Transcript Perfect Competition

5
The Firm and the Industry
Under Perfect Competition
Outline
● Types of Market Structure
● Perfect Competition Defined
● The Competitive Firm
● The Competitive Industry
● Perfect Competition and Economic
Efficiency
Types of Market Structure
● A market is a set of buyers and sellers
whose behavior affects P at which a good is
sold.
♦ E.g., Cisco stock sold in CA and WI is
considered to take place in the same market, so
markets don't necessarily refer to a
geographical area.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Types of Market Structure
● Economists describe different types of
markets by:
1. the number of firms
2. whether the products of different firms are
identical or different
3. how easy it is for new firms to enter the market
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Types of Market Structure
● The 4 major types of markets can be viewed on
a continuum.
Perfect
Competition
Monopolistic
Competition
(many small firms
selling identical
products)
(many small firms
producing slightly diff.
products)
Oligopoly
(few large firms)
Pure
Monopoly
(single firm)
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Perfect Competition Defined
● 4 conditions required for perfect competition:
1. Numerous small firms and customers –individual buyers
and sellers do not impact P.
2. Homogeneity of product –products are identical.
3. Freedom of entry and exit –no barriers to enter, such as
advertising costs or large sunk costs. Freedom to exit, so
firms can leave the industry if it proves unprofitable.
4. Perfect information –each firm and customer is well
informed about P. They know if 1 firm is selling at a
lower P.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Perfect Competition Defined
● These 4 conditions are rarely met.
♦ E.g., Ford stock –millions of buyers and sellers;
shares are identical; entry into market is easy; and info
about stock is available. Or fishing and farming.
● If perfect competition is so rare, then why study it?
♦ Standard by which all other markets are judged.
♦ Most efficient market because industry produces what
society wants using scarce resources most effectively.
♦ Understand what an ideally functioning market can
accomplish. See how far monopolist deviates.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Competitive Firm
● Firm is a P taker –it can produce as much or as little as it
likes without affecting market P.
● Firm must match P offered by its competitors because
products are identical. Otherwise, consumers shift their
purchases to another firm.
● Industry, which is comprised of all the individual firms,
can impact P through the forces of S and D.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Competitive Firm
● Firm’s D Curve under Perfect Competition:
● Horizontal demand
● Cannot impact market price
♦ E.g., Farmer Jones can double or triple Q and it has no
effect on P corn. Jones is insignificant to the market
exchange in Chicago, so she must accept P that a
broker quotes her.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
FIGURE 1. Demand Curve for a Firm
under Perfect Competition
Price per Bushel
in Chicago
D
A
B
C
Industry
supply
curve
E
$8
$8
S
Industry
demand
curve
Firm’s demand
curve
S
D
0
1
2
3
4
Truckloads of Corn
Sold by Farmer Jones
per Year
(a)
0
100 200 300 400
Total Sales in Chicago
in Thousands of Truckloads
per Year
(b)
The Competitive Firm
● Short-Run Equilibrium for the Perfectly
Competitive Firm:
♦ Profit-max Q is where MR = MC.
♦ D (or AR curve) is horizontal. So D is the MR curve
or MR = P.
■ If a firm ↑Q by 1 unit, it still receives the same P.
♦ At an optimum Q: MR = P = MC → P = MC.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
TABLE 1. Revenues, Costs, and
Profits of a Competitive Firm
Quantity
(1,000's
of bushels)
Total
Revenue
($1,000's)
Marginal
Revenue
($1,000's)
Total Cost
($1,000's)
Marginal
Cost
($1,000's)
Total
Profit
($1,000's)
0
0
------
0
------
0
10
80
80
85
85
-5
20
160
80
150
65
10
30
240
80
180
30
60
40
320
80
230
50
90
50
400
80
300
70
100
60
480
80
450
150
30
70
560
80
700
250
-140
Revenue and Cost per Bushel
FIGURE 2. Short-Run Equilibrium of
the Perfectly Competitive Firm
MC
AC
B
$8
$6
D = MR = AR = P
A
4
0
50,000
Bushels of Corn per Year
Short-Run Profit: Graphic
Representation
● To measure profit graphically, compare height of D
curve with height of AC curve.
● Recall: Profit = TR - TC
TR = P x Q
TC = AC x Q
● Since Q is identical, we can graphically compare P and
AC to see if firm earns SR profits or losses.
● If P > AC → firm earns profits or if P < AC → firm
incurs losses.
Short-Run Profit: Graphic
Representation
● Profit per unit = revenue per unit (P) - cost per unit
(AC). If P > AC → firm makes a profit on each unit.
● E.g., AC = TC/Q = $300,000/50,000 = $6 and P = $8, so
the profit per unit is $2 or vertical distance between
points B and A in Fig. 2.
● Total profit = profit per unit (P-AC) x Q
$100,000 = $2 x 50,000 = area labeled $8 $6 A B.
● MR = MC indicates profit-max Q but it doesn't show
whether the firm earns profits or incurs losses. We must
compare P and AC to determine this.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Short-Run Losses: Graphic
Representation
● If D is weak or costs are high, the firm’s most profitable
option may lead to a loss.
● Assume P is $4 per bushel and relevant data in Table 2.
● Jones still produces Q at P = MR = MC to min. losses.
● Q = 30,000 where MR  MC.
● Total loss is $5,000 = per unit loss (AC - P) of $0.167 x
Q of 30,000. Losses are shown by area $4 $4.16 C D in
Fig. 3 below.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
TABLE 2. Revenues, Costs, and
Losses of a Competitive Firm
Quantity
(1,000's
bushels)
Total
Revenue
($1,000's)
Marginal
Revenue
($1,000's)
Total Cost
($1,000's)
Marginal
Cost
($1,000's)
Total Profit
($1,000's)
0
0
------
45
------
-45
10
40
40
65
20
-25
20
80
40
90
25
-10
30
120
40
125
35
-5
40
160
40
170
45
-10
50
200
40
220
50
-20
60
240
40
275
55
-35
70
280
40
335
60
-55
MC
per Bushel
Revenue and Cost
FIGURE 3. Short-Run Equilibrium of
Competitive Firm with Losses
AC
C
$4.16
4.00
0
D
D = MR = AR = P
30,000
Bushels of Corn per Year
Shutdown and Break-Even
Analysis
● Firms can't endure a loss forever.
● Sunk costs = costs that cannot be escaped in SR.
♦ E.g., restaurant owner has signed a one-year lease on
a building.
● If firm shuts down → TR = 0 and TVC = 0, but
TFC (or sunk costs) remain. Sometimes it is
better to remain in operation until the sunk costs
expire.
Shutdown and Break-Even
Analysis
● 2 rules that govern the shutdown decision:
1. If TR > TC → firm earns positive profits and should
remain open in SR and LR.
2. Firm should operate in SR if TR > TVC, but should
plan to close in LR if TR < TC.
● Proof:
♦ Loss if the firm stays open = TC - TR
♦ Loss if the firm shuts down = TFC = TC - TVC
● So stay open in SR if: TC - TR < TC - TVC
or TR > TVC.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
TABLE 3. The Shutdown Decision
($1,000's)
Firm A
Firm B
TR
100
100
TVC
80
130
Sunk Cost
60
60
TC
140
190
Loss if firm closes
60
60
Loss if the firm stays open
40
90
Shutdown and Break-Even
Analysis
● In Table 3, both firms have the same TR and TFC, but
differ in their TVC.
● Both firms should close in LR because TC > TR.
● Yet, firm A should remain open in SR because it earns
$20,000 in TR above TVC, which can go toward TFC.
● Firm B should close now. By operating in SR, it adds
$30,000 in TVC above TR, which can be avoided by
closing.
FIGURE 4. Shutdown Analysis
MC
Price
P3
P2
B
A
P1
AC AVC
P3
P2
P1
0
Quantity Supplied
Shutdown and Break-Even
Analysis
● This firm operates at a loss whether P is P1, P2, or P3.
● Lowest P to keep the firm open in SR is where P  AVC.
● Stay open in SR if: TR > TVC
P x Q > AVC x Q
Since Q is equal,
P > AVC.
● Firm will shut down immediately if P < AVC.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Shutdown and Break-Even
Analysis
● At P = P1 → shutdown; firm cannot cover TVC.
● At P = P3 → firm earns revenues above TVC so stay
open in SR and produce at pt A where P3 = MC. But,
firm will close in LR as TR < TC.
● At P = P2 → firm is indifferent between remaining open
and closing since TR just covers TVC. If firm stays
open it will produce at pt B where P2 = MC. P2 is lowest
P which Q > 0 and it’s the min pt on AVC curve.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Competitive Firm’s Short-run
Supply Curve
● SR S curve for competitive firm = portion of MC
curve that lies above the min pt on AVC curve.
● Supply tells us how much output is produced at
different prices.
● In SR: (1) If P > AVC → produce where P = MC.
So for any P above pt B, MC tells us the Qs.
(2) If P < AVC then Qs = 0.
The Competitive Industry’s Shortrun Supply Curve
● SR for industry: too brief a period of time for new firms
to enter or old firms to leave. Number of firms is fixed.
● LR for industry: long enough period of time for any firm
that so chooses to enter or leave. Also, each firm can
adjust its Q to fit LR costs.
● SR industry S curve is horizontal summation of the
individual firm's S curves.
● SR industry S curve has (+) slope because individual
firms have MC curves that slope upward.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
FIGURE 5. Derivation of the Industry
Supply Curve
e
$8.00
c
6.00
Corn Industry
s
s
Price per Bushel
Price per Bushel
Typical Corn Farmer
S
E
$8.00
C
6.00
S
45 50
45 50
Quantity Supplied in
Thousands of Bushels
Quantity Supplied in
Millions of Bushels
(a)
(b)
The Competitive Industry’s Shortrun Supply Curve
● In Fig. 5, if 1,000 identical firms each supplied 45,000
when P = $6 → industry Qs is 45,000 x 1,000 = 45
million. Repeating this process for every P derives
industry S curve.
● Entry of new firms shifts SR industry S curve out.
● Exit of old firms shifts SR industry S curve in.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The Competitive Industry
● Industry S and market D determine equilibrium P and Q.
● Individual firms face horizontal D curves because they
are so small. If 1 firm doubled its Q, market P is
unchanged. But if every firm in industry doubled their Q,
↓P to induce consumers to purchase the add. Q.
● In Fig. 6, equilibrium → P = $8 and Q = 50 million.
● Recall: if P = $6 → shortage = 27. ↑P toward E as
frustrated buyers bid up prices.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
FIGURE 6. Supply-Demand
Equilibrium of a Competitive Industry
S
Price per Bushel
D
$10.00
E
8.00
C
6.00
A
D
S
0
45 50
Quantity of Corn in
Millions of Bushels
72
Industry and Firm Equilibrium
in the Long Run
● LR equilibrium may differ from SR equilibrium
because:
1. number of firms may differ
2. firms can vary their plant size in LR
♦ Thus, firm and industry cost curves differ in LR.
● Firms enter or exit based on Π earned in industry.
♦ SR profits → new firms enter
♦ SR losses → existing firms exit
● If firms earn high profits in an industry then new firms
enter, forcing ↓P as SR industry S curve shifts out.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
FIGURE 7. Entry of Firms into the
Competitive Industry
Typical Firm
Industry
MC
(1,000 firms)
S0
e
$8.00
6.00
a
D0
D1
b
Price per Bushel
Price per Bushel
AC
D
E
$8.00
A
6.00
S0
D
S1
40 45 50
Quantity of Corn in
Thousands of Bushels
(a)
(1,600 firms)
S1
50
Quantity of Corn in
Millions of Bushels
(b)
Typical firm earns profits at point e which encourages
the entry of 600 new firms. This shifts industry S curve
out and lowers P.
72
Entry of Firms into the
Competitive Industry
● SR profits (point e in Fig. 7) encourages 600 firms to
enter which shifts industry S out and pushes P down to
$6 (new SR equilibrium point A).
● Existing firms react to ↓P by setting new P = MC and
lowering their Q to 45,000.
● At P = $6 → 1,600 firms produce 45,000 each so
industry Qs = 72M.
● Point A is another SR equilibrium as typical firm earns
profits. Note: P > AC and per unit profits = a – b.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
FIGURE 8. LR Equilibrium of the
Competitive Firm and Industry
Typical Firm
Industry
AC
m
$5.00
D2
Price per Bushel
Price per Bushel
MC
D
(2,075 firms)
S2
M
$5.00
S2
83
40
Quantity of Corn in
Thousands of Bushels
(a)
D
Quantity of Corn in
Millions of Bushels
(b)
Point m is a LR equilibrium where typical firm earns zero
profits and produces where P = AC = MC.
Entry of Firms into the
Competitive Industry
● Entry continues until all profits are competed away. SR
Industry S will shift out until P = min AC.
● LR equilibrium (point m in Fig. 8) is where typical firm
earns zero profits and produces where P = AC = MC.
● There are no profits in LR.
♦ SR profits → firms enter and ↓P until all profits end.
♦ SR losses → firms leave and ↑P until all losses end.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Zero Economic Profit
● Why do firms stay in the industry if profits are zero in
LR?
● Recall: economist's definition of profit includes
opportunity cost of any K or L supplied by firm's
owners. 0 economic Π → (+) accounting Π
● E.g., if investors can earn 15% on their funds elsewhere
→ firm must earn 15% to cover opportunity cost of its
K. If not, funds will not be given to the firm because
investors will go elsewhere.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
Zero Economic Profit
● Zero economic profit indicates firms are earning
the normal economy-wide rate of profit (in the
accounting sense).
♦ An industry whose K earns a higher rate of return than
K invested elsewhere attracts K into the industry. This
shifts SR industry S curve out and ↓P until econ Π = 0.
♦ If K invested in an industry earns a lower return than K
invested elsewhere, funds dry up in the industry. This
shifts SR industry S curve in and ↑P until econ Π = 0.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
The LR Industry Supply Curve
●
LR industry S curve reflects:
Entry and exit of firms → shifts SR industry S curve toward
its LR position.
Each firm is freed of its sunk cost commitments → each firm
is operating on its LR AC curve.
1.
2.
♦
LR industry S curve = Industry’s LR AC curve
because LR Π = 0, so industry P = industry LR AC.
♦
♦
If P > LRAC → firms enter, attracted by profits
If P < LRAC → firms exit, due to losses
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
FIGURE 9. SR Industry Supply and
LR Industry Average Cost
Price, Average Cost per Bushel
S
B
$7.00
S
4.00
0
A
70
Output in Millions of Bushels of Corn
LRAC
If LR P = $4 and
current P = $7→
firms earn $3 in
economic Π on
each bushel
they sell → entry
of new firms →
S shifts out to
LRAC.
Perfect Competition and
Economic Efficiency
● Perfect competition leads to great efficiency in LR as
firms must produce where P = min LR AC curve. Thus,
output of competitive industries is produced at lowest
possible cost to society.
● In Table 4, industry produces 12 million bushels by
having 120 firms produce 100,000.
● Total industry cost = AC x industry output, so total
industry cost is lowest by having each firm produce at
lowest AC possible.
Copyright© 2006 Southwestern/Thomson Learning All rights reserved.
TABLE 4. AC for the Firm and
Total Cost for the Industry
Firm's Q
Firm's AC
Number
of firms
Industry
Output
Industry
Total Cost
60,000
$0.90
200
12,000,000
$10,800,000
100,000
0.70
120
12,000,000
8,400,000
120,000
0.80
100
12,000,000
9,600,000