Microeconomics: Unit 3 – Producer’s Theory (Competition) | MIT

Unit 03 – Producer’s Theory (Competition).

Perfect Competition

Working with the firm’s cost function enables us to learn how much of each input the firm should optimally use to produce a given level of output. However, the firm still has to decide how much output it should produce. This decision depends on the type of market the firm is operating in. We begin with the most common type of market: perfect competition.

Technically perfect competition exists whenever firms are price takers on both the output and input markets. No action they take affects either the price at which they sell their goods.

There are four conditions for the existence of perfect market:

1. Identical products;

2. Full information of all prices;

3. Low transaction/shopping costs;

4. Free entry and exit of firms.

Profit maximization in the short-run

. What is profit? Profit is revenue minus costs | Profit = R – C

. What are costs? There are two types of costs:

1. Accounting: cash flow costs (what you pay)

2. Economic: opportunity costs (what you could have done with your cash; i.e. the value of your time)

The firm chooses to produce where marginal cost equals price. When it produces where marginal cost equals price, then what profits does it make? On each unit it makes profits of the difference between the price and average cost.

//Marginal cost is the cost of the next unit

// Average cost is the cost of all the units you’ve made

Profit maximization occurs at the point where price equals marginal cost. Because that is the point of greatest gap between revenues and costs.


MC = q + t – the curve shifts up and the producer produces less.

By imposing a tax, producers dramatically reduce their profits.

Conditions of short-run profit maximization

. Set price equal to marginal cost

. Check whether the firm wants to shut down

Shut down decision

Even with negative numbers, it’s advisable not to shut the firm down due to the notion of sunk costs. In the short-run, the fixed costs that you paid to produce are sunk (you’ll not shut down unless you lose more than you invested). In the long-run, they’re changeable, you can just leave.

Negative profits: the producer will stay in business, in the short-run, as long as its price covers its variable costs | Revenue >=VC; P >=VC/Q; P>=AVC

Short-run firm supply curves

. Set price equal to marginal cost to figure out what the firm is going to produce | P = MC — > q*

. Check that price is greater than or equal to AVC | P >=AVC

Supply curves are marginal cost curves above the point where price equals average variable cost. Therefore, the definition is the following: it’s the marginal cost curve above p, which is greater than or equal to average variable cost (zero profit point).

Where do market supply curves come from?

// In the short-run market equilibrium

. Cost function – capital/fixed costs | Firm Supply Curve – P = MC

. Add up firm supply curves to get a market supply curve

Example: In a hypothetical scenario of 5 firms. The more firms, the more elastic the curve will become.

. Intersect market supply with market demand to get the equilibrium price

. Each firm decides how much to produce | Qd = Qs

// In the long-run market equilibrium = no one wants to lose money!

. Difference: derive the number of firms (entry and exit). If profits are made, firms will enter, if losses are made, firms will exit until they reach zero profit. Profits will always be zero in this case.

. Zero profit because entry drives prices down to average cost | P = AVC; Profits = 0  | Profits = Pq – C

. Cost minimization: firms will minimize their costs


. In this case, the market supply curve is upward sloping and there are i. Barriers to entry or exit; ii. Firms might differ (capacity constraints / upward slope input supply) and iii. Input prices might rise as the market expands.


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