E x a m p l e market a is a perfectly competitive

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Unformatted text preview: If this manufacturer operates in a perfectly competitive market, how does it decide what price to charge for its products? E X A M P L E : Market A is a perfectly competitive market. Currently, the equilibrium price is $10. The total revenue and marginal revenue data for one seller in this market look like the following: Units of output Total revenue Marginal revenue 1 2 3 $10 20 30 $10 10 10 This firm’s total cost and marginal cost data look like the following: Units of output Total cost Marginal cost 1 2 3 $6 14 24 $6 8 10 Section 1 A Perfectly Competitive Market 191 08 (186-221) EMC Chap 08 11/17/05 5:27 PM Page 192 Now ask what quantity of output this firm will produce. You know that it wants to produce the quantity of output at which marginal revenue equals marginal cost: MR = MC occurs at a quantity of 3 units. Now ask what price it will charge for each of the 3 units it sells. Because the firm is a price taker, it takes the equilibrium price of $10. So, it produces 3 units and charges a price of $10 for each unit. How much profit does this firm earn? We know that profit is the difference between total revenue and total cost. When the firm produces 3 units of output its total revenue is $30 and its total cost is $24, so it follows that this firm’s profit is $6. QUESTION: How did you get the dollar amounts in the marginal revenue (MR) column and in the marginal cost (MC) column? ANSWER: Remember from Chapter 7 that marginal revenue is the additional revenue from producing an additional unit of a good. Notice that when the firm sells 1 unit of the good its total revenue is $10 and when it sells 2 units of a good its total revenue is $20. What is the additional revenue generated due to selling the additional unit (the second unit)? Obviously the answer is $10. The same holds going from selling 2 units to 3 units. The total revenue for the firm when it sells 2 units is $20 and it is $30 when it sells 3 units; therefore the additional revenue due to selling the additional unit (the third unit) is $10. Here is the MR equation from Chapter 7: Marginal revenue (MR) Suppose 200 sellers operate in market X, a perfectly competitive market. Each of the sellers produces good X and sells it for its current equilibrium price, $10. Furthermore, all 200 firms earn profits. Will things stay as they are currently? Not likely. According to the fourth characteristic of a perfectly competitive market, easy entry is an aspect of a perfectly competitive market. In other words, firms that are currently not in market X can easily get into that market. Nothing is holding them out. As long as sellers are earning profits in that market, the answer is yes. As new firms enter market X, the number of firms in the market increases, say from 200 to 250. With more firms, the supply of good X increases. (Remember from Chapter 5 that as the number of sellers increases, the supply of the good increases too—the supply curve shifts rightward.) When the supply of a good rises, equilibrium price falls. Furthermore, as price falls, so does profit. Profit, remember, is total revenue (price times number of units sold) minus total cost. In this case, as price falls, so do total revenue and profit. How long will new firms keep entering market X? Until they see no reason to do ∆TR/∆Q As to the dollar amounts in the marginal cost (MC) column, we just made up these dollar amounts. Often, in the real world, marginal cost rises as a firm produces additional units of a good, so we had the marginal cost dollar amounts rise in our example. 192 Chapter 8 Competition and Markets Profit Is a Signal in a Perfectly Competitive Market What is likely to happen if this fastfood restaurant’s profits begin to climb? 08 (186-221) EMC Chap 08 11/17/05 5:27 PM Page 193 so—that is, until the competition eliminates the profit. When profit falls to zero and total revenue exactly equals total cost, firms will no longer have a monetary incentive to enter market X. In a perfectly competitive market, then, profit acts as a signal to firms that are currently not in the market. It says, “Come over here and get me.” As new firms gravitate toward the profit, they increase the supply of the good that is earning profit and thus lower its price. As they lower its price, the profit dissipates. The process ends when firms no longer see an incentive to enter the market to obtain profit: Profit exists → New firms enter the market → Supply rises → Price falls → Price falls until firms no longer see an incentive to enter the market QUESTION: Can you give us some exam- ples of profit (in a market) that signals other firms to enter into the the market, ultimately reducing the price that consumers pay? ANSWER: Think about the prices you sometimes pay for new goods (goods that have just been introduced). When the VCR was introduced, its price was more than $1,000. The profit in the VCR market acted as a signal to new firms to enter that market. As they did, the supply of V...
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This document was uploaded on 01/16/2014.

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