Economics - Perfect Competition - Quick Guides

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Study GuideEconomics–Perfect Competition1.Long-Run Supply1.1What Does “Long Run” Mean?In thelong run, firms can changeallof their inputs.This includes things like factory size, machines, and technology.Because firms are flexible in the long run:•New firms can enterthe market•Existing firms can leavethe marketIn aperfectly competitive market, there areno barriersto entry or exit. This means firms are freeto join or leave whenever they want.1.2Entry and Exit of Firms•If firms are makingeconomic profits, new firms are attracted to the market.•If firms are makinglosses, some firms will leave the market.As a result, thenumber of firms does not stay fixedin the long run.1.3Zero Economic Profits in the Long RunBecause of free entry and exit:•Profits donot last forever•Losses also donot continue foreverWhy does this happen?•Profits → new firms enter → more supply → price falls•Losses → firms exit → less supply → price rises

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Study GuideEventually:•Every firm earnszero economic profit•Firms earnnormal profit(just enough to stay in business)•The market reacheslong-run equilibriumLong-run equilibriumoccurs when:•All firms earnzero economic profit•No firms want to enter or leave the market1.4Minimization of Long-Run Average Total CostIn the long run, firms aim to produce at thelowest possible cost per unit.Since all inputs are adjustable:•Firms can change factory size•Firms can adopt better production methodsMinimum Efficient Scale (MES)•MES is the level of output whereaverage cost is lowestTwo possible situations:1.If output is too low2.→ Firm experienceseconomies of scale3.→ Firm increases output to reach MES4.If output is too high5.→ Firm experiencesdiseconomies of scale6.→ Firm reduces output to reach MESIn the long run, firmsalways operate at MES, wherelong-run average total cost (LRATC) isminimum.

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Study Guide1.5Long-Run Profit Maximization by a FirmFigure 1The firm’s long-run profit-maximizing decisionExplanation of the Diagram•The firm maximizes profit where:•Marginal Cost (MC) = Marginal Revenue (MR)•This determines the equilibrium output levelQ•At this point:oPrice = Average Total CostoEconomic profit =zerooFirm produces at theminimum point of LRATCThis confirmslong-run equilibrium for an individual firm.

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Study Guide1.6Long-Run Market Supply Curve•Short-run market supply= horizontal sum of all firms’ supply curves•Long-run market supplydepends on how costs change as industry output changesTo understand this, we look attwo types of industries.1.7Constant-Cost IndustryFigure 2Long-run market supply curvesWhat Happens Here?•Firms’ production costsdo not changeas industry output increasesStep-by-step:1.Market is initially in equilibrium atP₁2.Demand increases fromD₁to D₂3.Price rises toP₂(short run)4.Firms earneconomic profits5.New firms enter the market6.Supply shifts fromS₁to S₂7.Price falls back toP₁

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Study GuideKey Result•Long-run market supply curve ishorizontal•Price stays the same even when output increases1.8Increasing-Cost IndustryWhat Happens Here?•Firms’ costsincreaseas industry output increases•(due to higher wages, land prices, raw material costs, etc.)Step-by-step:1.Market starts at priceP₁2.Demand increases fromD₁to D₂3.Price rises toP₂(short run)4.Firms earneconomic profits5.New firms enter the market6.Supply shifts fromS₁to S₂7.Final price settles atP₃Key Result•P₃> P₁•Long-run market supply curve isupward slopingSummary•In thelong run, all inputs are variable•Firms enter with profits and exit with losses•Long-run equilibrium meanszero economic profit•Firms produce atminimum LRATC•Constant-cost industry→ horizontal long-run supply•Increasing-cost industry→ upward-sloping long-run supply

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Study Guide2.Conditions for Perfect CompetitionWhen economists study how a firm makes production decisions, they first look at thetype of marketthe firm operates in. This is called themarket structure.Market structure helps us understand how firms set prices, decide output levels, and compete witheach other.The structure of a market depends onfour main characteristics. Let’s look at them step by step.1. Number and Size of FirmsIn some markets, there are only a few big firms. In others, there are many small firms.In aperfectly competitive market, there aremany firms, andeach firm is very smallcompared tothe entire market.Because no single firm is large,no firm has power over the market price.Key idea:Each firm’s individual decisions have almost no effect on the whole market.2. Ease of Entry and ExitAnother important feature of a market is how easy it is for firms toenterorleave.In perfect competition:•New firms canenter easilyif they see a chance to earn profits.•Existing firms canexit easilyif they are facing losses.There areno major barriers, such as high startup costs, government restrictions, or control byexisting firms.Key idea:Firms are free to come and go based on profit or loss.

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