Perfect+competition+-&nbsp;Interpretation+of+the+long-run+supply+curve


 * __Perfect Competition__**

The concept of perfect competition applies to widely available commodity products where there are many companies and no single company can influence pricing. In the long run, companies that are engaged in a perfectly competitive market earn zero economic profits. Perfect competition is based on 5 assumptions as follows (1): 1) There are many buyers and sellers in a market with no single dominant buyer or seller. 2) Each company makes a substantially equivalent product. 3) Buyers and sellers have access to perfect information about price. 4) There are no transaction costs. 5) There are no barriers to entry into or exit from the market.

All goods in a perfectly competitive market are considered perfect substitutes, and the demand curve is perfectly elastic for each of the small, individual firms that participate in the market. These firms are price takers - if one firm tries to raise its price, there would be no demand for that firm's product - consumers would buy from another firm at a lower price instead.


 * __Maximimizing Profits__**

In order to maximize profits in a perfectly competitive market, firms set marginal revenue (MR) = marginal cost (MC). MR is the slope of the revenue curve (P x Q), which is also equal to the demand curve (D) and price (P). It is possible in the short-term for economic profits to be positive, 0, or negative. If a firm's economic profit is negative, it should continue operating if the price exceeds its average variable cost (AVC) curve because the firm will recognize revenue on each product sold that will reduce its loss compared to the loss it would incur if it shutdown completely. If the firm's price is less than its AVC, it would be better of shutting down because it would lose even more money with each product sold than it would if it shutdown and only had a loss equal to its fixed costs.(1)


 * __Interpretation of Long-Run Supply Curve:__**

If firms in a perfectly competitive market are earning positive economic profits, the following sequence of events will occur: 1) More firms will enter the market, which will shift the supply curve to the right. 2) As the supply curve shifts to the right, the demand curve (price) will go down. 3) As the price goes down, economic profit will decrease until it becomes zero.

If firms in a perfectly competitive market are earning negative economic profits, the following sequence of events will occur: 1) More firms will leave the market, which will shift the supply curve to the left. 2) As the supply curve shifts to the left, the demand curve (price) will go up. 3) As the price goes up, economic profit will increase until it becomes zero.

In the long-run perfectly competitive market, the equilibrium point occurs where the demand curve (price) intersects the marginal cost (MC) curve and the minimum point of the average cost (AC) curve. (1) Graph courtesty of [|www.answers.com]
 * __Questions:__**

1. You are a producer and seller of grain in a perfectly competitive market. You are earning negative economic profits and are considering shutting down to save money. After analyzing your business you find that the average variable cost for your grain is $12/bushel. The price of grain per bushel that you sell at is $15, and you have fixed costs each month of $50,000. Should you...

A. Keep operating at an economic loss B. Shut down your operation at least temporarily C. Look for different markets to exploit

Answer: A. Since your price is higher than the Average Variable Cost, you should keep operating instead of shutting down and taking the fixed costs as loss.

2. You are a producer of barley, and doing quite well in your market. Currently you are making economic profits, but starting to see a slight decline in revenue per month, although your price has not changed. What can you expect is most likely happening in your market?

A. Interest in barley is declining B. Subsitutes for barley must be increasing C. Other producers are starting to enter the market Answer: C. Most likely other producers are entering the market, because their are economic profits to be had.

3. In the long run, where can you expect that the price of the commodity intersects the graph of the Average Cost Curve?

A. Somewhere near the middle B. Wherever the price dictates it should intersect C. At the minimum point of the curve

Answer: C. In the long run, price always equals the minimum of the average cost curve, exhausting all economies of scale.

4. What happens as a result of other firms entering into a competitive market?

A. Supply curve shifts outward B. Price decreases C. Price stays the same D. None of the above E. A and B

Answer: A and B. When firms enter a competitive market, the supply curve shifts outward and price decreases, at least temporarily.

5. A relatively new producer of green beans is examining his business. He expects an increase in demand for green beans in the upcoming season, so he decides to raise his price slightly to hopefully capitalize on this increase in demand. What do expect will happen?

A. He will make a nice profit from raising his price. B. He will make nothing. C. The market will even out, and he won't make any more than his competitors.

Answer: B. The elasticity of demand in a competitive market is perfectly elastic. If a producer raises his price even slightly, no one will buy from that producer.

6. In a perfectly competitive market, where is the price set in relation to the marginal cost curve?

A. P>MC B. P=MC C. P<MC

Answer: B. In perfect competition, Price is always set to where Marginal Cost and Demand intersect.

7. True or False. To maximize profits, a perfectly competitive firm produces the output at which price equals marginal cost in the range over which marginal cost is increasing.

Answer: True. This is a true statement regarding perfect competition and profit maximizing.

8. Which of the following is not a characteristic of a perfectly competitive market?

A. Many buyers and sellers in the market, all of which are "small" relative to the market. B. Each firm produces a variety of different products. C. Buyers and sellers have perfect information. D. There are no transaction costs. E. There is free entry into and exit from the market.

Answer: B. All firms in perfectly competitive markets produce homogenous product.

Examples of Perfectly Competitive Markets: 1. Agriculture 2. Baby sitters

(1) Baye, M.R. __Managerial Economics and Business Strategy__. 5th Edition. McGraw-Hill/Irwin: Madison, WI, 2006.