Chap011 Mkt Structure Perfect Competition

8/2/2019 Chap011 Mkt Structure Perfect Competition

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McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Perfect Competition

Chapter 11


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Laugher Curve

Q. How many economists does it take toscrew in a light bulb?

A. Eight.

One to screw it in and seven to holdeverything else constant.


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Perfect Competition

The concept of competition is used in twoways in economics.

Competition as a process is a rivalry amongfirms.

Competition as the perfectly competitive

market structure.


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A Perfectly Competitive

Market A perfectly competitive marketis one in

which economic forces operate

unimpeded.


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A Perfectly Competitive

Market A perfectly competitive market must meet

the following requirements:

Both buyers and sellers are price takers. The number of firms is large.

There are no barriers to entry.

The firms products are identical. There is complete information.

Firms are profit maximizers.


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The Necessary Conditions for

Perfect Competition Both buyers and sellers are price takers.

Aprice takeris a firm or individual who takes

the market price as given. In most markets, households are price takers

they accept the price offered in stores.


7/75McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.


Perfect Competition Both buyers and sellers are price takers.

The retailer is not perfectly competitive.

A retail store is not a price taker but a pricemaker.


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9/75McGraw-Hill/Irwin 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.


Perfect Competition There are no barriers to entry.

Barriers to entry are social, political, or

economic impediments that prevent otherfirms from entering the market.

Barriers sometimes take the form of patentsgranted to produce a certain good.


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Perfect Competition There are no barriers to entry.

Technology may prevent some firms from

entering the market. Social forces such as bankers only lending to

certain people may create barriers.


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Perfect Competition The firms' products are identical.

This requirement means that each firm's

output is indistinguishable from anycompetitor's product.


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Perfect Competition There is complete information.

Firms and consumers know all there is to

know about the market prices, products,and available technology.

Any technological breakthrough would beinstantly known to all in the market.


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Perfect Competition Firms are profit maximizers.

The goal of all firms in a perfectly competitive

market is profit and only profit. The only compensation firm owners receive is

profit, not salaries.


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The Definition of Supply and

Perfect Competition If all the necessary conditions for perfect

competition exist, we can talk formally

about the supply of a produced good.


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Perfect Competition Supplyis a schedule of quantities of

goods that will be offered to the market at

various prices.


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Perfect Competition When a firm operates in a perfectly

competitive market, its supply curve is that

portion of its short-run marginal cost curveabove average variable cost.


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Demand Curves for the Firm

and the Industry The demand curves facing the firm is

different from the industry demand curve.

A perfectly competitive firms demandschedule is perfectly elastic even thoughthe demand curve for the market is

downward sloping.


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Demand Curves for the Firm

and the Industry Individual firms will increase their output in

response to an increase in demand even

though that will cause the price to fall thusmaking all firms collectively worse off.


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Market supply

Marketdemand1,000 3,000

Price

$108

6

4

2

0Quantity

Market Firm

Individual firmdemand

Market Demand Versus

Individual Firm Demand Curve

10 20 30

Price

$108

6

4

2

0Quantity


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Profit-Maximizing Level of

Output The goal of the firm is to maximize profits.

Profit is the difference between total

revenue and total cost.


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Output What happens to profit in response to a

change in output is determined by marginal

revenue (MR) and marginal cost (MC). A firm maximizes profit when MC= MR.


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Output Marginal revenue(MR) the change in

total revenue associated with a change in

quantity. Marginal cost(MC) the change in total

cost associated with a change in quantity.


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Marginal Revenue

A perfect competitor accepts the marketprice as given.

As a result, marginal revenue equals price(MR = P).


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Marginal Cost

Initially, marginal cost falls and then beginsto rise.

Marginal concepts are best definedbetween the numbers.


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Profit Maximization:MC = MR

To maximize profits, a firm should producewhere marginal cost equals marginal

revenue.


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How to Maximize Profit

If marginal revenue does not equalmarginal cost, a firm can increase profit by

changing output. The supplier will continue to produce as

long as marginal cost is less than marginal

revenue.


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How to Maximize Profit

The supplier will cut back on production ifmarginal cost is greater than marginal

revenue. Thus, the profit-maximizing condition of a

competitive firm is MC = MR = P.


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C

A

P = D = MR

Costs

1 2 3 4 5 6 7 8 9 10 Quantity

60

5040

30

20

10

0

A

B

MC

Marginal Cost, Marginal

Revenue, and Price

0

123456789

10

$28.00

20.0016.0014.0012.0017.00

22.0030.0040.0054.0068.00

Price = MR QuantityProduced

MarginalCost

$35.00

35.0035.0035.0035.0035.0035.0035.0035.0035.0035.00



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The Marginal Cost Curve Is the

Supply Curve The marginal cost curve is the firm's supply

curve above the point where price exceeds

average variable cost.


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Supply Curve The MC curve tells the competitive firm

how much it should produce at a given

price. The firm can do no better than produce the

quantity at which marginal cost equals

marginal revenue which in turn equalsprice.


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Firms Supply Curve

A

B

CMarginal cost

Cost,Price

$70

60

5040

30

2010

0 1 Quantity2 3 4 5 6 7 8 9 10


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Firms Maximize Total Profit

Firms seek to maximize total profit, notprofit per unit.

Firms do not care about profit per unit. As long as increasing output increases total

profits, a profit-maximizing firm should

produce more.


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Profit Maximization Using

Total Revenue and Total Cost Profit is maximized where the vertical

distance between total revenue and total

cost is greatest. At that output, MR(the slope of the total

revenue curve) and MC(the slope of the

total cost curve) are equal.


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TC TR

0

Totalcost,reve

nue

$385350

315280245210175140

1057035

Quantity1 2 3 4 5 6 7 8 9

Profit Determination Using Total

Cost and Revenue Curves

Maximum profit =$81

$130

Loss

Loss

Profit

Profit =$45



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Total Profit at the Profit-

Maximizing Level of Output The P = MR = MCcondition tells us how

much output a competitive firm should

produce to maximize profit. It does not tell us how much profit the firm

makes.


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Determining Profit and Loss

From a Table of Costs Profit can be calculated from a table of

costs and revenues.

Profit is determined by total revenue minustotal cost.


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P = MR Output Total CostMarginal

Cost

Average

Total Cost

Total

Revenue

Profit

TR-TC

0 40.00 0 40.00

35.00 1 68.00 28.00 68.00 35.00 33.00

35.00 2 88.00 20.00 44.00 70.00 18.00

35.00 3 104.00 16.00 34.67 105.00 1.00

35.00 4 118.00 14.00 29.50 140.00 22.0035.00 5 130.00 12.00 26.00 175.00 45.00

35.00 6 147.00 17.00 24.50 210.00 63.00

Costs Relevant to a Firm



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P = MR Output Total CostMarginal

CostAverageTotal Cost

TotalRevenue

ProfitTR-TC

35.00 4 118.00 14.00 29.50 140.00 22.00

35.00 5 130.00 12.00 26.00 175.00 45.00

35.00 6 147.00 17.00 24.50 210.00 63.00

35.00 7 169.00 22.00 24.14 245.00 76.00

35.00 8 199.00 30.00 24.88 280.00 81.0035.00 9 239.00 40.00 26.56 315.00 76.00

35.00 10 293.00 54.00 29.30 350.00 57.00

Costs Relevant to a Firm



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From a Graph Find output where MC = MR.

The intersection ofMC = MR (P) determines

the quantity the firm will produce if it wishesto maximize profits.


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From a Graph Find profit per unit where MC = MR.

Drop a line down from where MC equals MR,

and then to the ATC curve. This is the profit per unit.

Extend a line back to the vertical axis to

identify total profit.


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From a Graph The firm makes a profit when the ATC

curve is below the MR curve.

The firm incurs a loss when the ATC curveis above the MR curve.


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Determining Profit and Loss From

a Graph Zero profit or loss where MC=MR.

Firms can earn zero profit or even a loss

where MC = MR. Even though economic profit is zero, all

resources, including entrepreneurs, are beingpaid their opportunity costs.


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(a) Profit case (b) Zero profit case (c) Loss case

Determining Profits Graphically

Quantity Quantity Quantity

Price65605550

454035302520

151050

65605550

454035302520

151050

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

D

MC

A P = MR

B ATC

AVCE

Profit

C

MC

ATC

AVC

MC

ATC

AVC

Loss

65605550

454035302520

151050

1 2 3 4 5 6 7 8 910 12

P = MR

P = MR

Price Price

The McGraw-Hill Companies, Inc., 2000Irwin/McGraw-Hill


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The Shutdown Point

The firm will shut down if it cannot coveraverage variable costs.

A firm should continue to produce as long asprice is greater than average variable cost.

If price falls below that point it makes sense toshut down temporarily and save the variablecosts.


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The Shutdown Point

The shutdown pointis the point at whichthe firm will be better off it it shuts down

than it will if it stays in business.


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The Shutdown Point

If total revenue is more than total variablecost, the firms best strategy is to

temporarily produce at a loss. It is taking less of a loss than it would by

shutting down.


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MC

P = MR

2 4 6 8 Quantity

Price

60

50

40

30

2010

0

ATC

AVC

Loss

A$17.80

The Shutdown Decision


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Short-Run Market Supply and

Demand While the firm's demand curve is perfectly

elastic, the industry's is downward sloping.

For the industry's supply curve we use amarket supply curve.


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Short-Run Market Supply and

Demand The market supply curve is the horizontal

sum of all the firms' marginal cost curves,

taking account of any changes in inputprices that might occur.


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Long-Run Competitive

Equilibrium Profits and losses are inconsistent with

long-run equilibrium.

Profits create incentives for new firms to enter,output will increase, and the price will falluntil zero profits are made.

The existence of losses will cause firms toleave the industry.


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Equilibrium Only at zero profit will entry and exit stop.

The zero profit condition defines the long-

run equilibrium of a competitive industry.


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Equilibrium MC

P = MR

0

60

5040

30

20

10

Price

2 4 6 8 Quantity

SRATC LRATC


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Equilibrium Zero profit does not mean that the

entrepreneur does not get anything for his

efforts. Normal profit the amount the owners of

business would have received in the next-

best alternative.


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Equilibrium Normal profits are included as a cost and

are not included in economic profit.

Economic profits are profits above normalprofits.


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Equilibrium Firms with super-efficient workers or

machines will find that the price of these

specialized inputs will rise. Rentis the income received by those

specialized factors of production.


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Equilibrium The zero profit condition makes the

analysis of competitive markets applicable

to the real world. To determine whether markets are

competitive, many economist focus on

whether barriers to entry exist.


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Adjustment from the Long Run

to the Short Run Industry supply and demand curves come

together to lead to long-run equilibrium.


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An Increase in Demand

An increase in demand leads to higherprices and higher profits.

Existing firms increase output. New firms enter the market, increasing output

still more.

Price falls until all profit is competed away.


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If input prices remain constant, the newequilibrium will be at the original price but

with a higher output.


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The original firms return to their originaloutput but since there are more firms in the

market, the total market output increases.


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In the short run, the price does more of theadjusting.

In the long run, more of the adjustment isdone by quantity.


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Profit$9

10 120

FirmPrice

Quantity

B

A

Market Response to an Increase

in DemandMarket

Quantity

Price

0

B

A

C

MC

AC

SLR

S0SR

D0

7

700

$9

8401,200

D1

S1SR

7



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Long-Run Market Supply

In the long run firms earn zero profits.

If the long-run industry supply curve is

perfectly elastic, the market is a constant-cost industry.


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Long-Run Market Supply

Two other possibilities exist:

Increasing-cost industry factor prices rise

as new firms enter the market and existingfirms expand capacity.

Decreasing-cost industry factor prices fallas industry output expands.


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An Increasing-Cost Industry

If inputs are specialized, factor prices arelikely to rise when the increase in the

industry-wide demand for inputs toproduction increases.


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This rise in factor costs would force costsup for each firm in the industry and

increases the price at which firms earnzero profit.


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Therefore, in increasing-cost industries, thelong-run supply curve is upward sloping.


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A Decreasing-Cost Industry

If input prices decline when industry outputexpands, individual firms' marginal cost

curves shift down and the long-run supplycurve is downward sloping.


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A Decreasing-Cost Industry

Input prices may decline to the zero-profitcondition when output rises.

New entrants make it more cost-effectivefor other firms to provide services to allfirms in the market.


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An Example in the Real World

K-mart decided to close over 300 storesafter experiencing two years of losses (a

shutdown decision). K-mart thought its losses would be

temporary.


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Price exceeded average variable cost, so itcontinued to keep some stores open even

though those stores were losing money.


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Price

Quantity

MC

ATC

AVC

P = MR

Loss



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After two years of losses, its prospectivechanged.

The company moved from the short run tothe long run.


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They began to think that demand was nottemporarily low, but permanently low.

At that point they shut down those storesfor which P < AVC.


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Perfect Competition

End of Chapter 11

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Chap011 Mkt Structure Perfect Competition