A Quick Review (And Example) Of Perfect Competition

Perfectly competitive firms are so small they donпÑ--Ð...t have any market power (power to set price). Instead, these little firms respond as best they can to market conditions, trying to make a profit with the price that prevails in the market. Of course, the price is established by demand and supply in the industry as a whole, but no individual producer has an ability to move this price up or down.

Imagine that we have a market demand function given by P = 1010 пÑ--Ð... .08Q, where P is the market price in the industry and Q is the total output of the good by producers in this particular industry. The demand curve is downward sloping, because consumers are willing to consume more of this good at lower prices but less of this good at higher prices (income and substitution effects).

LetпÑ--Ð...s say that the total cost function faced by all firms is TC = 10,000 + 10q + q2 (they all have access to best-practice technology which affects these costs, and they are all able to hire workers and other inputs to produce goods and services. Therefore, every firm has the same costsпÑ--Ð....no one has a special technological or cost advantage). In this function, q is the amount of output by the individual firm. That means that the marginal cost (or MC) function is MC = 10 + 2q.

There are 100 firms in this industry. As we remember from first year, the marginal cost curve of the individual firm tells us how much that firm will be willing to supply at different possible prices. If the firm faces a price that is below its AVC, it would prefer to temporarily shut down, rather than not even be able to cover its variable costs with revenue. But apart from this qualification, the MC curve is the supply curve of the individual firm (it tells us how much the firm will supply at different prices it might face).

If the MC curve is the supply curve of the firm, and if...