Principles of Economics II 
(Microeconomics)

A. A market is perfectly competitive when:

1. Many firms are selling an identical product.

2. Many buyers demand that product.

3. Entry into the industry is not restricted.

4. Firms already in the industry have no advantage over potential new entrants.

5. Firms and buyers are completely informed about each firm’s price for the product.

B. Each firm in a perfectly competitive market is a price taker, that is, a firm that cannot affect the price of its product.

1. Price-taking behavior occurs when a single firm produces a tiny fraction of the market’s total output and buyers are informed about competitors’ prices.

C. Although market demand is not perfectly elastic, demand for a price-taking firm’s product is perfectly elastic.

D. The firm’s total economic profit equals its total revenue minus its total opportunity cost. Its goal is to maximize its economic profit.

1. Part of the opportunity cost is the normal profit, the return the firm’s entrepreneur can obtain in the best alternative business.

2. Total revenue is the number of units sold times the price per unit,

3. Marginal revenue, MR, is the change in total revenue brought about by a one-unit increase in the quantity sold. For a perfectly competitive firm, marginal revenue equals the market price of the product, or MR = P.

4. Average revenue is total revenue per unit sold, that is, total revenue divided by quantity. Thus average revenue equals the price of the product, P.

E. In both the short and long run, a perfectly competitive firm faces two decisions.

1. In the short run, the number of firms in the industry and the sizes of their plants are fixed. A firm’s short-run decisions are:

a) Whether to shut down temporarily.

b) If the firm decides to produce, how much to produce.

2. In the long run, firms can enter or exit the industry and change the scale of their operations. A firm’s long-run decisions are:

a) Whether to change plant size.

b) Whether to remain in the industry.

F. Because the firm cannot affect the price of its product, to maximize its economic profit the company adjusts the level of its production.

1. The level of production at which total revenue minus total opportunity cost is largest is the profit-maximizing level.

2. The break-even point is the amount of output at which total revenue equals total cost.

G. Marginal analysis can be used to determine the profit-maximizing amount of production. Profit is maximized by producing the level of output at which marginal revenue equals marginal cost, that is, by producing so that MR = MC.

1. If the marginal revenue from an additional unit of output exceeds its marginal cost, or MR > MC, producing the unit is profitable.

2. If the marginal revenue from an additional unit of output is less than its marginal cost, or MR < MC, producing the unit is not profitable.

H. The shutdown point is the level of output and price at which the firm just covers its total variable cost.

1. If the price of the product is less than the minimum average variable cost, or P < AVC, the firm will shut down because this action minimizes the firm’s loss. In this case, the firm’s economic loss equals its total fixed cost.

I. A perfectly competitive firm’s short-run supply curve shows how a firm’s profit-maximizing output varies as the price changes, other things remaining constant.

1. As long as P > AVC, the business produces the level of output at which the price equals marginal cost. For this range of prices the firm’s supply curve is its MC curve.

2. If P < AVC, it shuts down, so for this range of prices the firm’s supply curve runs along the vertical axis.

J. The short-run industry supply curve shows how the industry’s quantity supplied varies as the price varies. It is the horizontal sum of the supply curves of the firms in the industry.

A. The short-run equilibrium market price and quantity are determined by the intersection of the short-run industry supply curve and demand curve.

1. In the short run, the number of firms and the sizes of their plants are fixed.

B. At short-run equilibrium, an individual firm may be making an economic profit, earning a normal profit, or incurring an economic loss. Whether it earns an economic profit, a normal profit, or incurs an economic loss, depends on a comparison of the price and average total cost.

1. If the price of the product is more than the profit-maximizing average total cost, or P > ATC, the firm earns an economic profit.

2. If the price of the product equals the profit-maximizing average total cost, or P = ATC, the firm earns a normal profit. This situation is illustrated in Figure 12.1.

3. If the price of the product is less than the profit-maximizing average total cost, or P < ATC, the firm incurs an economic loss.

a. To verify these results, take the case of P > ATC. Multiplying both sides by quantity, gives (P)(q) > (ATC)(q). Now, (P)(q) = TR, where TR is total revenue, and (ATC)(q) = where TC is total cost. Thus the inequality P > ATC implies that TR > TC, which means that the firm earns an economic profit. The other two assertions may be confirmed similarly.

C. As time passes, long-run adjustment in the form of entry (new firms joining the industry), or exit (firms leaving the industry) may occur. Economic profits motivate entry and economic losses trigger exit. In the long run, firms also can adjust their plant size.

1. As firms enter or exit an industry, the industry supply curve shifts.

a) If firms in an industry are making an economic profit, new ones enter. As a result, the industry supply curve shifts rightward, the price of the product falls, the total quantity sold increases, and the economic profits of the existing ones decline.

b) If firms in an industry are incurring an economic loss, some exit the industry. As a result, the industry supply curve shifts leftward, the price of the product rises, the quantity sold decreases, and the economic losses of the remaining firms shrink.

D. Firms change their plant sizes whenever doing so is profitable. If the price of the product exceeds the minimum long-run average cost (P > LRAC ), firms expand their plants.

E. Long-run equilibrium occurs in a competitive industry when:

1. Economic profits are zero so that entry and exit cease.

2. Long-run average cost is at its minimum so that no firm has an incentive to change the size of its plant.