Exam 5 Study Guide: Perfect Competition and Monopolistic Competition

Chapter 12: Firms in Perfectly Competitive Markets

Perfectly Competitive Markets

Perfect competition is a market structure where many firms sell identical products, and no single firm can influence the market price. This section explores the defining features and implications of perfect competition.

• Market Structure: Models of how firms interact with buyers to sell their output.

• Perfectly Competitive Market:

  • Many buyers and sellers

  • Firms sell identical products

  • No barriers to entry for new firms

• Price Takers: Firms are unable to affect the market price; each firm accepts the market price as given.

• Demand Curve: Sellers in perfect competition face a horizontal and perfectly elastic individual demand curve.

How a Firm Maximizes Profit in a Perfectly Competitive Market

Firms in perfect competition maximize profit by producing the quantity where marginal revenue equals marginal cost.

• Profit: $\text{Profit} = \text{Total Revenue} - \text{Total Cost}$

• Average Revenue: Total revenue divided by quantity of product.

• Marginal Revenue: Change in total revenue from selling one more unit of the product.

• For perfectly competitive firms: $\text{Price} = \text{Average Revenue} = \text{Marginal Revenue}$

• Profit-Maximizing Rule: $\text{MR} = \text{MC}$

• Special Case: Since $P = MR$, profit-maximizing level of output is where $MR = MC$.

• Profit Equations:

  • $\text{Profit} = (P \times Q) - TC$

  • $\frac{\text{Profit}}{Q} = P - ATC$

  • $\text{Profit} = (P - ATC) \times Q$

• At the quantity Q where MR = MC:

  • If $P > ATC$, the firm is making a profit

  • If $P = ATC$, the firm is breaking even

  • If $P < ATC$, the firm is making a loss

Deciding Whether to Produce or to Shut Down in the Short Run

Firms must decide whether to continue production or shut down based on their ability to cover variable costs.

• Shutdown Decision: Based on variable costs

• The firm should produce nothing if $\text{Total Revenue} < \text{Variable Cost}$, or $P < AVC$

• If $P \geq AVC$, produce Q where $MR = MC$

• The firm's marginal cost curve is its supply curve only for prices at or above average variable cost.

Entry and Exit of Firms in the Long Run

Entry and exit of firms in perfect competition drive the market toward zero economic profit in the long run.

• Economic Profit: $\text{Economic Profit} = \text{Total Revenue} - \text{Explicit Costs} - \text{Implicit Costs}$

• Positive economic profits attract new firms, increasing supply and lowering price until all firms break even.

• Economic losses cause some firms to exit, decreasing supply and raising price until all firms break even.

• Long-Run Competitive Equilibrium: All firms break even; no incentive for entry or exit.

• Long-Run Supply Curve: Shows the relationship between price and quantity supplied after firms have entered or exited the market.

• Industry Types:

  • Increasing-cost industries: Upward sloping long-run supply curve (higher costs as industry expands).

  • Decreasing-cost industries: Downward sloping long-run supply curve (lower costs as industry expands).

Perfect Competition and Efficiency

Perfect competition leads to both productive and allocative efficiency, ensuring resources are used optimally.

• Productive Efficiency: Goods or services are produced at the lowest possible cost.

• Allocative Efficiency: Production matches consumer preferences; marginal benefit equals marginal cost.

• Perfectly competitive firms are productively and allocatively efficient because they produce where $P = MC$.

Chapter 13: Monopolistic Competition: The Competitive Model in a More Realistic Setting

Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market

Monopolistic competition describes markets with many firms selling differentiated products, facing downward-sloping demand curves.

• Monopolistic Competition:

  • Many firms

  • Firms sell differentiated products

  • No barriers to entry for new firms

  • Firms have zero long-run profit, but do not face a horizontal demand curve

• Differentiated Products: Products are similar but not identical.

• Marginal Revenue: For downward-sloping demand curves, marginal revenue is less than price and decreases as quantity increases.

  • $MR = \frac{\Delta TR}{\Delta Q}$

How a Monopolistically Competitive Firm Maximizes Profit in the Short Run

Profit maximization occurs where marginal revenue equals marginal cost, similar to perfect competition.

• Profit-Maximizing Rule: $MR = MC$

• Steps to Find Profit/Loss:

  1. Use $MR = MC$ to identify profit-maximizing quantity $Q^*$

  2. Draw vertical line at that quantity

  3. Find price where the vertical line hits demand

  4. Find average cost where the vertical line hits ATC

  5. The difference between $P$ and $ATC$ is profit per unit

  6. Show profit/loss with rectangle width $(P - ATC)$ and length $(Q^* - 0)$

What Happens to Profits in the Long Run?

Entry and exit of firms in monopolistic competition drive profits to zero in the long run, but firms may still operate with excess capacity.

• If there are economic profits in the short run:

  • Economic profit attracts new firms, decreasing demand for existing sellers

  • Demand will decrease until sellers break even (zero economic profit)

• If there are losses in the short run:

  • Losses will cause existing firms to exit, increasing demand for remaining sellers

  • Demand will increase until sellers break even (zero economic profit)

• In the long run, the firm must break even such that the demand curve is tangent to the ATC curve.

• Zero economic profit in the long run is not necessarily inevitable if the firm can lower cost or build brand loyalty.

Comparing Monopolistic Competition and Perfect Competition

Monopolistic competition differs from perfect competition in terms of efficiency and product differentiation.

• Perfectly competitive firms achieve both productive and allocative efficiency.

• Monopolistically competitive firms achieve neither.

• Monopolistic competitors are not allocatively efficient because they produce where $P > MC$.

• Excess Capacity: Firms could decrease ATC by increasing output.

• Lack of efficiency may be a bad situation for consumers, but product differentiation can provide benefits.

How Marketing Differentiates Products

Marketing and advertising play a key role in differentiating products and influencing demand elasticity.

• Advertising to Differentiate: Effectively makes the demand curve more inelastic, allowing firms to maintain higher prices.