AP Microeconomics Unit 3B: Perfect Competition

Characteristics of Perfectly Competitive Firms

This market structure is characterized by many, many, many (“very many”) firms, homogenous (identical) products that are perfect substitutes, and Low Barriers to Entry, where sellers do not advertise and firms are “Price Takers”.

Barriers to entry

In perfect competition, there are Low Barriers to Entry, making it Easy for firms to enter and exit the industry.

Homogenous products

These are identical products that are perfect substitutes for one another.

Market (or Industry) Graph vs Firm Graph

Perfect competition ALWAYS includes side-by-side graphs. The Market (Industry) Graph uses supply (S) and demand (D) to determine the equilibrium price (P

e) and quantity (Qe), while the Firm Graph shows the cost curves (MC, ATC) and the firm’s horizontal demand curve, which represents MR=D=AR=P.

Price Taker

Firms that are Price Takers accept the market price, meaning they have no control over price, and the price is the same for every unit sold.

MRDARP means MR=D=AR=P

This acronym signifies that Marginal Revenue (MR), Demand (D), Average Revenue (AR), and Price (P) are all the same value in perfect competition because every unit sells for the same price.

Profit Maximizing Rule

The rule for maximizing profit is to Produce at a level of output (quantity) where Marginal Revenue (MR) equals Marginal Cost (MC),. This rule applies to all market structures but only if price is above Average Variable Cost (AVC). For perfectly competitive firms, this rule can be restated as P = MC.

Economic loss = negative economic profit

This occurs when the firm's price (MR=D=AR=P) is below the Average Total Cost (ATC) curve at the profit-maximizing quantity. Firms making losses in the short run will exit the industry in the long run,.

Normal profit

This is the condition where a firm’s Economic Profit = 0 (meaning Total Revenue equals Total Cost),. It is the outcome for ALL perfectly competitive firms in the long run, occurring when Price = MC = Minimum ATC.

Marginal Revenue

Marginal Revenue (MR) is calculated by the change in total revenue divided by the change in quantity (ΔTR/ΔQ).

Shut down rule

A firm making losses will stay in business as long as its price (MRDARP) is above the Average Variable Cost (AVC). If the price falls below AVC, the firm must shut down (produce zero output) because its revenue would not be enough to cover variable costs, leading to greater losses than just fixed costs,.

Relationship between a firm’s marginal cost curve and the market supply curve

The firm’s Short-run Supply Curve is the Marginal Cost (MC) curve above the AVC curve. The total quantity supplied in the market is the summation of individual output decisions of all identical firms.

Per-unit taxes

A per-unit tax affects a firm’s variable costs ONLY. This causes the MC, AVC, and ATC curves to shift, which shifts the market supply curve and WILL affect the quantity produced.

Lump sum taxes

A lump sum tax only affects a firm’s fixed costs. This causes only the Average Fixed Cost (AFC) and ATC curves to shift, but the MC curve does not shift. Consequently, the market supply curve will NOT shift, and the tax WILL NOT affect the quantity produced.

Allocative Efficiency

This type of efficiency is achieved when production matches “What society wants” (S=D). It occurs when MR=D=AR=P intersects Marginal Cost (MC).

Productive Efficiency

This type of efficiency is achieved when production occurs at the “Lowest possible average cost”. It occurs when MR=D=AR=P intersects the minimum ATC point.

Constant cost vs. increasing cost vs. decreasing cost industries:

Constant-Cost Industry

Cost curves stay the same when firms enter or exit. When the market returns to the long run, the price returns to the original long-run equilibrium, and individual firms produce the same quantity.

Increasing-Cost or Decreasing-Cost Industries

These industries are characterized by cost curves that change (shift) when firms enter or exit,. When the market moves back to long-run equilibrium, both market output and price change. In an increasing-cost industry, firms entering may cause costs to increase (e.g., fighting for resources), leading to a new long-run equilibrium at a higher price.