15 June 2013

Perfect Competition (Week 9)

PowerPoint Slides by Mr Neil Lau

I-Station Solutions Sdn Bhd

An Introduction to Perfect Competition

Market structure describes the following: Number of suppliers (or sellers) Products degree of uniformity (selling identical products?) Ease of entry and exit into the market Forms of competition among forms (how do firms compete) Industry All firms supplying output to a market

Perfectly Competitive Market Structure

Many buyers and sellers Commodity; standardized product Fully informed buyers and sellers No barriers to entry Individual buyer or seller No control over price Price takers

Demand Under Perfect Competition

Market price Determined by Supply and Demand Demand curve facing one supplier Horizontal line at the market price Perfectly elastic (remember?) Price taker (Seller has no power to set the price) Why?

Market Equilibrium and a Firms Demand Curve in Perfect Competition

(a) Market equilibrium
S Price per bushel

(b) Firms demand

Price per bushel

$5

$5

D 0

1,200,000

Bushels of wheat per day

10

15

Bushels of wheat per day

Market price ($5)- determined by the intersection of the market demand and market supply curves. A perfectly competitive firm can sell any amount at that price. The demand curve facing the perfectly competitive firm - horizontal at the market price.

Short-Run Profit Maximization

Maximize economic profit when Quantity at which TR exceeds TC by the greatest amount Total revenue TR Total cost TC (include implicit?) Profit = TR TC If TR > TC: economic profit If TC > TR: economic loss

Short-Run Profit Maximization

Marginal revenue MR = P = AR (perfect competition) Marginal cost MC Maximize economic profit: Increase production as long as each additional unit adds more to TR than TC Golden rule Expand output: if MR>MC Stop before MC>MR

Short-Run Cost and Revenue for a Perfectly Competitive Firm

Total dollars

$60 48

(constant) Total cost Total revenue (=$5 q) Maximum economic profit = $12

Short-Run Profit Maximization

(a) Total revenue minus total cost TR: straight line, slope=5=P TC increases with output Max Economic profit: where TR exceeds TC by the greatest amount OR (b) Marginal cost equals marginal revenue (MR.MC) MR: horizontal line at P=$5 Max Economic profit: at 12 bushels, where MR=MC

15 0 5 7 10 12 15 Bushels of wheat per day

Dollars per bushel

e $5

Marginal cost Average total cost

Profit a

d = Marginal revenue = Average revenue

10 12 15

Bushels of wheat per day

Minimizing Short-Run Losses

When should you shut down if not making economic profit in the short run? TC = FC+VC If shut down in short run: still have to pay fixed cost If TC<TR: economic loss Produce if TR>VC (P>AVC) or (TR/Q > VC/Q) Revenue covers variable costs and a portion of fixed cost (you can cover a bit of fixed cost here) Loss < fixed cost Shut down if TR<VC (P<AVC) Loss = FC (you dont pay VC here)

Minimizing Short-Run Losses

Total cost
Total dollars

Total revenue (=$3 q)

Short-Run Loss Minimization

(a) Total revenue minus total cost
TC>TR; loss Minimize loss: 10 bushels

$40 30 15 0 5 10

Minimum economic loss = $10

15

Bushels of wheat per day Average total cost Average variable cost

Marginal cost
Dollars per bushel

$4.00 3.00 2.50

Loss

(b) Marginal cost equals marginal revenue

MR=MC=$3; ATC=$4 P=$3; P>AVC Continue to produce in short run

d = Marginal revenue = Average revenue

10

15

Bushels of wheat per day

Firm and Industry Short-Run S Curves

Short-run firm supply curve Upward sloping portion of MC curve Above minimum AVC curve Short-run industry supply curve Horizontal sum of all firms short-run supply curves

Summary of Short-Run Output Decisions

Break-even Firms short-run S curve Marginal cost point 5 p5>ATC, q5, economic profit d5 Average total cost 4 p4=ATC, q4, normal profit d4 Average variable cost 3 ATC>p3>AVC, q3, loss <FC d3 2 p2=AVC, q2 or 0, loss=FC d2 1 d1 p1<AVC, shut down, Shutdown q1=0,loss=FC point q1 q2 q3 q4 q5 Quantity per period

p5 Dollars per unit

p4
p3 p2 p1 0

Aggregating Individual Supply to Form Market Supply

(a) Firm A Price per unit SA (b) Firm B SB (c) Firm C SC SA + SB + SC = S (d) Industry, or market, supply

p p

p p

p p

p p

10 20
Quantity per period

10 20
Quantity per period

10 20
Quantity per period

30

60

Quantity per period

Firm Supply and Market Equilibrium

Short run, perfect competition Market converges to equilibrium P and Q Firm Max profit Min loss Shuts down temporarily

Short-Run Profit Maximization and Market Equilibrium

Market price $5 determines the perfectly elastic demand curve (and MR) facing the individual firm.

S = horizontal sum of the supply curves of all firms in the industry Intersection of S and D: market price $5

Perfect Competition in the Long Run

Long run

Firms enter/exit the market Firms adjust scale of operations

Increase or decrease quantity Until average cost is minimized (smallest)

All resources are variable

Perfect Competition in the Long Run

Economic profit in short run attracts new firms

New firms enter market in long run

Existing firms expand in long run

Market S increases (shift rightwards)

P decreases (P < ATC)

Economic profit disappears

Firms break even (P = ATC)

Perfect Competition in the Long Run

Economic loss in short run discourage new firms

Some firms exit the market in long run Some firms reduce scale in long run Market S decreases (shift leftwards)

P increases (P>ATC ?) Economic loss disappears

Firms break even (P=ATC)

Zero Economic Profit in the Long Run

Firms enter, leave, change scale

Market:

S shifts; P changes d(P=MR=AR) shifts Long run equilibrium

Firm

MR=MC =ATC=LRAC Normal profit Zero economic profit

Long-Run Equilibrium for a Firm and the Industry

(a) Firm
MC Dollars per unit ATC e LRAC Price per unit

(b) Industry or market

S

p D

Quantity per period

Quantity per period

Long run equilibrium: P=MC=MR=ATC=LRAC. No reason for new firms to enter the market or for existing firms to leave. As long as the market demand and supply curves remain unchanged, the industry will continue to produce a total of Q units of output at price p.

Long-Run Adjustment to a Change in Demand

Effects of an Increase in Demand (rightward shift)

Short run

P increases; d increases Firms increase quantity supplied Economic profit New firms enter the market (attracted by economic profit) S increases, P decreases Firms d curve decreases Normal profit

Long run

Long-Run Adjustment to an Increase in Demand

(a) Firm
MC Dollars per unit p Profit Price per unit d ATC LRAC p

(b) Industry or market

S b S

a
p

c D D

S*

Quantity per period

Qa Q b

Qc

Quantity per period

Increase in D to D moves the market equilibrium point from a to b; firms demand increases to d; economic profit in short run.

Long run: new firms enter the industry; supply increases to S; price drops back to p; firms demand drops back to d.

Long-Run Adjustment to a Change in D

Effects of a Decrease in Demand

Short run

P decreases; d decreases Firms decrease quantity supplied

Economic loss
Firms exit the market S decreases, P increases Firms d curve increases Normal profit

Long run

Long-Run Adjustment to a Decrease in Demand

(a) Firm
MC Dollars per unit Price per unit

(b) Industry or market

S S

ATC LRAC p p Loss

g p p f

d
d

Long run S*
D

D Qa

Quantity per period

Qg

Qf

Quantity per period

Decrease in D to D moves the market equilibrium point from a to f; firms demand decreases to d; economic loss in short run.

Long run: firms exit the industry; supply decreases to S; price increases back to p; firms demand rises back to d.

The Long-Run Industry Supply Curve

Short run Change quantity supplied along MC curve until MR=MC Long run industry supply curve S* After firms fully adjust Constant-cost industries LRAC doesnt shift with output Long run S* curve for industry: straight horizontal line

Increasing Cost Industries

Average costs increase as output expands Effects of an increase in demand Short run P increases; d increases Firms increase q; Economic profit Long run New firms enter the market; Market: S increases; P decreases Firm: MC and ATC increase; d curve decreases; Zero economic profit

An Increasing-Cost Industry

D increases to D, new short-run equilibrium: point b. Higher price pb; firms demand curve shifts up (db); economic profit, which attracts new firms. Input prices go up, MC and ATC curves shift up. Market S increases to S; new price pc, firms demand curve shifts down to dc; normal profit.

Perfect Competition and Efficiency

Productive efficiency: Making Stuff Right Produce output at the lowest possible cost Min point on LRAC curve P = min average cost in long run Allocative efficiency: Making the Right Stuff Produce output that consumers value most or lowest possible price (why P is not zero?) Marginal benefit = P = Marginal cost Allocative efficient market

Whats So Perfect About Perfect Competition?

Consumer surplus Consumers pay less (P) than they are willing to pay (along D curve) Producer surplus Producers are willing to accept less (along S curve; MC) than what they are receiving (P) Gains from voluntary exchange Consumer and producer surplus Productive and allocative efficiency Maximum social welfare

Consumer Surplus and Producer Surplus for a Competitive Market

Dollars per unit S Consumer surplus Producer surplus m

Consumer surplus: area above the market-clearing price ($10) and below the demand.
Producer surplus: area above the short-run market supply curve and below the market-clearing price At p=$5: no producer surplus; the price just covers each firms AVC. At p=$6: producer surplus is the area between $5, $6, and S curve.

$10 6 5

100,000 200,000 120,000

Quantity per period

15 June 2013

The End

I-Station Solutions Sdn Bhd

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