Producer Behavior

Profit Maximizing

Marginal returns = marginal costs is the point where profit is maximized.
In perfect competition, which is useful for modelling, AR = MR, which is equal to price and demand, as PED is infinite and thus a straight horizontal line.

When MR > MC, the firm carn increase its output to gain more profit.
When MR < MC, the firm should reduce its output to minimize losses.
When MC = MR, there is no change in profits, meaning that this is the level of output where profit is maximized.

In imperfect markets, PED cannot equal infinity. The demand curve is always sloping downward.
The marginal revenue curve is thus also downwards sloping and is touches the x-axis at the halfway point at which the demand curve touches the x-axis.
This means that PED is higher towards the upper half of the demand curve and PED is less towards the lower half of the demand curve.

The point where MR and MC intersect is the quantity where profit is maximized.
However, the point on the demand curve at that quantity is the price at which profit is maximized.
The profit maximizing rule is used by every firm in every market structure to determine the quantity the firm should produce to maximize profits.

Each market structure is evaluated on its allocation efficiency.
Achieved when just the right amount of goods and services are produced from society's point of view so that scarce resources are allocated in the best possible way.
It is achieved when, for the last unit produced, price (P, AR) is equal to marginal cost (MC).
MC = AR
The firm produces the optimal mix of goods and services required by consumers.
Also called the social optimum level.
In imperfect markets, where PED doesn't equal infinity, the MR curve doesn't equal the D=AR curve. This means that where MC = AR isn't the same as where MC = MR. Allocative efficiency is not where profit is maximized in an imperfect market.

MC=AC
As the intersection of the MC and AC curve is at the lowest point of the AC curve, when AC is lowest when MC = AC.
The firm produces its product at the lowest possible unit cost (average cost).

Perfectly competitive firms are perfectly efficient.
Firms with high costs are forced to exit the industry. Abnormal profit signals firms to join the market.
Profit maximizing perfectly competitive firms are always allocatively efficient (P = MC)
And in the long run they produce at the lowest average cost of production.

Allocatively efficient
Offers the lowest price possible for consumers, productively efficient
High competition ensures inefficient producers exit the market
The market is very responsive to consumers tase/demand
Disadvantages of Perfect Competition
Unrealistic; There will always be imprefect information and products aren't truly identical
No economies of scale
Lack of product variety
Unable to engage in R&D to improve efficiency (only normal profits in the long run)

Market power is the measure of how much control a firm has over its price.
Due to the characteristics of perfect competition, firms in a perfectly competitive markte have no market power and thus no control over the price.
They are price takers as they must take whatever price is set by the market.

Why are all firms in perfect competition price takers?
Because of perfect substitutes, identical products, perfect knowledge, and a large number of firms in the market, if one firm tries to charge a higher price, no one will purchase their goods.
This results in a perfectly elastic demand curve for firms in perfect competition.
If a firm were to lower their price, everyone would flock to them.

There are two diagrams put together side-by-side when drawing a firm that participates in perfect competition.
Additionally, because no firm has control over the price, the MR is also euqal to the price.
Firms must take the price from the parket, meaning they are price takers.
MR = D = AR = P

Due to low barriers, firms are able to join, or leave perfectly competitive markets with ease.
When firms make abnormal profits or losses in the short run, other firms react by either leaving or entering the market.

If a firm is making abnormal economic profits, then other firms will enter the market.
As the number of firms in the market increases, the supply is increased, causing a reduction in the price.
This leads the abnormal profit to be reduced to normal profit, at which point things stabilize.
This stabilized situation is the long run.

If firms are making losses then they will begin to leave the market, leading to a reduction in supply, as there are now less firms in the market.
The reduction in supply leads to a rise in price, this trend continues until profits are increased and normal profit is reached.

Perfect competition, firms can only make abnormal profits or losses in the short run.
In the long run, there will only be normal profits.