Competitive Market

Theory Competitive Firms

What can I do to maximize my firm’s profits? To answer this question we will only look at a structure called “perfect competition”, which consists in a very large number of firms producing homogenous product.

We will consider an industry consisting of so many firms that each firm takes the market-determined price as given and will attempt to maximize its profit.

Three fundamental questions:

1. Should I produce or shutdown?

2. What is the appropriate level of production?

3. Amounts of each input should I use?

Principles

Profit Maximization

The firm will increase in any activity so long as the additional revenue from the increase exceeds the additional cost of the increase.

The firm will choose to expand output so long as the added revenue from the expansion (marginal revenue) is greater than the added cost of the expansion (marginal cost).

From the Input side, profit maximization is:

Here, we are interested in the special case in which the price of the input is given to the firm by the market.

The marginal revenue product of each must equal its price. In this way profit is maximize. Let’s not forget that profit includes also the implicit costs, such as the manager’s salary.

Normal Return: economist refers to it as the opportunity cost of using the owner’s capital. Any return over and above the “normal” return is called “pure profit” or “economic profit”.

Characteristics of Perfect Competition

Perfect Competition is that neither buyers nor producers recognize any competitiveness among themselves.

Conditions:

1. The product must be identical to the product of every other firm. Here buyers are indifferent.

2. Each firm in the industry must be so small relative to the total market that it cannot affect market price. The actions of any individual firm do not affect market supply.

3. Free Entry and Exit.

Demand Curve for an Individual Firm

Marginal Revenue of a perfectly competitive firm is the market-determined price of the product it produces and sells.

A perfectly competitive firm faces and horizontal demand because: industry produces an homogeneous product and each firm is small relative to the market. So, the firm can sell all it wants at the going market price.

A change in the rate of sales per period of time will change the firm’s revenue, but it will not affect market price. The producer in a perfectly competitive market, therefore, does not have to reduce price in order to expand the rate of sales. Any number of units can be sold at the market

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