Market: Perfect Competition

Agenda for discussion

Market structure Perfect Competition Market Demand and Market Supply The Competitive Firms Demand Curve Equilibrium of the industry in the perfect competition Equilibrium of the firm: Profit Maximization The Shutdown Point

Market structure
The characteristics of a market that influence how trading takes place
1. How many buyers and sellers? 2. Products: standardized or significantly different? 3. Barriers to entry/exit ?

Market structure
Types of markets
Perfect competition Monopoly Monopolistic competition

Perfect CompetitionCharacteristics
Many buyers and sellers
no individual decision maker can significantly affect the price of the product

Standardized product
buyers do not perceive differences between the products

Sellers can easily enter/exit the market

no significant barriers to discourage new entrants

Perfect CompetitionCharacteristics
Each firm attempts to maximize profits Each firm is a price taker

Its actions have no effect on the market price

Information is perfect Transactions are costless

Market Demand curve of the Industry

To derive the market demand curve, we sum the quantities demanded at every price
px Individual 1s demand curve px Individual 2s demand curve px Market demand curve

px*

x1
x1*

x2 x
x2*

X x
X*

x1* + x2* = X*

Market Supply Curve of the industry

To derive the market supply curve, we sum the quantities supplied at every price
P Firm As supply curve sA P sB P Firm Bs supply curve Market supply curve S

P1

q1A

quantity

q1B

quantity

Q1

Quantity

q1A + q1B = Q1

Equilibrium of Industry under perfect competition

Sl. No. Price ( in Rs.) Market Market Supply Demand (Pen) = total (Pen) = total of of individual individual demand demand 2500 2400 2200 2000 1800 1500 1200 1000 800 500 400 100 400 500 600 1000 1300 1500 1800 2000 2500 2800 3000 3500 Equilibrium Or Disequilibrium

1 2 3 4 5 6 7 8 9 10 11 12

5 10 15 20 25 30 35 40 45 50 55 60

Disequilibrium Disequilibrium Disequilibrium Disequilibrium Disequilibrium Equilibrium Disequilibrium Disequilibrium Disequilibrium Disequilibrium Disequilibrium Disequilibrium

Perfect Competition
Individual Demand Curve Quantity Demanded at Different Prices Quantity Supplied at Different Prices Individual Supply Curve

Added together Market Demand Curve Quantity Demanded by All Consumers at Different Prices

Added together Quantity Supplied by All Firms at Different Prices Market Supply Curve

Market Equilibrium
P S D Q

Quantity Demanded by Each Consumer

Quantity Supplied by Each Firm

Equilibrium of the firm: Break even point Total Cost and Total Revenue

Total Revenue
Total Cost

The amount that the firm receives for the sale of its output. The amount that the firm pays to buy inputs.

Profit is the firms total revenue minus its total cost.

Profit = Total revenue - Total cost

Equilibrium of the firm: Break even point Total Cost and Total Revenue
Quantity 1 2 3 Price 400 400 400 Total Revenue 400 800 1200 Total Cost 550 1000 1200 Break even point Break even point

4
5

400
400

1600
2000

1500
1700

6
7 8

400
400 400

2400
2800 3200

1850
1950 2500 Maximum Profit

Equilibrium of the firm: Break even point Total Cost and Total Revenue
Price, TR And TC 2,800 1,950 Break Even point A

TR

TC Profit = TR-TC Maximum Profit = 850

550

Slope = 400

10 Quantity

Equilibrium of the firm: Marginal Cost and Marginal Revenue

Total Profit = TR TC Equilibrium of the firm : MR=MC

The Competitive Firms Demand Curve

1. The intersection of the market supply and the market demand curve Price Market S Price 3. The typical firm can sell all it wants at the market price Firm

400 D

Rs400

Demand Curve Facing the Firm

Output 2. determines the equilibrium market price

Output 4. so it faces a horizontal demand curve.

Profit Maximization
Price

(MR=MC)

Profit maximization MR=MC 400

MC

d = MR

10 Output

Profit Maximization
Total Profit = TR TC MR>MC increase output Maximize profit: MR=MC Measuring Total Profit
Profit per unit = P ATC

If P > ATC the firm earns profit If P < ATC the firm suffers a loss

Measuring Profit or Loss

Total profit = profit per unit *Q ATC Profit per unit=revenue per unit - cost per unit Profit per unit (`Rs.100) MC d = MR MR=MC Q=7

Price

400 300

Output

Measuring Economic Profit or Loss

Price Total loss = loss per unit *Q Loss per unit= cost per unit - revenue per unit Loss per Unit(100) MR=MC Q=5 300 200

MC
ATC d = MR Output

The Firms Short-Run Supply Curve

The firm takes the market price as given decides how much output to produce at that price Profit-maximizing output level: P=MC As price of output changes, firm will slide along its MC curve in deciding how much to produce

The Firms Short-Run Supply Curve

(a)

(b)
Price

ATC 3.50 2.50 2.00 1.00 0.50

MC d1=MR1 d2=MR2 d3=MR3 d4=MR4 d5=MR5

Firm's Supply
Curve

3.50 2.50 2.00 1.00 0.50 2,000 4,000 7,000 5,000

Output

AVC

1,000 4,000 7,000 2,000 5,000

Output

The Shutdown Point

Price at which a firm is indifferent between producing and shutting down If P>AVC produce If P<AVC shut down Firms supply curve
Is its MC curve for all prices above AVC

Competitive Markets in the Short- Run

Fixed number of firms in industry Market supply curve
Quantity of output - all sellers in a market will produce at different prices Add up the quantities of output supplied by all firms in the market at each price

Competitive Markets in the ShortRun

1. At each price . . . Firm
Price Firm's Supply Curve 3.50 2.50 2.00 3.50 2.50 2.00 1.00 0.50 Price Market Supply Curve 3.The total supplied by all firms at different prices is the market supply curve. Market

1.00 0.50 2,000 4,000 7,000 5,000

2. the typical firm supplies the profit-maximizing quantity. Output

400,000 700,000 Output 200,000 500,000

Short-Run Equilibrium
Competitive firms can earn economic

profit, or suffer an economic loss

The market sums buying and selling preferences of individual consumers and producers, and determines market price Each buyer and seller Takes market price as given Is able to buy or sell the desired quantity

Short-Run Equilibrium in Perfect Competition

1. When the demand curve is D1 and market equilibrium is here . . . Price 3.50 Market S 2. the typical firm operates here, earning economic profit in the short run. Firm Price MC ATC 3.50 Loss per unit at p =2 2.00 d1 d2 Profit per Bushel at p = 3.50 4,000 7,000

2.00

D1

D2
400,000 700,000

Output

Output

3. If the demand curve shifts to D2 and the market equilibrium moves here . . .

4. the typical firm operates here and suffers a short-run loss.

Competitive Markets in the Long Run

New firms can enter the market Existing firms can exit the market Profit and loss in the long run
Economic profit - outsiders enter the market Economic losses - firms exit the market

From SR Profit to LR Equilibrium

Economic profit attracts new entrants Market supply curve - shifts rightward Market price - falls Demand curve facing each firm - shifts downward Each firm - decreases output

Positive economic profit attracts new entrants until economic profit = 0

Long-Run Equilibrium
Market Price A 4.50 S1 With initial supply curve S1, market price is 4.50 Firm Price so each firm earns an economic profit. 4.50

MC A d ATC 1

900,000

Output

9,000

Output

From Short-Run Profit to Long-Run Equilibrium

Market Price A 4.50 4.50 S1 S2 Price

Firm

MC A d ATC 1 E

2.50

E D

2.50

d2

900,000 1,200,000
Profit attracts entry, shifting the supply curve rightward

Output

5,000

9,000

Output

until market price falls to Rs. 2.50 and each firm earns zero economic profit.

From SR Loss to LR Equilibrium

Economic losses - firms exit the market Market supply curve - shift leftward Market price - rises Demand curve facing each firm - shifts upward

Economic loses firms exit until economic loss = 0 In the LR, firms earn normal profit zero economic profit

Perfect Competition and Plant Size

In LR equilibrium, every firm will select
Plant size Output level

And
Operate at minimum point of LRATC curve

Perfect Competition and Plant Size

1. With its current plant and ATC curve the firm earns zero economic profit. Price MC1 P1 P* LRATC 3. As all firms increase plant size and output, market price falls to its lowest possible level . . . Price LRATC

ATC1
d1 = MR1

MC2 ATC
E

d2 = MR2

q1

Output

q*

Output

2. The firm could earn positive profit with a larger plant, producing here

4. and all firms earn zero economic profit and produce at minimum LRATC.

A Summary of the Competitive Firm in the LR

In long-run equilibrium, the competitive firm produces Q where: MC=minimum ATC=minimum LRATC=P Consumers are getting the best deal they could possibly get

An Increase in Demand
Short-run Rise in market price Rise in market quantity Economic profits Long-run Market equilibrium changes The long-run supply curve Relationship between market price and market quantity - after all long-run adjustments have taken place

Constant Cost Industry

Entry has no effect on input prices Industry output has no effect on individual firms cost curves Horizontal long-run supply curve The industry
supplies any amount of output demanded at an unchanged price

Constant-Cost Industry
Price

Market
S1

Price

Firm
MC ATC LRATC d1 = MR1

P1

P1

D1 Q1 Output q1 Output

Constant Cost Industry

Price
PSR

Market
S1 B
S2

Price
PSR

Firm
B MC
dSR = MRSR

C
P1 A SLR D2 D1 Q1 QSR Q2 Output q1 qSR P1 A

ATC LRATC d1 = MR1

Output

Increasing Cost Industry

Entry causes input prices to rise Each firms LRATC curve shifts upward as industry output increases Zero economic profit occurs at a higher price The long-run supply curve slopes upward

Increasing Cost Industry

Price
PSR P2 P1 A D2 D1 Q1 Q2 Output q1 Output

Market
S1 B C
S2 SLR

Price

Firm
LRATC2 LRATC1 d2 = MR2 d1 = MR1

C P2 P1 A

Decreasing Cost Industry

Entry by new firms decreases input prices Each firms LRATC curve shifts downward as industry output increases Zero economic profit occurs at a lower price The long-run supply curve slopes downward

Decreasing Cost Industry

Price

Market
S1

Price

Firm

PSR P1 P2 A

B C

LRATC1

S2
P1 SLR D1 P2 A C d1 = MR1 LRATC2 d2 = MR2

D2
Output q1 Output

Q1

Q2

Market Signals and the Economy

Market signals Price changes - cause changes in production to match changes in consumer demand Demand increases - price rises signals firms to enter the market industry output increases Demand decreases price falls signals firms to exit the market industry output decreases

A Change in Technology
A technological advance
rightward shift of the market supply curve market price decreases Short run - economic profit Long run - zero economic profit

Firms that refuse to use the new technology will not survive.

A Change in Technology
Market
Price S1 Price

Firm

S2

LRATC1 3

A
3 B 2 D 2

LRATC2 d1 = MR1
d2= MR

Q1

Q2

Output

1000

Output

Effects of Taxation Under Perfect Competition

There are three types of tax, government can impose: a Lump Sum Tax, a Profit Tax, and a Specific Tax (or Tax Per Unit of Output)

Imposition of Lump Sum Tax

The lump sum tax is like a fixed cost of the firm. Effect of this tax is similar to that increase in the fixed cost. This tax results in an upward shift of both AFC and ATC. The AVC and MC curves are not affected. (The tax is in the form of a fixed cost to the firm). MC curve is the supply curve of the firm, the equilibrium position of the firm is not affected in the short run. The same out put will be produced and the market supply and price will not change in the short run.

Imposition of Lump Sum Tax

Price

ATC Lump sum tax

ATC AVC MC

d = MR AFC lump sum tax

AFC

Q OUTPUT

Imposition of Profit Tax

A profit tax is related to the percentage of the net profit of the firm. Effect of profit tax is same as imposition of lump sum tax. It reduces the profit but does not affect the MC. In the short run equilibrium of the firm and industry will not change. In Long run firms were earning only normal profit. In the long run supply in the market would shift to the left and new equilibrium would be reached, with a higher price, lower quantity and smaller number of firms.

Imposition of profit tax

Price
P P1

Market
S2 B A
S1

D1

Q1

Output

Imposition of specific sales tax

This tax is related to the given amount of money i.e. per unit of output produced. This tax affects the MC curve. MC curve is supply curve of the firm. In this tax MC curve shift upwards to the left and price will rise. Market supply curve also shift upward to the left and price will rise.