Transcript Perfect Competition - Widener University

Perfect Competition
Assumptions of Perfect Competition
1. Homogeneous or identical products –
every seller’s product is the same as
every other seller’s product.
2. Many small independent firms
3. Easy entry & exit into the industry –
all resources are perfectly mobile.
4. Firms, consumers, & resource owners
have perfect knowledge of relevant
economic & technical data.
The perfectly competitive firm is a price
taker that sells its product at the market
price. Why?
If the firm tried to charge more than the
market price, it would lose all its business to
its competitors who sell the identical product.
The firm can sell as much as it wants at the
market price, since it is very small relative to
the market. The firm, therefore, has no
incentive to charge less than the market
price.
Since the perfectly competitive firm always
sells its product for the market price, the
demand curve for its product is horizontal at
the market price.
P
D
Q
Consider a perfectly competitive firm whose product
sells for $10. The firm’s costs are as shown below.
Quantity
of output
(Q)
Price
(P)
0
Total
Revenue
(TR)
Total Fixed
Cost (TFC)
Total Variable
Cost (TVC)
10
12
0
1
10
12
2
2
10
12
3
3
10
12
5
4
10
12
8
5
10
12
13
6
10
12
23
7
10
12
38
8
10
12
69
Total
Cost
(TC)
Total
Profit
()
Marginal
Revenue
(MR)
Marginal
Cost
(MC)
Total Revenue is TR = PQ
Quantity
of output
(Q)
Price
(P)
Total
Revenue
(TR)
Total Fixed
Cost (TFC)
Total Variable
Cost (TVC)
0
10
0
12
0
1
10
10
12
2
2
10
20
12
3
3
10
30
12
5
4
10
40
12
8
5
10
50
12
13
6
10
60
12
23
7
10
70
12
38
8
10
80
12
69
Total
Cost
(TC)
Total
Profit
()
Marginal
Revenue
(MR)
Marginal
Cost
(MC)
Total Cost is TC = TFC + TVC.
Quantity
of output
(Q)
Price
(P)
Total
Revenue
(TR)
Total Fixed
Cost (TFC)
Total Variable
Cost (TVC)
Total
Cost
(TC)
0
10
0
12
0
12
1
10
10
12
2
14
2
10
20
12
3
15
3
10
30
12
5
17
4
10
40
12
8
20
5
10
50
12
13
25
6
10
60
12
23
35
7
10
70
12
38
50
8
10
80
12
69
81
Total
Profit
()
Marginal
Revenue
(MR)
Marginal
Cost
(MC)
Profit is  = TR –TC
Quantity
of output
(Q)
Price
(P)
Total
Revenue
(TR)
Total Fixed
Cost (TFC)
Total Variable
Cost (TVC)
Total
Cost
(TC)
Total
Profit
()
0
10
0
12
0
12
-12
1
10
10
12
2
14
-4
2
10
20
12
3
15
5
3
10
30
12
5
17
13
4
10
40
12
8
20
20
5
10
50
12
13
25
25
6
10
60
12
23
35
25
7
10
70
12
38
50
20
8
10
80
12
69
81
-1
Marginal
Revenue
(MR)
Marginal
Cost
(MC)
Marginal Revenue is MR =ΔTR/ΔQ .
For a perfectly competitive firm, MR is constant & equal to the price of the product.
Quantity
of output
(Q)
Price
(P)
Total
Revenue
(TR)
Total Fixed
Cost (TFC)
Total Variable
Cost (TVC)
Total
Cost
(TC)
Total
Profit
()
Marginal
Revenue
(MR)
0
10
0
12
0
12
-12
---
1
10
10
12
2
14
-4
10
2
10
20
12
3
15
5
10
3
10
30
12
5
17
13
10
4
10
40
12
8
20
20
10
5
10
50
12
13
25
25
10
6
10
60
12
23
35
25
10
7
10
70
12
38
50
20
10
8
10
80
12
69
81
-1
10
Marginal
Cost
(MC)
Marginal Cost is MC =ΔTC/ΔQ
Price
Total
Revenue
Total
Fixed
Cost
Total
Variable
Cost
Total
Cost
Total
Profit
Marginal
Revenue
Marginal
Cost
0
10
0
12
0
12
-12
---
---
1
10
10
12
2
14
-4
10
2
2
10
20
12
3
15
5
10
1
3
10
30
12
5
17
13
10
2
4
10
40
12
8
20
20
10
3
5
10
50
12
13
25
25
10
5
6
10
60
12
23
35
25
10
10
7
10
70
12
38
50
20
10
15
8
10
80
12
69
81
-1
10
31
Quantity
of output
Notice that when Q = 6, MR=MC
and profit is at its maximum.
Price
Total
Revenue
Total
Fixed
Cost
Total
Variable
Cost
Total
Cost
Total
Profit
Marginal
Revenue
Marginal
Cost
0
10
0
12
0
12
-12
---
---
1
10
10
12
2
14
-4
10
2
2
10
20
12
3
15
5
10
1
3
10
30
12
5
17
13
10
2
4
10
40
12
8
20
20
10
3
5
10
50
12
13
25
25
10
5
6
10
60
12
23
35
25
10
10
7
10
70
12
38
50
20
10
15
8
10
80
12
69
81
-1
10
31
Quantity
of output
Notice also that at that profit-maximizing output,
price is equal to marginal cost
P=MC
Price
Total
Revenue
Total
Fixed
Cost
Total
Variable
Cost
Total
Cost
Total
Profit
Marginal
Revenue
Marginal
Cost
0
10
0
12
0
12
-12
---
---
1
10
10
12
2
14
-4
10
2
2
10
20
12
3
15
5
10
1
3
10
30
12
5
17
13
10
2
4
10
40
12
8
20
20
10
3
5
10
50
12
13
25
25
10
5
6
10
60
12
23
35
25
10
10
7
10
70
12
38
50
20
10
15
8
10
80
12
69
81
-1
10
31
Quantity
of output
P = MC because
for the perfectly competitive firm, P = MR
& for the profit-maximizing firm, MR = MC.
Price
Total
Revenue
Total
Fixed
Cost
Total
Variable
Cost
Total
Cost
Total
Profit
Marginal
Revenue
Marginal
Cost
0
10
0
12
0
12
-12
---
---
1
10
10
12
2
14
-4
10
2
2
10
20
12
3
15
5
10
1
3
10
30
12
5
17
13
10
2
4
10
40
12
8
20
20
10
3
5
10
50
12
13
25
25
10
5
6
10
60
12
23
35
25
10
10
7
10
70
12
38
50
20
10
15
8
10
80
12
69
81
-1
10
31
Quantity
of output
On a graph, the perfectly competitive firm
making a positive economic profit looks like
this. The horizontal demand curve lies above
the minimum of the ATC curve.
MC
$
P
ATC
D = MR
Q*
Quantity
Sometimes the best the firm can do is break
even (make zero economic profits).
This occurs when the price (& the demand
curve) are at the minimum of the ATC curve.
$
P
MC
ATC
AVC
D = MR
Quantity
What if the demand curve lies below the
minimum of the ATC curve but above the
minimum of the AVC curve?
$
MC
ATC
AVC
P
D = MR
Quantity
Then the firm will have an economic loss.
However, the firm will still operate.
If the firm were to shut down & produce nothing,
its loss would equal its fixed cost.
But since the price is greater than the variable
costs per unit (AVC), by operating the firm will be
able to cover its variable costs & part of its fixed
costs.
So its loss would be smaller than the amount of
fixed cost.
So it pays to operate, as long as the price is above
the minimum of the average variable cost.
Mathematically, the situation works like this:
P > AVC
So, PQ > AVC (Q),
[Now since AVC = TVC / Q ,
AVC (Q) = TVC.]
So, PQ > TVC
TR > TVC
TR – TC > TVC – TC
 > TVC – TC
 > – TC + TVC
 > -1(TC – TVC)
 > – TFC
If the firm produced nothing,
 = TR – TC
= TR – (TVC+TFC )
= 0 – (0+TFC)
= – TFC
So the firm does better by
operating than by shutting
down.
If the price equals the minimum value of the
AVC curve, the firm will lose the same
amount if it shuts down or if it operates.
$
MC
ATC
AVC
P
D = MR
Quantity
However, if the price is below the minimum
of the AVC curve,
the firm is unable to cover even the variable costs,
& it should shut down.
It would lose more by operating than by shutting
down.
Consequently, the minimum of the AVC curve is
called the shutdown point.
Graphically, the firm’s horizontal demand curve
lies below the minimum of the AVC curve:
$
MC
ATC
AVC
P
D = MR
Quantity
So we have these
five possible cases:
1. Positive economic profits
2. Break even
3. Operate at a loss
4. Lose same amount if operate or shutdown
5. Shutdown
$
P1
P2
P3
P4
P5
MC
ATC
AVC
Quantity
Using this information and the fact that the
firm maximizes profits by producing where
MR = MC, we can determine the firm’s short
run supply curve.
If the price is P1, the firm produces output Q1, where
MR = MC.
(The numbering of the prices in the upcoming slides
does not correspond to the numbering in our 5 case
discussion.)
MC
$
ATC
AVC
D1 = MR1
P1
Q1
Quantity
If the price is P2, the firm produces output Q2 .
ATC
MC
$
AVC
D2= MR2
P2
Q2
Quantity
If the price is P3, the firm produces output Q3.
MC
$
ATC
AVC
D3 = MR3
P3
Q3
Quantity
If the price is P4, the firm produces output Q4.
MC
$
ATC
AVC
D4 = MR4
P4
Q4
Quantity
If the price is P5, the firm produces output Q5 (or
shuts down – it loses the same amount either way).
MC
$
ATC
AVC
D5 = MR5
P5
Q5
Quantity
So in determining the quantity the firm would
supply at each price, we have actually traced out
the points of the MC curve above the minimum of
the AVC curve.
$
MC
ATC
AVC
Quantity
So this is the firm’s short run supply curve.
Price
S
Quantity
To determine the industry or market short run
supply curve, horizontal sum the individual firms’
supply curves.
Price
S1 S2 S3 S4 S5
Industry
supply curve
Quantity
That means that for each price, we add the amounts all the
firms are willing to supply.
For example, if there are five firms who at a price of $25 will
supply 10, 20, 30, 40, & 50 units each, the total supplied by
the industry at that price is 10 + 20 + 30 + 40 + 50 = 150 .
Price
S1 S2 S3 S4 S5
Industry
supply curve
25
10
20
30
40
50
Quantity
150
How do perfectly competitive firms & industries
adjust to changes in demand conditions &
what are the implications for the
long run market supply curve?
Let’s start with the simplest case, which is
the constant cost industry.
Constant Cost Industry
an industry in which costs of production
remain constant as industry output expands
Start with the market.
Market
P
S
P0
D
Q*
Q
Put in a typical firm
in long run equilibrium (zero profits).
Market
Firm
P
S
P
MC
D= MR
P0
P0
ATC
D
Q*
Q
q*
q
Suppose demand increases.
Firm
Market
MC
P
ATC
S
P0
D= MR
P0
D D’
Q*
Q
q*
q
Price rises and profits are made.
Firm
Market
MC
P
S
P1
D1= MR1
P1
P0
P0
ATC
D= MR
D D’
Q* Q1
Q
q* q1
q
New firms enter the industry, increasing supply.
Firm
Market
MC
P
S
P1
P0
S’
P1
P0
ATC
D1= MR1
D= MR
D D’
Q*Q1
Q
q* q1
q
Price falls to original level, & profits return to zero.
Firm
Market
MC
P
S
P1
P0
S’
P1
P0
ATC
D1= MR1
D= MR
D D’
Q* Q1 Q2
Q
q*
q
The Long Run Supply Curve
The initial market point and the final one are
long run equilibrium points and therefore
are on the long run supply curve for this
industry.
(The middle point - the black one - is not on
the long run supply curve, since it is not a
long run equilibrium point.)
For a constant cost industry, the long run
supply curve is a horizontal line.
The Long Run Supply Curve
Market
P
S
P1
S’
long run
supply curve
P0
D D’
Q* Q1 Q2
Q
Increasing Cost Industry
an industry in which costs of production
increase as industry output expands
Start with the market.
Market
P
S
P0
D
Q*
Q
Put in a typical firm
in long run equilibrium (zero profits).
Firm
Market
P
S
P
MC
D= MR
P0
P0
ATC
D
Q*
Q
q*
q
Suppose demand increases.
Market
Firm
MC
P
ATC
S
P0
D= MR
P0
D D’
Q*
Q
q*
q
Price rises and profits are made.
Firm
Market
MC
P
S
P1
D1= MR1
P1
P0
P0
ATC
D= MR
D D’
Q* Q1
Q
q* q1
q
New firms enter the industry, increasing supply.
Firm
Market
MC
P
S
P1
P0
S’
P1
P0
ATC
D1= MR1
D= MR
D D’
Q*Q1
Q
q* q1
q
However, as industry output expands,
demand for the inputs rises. The prices
of the inputs increase, and therefore
production costs increase.
So we see an upward shift in the cost
curves.
Cost curves shift upward.
Firm
Market
P
MC1
S
P1
P0
ATC
S’
P1
P0
D D’
Q*Q1
Q
ATC1
D1= MR1
D= MR
MC
q* q1
q
The market supply curve shifts to the right
just enough, so that the equilibrium
price will be at the minimum of the new
ATC curve and we have zero profits.
So the price rises and then falls but not to
the original price level.
The new long run equilibrium price is higher
than the original price.
Firm
Market
MC1
P
S
P1
P2
P0
Q*Q1
Q
ATC
D1= MR1
D2 =MR2
D= MR
S’
P1
P2
P0
D D’
ATC1
MC
q2 q* q1
q
The Long Run Supply Curve
The initial market point and the final one are
long run equilibrium points and therefore
are on the long run supply curve for this
industry.
For a increasing cost industry, the long run
supply curve is upward sloping.
The Long Run Supply Curve
Market
P
S
P1
P2
P0
S’
D D’
Q*Q1
Q
long run
supply curve
Decreasing Cost Industry
an industry in which costs of production
fall as industry output expands
Start with the market.
Market
P
P0
S
D
Q*
Q
Put in a typical firm
in long run equilibrium (zero profits).
Firm
Market
P
P
P0
P0
MC
ATC
D= MR
S
D
Q*
Q
q*
q
Suppose demand increases.
Firm
Market
MC
P
P0
ATC
D= MR
P0
S
D D’
Q*
Q
q*
q
Price rises and profits are made.
Firm
Market
MC
P
ATC
P1
D1= MR1
P1
P0
P0
D= MR
S
D D’
Q* Q1
Q
q* q1
q
New firms enter the industry, increasing supply.
Firm
Market
MC
P
ATC
P1
D1= MR1
P1
P0
P0
D= MR
S
D D’
S’
Q*Q1
Q
q* q1
q
As industry output expands, area
infrastructure (such as roads and
bridges) improves and therefore costs of
transporting inputs and outputs
decrease.
So we see an downward shift in the cost
curves.
Cost curves shift downward.
Firm
Market
MC
P
ATC
P1
D1= MR1
P1
P0
P0
D= MR
S
D D’
S’
Q*Q1
Q
q* q1
q
The market supply curve shifts to the right
just enough, so that the equilibrium
price will be at the minimum of the new
ATC curve and we have zero profits.
So the price rises and then falls to below
the original price level.
The new long run equilibrium price is lower than
the original price.
Firm
Market
MC
P
ATC
P1
P0
P2
D1= MR1
P1
P0
P2
S
D= MR
D2= MR2
D D’
S’
Q*Q1
Q
q* q1 q2
q
The Long Run Supply Curve
The initial market point and the final one are
long run equilibrium points and therefore
are on the long run supply curve for this
industry.
For a decreasing cost industry, the long run
supply curve is downward sloping.
The Long Run Supply Curve
Market
P
P1
P0
P2
long run
supply curve
S
D D’
S’
Q*Q1
Q2
Q
We have seen that in long run equilibrium,
the perfectly competitive firm always operates
at the minimum of its SR ATC curve.
In LR equilibrium, it will also be at the minimum of
its LR ATC. Why?
When the firm is maximizing LR profits,
MR = LR MC.
Since for a perfectly competitive firm, P=MR,
P = LR MC.
But since the firm has zero economic profits,
P = LR ATC.
So LR MC must equal LR ATC. Where does that
occur?
At the minimum of the LR ATC.
So in LR equilibrium, a perfectly competitive firm
operates at the minimum of both the SR & LR ATC
curves, where those curves intersect the LR & SR
MC curves.
LR MC
P
SR MC
LR ATC
SR ATC
P0
D= MR
q*
q