Transcript Perfect Competition

PERFECTLY COMPETITIVE
MARKET STRUCTURE
AGR 130 Introduction to Agricultural Economics
Murray State University
Factors of Perfectly Competitive
Markets
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Large number of buyers and sellers
Homogenous product
Freedom of entry and exit (zero/minimal entry and
exit barriers)
Perfect Information
Perfectly Competitive Markets
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The key to perfectly competitive markets is that
there are a large number of buyers (consumer
demand) and a large number of sellers (producer
supply), each of who is so small relative to the total
market that their individual actions will not affect
the market.
In perfect competition, both buyers and sellers
recognize that the price is something beyond their
individual control.
Each potential participant in the market can only
make a “take-it-or-leave-it” decision at the price
dictated by the market
Perfectly Competitive Markets
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In perfect competition, both buyers and sellers
recognize that the price is something beyond their
individual control.
Each potential participant in the market can only
make a “take-it-or-leave-it” decision at the price
dictated by the market
The Perfectly Competitive Firm
The basic theory of a perfectly competitive
firm assumes that the firm is so small in relation
to the market that actions by the firm do not
affect the market.
 This model closely approximated the typical
family farm.
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Conditions of a Perfect Competition
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The most important characteristic of a perfectly
competitive firm is that it is atomistic.
Meaning, the perfectly competitive firm is so small
relative to the market that any action by the firm
will not have a noticeable effect on the market.
Example: The typical family farm in the corn-belt is
certainly perfectly competitive, for if that farmer
decided to halt production or destroy the crop; the
impact on the markets for corn would be
unnoticeable.
Perfect Competition Cont.
However, Ocean Spray, the processor of about
80% of the U.S. Cranberry crop, is hardly a
perfectly competitive firm.
 This does not mean that Ocean Spray is not a
very competitive company, just that it is a
company that does not fit the perfectly
competitive model of a firm.
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Perfect Competition Cont.
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Another condition of perfect competition is that
each firm in the market produces a homogeneous
product.
 That
is, each producer’s output cannot be distinguished
from that of another producer.
Perfect Competition Cont.
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A third strong assumption about a perfectly
competitive firm is that resources (i.e., factors of
production such as labor, capital, and land) are
free to move in and out of production.
 That
is, if a farmer decides to be a computer technician
instead of a farmer, it could be done without any costs
involved.
Perfect Competition Cont.
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A fourth assumption of a perfect competition is that
all market participants share the same knowledge
about the market (buyers and sellers both know
what is going on in related markets, and so on).
Behavior of a Perfectly Competitive
Firm
The four characteristics of a perfectly
competitive market mean that the
perfectly competitive firm is a price taker,
not a price maker.
 A price maker is a market in which the
individual producer or consumer is able to
establish price.
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Perfectly Competitive Behavior Cont.
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Example: A typical farmer is told what the prices are
for the inputs he purchases and is told what price he
can receive at any given time for his product.
The only decision the farmer makes is whether to accept
the given price or not.
Glory be to the soybean farmer who proudly tells the
grain elevator operator that he is going to demand
$5.50 per bushel, when the market price is $5.25.
Until he accepts the market price, the farmer will never
be able to sell his crop.
Truly, the farmer is a price taker.
Remember: Markets make prices and perfectly
competitive firms take prices.
Perfectly Competitive Behavior Cont.
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Example: Ocean Spray
The difference between the perfectly competitive firm
and Ocean Spray should be clear.
Ocean Spray set the price at which it sells frozen
concentrated cranberry juice to food wholesalers rather
than being dictated by the market.
Ocean Spray is at the mercy of the market.
If it sets the price too high, consumers will not buy.
If consumers do not buy, then wholesalers won’t but it
and they will loose the market.
Ocean Spray is a price maker rather than a price taker.
Accounting Profit vs. Economic Profit
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In basic economics, it is always assumed that the
perfectly competitive firm makes management
decisions with the sole objective of maximizing
economic profit.
For most of us, profit is simply the difference
between the receipts of a firm and its expenses.
This concept is what most economists call an
accounting profit.
This is the profit that is typically reported by an
accountant.
Accounting Profit
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When reporting accounting profit, the only cost considered are
those which payment is actually made. This can be misleading
because it may omit some very important costs of production.
FARM A
Big city lawyer who rents
land, hires all machinery
services, and hires all labor.
FARM B
Family Farmer who owns land,
own equipment, and uses only
own labor.
Revenue (400 acres of
wheat; 30 bu/acre @
$5/bu
$60,000
$60,000
(-) Operating Expenses
$30,000
$30,000
(-) Land Rent ($30/acre)
$12,000
$.00
(-) Machinery ($20/acre) $8,000
$.00
(-) Hired Labor ($5/acre) $2,000
$.00
(=) Accounting Profit
$30,000
$8,000
Accounting Profit
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In the previous slide the two farms are similar in
every respect except that Farm A makes cash
payment for some items for which Farm B makes no
cash payment.
As a result, the accounting profits for Farm B greatly
exceed those of Farm A.
Notice that the accountant entered zero for labor
on Farm B’s account since no cash payment for labor
was made.
Does this imply that the value of the
farmer’s labor is zero?
Answer:
 Of course not!
 Now we can understand how the accounting
profit can be misleading.
 The labor of Farm B is quite valuable, even if a
cash payment for its use is not made.
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Economic Profit
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The economist measures value, not payment, in the
calculation of Economic Profit.
For those productive services for which a cash
payment is not made, the economist estimates their
value using the concept of opportunity cost.
Recall that Opportunity Cost is an estimate of how
much payment a resource would receive if that
resource were employed in another activity.
The economist uses this to estimate the Value in the
calculation of the economic profits of a firm.
Economic Profit
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To compute the economic profit of Farm B in the
previous slide, it would be necessary to include the
opportunity costs of the farmer’s land, labor, and
machinery.
The opportunity costs of the land would be equal to
what the farmer would be paid for the land if he
rented it out rather than farming it.
The opportunity cost of the farmer’s labor is equal
to what the farmer could earn if he were employed
in the highest paying alternative employment.
Economic Profit
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The opportunity cost of the farmer’s machinery is what he
would have to pay to acquire the same services on a custom
hire basis.
Custom hire refers to the common practice of one farmer
(without machinery) hiring another farmer (with machinery)
to perform plowing, planting and harvesting work on a
fixed-rate basis.
Since each of these three opportunity costs would be
roughly equal to the payments made for the factor services
by Farm A, the economic profits of the two farms would be
similar even though their accounting profits are greatly
different.
Remember: The economic profit includes the value of all
factors of production regardless of whether they are
actually paid or not (the term profit will always refer to
economic profit).