare to find markets where these three assumptions hold, this is still our benchmark model for analysis. Profit maximization It is very reasonable to assume that the firm has profit maximization as a goal. What are profits? They are the difference between revenue and costs, or mathematically: π ( q ) = R ( q ) - c ( q ). We have already explored the cost part of this in previous sections.
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