Chapter 8 PERFECT COMPETITION

1. What is perfect competition?

The short run is a production period where at least one resource cannot be altered.

1.a. The definition of perfect competition: The perfectly competitive market comprises many sellers, a nondifferentiated product, free entrance and exit, and perfect information for buyers and sellers.

The typical farm approximates the definition of perfect competition. The farmer is a price taker.

1.b. The demand curve of the individual firm: The curve is a horizontal line at the market price, indicating perfectly elastic demand - people will buy as much as you can sell at the market price.

1.c. Profit maximization
Profit maximization occurs when TR exceeds TC by the greatest amount. This occurs where MC = MR. Since the demand curve is flat or perfectly elastic, MR = P, so firms maximize profits when MC = P.

1.d. Short-run profits and losses: The perfectly competitive firm can generate profits on losses in the short run. If P exceeds AC at the profit maximizing output, profits are made. 

If AC exceeds price at the profit maximizing level of output, losses are incurred. 

1.e. Short-run breakeven and shutdown prices: In order to operate in the short run, the firm must earn revenues at least equal to variable cost. 

The breakeven price equals minimum ATC. The shutdown price equals minimum AVC. 

1.f. The firm's supply curve in the short run: The individual firm's supply curve is that portion of the MC curve that lies above minimum AVC.

The long run is the production period during which all resources are variable, that is, firms enter and leave the industry.

2.a. The market supply curve and exit and entry: The market supply curve will shift to the right when firms enter the industry and shift to the left when firms leave. Firms will enter when profits are being made, thereby shifting the market supply curve to the right and lowering market price. Firms will leave when economic losses are being incurred, thereby shifting the market supply curve to the left and raising market price.

2.b. Normal profit in the long run

Losses drive firms out of the industry, which decreases market supply and raises price. But the price can only rise to equal minimal LRATC, because at that price there is zero economic loss, and no further incentive for firms to exit the industry.

When P = minimal LRATC, firms are making only normal (zero economic) profits. No firms enter or leave; thus, the market is in long-run equilibrium. 

2.c. Constant, increasing, and decreasing cost industries: When new firms enter an industry and their use of resources does not cause resource prices to increase, this is known as a constant cost industry. A traditional example was commercial fishing. 

When new firms enter an industry and their use of resources causes resource prices to increase, this is known as an increasing cost industry. Scrap metal processing is a example, because the more firms enter the industry, the more they bid up the price of scrap.

When new firms enter an industry and their use of resources causes resource prices to fall, this is known as a decreasing cost industry. VCR manufacturing is an example. 

2.d. The predictions of the model of perfect competition: These are zero economic profits (MR = MC); production at minimum point on LRATC; and price = MC (economic efficiency). 

2.d.1. Producer surplus: When the firm receives a price above MC.

Rent control (like any price ceiling) reduces producer surplus by preventing landlords from charging the full height of the demand curve.

1. Write a short essay on what economic profits and economic losses will accrue based on the relationship between firms' short-run ATC and MR and what will occur in the long run. 

2. How do price floors in agriculture set by the federal government change producer and consumer surpluses for food products?