Transcript Lecture 5 - Har Wai Mun

UBEA 1013: ECONOMICS
CHAPTER 5:
MARKET STRUCTURE: PERFECT COMPETITION
5.1 Characteristic
5.2 Short-run Decision: Profit Maximization
5.3 Short-run Decision: Minimizing Loss
5.4 Long-run Adjustment
5.5 External Changes:
Consumer Preference & Technology
5.6 Efficiency of Perfect Competition
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UBEA 1013: ECONOMICS
5.1 Characteristic
i. Many firms: A single firm’s production is relatively very small
compare to the market demand.
ii. Homogenous product: product/service has no unique
characteristic, so consumers don’t care which firm they buy from.
iii. Perfect information: Firms are price taker because of (i), (ii)
and buyers & sellers are well informs about price. No transaction
cost assumed. Firm only decide how much to produce >> results
in perfectly elastic demand.
iv. Free entry / exit: No legal, technology, capital, incumbent
advantage or others constraint to entry/exit. No transaction cost
assumed. New firms enter (existing firms exit) if industry earning
above (negative) normal profit. (>> economic profit = 0 >>
normal profit = normal rate of return)
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UBEA 1013: ECONOMICS
5.1 Characteristic
Figure 5.1: Market and Firm’s Demand Curve
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UBEA 1013: ECONOMICS
5.2 Short-run Decision: Profit Maximization
Profit, π (q) = TR (q) – TC (q)
Differentiating against quantity on the above equation gives the rate of
change of each variable.
(Δ π / Δq) = (ΔTR / Δq) – (ΔTC / Δq)
= MR – MC
Profit maximization is when (Δ π / Δq) = 0. Why?
(Δ π / Δq) > 0; MR > MC; should increase q
(Δ π / Δq) < 0; MR < MC; should decrease q
(Δ π / Δq) = MR – MC = 0
»» MR = MC
(is the profit maximization condition)
»» MR = p = MC (one price for every level of output & the
whole market/industry )
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UBEA 1013: ECONOMICS
5.2 Profit maximization
Figure 5.2: Profit Maximization Condition
In a perfect competition market structure, ATR is equal to
MR equal to price. Therefore, graphically, firm earns profit if
its price is above its ATC curve.
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UBEA 1013: ECONOMICS
5.2 Profit maximization
Figure 5.3: Firm Earning Positive Profit in Short-run
Total revenue = ($5.00 X 300 = $1,500)
Total cost = ($4.20 X 300 = $1,260)
>> Total profit = [($5.00 - $4.20)*300 = $240]
or [$1,500 - $1,260 = $240]
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UBEA 1013: ECONOMICS
5.3 Short-run Decision: Minimizing Loss
If average revenue less than average total cost, a firm
suffer losses.
However, it is whether average (total) revenue less
than average (total) variable cost or not is the critical
factor for the firm to either continue operation or shut
down.
TR – TVC = Operating profit. Positive operating profit
(TR – TVC > 0) can be used to offset fixed costs and
reduce total losses.
So, it is better for the firm to keep operating.
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UBEA 1013: ECONOMICS
5.3 Minimizing loss
If the operating profit is negative (TR < TVC), the firm
suffers operating losses that push total losses above
fixed costs.
So, it is better to shut down.
Summary:
TR > TVC: Decision = Keep operating (in short term)
TR < TVC: Decision = Shut down
Those decisions is known as minimizing losses.
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UBEA 1013: ECONOMICS
5.3 Minimizing loss
Figure 5.4: Minimizing Losses with Positive Operating Profit
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UBEA 1013: ECONOMICS
5.3 Minimizing loss
Table 5.1: Comparison of Losses
Case 1: Shut-down
Total Revenue (q=0)
$
0.00
Minus:
Case 2: Operate at price = $3.50
Total revenue ($3.50*225)
$
787.50
Minus:
Variable cost
0.00
Variable cost ($3.10*225)
Operating profit/loss
(TR –TVC)
0.00
Operating profit/loss
(TR –TVC)
Minus:
(697.50)
90.00
Minus:
Fixed cost
(225.00)
Fixed cost
(225.00)
Total profit/loss
(225.00)
Total profit/loss
(135.00)
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UBEA 1013: ECONOMICS
5.3 Minimizing loss
Figure 5.5: Shut Down Point & Short-run Supply Cost
Minimum market price for the firm to make a shut down decision
>>> MR = MC = AVC
Firm supply curve
>>> P = MR = MC (but above AVC)
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UBEA 1013: ECONOMICS
5.3 Minimizing loss
Figure 5.6: Industry Short-run Supply Curve
To be continue next week …..
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UBEA 1013: ECONOMICS
5.4 Long-run Adjustment
In long run, firm only earn zero economic profit
Zero econ profit
Normal
profit
Total Revenue
Total
economic
cost
Total
accounting
cost
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UBEA 1013: ECONOMICS
5.4 Long run adjustment
WHY zero economic profit ???
A) FREE ENTRY & EXIT
When economic profit > 0:
>> Encourage NEW firms to come in
>> Market supply increase (SS curve shift rightward)
>> Price drop >> TR drop >> profit drop
>> When economic profit = 0, no incentive to come in
When economic profit < 0:
>> Incentive for existing (losing) firms to exit
>> Market supply drop (SS curve shift leftward)
>> Price increase >> TR increase >> loss reduced
>> When economic profit = 0, no incentive to exit
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UBEA 1013: ECONOMICS
5.4 Long run adjustment
Entry & Exit
Figure 5.7: Exit in Short-run Losses Situation
Only normal profit in the long run that did not
encourage entry or exit from the industry
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UBEA 1013: ECONOMICS
5.5 External Changes: Consumer Preference & Technology
A1) Changing preference: Increase in demand
When preference increase:
>> DD curve shift rightward, qty & price increase
>> Existing firm gain positive economic profit
>> Incentive for expansion or new firms entry
>> Market SS increase: SS curve shift rightward, qty increase
but price drop until each firm earn zero economic profit
>> With the increase of new firms, the market share for each firm
in the industry decrease, thus a firm might end up producing
qX0 units of output
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UBEA 1013: ECONOMICS
5.5 External Changes
A2) Changing preference: Decrease in demand
When preference drop:
>> DD curve shift leftward, qty & price decrease
>> Existing firm suffer economic losses
>> Incentive for contraction or exit
>> Market SS decrease: SS curve shift leftward, qty drop but
price increase until each firm earn zero economic profit
>> With the exit of firms, the market share for each firm in the
industry increase, thus a firm might end up producing qY0
units of output
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UBEA 1013: ECONOMICS
5.5 External Changes
B) Advancing technology: Technology improvements
(a) Adopt new technology
(b) Old technology firm
Produce at lower cost
Positive economic profit
Economic loss
New firms entry
SS up, P down
Adopt new
technology
Profit reducing
Exit
SS down, P up
Zero economic profit
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UBEA 1013: ECONOMICS
5.6 Efficiency of Perfect Competition
(a) What will be produced?
(i) Produce what people want
(ii) SS – DD free interaction
(iii) Produce at P = MC
(b) How will it be produced?
(i) Incentive to use best
technology to lower cost.
(ii) MPL = PL
(c) Who will get what is
produced?
(i) Purchasing power (income)
(ii) Free to choose, subject to
purchasing power constraint
End
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