BackSellers and Incentives in Perfect Competition: Microeconomics Study Notes
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Chapter 6: Sellers and Incentives
Learning Objectives
Understand the role of sellers in perfectly competitive markets.
Analyze the seller’s problem: production, costs, and revenues.
Connect the seller’s problem to the supply curve.
Define and calculate producer surplus.
Distinguish between short-run and long-run decisions.
Explain long-run competitive equilibrium in markets.
Sellers in a Perfectly Competitive Market
Conditions of Perfect Competition
No buyer or seller is large enough to influence the market price: All participants are price takers.
Identical goods: Products are homogeneous, so buyers do not prefer one seller over another.
Free entry and exit: Firms can enter or leave the market without barriers, ensuring profits are competed away in the long run.
Implications of Perfect Competition
Individual sellers cannot set prices above the market level.
Firms respond to profit opportunities by entering or exiting the market.
The Seller’s Problem
Three Key Questions for Sellers
How to make the product? (Production: transforming inputs into outputs)
What is the cost of making the product? (Cost analysis: fixed and variable costs)
How much can the seller get for the product in the market? (Revenue: price and quantity sold)
Production Concepts
Physical capital: Machines, buildings, and other tools used in production.
Short run: Some inputs (e.g., capital) are fixed.
Long run: All inputs can be varied.
Variable factor of production: Inputs that can be changed in the short run (e.g., labor).
Fixed factor of production: Inputs that cannot be changed in the short run (e.g., factory size).
Marginal Product and the Law of Diminishing Returns
Marginal product: The change in total output from using one more unit of input.
Initially, marginal product increases due to specialization.
Eventually, law of diminishing returns sets in: each additional worker adds less output.
Marginal product can become negative if too many workers crowd fixed capital.
Cost Concepts
Total Cost (TC): Sum of all costs incurred in production.
Variable Cost (VC): Costs that change with output (e.g., wages).
Fixed Cost (FC): Costs that do not change with output (e.g., rent).
Average Total Cost (ATC):
Average Variable Cost (AVC):
Average Fixed Cost (AFC):
Marginal Cost (MC):
Revenue and Profit
Total Revenue (TR):
In perfect competition, firms are price takers: they can only choose quantity, not price.
Profit:
Accounting profit: Only explicit costs are subtracted from revenue.
Economic profit: Both explicit and implicit (opportunity) costs are subtracted.
Profit Maximization Rule
Firms maximize profit where Marginal Revenue (MR) = Marginal Cost (MC).
In perfect competition, .
Profit calculation:
If , economic profit is positive; if , there is an economic loss; if , the firm breaks even.
From the Seller’s Problem to the Supply Curve
Marginal Cost and Supply
The supply curve for a firm in perfect competition is the portion of its MC curve above AVC.
Firms will not supply if the price falls below AVC (shutdown point).
Price Elasticity of Supply
Price elasticity of supply: Measures responsiveness of quantity supplied to price changes.
Formula:
Elastic supply: ; Inelastic supply: ; Unit-elastic: .
Elasticity is higher with more inventory, easier hiring, and longer time horizons.
Shutdown Rule
In the short run, a firm should shut down if .
Fixed costs are sunk in the short run and do not affect shutdown decisions.
Producer Surplus
Definition and Calculation
Producer surplus: The difference between the market price and the minimum price a firm would accept (its MC).
Graphically, it is the area above the supply curve and below the market price.
For a linear supply curve,
From the Short Run to the Long Run
Short Run vs. Long Run
Short run: Some inputs are fixed; firms can only adjust variable inputs (e.g., labor).
Long run: All inputs are variable; firms can adjust capital and scale of operation.
Returns to Scale
Economies of scale: ATC falls as output increases (e.g., due to specialization or large set-up costs).
Constant returns to scale: ATC remains unchanged as output increases.
Diseconomies of scale: ATC rises as output increases (e.g., due to management inefficiencies).
From the Firm to the Market: Long-Run Competitive Equilibrium
Entry and Exit
In the long run, firms can freely enter or exit the market.
Entry occurs when economic profits exist; exit occurs when firms face economic losses.
In equilibrium, economic profit is zero: .
Market Adjustments
Entry of new firms increases supply, lowering price and profits.
Exit of firms decreases supply, raising price and reducing losses.
Long-run supply curve is typically horizontal (perfectly elastic) at the minimum ATC.
Evidence-Based Economics: Ethanol Subsidy Example
Impact of Subsidies
A subsidy increases short-run profits, attracting new firms to the market.
As more firms enter, market supply increases, price falls, and profits return to zero in the long run.
Application: Lab Experiment Data
Price per Gallon | Total Number of Gallons (millions) |
|---|---|
$1.40 | 2 |
$1.35 | 4 |
$1.30 | 6 |
$1.25 | 8 |
$1.20 | 10 |
$1.15 | 12 |
$1.10 | 14 |
$1.05 | 16 |
$1.00 | 18 |
$0.95 | 20 |
$0.90 | 22 |
$0.85 | 24 |
Summary Table: Key Cost Concepts
Concept | Formula | Description |
|---|---|---|
Average Total Cost (ATC) | Total cost per unit of output | |
Average Variable Cost (AVC) | Variable cost per unit of output | |
Average Fixed Cost (AFC) | Fixed cost per unit of output | |
Marginal Cost (MC) | Cost of producing one more unit | |
Total Revenue (TR) | Total income from sales | |
Profit | Net earnings |
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