Session Overview
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Working with the firm’s cost function enables us to learn how much of each input the firm should optimally use to produce a given level of output. However, the firm still has to decide how much output it should produce. This decision depends on the type of market the firm is operating in. We begin by analyzing the most common type of market: perfect competition. Firms, like auto racers, operate in a competitive environment. This image is a work of the US Federal Government and in the public domain. Source: Wikipedia. |
Keywords: Perfect competition; search theory; residual demand; cost measurement; profit maximization.
Session Activities
Readings
Read the recitation notes, which cover new content that adds to and supplements the material covered in lecture.
Before watching the lecture video, read the course textbook for an introduction to the material covered in this session:
- [R&T] Chapter 9, “Competitive Markets for Goods and Services.”
- [Perloff] Chapter 8, “Competitive Firms and Markets.” (optional)
Lecture Videos
Resources
Check Yourself
Concept Quiz
This concept quiz covers key vocabulary terms and also tests your intuitive understanding of the material covered in this session. Complete this quiz before moving on to the next session to make sure you understand the concepts required to solve the mathematical and graphical problems that are the basis of this course.
Question 1
What is the definition of perfect competition?
All firms maximize profits and have optimal levels of labor and capital in perfect competition, but this does not define perfect competition; even firms that are monopolists or oligopolists will maximize profits and set the optimal levels of labor and capital. It is necessary for at least one firm to be producing the good of interest in perfect competition, but not sufficient.
Question 2
Consider the market for shoes. If one of the following statements is true, we can conclude that it is not perfectly competitive. Which statement, if true, is evidence against perfect competition?
If entry and exit into a market is restricted, then this is a violation of perfect competition. The other three answers define perfect competition, rather than being in violation of it.
Question 3
In a competitive market, the marginal revenue for selling an additional good is, by definition, equal to what quantity?
In a competitive market, every firm is a price-taker, and its decisions about how much to produce do not affect the price. Accordingly, if it sells one more unit, the marginal revenue is the prevailing price.
Question 4
A firm should shut down if what condition holds?
If price is below average total cost, but greater than average variable cost, then the firm has negative profits. However, it is still optimal to continue operating to avoid forgoing the fixed costs already paid.
Question 5
What is true about the individual firm demand curve that each firm faces in a competitive market?
The individual firm demand curve in a perfectly competitive market is perfectly elastic, or horizontal. Since the firm is a price-taker, it can sell as many units of the output good as it wants to at that price.
Further Study
These optional resources are provided for students that wish to explore this topic more fully.
Additional Readings
Learn more about Nobel Laureate Peter Diamond:
“Peter A. Diamond - Biographical.” Nobelprize.org.
