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EC111LectNG5 - University of Essex Department of Economics...

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1 University of Essex Session 20011-12 Department of Economics Autumn Term EC111: INTRODUCTION TO ECONOMICS PERFECT COMPETITION Perfect competition is one characterisation of the market the case where there are many buyers and sellers. It is an extreme case but very useful. The assumptions are: Firms sell a standardised (or homogenous) product. Firms are price takers (each is very small relative to the total market). In the long run firms can freely enter or exit the market. Buyers have perfect information on prices. This characterisation is where buyers and sellers are essentially anonymous; there is no scope for strategic interaction among them. One consequence of these assumptions is that the individual firm can sell as much as it likes at the going price. The demand curve facing the firm is perfectly elastic. This price is determined by total supply and total demand in the market. P P 1 q
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2 The perfectly competitive firm in the short run Total revenue and total cost Total Revenue (TR) is a straight line because every unit can be sold at price P. Marginal revenue, MR = P is the slope of the TR function. Total cost TC, is Fixed Cost, F, plus Variable Cost, VC. We assume that TC gets flatter and then steeper. The slope of the TC function is Marginal Cost MC The vertical difference is profit. Π = TR – TC. Maximum profit is where the two curves are parallel. This is where MC = MR = P. [Note: this is all in the short run but I have dropped the ‘SR’ prefix] q* q TC TR, TC TR Slope = MC Slope = MR
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3 Marginal Cost Average Costs, and Marginal Revenue This is exactly the same situation depicted using Total Revenue and Total Cost but here in terms of MR and MC Note that: MC crosses AC from below at the minimum of AC. Q: why is this? The firm maximises its profit where MR = P = MC. Profit is the area (P AC)×q. As the price increases the firm moves up its marginal cost curve; output and profits increase. If P falls to the minimum of AC the firm makes zero profit. Q: will it continue to produce anything? The firm’s s upply curve is its marginal cost curve down to AVC. Q: why is that? P, AC, MC P 1 AC 1 q* q AVC AC MC
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4 Marginal and average costs in the long run This diagram for the long run looks very similar to that of the short run, but note: In the long run the firm can adjust both its labour and its capital; the
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