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Perfect Competition
Lecture Plan
Market Morphology Features of Perfect Competition Demand and Revenue of a Firm Market Demand Curve and Firms Demand Curve Equilibrium of Firm Short Run Price and Output for the Competitive Industry and Firm Market Supply Curve and Firms Supply Curve Long Run Price and Output for the Industry and Firm
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Chapter Objectives
To introduce the basics of market morphology and identify the different market structures. To examine the nature of a perfectly competitive market. To understand market demand and firms demand under perfect competition. To help analyze the pricing and output decisions of a perfectly competitive firm in the short run and long run.
Market
Defined as the institutional relationship between buyers and sellers. Market refers to the interaction between buyers and sellers of a good (or service) at a mutually agreed upon price. Such interaction may be at a particular place, or may be over telephone, or even through the Internet! Sellers and buyers may meet each other personally, or may not ever see each other, as in E-commerce. Thus market may be defined as a place, a function, a process.
Market Morphology
Markets may be characterized on the basis of:
Number, size and distribution of sellers in any market Whether the product is homogeneous or differentiated Number and size of buyers:
large number of buyers but small size of individual buyer, the market will be evenly balanced between buyers and sellers. small number of buyers but their size is large, the market is driven by buyers preferences.
Absence or presence of financial, legal and technological constraints Perfect Competition Monopoly Monopolistic competition Oligopoly
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Thus we have:
Market Morphology
Type of market Number of firms Nature of product Number of buyers Freedom of entry and exit Examples
Perfect competition
Very Large
Homogeneous (undifferentiated)
Very Large
Unrestricted
Monopolistic competition
Oligopoly
Many
Few
Differentiated
Undifferentiated or differentiated Unique
Many
Few
Unrestricted
Restricted
Monopoly
Single
Many
Restricted
Monopsony
Many
Undifferentiated or differentiated
Single
Not applicable
Features
Presence of large number of buyers and sellers Homogeneous product Freedom of entry and exit Perfect knowledge Perfectly elastic demand curve Perfect mobility of factors of production No governmental intervention Price determined by market and Firm is a price taker.
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d PQ dQ
Firms are price takers and can supply as much as they want at the existing price in the market, thus: AR= MR= P(2)
Profit
Loss
Q1
Q*
Q2
Output
Maximum Profit O Q1 Q* Q2
Output
Profit () = TR - TC. Profit curve () begins from the negative axis, implying that the firm incurs losses at an output less than OQ1. At point A, i.e. output Q1 firm earns no profit no loss. Firm earns maximum profit at output OQ*. At point B, TR=TC again; profit is equal to zero, at output OQ2. Rational firm would try to maximise profit. 9
The market demand curve is the horizontal summation of individual demand curves.. The demand curve for an individual firm is a horizontal straight line showing that
the firm can sell infinite volume of output at the same price.
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INDUSTRY
S
Market Supply Price
Price
FIRM
P*
E S
P=AR=MR
D Q* Output
Output
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Equilibrium of Firm
Two conditions must be fulfilled for a profit maximizing firm to reach equilibrium:
First order condition: MR=MC or
d dR(Q) dC (Q) dQ dQ dQ
=0
Second order condition: Slope of MR curve < MC dMR dMC curve or <0
dQ dQ
The second order condition is a sufficient condition, because if the inequality sign is reversed, we arrive at a point of loss maximization.
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Short Run Price and Output for the Competitive Industry and Firm
In short run an individual firm may be in equilibrium and may earn
Supernormal profit: Normal profit: Losses: AR>AC AR=AC AR<AC
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Supernormal Profit
Firm is in equilibrium at OQ* output at market price P*, where both the conditions of equilibrium are fulfilled. TR= OP*EQ* (TR= AR.Q) TC= OABQ* (TC=AC.Q) Profit = AP*EB = (OP*EQ*-OABQ*) This is the supernormal profit made by the firm in the short run, because the market price P* (AR) is greater than average cost.
AR>AC
Price
MC E B
AC
P* A
AR=MR
Q *
Quantity
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Supernormal Profit
Firm is in equilibrium at OQ* output at market price P*, where both the conditions of equilibrium are fulfilled i.e. point E. TR= OP*EQ* (TR= AR.Q) TC= OABQ* (TC=AC.Q) Profit = AP*EB = (OP*EQ*-OABQ*) This is the supernormal profit made by the firm in the short run, because the market price P* (AR) is greater than average cost.
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AR>AC
Price
MC E B
AC
P * A
AR=MR
Q *
Quantity
Normal Profit
AC=AR=MC=MR
Price
MC E
AC
P*
AR=MR
Q *
In the short run some firms may earn only normal profit (when average revenue is equal to average cost). Firm is in equilibrium at OQ* output at market price P*, where both the conditions of equilibrium are fulfilled. TR= OP*EQ* TC= OP*EQ* TR=TC Firm makes normal profit, and actually ends up producing at the break even level of output.
Quantity
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AR<AC
MC AC
A P*
B E
AR=MR
Q*
Quantity
Firm is in equilibrium at OQ* output at market price P*, where both the conditions of equilibrium are fulfilled (point E). TC= OABQ* TR= OP*EQ* Loss= P*ABE = OP*EQ* - OABQ* The firm incurs loss or subnormal profit in the short run because the AC of producing this output is more than the market price hence TR<TC. The firm continues to produce at loss in the short run in anticipation of price rise.
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P*
AR=M R
Q*
Quantity
A firm incurring losses in the short run will not withdraw from the market, but will wait for market conditions to improve in the long run. Firm would continue production till price > average variable cost (P>AVC or AR>AVC). Point A denotes the shut down point, where price P* = AVC=AR. Any increase in VC above A or any fall in market price below P* will cause the firm to shut down.
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Condition II: If Price minimum AVC, then choose any output that would maximize profit. For any price above minimum AVC, the firm would choose an output level that would satisfy the conditions of profit maximization.
The supply curve of the firm would be identical to the short run marginal cost curve above the minimum point of the AVC curve.
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Long Run Price and Output for the Industry and the Firm
In the long run perfectly competitive firms earn only normal profits. AR=MR=MC=AC The reason is the unrestricted entry into and exit of firms from the industry in the long run. When existing firms enjoy supernormal profits in the short run new firms are attracted to the industry to gain profits.
The supply of the commodity in the market increases. Assuming no change in the demand side, this lowers the price level.
When firms are making losses in the short run, some may be forced to leave the industry in the long run.
Their exit from the industry causes a reduction in the supply of the product and as a result the equilibrium price rises.
This process of adjustment continues up to the point where the price line becomes tangential to the AC curve.
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Long Run Price and Output for the Industry and the Firm
Price
P1 P* P2 O
Prevailing price is OP1, Equilibrium at Point E1 and AR=MR=MC=AC Output OQ1 Firms earn supernormal LMC profit (AR>AC) LAC This will attract more firms, E1 increase in supply will reduce E* AR=MR the price till AC=AR, i.e. at P* E2 Prevailing price is OP2, Equilibrium at Point E2 and Output OQ2 Firms earn loss (AR<AC) Q2 Q* Q1 Quantity Some firms will exit, decrease in supply will increase the price till AC=AR, 22 i.e. at P*
Summary
A market is a place / process of interaction between sellers and buyers that facilitates exchange of goods and services at mutually agreed upon prices. Perfect competition is defined as a market structure which has many sellers selling homogeneous products at the market price. The equilibrium price is determined by demand and supply in the market Each firm sells a very small portion of the total industry output; hence it can not affect the price in the market and has to accept the price given to it by the market. As such, it is regarded as a price taker. A firm faces a perfectly elastic demand curve; hence average revenue is constant and is equal to marginal revenue. Profit maximizing output is that where marginal cost is equal to marginal revenue while marginal cost is increasing.
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Summary
In the short run firms can earn supernormal profits, or normal profits, or even loss. This depends on the position of the short run cost curves. The supply curve of the firm would be identical to the short run marginal cost curve above the minimum point of the AVC curve. The industry supply curve is obtained by the horizontal summation of the supply curves of all firms in the industry. In the long run perfectly competitive firms earn only normal profits. If firms are making supernormal profits in the short run, this would attract new firms and if firms are incurring losses; some firms would exit the market, leaving existing firms with normal profits in either case.
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