Economics Perfectly Competitive Market Structure

Topics: Economics, Microeconomics, Costs Pages: 5 (1635 words) Published: April 12, 2011
draw a diagram of a perfectly competitive firm earning a positive economic profit assume the wages, which the firm pays to its workers, falls. Illustrate the impact of such an event on the price, output and profits of this firm

2. Examine the following statement to see whether it is true or false. If it is true, explain why it is true. If it is false, explain why it is false and then write the statement correctly. A profit maximising perfectly competitive firm should select the output level at which the difference between the marginal revenue and marginal cost is greatest. This is equivalent to selecting the output where the spread between total revenue and total cost is greatest.

In the short-run, it is possible for an individual firm to make an economic profit. This situation is shown in this diagram, as the price or average revenue, denoted by P, is above the average cost denoted by C .

However, in the long period, economic profit cannot be sustained. The arrival of new firms or expansion of existing firms (if returns to scale are constant) in the market causes the (horizontal) demand curve of each individual firm to shift downward, bringing down at the same time the price, the average revenue and marginal revenue curve. The final outcome is that, in the long run, the firm will make only normal profit (zero economic profit). Its horizontal demand curve will touch its average total cost curve at its lowest point. (Seecost curve.) In a perfectly competitive market, a firm's demand curve is perfectly elastic. at a loss [R < TC (revenue less than total cost) or P < ATC (price less than unit cost)] must decide whether to continue to operate or temporarily shutdown.[14] The shutdown rule states "in the short run a firm should continue to operate if price exceeds average variable costs."[15] Restated, the rule is that for a firm to continue producing in the short run it must earn sufficient revenue to cover its variable costs.[16] The rationale for the rule is straightforward. By shutting down a firm avoids all variable costs.[17]However, the firm must still pay fixed costs.[18] Because fixed cost must be paid regardless of whether a firm operates they should not be considered in deciding whether to produce or shutdown. Thus in determining whether to shut down a firm should compare total revenue to total variable costs (VC) rather than total costs (FC + VC). If the revenue the firm is receiving is greater than its total variable cost (R > VC) then the firm is covering all variable cost plus there is additional revenue (“contribution”), which can be applied to fixed costs. (The size of the fixed costs is irrelevant as it is a sunk cost. The same consideration is used whether fixed costs are one dollar or one million dollars.) On the other hand if VC > R then the firm is not even covering its production costs and it should immediately shut down. The rule is conventionally stated in terms of price (average revenue) and average variable costs. The rules are equivalent (If you divide both sides of inequality TR > TVC by Q gives P > AVC). If the firm decides to operate, the firm will continue to produce where marginal revenue equals marginal costs because these conditions insure not only profit maximization (loss minimization) but also maximum contribution. Another way to state the rule is that a firm should compare the profits from operating to those realized if it shutdown and select the option that produces the greater profit.[19][20] A firm that is shutdown is generating zero revenue and incurring no variable costs. However the firm still has to pay fixed cost. So the firm’s profit equals fixed costs or (- FC).[21] An operating firm is generating revenue, incurring variable costs and paying fixed costs. The operating firm's profit is R - VC - FC . The firm should continue to operate if R - VC - FC ≥ - FC which simplified is R ≥ VC.[[22][23] The difference between revenue, R, and variable costs, VC, is the...
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