Transcript Perfect Competitive Market

Perfect Competition
Sometimes referred to as Pure
Competition or just The
Competitive Firm
Market Structure (there are
4) (what is it?)

A specific environment the firm
operates in which influences decisions
on pricing and output.
Background on Markets
When economists analyze the production
decisions of a firm, they take into account
the structure of the market in which the
firm is operating.
Four Different Market Structures:
 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly
Market Model Price/Output
Market economy… varies from one seller to
many sellers…
None is “typical.”
Each unique and attempting to operate with
his “self-interest” in mind.
Look at the “Models” for the 4 market
categories… How does each determine
the price to charge and the output to
produce?
Market structure
characteristics
All four market structures have four distinguishing
characteristics:
 The number and size of the firms in the market.
 The ease with which firms may enter and exit the
market.
 The degree to which firms’ products are
differentiated.
 The amount of information available to both
buyers and sellers regarding prices, product
characteristics and production techniques.
The Theory of Perfect Competition is
based on 4 assumptions
:
(1) There
are many sellers and many buyers,
none of which is large in relation to total
sales or purchases.
(2) Each firm produces and sells a
homogeneous product.
(3) Buyers and sellers have all relevant
information with respect to prices, product
quality, sources of supply, and so on.
(4) There is easy entry into and exit from the
industry.
Perfect Competitive Market
Why teach about a non-existent form
of competition?
 Questions to answer:
 What are profits?
 What are the unique characteristics of
competitive firms
 How much output will a competitive
firm produce

A Perfectly Competitive Firm is
a Price Taker

A seller that does not have the
ability to control the price of the
product it sells; it takes the price
determined in the market.
Distinction in terminology
Speak of “the firm” we are referring to
the individual firm.
Speak of the “market,” we are referring
to the industry. We mean all the
firms in the aggregate.
The Demand Curve of the
Perfect Competitor

Question

If the perfectly competitive firm is a
price taker, who or what sets the
price?
The Demand Curve of the
Perfect Competitor

The perfectly competitive firm is a
price taker, selling a homogenous
commodity with perfect substitutes.

Will sell all units for $5

Will not be able to sell at a higher
price

Will face a perfectly elastic demand
curve at the going market price
Figure 24-1 The Demand Curve
for a Producer of Secure Digital
Cards
How Much Should the
Perfect Competitor
Produce? (cont'd)
Profit p = Total revenue (TR) – Total cost (TC)
TR = P x Q
TC = TFC + TVC
P determined by the market in perfect competition
Q determined by the producer to maximize profit
Figure 24-2 Profit
Maximization, Panel (a)
Take a personal look?
How many of you owned a computer 15 years
ago?
 How many still own a compact disc player today?
 How many have discarded the VCR in favor of a
DVD?
 Do you own an Ipod?
 Do you own an IPhone?
 Do you own an Ipad?
 Do you own a Blackberry?
 Do you own a graphing calculator?
 Did your parents have a graphing calculator
 How did your parents type project papers for
economics class?
Competition & technology advancement has
brought the above changes about.

Price Taker Discussion
When there are many firms, all producing and
selling the same product using the same inputs
and technology, competition forces each firm to
charge the same market price for its good.
 Because each firm sells the same homogeneous
product, no single firm can increase the price
that it charges above the price charged by other
firms in the market (without losing business.)
 No single firm can affect the market price by
changing the quantity of output it suppliesbecause many firms- each firm is small in size.
Cannot change the amount of
sand.
Demand Curve
Individual firm/industry



The perfect competitor faces a horizontal or
perfectly elastic demand curve.
The demand curve is identical to the
Marginal Revenue Curve (because the firm
can sell as much as it wants to sell at
market price.) It is not necessary to lower
the price to sell more.
The demand curve for the entire industry
slopes downward (this is a result of
aggregate entries and exits into the market.)
Price Taker’s Demand Curve
• The market forces of supply and demand determine price.
• Price takers have no control over the price that they may
charge in the market. If such a firm was to offer their
good/service at a price above that established by the market
they would buy elsewhere.
Price
Price
Market
Supply
Individual firms must
take the market price.
P
Demand for
Single Firm
Price is determined
in the market.
P
Market
Demand
Output / Time
Output / Time
Demand Curve


Market Demand
Curves vs. Firm
Demand Curves
While the actions of
a single competitive
firm are negligible,
the unified actions
of many such firms
are not.

The individual
firm’s equilibrium
quantity of output
will be completely
determined by the
amount of output
the individual firm
chooses to supply
SHORT RUN





In the short-run, individual firm may make profit
or loss
In long run will break even
You can always tell if the firm is making a profit
or loss by looking at the DEMAND CURVE AND
THE ATC CURVE
If the demand curve is ABOVE the ATC curve
at any point the firm will make a profit.
If the demand curve is always BELOW the
ATC curve the firm will lose money.
Price Quantity
$8
8
8
8
8
8
8
8
8
1
2
3
4
5
6
7
8
9
Total
Revenue
$ 8
16
24
32
40
48
56
64
72
Total Revenue
Total Revenue
$96
88
80
72
64
56
48
40
32
24
16
8
0
Total revenue
pe= $8
1 2 3 4 5 6 7 8 9 10 11 12
Quantity
Most profitable point for
any firm
Profit maximization is where
MC = MR
Efficiency:
A firm operates at peak efficiency when
it produces its product at the lowest
possible cost… That would be at the
MINIMUM POINT OF ITS ATC
CURVE – the break even point.
Profit-Maximization Rule
Profit is maximized by producing the
quantity of output at which MR = MC.
 For Perfect Competition, profit is
maximized when P = MR = MC*


* This condition is unique for perfect competition and does not hold for other
market structures.
Realization
Marginal Cost
 A firm’s goal is not to maximize
revenues, but to maximize profits.
 Marginal revenue is compared to marginal
costs to determine the best level of output.


What an additional unit of output brings in
is its marginal revenue (MR).
Profit Maximization
$18
Marginal cost
Price or Cost (per bushel)
16
14
p = MC
MRB
Profits decreasing
Price (= MR)
12
10
Profits increasing
8
Profit-maximizing
rate of output
6
4
2
0
MCB
1
2
3
4
5
Quantity (bushels per day)
6
7
Profit Maximization when the
• In the short run, the price
Firm is a Price Taker
taker
will expand output until
marginal
revenue (price) is just equal to
marginal cost.
• This will maximize the firm’s
profits (rectangle BACP).
Price
MC
p = MC
Profit
P
• When P > MC then the firm can C
make more on the next unit sold
than it costs to increase output
for that unit. In order for the
firm to maximize its profits it
increases output until MC = P.
• When P < MC then the firm
made less on the last unit sold
than it cost for that unit. In
order for the firm to maximize
0
its profits it decreases output
until MC = P.
ATC
B
d (P = MR)
A
P > MC
P < MC
decrease q
Increase q
q
Output
/ Time
Marginal Revenue / Marginal Cost Approach
Marginal Marginal
Revenue Cost
Profit
Output (MR)
(MC) (TR - TC)
0
1
2
..
.
8
9
10
11
12
13
14
15
16
17
18
19
20
21
---5
5
..
.
5
5
5
5
5
5
5
5
5
5
5
5
5
5
---$ 4.80
$ 3.95
..
.
$ 1.50
$ 1.25
$ 1.00
$ 1.25
$ 1.75
$ 2.50
$ 3.50
$ 4.75
$ 6.00
$ 7.25
$ 8.25
$ 9.50
$ 13.00
$ 17.00
- 25.00
- 24.80
- 23.75
..
.
- 8.00
- 4.25
- .25
3.50
6.75
9.25
10.75
11.00
10.00
7.75
4.50
0.00
- 8.00
- 20.00
• We can show the relationship between the
TR/TC and the MR/MC approach.
• Below, low levels of output deliver
marginal revenue to the firm greater than
the marginal cost of increased output.
• After some point, though, additional units
cost more than their marginal revenue.
• Profit is maximized where P = MR = MC.
• Both the TR/TC and the MR/MC method
yield the same profit maximizing output, q=15
Price and Cost
Per Unit
9
7
5
MC
Profit Maximum
P = MR = MC
MR
3
1
Output Level
2 4 6 8 10 12 14 16 18 20 22
Operating
• In the graph to the right, the firm
operates at an output level where
p = MC, but here ATC > MC
resulting in a loss for the firm.
• The magnitude of the firm’s
short-run losses is equal to the
size of the of the rectangle BACP1
• A firm experiencing losses but
covering its average variable costs
will operate in the short-run.
• A firm will shutdown in the
short-run whenever price falls
below average variable cost (P2).
• A firm will shutdown in the
long-run whenever price falls
below average total cost.
PriceMC
ATC
Loss
AVC
C
P1
A
B
d (P = MR)
P2
p = MC
0
q
Output
/ Time
Where is pure profit? Normal
Profit?
• Given Pe, firm produces qe where MC = MR
 If AC = AC1, break-even
• If AC = AC2, losses
• If AC = AC3, economic profit
Long Run

In the long run there is time for firms to
enter or leave the industry. This factor
ensures that the firm will make ZERO
profits in the long run.
Terminology Check
Pure Profit (attracts individual firms into
the market)
Zero or Normal Profit (can still make a
decent living, but cannot go to
Germany for vacation.) Firms not
attracted at this profit level.
Going into Business-
Pure Competition in 60
seconds

http://www.youtube.com/watch?v=nv9
gzUUU7Mk
Long Run

In the LR, no firm will accept losses.

It will simply close up shop and go
out of business.

But also remember – one firm leaving
the industry WILL NOT affect market
price.
LR Continued



If one firm is losing money, presumably others
are too.
When enough firms go out of business, industry
supply declines which pushes price up…
This price rise is reflected in a new demand
curve for the firm.
P
D1
D2 S2 S1
Q
MC
ATC
$60
$50
MR (D)

For the perfect competitor in the LR,
the most profitable output is at the
minimum point of its ATC curve.

The firm is forced to operate at peak
efficiency and that is why it operates at the
minimum of its ATC curve.. Not anything to
do with virtue------- just competition.
Remember… Firm Demand Curve is
Different from Industry’s Demand Curve
Price
Price
Market
Supply
Individual firms must
take the market price.
P
Demand for
Single Firm
P
Market
Demand
Output / Time
Output / Time
Point of Fact
For virtually every industry---- a firm will be
able to lower its ATC if it can expand up to
a certain point.
 If it expands beyond that point… ATC will
rise.
 Two concepts: Increasing and Decreasing
costs.
 The third alternative is constant costs.

Economies of Scale
Economies of scale
COST (dollars per unit)
Constant returns to scale
Diseconomies of scale
ATC3
ATC1
ATCS
ATCS
m1
c
c
0
QM
RATE OF OUTPUT
(units per period)
0
ATCS
ATC2
m2
QM
RATE OF OUTPUT
(units per period)
m3
c
0
QM
RATE OF OUTPUT
(units per period)
The Long-Run Industry
Situation: Exit and Entry
(cont'd)

Constant-Cost Industry

An industry whose total output can be
increased without an increase in longrun per-unit costs

Its long-run supply curve is horizontal.
The Long-Run Industry
Situation: Exit and Entry
(cont'd)

Increasing-Cost Industry

An industry in which an increase in
industry output is accompanied by an
increase in long-run per unit costs

Its long-run industry supply curve
slopes upward.
The Long-Run Industry
Situation: Exit and Entry
(cont'd)

Decreasing-Cost Industry

An industry in which an increase in
industry output leads to a reduction in
long-run per-unit costs

Its long-run industry supply curve
slopes downward.
Decreasing Cost Industry
Decreasing cost industry can lower
ATCs by increasing output – thus
taking advantage of “economies of
scale”
 examples such as discounts from
buying or selling large quantities,
declining average fixed cost as output
expands, and lower costs resulting
from specialization

Increasing Cost Industry
Increasing Cost Industries “diseconomies
of scale” overwhelm economies of scale.
 These diseconomies drive costs up,
pushing firms into the rising segment of
their ATC curves. (examples would be
managerial inefficiencies, cost of
maintaining a huge bureaucracy,
difficulties of communication among
various branches, also diminishing
returns.)

Factor Costs
Factor costs mean wages, rent and interestare far the most important determinants of
whether costs are falling, constant or
increasing.
 Usually factor costs will eventually rise
which makes every industry an increasing
costs industry. Example: as more and more
land is used by an expanding industry, rent
will be bid up…
Time influences supply: Whether industry
is in SR or LR …all can adjust in LR if
desire to do so.

Katrina Cottages
Profit
- what kind is it???




Pure Profit -an amount above that
necessary to keep the owner in the
industry… is not considered part of total
cost
Pure profit is the residual after all costs
(including normal profit) have been met
Pure profit will attract other firms into
the market
Normal Profit will not induce firms into
the market- nor are they low enough to
force others to leave.. Breaking even..
Basic Info
As long as MR is greater than MC the
firm will find an advantage in
increasing its production.
 Rule is: The most profitable point for
any firm is the point at which MC =
MR. The firm can improve its profit
position by increasing its output up to
the point where MC crosses MR.

Shutdown point for a firm




A firm compares total revenue with total cost
to see what its profit or loss is.
Remember there are fixed and variable costs.
Fixed costs have to be paid whether
operating or not.
Suppose: a firm’s total cost is $300,000 at a
certain level of output. $200,000 made up of
variable costs,such as labor and raw
materials and $100,000made up of fixed costs
such as interest payments, taxes, and rent.
Shutdown Continued
If the firm’s total revenue is $240,000 it is
clearly taking a loss. The difference
between TR and TC in this case is
$60,000.
 Notice that the total revenue of $240,000
pays all of the firms variable costs
($200,000) and also pays $40,000 of its
fixed cost. If the firm were to shut down on
the other hand, its loss would total
$100,000- the amount of the fixed cost.

There may be instances where the firm
can pay all fixed and part of variable.
In those cases, it is possible the firm
will opt for that.
BUT…. For the most part, and for you
to remember… if firm can pay variable
and part of fixed, they will continue to
operate.
Shutdown Continued
As long as a firm can cover ALL of its variable
cost by remaining in operation, it will do so.
 ****It’s shutdown point will be where TR no
longer covers TVC.
Shutdown: when MR falls below the firm’s
minimum AVC. When a firm shuts down, it does
not necessarily leave the industry. Shutdown is a
SR response…and is based on fixed costs of
established plant and variable costs of operating
it.

Profit
Maximization and
Loss
Minimization for
the Perfectly
Competitive Firm:
Three Cases I


In Case 1, TR TC and
the firm earns profits.
It continues to
produce in the short
run.
Profit Maximization and
Loss Minimization for the
Perfectly Competitive
Firm: Three Cases II


In Case 2, TR < TC
and the firm takes a
loss.
It shuts down in the
short run because it
minimizes its losses by
doing so; it is better to
lose $400 in fixed costs
than to take a loss of
$450.
Profit Maximization and
Loss Minimization for the
Perfectly Competitive
Firm: Three Cases III


In Case 3, TR < TC and
the firm takes a loss.
It continues to produce in
the short run because it
minimizes its losses by
doing so; it is better to
lose $80 by producing
than to lose $400 in fixed
costs by not producing.
What Should a Perfectly
Competitive Firm Do in the Short
Run?


The firm should produce in the short run as long
as price (P) is above average variable cost
(AVC).
It should shut down in the short run if price is below
average variable cost.
Long-run Equilibrium
• The two conditions necessary for long-run equilibrium in a
price-taker market are depicted here.
• First, the quantity supplied and the quantity demanded must
be equal in the market, as shown below at P1 with output Q1.
• Second, the firms in the industry must earn zero economic
profit (that is, the “normal market rate of return”) at the
established market price (P1 below).
Price
Price
Ssr
MC ATC
P1
d
P1
D
q1
Firm
Q1
Output
Market
Output
The Lure of Profits




In competitive markets, economic profits attract
new entrants.
Low entry barriers permit new firms to enter
competitive markets.
The entry of new firms shifts the market supply
curve to the right.
As long as economic profits are available in
short-run competitive equilibrium, new entrants
will continue to be attracted.
p = MC

Short-run competitive equilibrium:
A Shift of Market Supply
Any short-run equilibrium will not
last.



As supply increases, price drops, to the minimum
of ATC.
Once at minimum of ATC, there are no longer
economic profits to attract firms to enter.
In long-run equilibrium, entry and exit cease, and
zero economic profit (i.e., normal profit) prevails.

Long-run equilibrium:
p =MC =minimum ATC
Short- vs. Long-Run
Equilibrium
PRICE OR COST
MC
pS
qS
QUANTITY
ATC
Long-run equilibrium
(p = MC = ATC)
PRICE OR COST
Short-run equilibrium
(p = MC)
MC
pS
pL
qL
QUANTITY
ATC
Long-Run Rules for Entry
and Exit
Price Level Result for typical firm
Market Response
P > ATC
Profits
New firms enter
industry, Existing firms
expand
P < ATC
Loss
Firms exit industry,
Existing firms contract
P = ATC
Break even
No exit or entry,
Existing firms maintain
current capacity
Further Supply Shifts
With strong competition, often the only
way for a firm to improve profitability is to
reduce costs.
 Cost reductions can be accomplished
through technological improvements. This
might increase productivity.


Technological improvements are illustrated
by a downward shift of the ATC and MC
curves.
Technology improvements noted below
PRICE (per computer)
Old MC New MC
Old ATC
New ATC
J
$700
N
R
0
430
600
QUANTITY (computers per month)
Allocative Efficiency

The market mechanism works best in
competitive markets.

Market mechanism - The market
mechanism is the use of market prices and
sales to signal desired output.
Allocative efficiency means that we are
producing the right output mix.
 The price signal the consumer gets in a
competitive market is an accurate
reflection of opportunity cost.

Production Efficiency

Production efficiency means that we
are producing at minimum average total
cost.

Efficiency (production) – Maximum
output of a good from the resources used
to produce it.
When competitive pressure on prices is
carried to the limit, the products in
question are also produced at the least
possible cost.
 Society is getting the most it can from its
available (scarce) resources. This market
model is the best “buy” for consumers.

Reality of Attaining a Profit







The sequence of events common to a competitive market
situation includes the following.
High prices and profits signal consumers’
demand for more output.
Economic profit attracts new suppliers.
The market supply shifts to the right
Prices slide down the market demand curve.
A new equilibrium is reached with increased
quantities being produced and sold and the
economic profit approaching zero.
Producers experience great pressure to keep
ahead of the profit squeeze by reducing costs.
Profits Are The Bottom Line