Microeconomics Lecture Notes Chinket Tola

Limkokwing University of Creative Technology

Microeconomics
Lecturer, Chinket Tola

Lecture Notes
Lecture 8 – Perfect Competition

Firm’s profit equals total revenue (TR) minus total cost (TC):
𝑃𝑟𝑜𝑓𝑖𝑡 = 𝑇𝑅 − 𝑇𝐶
We can rewrite this definition by multiplying and dividing the right side by quantity produced (𝑄):
𝑇𝑅 𝑇𝐶
𝑃𝑟𝑜𝑓𝑖𝑡 = ( − ) × 𝑄
𝑄 𝑄
𝑇𝑅 𝑇𝐶
where is average revenue, which is the price, 𝑃, and is average total cost, 𝐴𝑇𝐶, therefore
𝑄 𝑄
𝑃𝑟𝑜𝑓𝑖𝑡 = (𝑃 − 𝐴𝑇𝐶) × 𝑄

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Microeconomics Lecture Notes Chinket Tola
First consider a situation where the price is equal to $5 for a pack of frozen raspberries. The rule for a profit
maximizing perfectly competitive firm is to produce the level of output where Price= MR = MC, so the
raspberry farmer will produce a quantity of approximately 85, which is labeled as E' in Figure (a). Remember
that the area of a rectangle is equal to its base multiplied by its height. The farm’s total revenue at this price
will be shown by the rectangle from the origin over to a quantity of 85 packs (the base) up to point E' (the
height), over to the price of $5, and back to the origin. The average cost of producing 80 packs is shown by
point C or about $3.50. Total costs will be the quantity of 85 times the average cost of $3.50, which is shown
by the area of the rectangle from the origin to a quantity of 90, up to point C, over to the vertical axis and
down to the origin. The difference between total revenues and total costs is profits. Thus, profits will be the
blue shaded rectangle on top. The calculations are as follows:

Now consider Figure (b), where the price has fallen to $2.75 for a pack of frozen raspberries. Again, the
perfectly competitive firm will choose the level of output where Price = MR = MC, but in this case, the
quantity produced will be 75. At this price and output level, where the marginal cost curve is crossing the
average cost curve, the price the firm receives is exactly equal to its average cost of production. We call this
the break even point.

The farm’s total revenue at this price will be shown by the large shaded rectangle from the origin over to a
quantity of 75 packs (the base) up to point E (the height), over to the price of $2.75, and back to the origin.
The height of the average cost curve at Q = 75, i.e. point E, shows the average cost of producing this quantity.
Total costs will be the quantity of 75 times the average cost of $2.75, which is shown by the area of the
rectangle from the origin to a quantity of 75, up to point E, over to the vertical axis and down to the origin.
It should be clear that the rectangles for total revenue and total cost are the same. Thus, the firm is making
zero profit. The calculations are as follows:

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Microeconomics Lecture Notes Chinket Tola

In Figure (c), the market price has fallen still further to $2.00 for a pack of frozen raspberries. At this price,
marginal revenue intersects marginal cost at a quantity of 65. The farm’s total revenue at this price will be
shown by the large shaded rectangle from the origin over to a quantity of 65 packs (the base) up to point E”
(the height), over to the price of $2, and back to the origin. The average cost of producing 65 packs is shown
by Point C” or shows the average cost of producing 50 packs is about $2.73. Total costs will be the quantity
of 65 times the average cost of $2.73, which the area of the rectangle from the origin to a quantity of 50, up
to point C”, over to the vertical axis and down to the origin shows. It should be clear from examining the two
rectangles that total revenue is less than total cost. Thus, the firm is losing money and the loss (or negative
profit) will be the rose-shaded rectangle. The calculations are:

Consider the situation of the Yoga Center, which has signed a contract to rent space that costs $10,000 per
month. If the firm decides to operate, its marginal costs for hiring yoga teachers is $15,000 for the month. If
the firm shuts down, it must still pay the rent, but it would not need to hire labor. Table shows three possible
scenarios. In the first scenario, the Yoga Center does not have any clients, and therefore does not make any
revenues, in which case it faces losses of equal to the fixed costs. In the second scenario,
the Yoga Center has clients that earn the center revenues of $10,000 for the month, but ultimately
experiences losses of due to having to hire yoga instructors to cover the classes. In the third
scenario, the Yoga Center earns revenues of $20,000 for the month, but experiences losses of .

In all three cases, the Yoga Center loses money. In all three cases, when the rental contract expires in the
long run, assuming revenues do not improve, the firm should exit this business. In the short run, though, the
decision varies depending on the level of losses and whether the firm can cover its variable costs. In scenario
1, the center does not have any revenues, so hiring yoga teachers would increase variable costs and losses,
so it should shut down and only incur its fixed costs. In scenario 2, the center’s losses are greater because it
does not make enough revenue to offset the increased variable costs, so it should shut down immediately
and only incur its fixed costs. If price is below the minimum average variable cost, the firm must shut down.
In contrast, in scenario 3 the revenue that the center can earn is high enough that the losses diminish when
it remains open, so the center should remain open in the short run.

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Microeconomics Lecture Notes Chinket Tola

Scenario 1

If the center shuts down now, revenues are zero but it will not incur any variable costs and would only
need to pay fixed costs of $10,000.

𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − (𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠)

Scenario 2

The center earns revenues of $10,000, and variable costs are $15,000. The center should shut down
now.

𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − (𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠)

Scenario 3

The center earns revenues of $20,000, and variable costs are $15,000. The center should continue in
business.

𝑝𝑟𝑜𝑓𝑖𝑡 = 𝑡𝑜𝑡𝑎𝑙 𝑟𝑒𝑣𝑒𝑛𝑢𝑒 − (𝑓𝑖𝑥𝑒𝑑 𝑐𝑜𝑠𝑡𝑠 + 𝑣𝑎𝑟𝑖𝑎𝑏𝑙𝑒 𝑐𝑜𝑠𝑡𝑠)

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