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Unformatted text preview: 1 9. Perfect Competition Perfectly competitive markets The characteristics of perfect competition 1. All firms sell the same standardised (homogeneous) product. 2. The market has many buyers and sellers, each of which buys or sells only a small fraction of the total quantity exchanged. 3. All firms are price-takers. 4. Sellers are able to enter and leave a market as they like (in the long run). 5. Buyers and sellers are well informed. Perfectly competitive markets The outcomes of perfect competition 1. All firms maximise profits by setting MB = MC. Because firms are price takers, MB = P so all firms maximise profits by setting P = MC. 2. Firms respond to short run profits and losses by entering/exiting the market. Long run equilibrium occurs when economic profits are zero. 3. Long run equilibrium is efficient because P = MC. The central role of economic profit According to Adam Smith People are motivated by self-interest. The goal of profit maximisation will serve societys collective interest (under certain assumptions). The central role of economic profit Three types of profit Accounting profit: The difference between a firms total revenue and its explicit costs Accounting profit = total revenue explicit costs (payments for factors of production) Economic profit: The difference between a firms total revenue and the sum of its explicit and implicit costs. Economic profit = total revenue explicit costs implicit costs (opportunity cost of the resources supplied by the firms owners). Normal profit: The difference between a businesss accounting profit and its economic profit. It is equal to the opportunity cost of the resources supplied to a business by its owners. Normal profit = accounting profit economic profit. The central role of economic profit Calculating profit Suppose a firm has the following: TR [total revenue] = $400 000 Explicit costs (salaries) = $250 000/year Machinery and other equipment with a resale value of $1 mil ion Accounting profit $400 000 ( TR ) - $250 000 (explicit costs) = $150 000 To calculate economic profits, assume Annual interest on savings = 10% [Then the $1 mil ion spent on equipment could have earned $100 000/year had it been invested.] Economic profit $400 000 ( TR ) - $250 000 (explicit cost) - $100 000 (implicit cost) = $50 000 Normal profit Accounting profit ($150 000/year) Economic profit ($50 000/year) = $100 000/year 2 The three concepts of profit Total revenue Explicit costs Accounting profit Implicit costs Economic profit Explicit costs The central role of economic profit Why are the distinctions important?...
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