Micro CHAPTER 3.7:

CHAPTER SUMMARY

Everything we have learned so far applies to only one type of market - a perfectly competitive market. Markets in perfect competition must have certain characteristics:

• There are many, small firms in the market

• All the firms produce the same product (e.g. rice) - they cannot meaningfully differentiate their product from competition

• There are no/low barriers to entry - it is easy for firms to enter or exit the market

When these characteristics are true of a market, it has the following effects on the firms:

• There is no non-price competition (advertising, etc.)

• Firms are price-takers - they cannot choose their selling price, because they are set by the market overall

• Firms will break-even (make a normal profit) in the long-run, because if they are making economic profits, more firms will enter the market

• Firms are perfectly efficient in the long-run, because less efficient firms will fail to compete with more efficient firms

In perfectly competitive markets, the Supply & Demand chart is closely linked to the Production Function chart. This is because, since the firm is a price-taker, the firm's MR (selling price) is determined by the market. Notice in the blue circle below that the two charts are linked with the same price level.

Now that we have linked these charts, we can evaluate whether a firm will make a profit, make a loss, or shut down using information from the Supply & Demand chart. If the profit maximization point is above the ATC curve, the firm makes a short-run profit (Chart 1). If the profit maximization point is between the ATC and AVC curves, the firm makes a short-run loss, but continues to operate (Chart 2). If the profit maximization point is below the AVC curve, the firm is better off shutting down (Chart 3).

If outsiders see that firms in the market are making a profit, they will enter the market to try to make a profit as well, increasing supply and lowering the price level. If firms are making a loss, the ones making the greatest loss will exit the market, decreasing supply and increasing the price level. As a result, in a perfectly competitive market in long-run equilibrium, all firms will earn zero profit, as seen in the chart below.

Sometimes, a shift in demand can also change the long-run equilibrium. If demand increases, the equilibrium price will increase as well, allowing all firms to make a profit. This will cause new firms to enter the market, increasing supply, in turn decreasing the price level and the market will reach a new long-run equilibrium.

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