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CHAPTER 9. PERFECT COMPETITION Large numbers of small buyers and small sellers : The market is like a beach, and buyers and sellers are like grains of sand (one agent does not make any difference in the market by itself, just like adding or taking a grain of sand would not affect the landscape of the beach). No agent (buyer or seller) can individually affect the market because each agent accounts only for a very small fraction of the market. Free entry and exit of agents : There are not significant barriers preventing the entry of new agents or the exit of agents already in the market. Homogeneous products : Products from different sellers must be perfect substitutes. Ex: Bananas from a grocery store have the same quality as the bananas from another store (organic bananas and regular bananas, though, are different goods). Firms are Price - takers: In a perfectly competitive market the firm sells at the ongoing market price. This is related to the homogeneity of products: because products are perfect substitutes people will buy from the cheaper producer. So if a firm wants to enter the market it has to sell at the prevailing price in the market. In consequence, the firm is said to be price-taker . Before we move on, it is important to introduce an important concept. This concept is marginal revenue . Marginal Revenue : Marginal revenue is defined as the increase in total revenue that comes from selling an additional unit of output . Since in perfect competition the additional unit of output has to be sold at the market price, then the marginal revenue must be equal to the price. In the case of the competitive firm, marginal revenue equals price. PROFIT MAXIMIZATION AND THE COMPETITIVE FIRM The goal of the competitive firm is to maximize total profit. Since the firm is price taker, it does not have to worry about assigning prices to its production: the price has to be the ongoing market price. However, what the firm does have to worry about is how much output to produce. The rule that the competitive firm follows to maximize total profit is to produce the level of output for which marginal cost is equal to price . At this level of production the difference between total revenue and total cost is the largest. Since for the competitive firm we have that price is equal to marginal revenue, then we have that Total Profit is maximized when MC = Price = MR
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How does this work? Understanding that the firm maximizes total profit when price equals marginal cost requires you to understand marginal analysis . For this, please refer to the Appendix 1 at the end of these class notes. Here we will apply a similar reasoning to that discussed in the appendix. In the appendix it is said that the firm keeps producing as long as the marginal benefit of producing an extra table (i.e. the revenue generated by that extra table) is higher than the marginal cost of producing that table. The firm maximizes the gains of production when the marginal benefit of the last table equals its
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This note was uploaded on 04/08/2008 for the course ECON 120 taught by Professor Serpa during the Spring '08 term at Ill. Chicago.

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