(8) Perfect Competition

Total Video Time: 82 minutes

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Introduction

In the last module, we looked at production and costs for a typical firm. Now we start looking at the first of four market structures by examining perfect competition (PC). It describes a situation where lots of firms all produce the same product and consumers care mostly about finding the lowest price possible. These videos first explain the assumptions of the model and then explain how firms in a PC industry behave. We examine profit and losses and then explain what happens in the long run in the market if there are profits or losses. We finish up by talking about the efficiency of PC industries and then evaluate the market based on five different criteria.

Video 8.1: Market Structures and Outcomes (11 min)

This video briefly examines the four market structures that we’ll explore in much more detail in the next few modules. It then explains the five different criteria upon which we judge market performance.

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Video 8.2: Perfect Competition (13 min)

This video explains the six assumptions of the model of perfect competition and describes the kind of competitive environment in which firms operate.

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Video 8.3: Firm Demand (7 min)

This video derives the demand and MR curves for a PC firm based on what’s happening in the overall market. It then uses that MR curve, in combination with its MC curve, to determine its profit-maximizing level of output.

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Video 8.4: Profit and Losses (12 min)

In the last video, we determined how much output the firm should produce. Now we answer the next question a firm should ask (Is this a good or bad situation?) by examining whether firms in the market have profits or losses.

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Video 8.5: Shutdown Point and Supply (11 min)

This video addresses the third possible question for a firm: if it has economic losses, should it produce in the short run or shut down? It then uses this framework to explain what an individual firm’s supply curve looks like, and then uses that to derive a market supply curve.

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Video 8.6: Long-run Equilibrium and Efficiency (11 min)

This video introduces the concept of a long-run equilibrium: a situation in the market where prices and output are the same from period to period, and the number of firms is also constant across periods. It then explains what the effiency of perfectly competitive markets.

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Video 8.7: Evaluating Perfect Competition (8 min)

This video uses the five criteria we established in Video 8.1 to evaluate the outcome resulting from the model of perfect competition.

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Video 8.8: Increase in Demand (9 min)

This video walks you through the effects of a permanent increase in demand in a perfectly competitive market.

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In the Content area of D2L, in the Perfect Competition folder, you will find a variety of resources for you. You have a page of blank graphs that will help you practice working on these. And I’ve also gone through all 6 possible scenarios we can analyze with perfect competition and explained what happens to the firm and the market in both the short-run and long-run. One of these scenarios will be on your next exam, so please download them and work through them. If you don’t understand what is going on in any of them, please ask me for clarification.

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Implications of an Increase in MC: Excise Taxes

We’ve looked at taxes twice now: once in general and again when we talked about elasticity. But there’s an important long-run implication here so we have to go back to taxes one more time. Click here to open up the PDF file in a new window so you can follow along with the graphs. When we talked about a $1 tax on a market before, we found that the burden of the tax would be shared between consumers and producers. We later found that whichever side of the market is more inelastic will end up bearing the larger burden of the tax. But now we have to look at the long-run implications of something like this. If you’re a competitive firm and you’re earning zero economic profit, and you get hit with a tax of $1 per unit, what happens? The price goes up some, but not by the full $1. Suppose it increases $.75 because demand is relatively inelastic. So your MR increases by $.75 but your ATC increases by $1.00. Firms in a PC industry will have economic losses in the short run and will not be able to sustain this forever. Some will leave in the long run — enough of them have to leave so that supply shifts back enough for prices to rise by the full $1. Only then can the remaining firms get back to zero profit.

Thus, if the market is competitive and a tax is applied, in the long run consumers will bear the entire burden of the tax. Firms cannot pay any of the tax because they don’t have any economic profits to be able to do so. This is what some mean when they say “businesses don’t pay taxes; consumers do.” In the case of a perfectly competitive industry, they’re correct.

As the price rises because of the tax, consumers cut back their consumption. If the Qd falls by 20% because of the tax, this means that in the long run we would expect to have 20% fewer firms in the industry.

If the market is competitive, taxes will wipe out some firms and make consumers pay higher prices equal to the amount of the tax.

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