Chapter 24 Perfect Competition. 2 Learning Objectives Identify the characteristics of a perfectly competitive market structure Discuss the process

Chapter 24

Perfect Competition

2

Learning Objectives

Identify the characteristics of a perfectly competitive market structure

Discuss the process by which a perfectly competitive firm decides how much output to produce

Understand how the short-run supply curve for a perfectly competitive firm is determined

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Learning Objectives

Explain how the equilibrium price is determined in a perfectly competitive market

Describe what factors induce firms to enter or exit a perfectly competitive industry

Distinguish among constant-, increasing-, and decreasing-cost industries based on the shape of the long-run industry supply curve

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Did You Know That...

Under extreme perfectly competitive situations, individual buyers and sellers cannot affect the market price?

Economic profits that perfectly competitive firms may earn for a time ultimately disappear as other firms enter the industry?

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Characteristics of a Perfectly Competitive Market Structure

Perfect Competition

– A market structure in which the decisions of individual buyers and sellers have no effect on market price

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Perfectly Competitive Firm

– A firm that is such a small part of the total industry that it cannot affect the price of the product or service that it sells

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Price Taker

– A competitive firm that must take the price of its product as given because the firm cannot influence its price (Perfect Competitors are price takers and Monopolists are price searchers)

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Why a perfect competitor is a price taker

1. Large number of buyers and sellers

2. Homogenous products are perfect substitutes

3. Buyers and sellers have equal access to information

4. No barriers to entry or exit

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The Demand Curve of the Perfect Competitor

Question

– If the perfectly competitive firm is a price taker, who or what sets the price?

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Neither an individualbuyer nor seller caninfluence the price

The interaction of marketsupply and demand yieldsan equilibrium price of $5

The Demand Curve for a Producer of Flash Memory Pen Drives

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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

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The Demand Curve for a Producer of Flash Memory Pen Drives

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How Much Should the Perfect Competitor Produce?

Perfect competitor accepts price as given– Firm raises price, it sells nothing– Firm lowers its price, it earns less revenues than

it otherwise would

Perfect competitor has to decide how much to produce– Firm uses profit-maximization model

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The model assumes that firms attempt to maximize their total profits.

– The positive difference between total revenues and total costs

The model also assumes firms seek to minimize losses.

– When total revenues may be less than total costs

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Total Revenues

– The price per unit times the total quantity sold

– The same as total receipts from the sale of output

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P determined by the market in perfect competitionQ determined by the producer to maximize profit

TR = P x Q

Profit = Total revenue (TR) – Total cost (TC)

TC = TFC + TVC

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Profit Maximization

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TotalOutput/Sales/ Total Market Total Total

day Costs Price Revenue Profit

0 $10 $5 $0 $10

1 15 5 5 10

2 18 5 10 8

3 20 5 15 5

4 21 5 20 1

5 23 5 25 2

6 26 5 30 4

7 30 5 35 5

8 35 5 40 5

9 41 5 45 4

10 48 5 50 2

11 56 5 55 1

Profit Maximization

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Profit-Maximizing Rate of Production

– The rate of production that maximizes total profits, or the difference between total revenues and total costs

– The rate of production at which marginal revenue equals marginal cost

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Profit MaximizationTotal

Output/Sales/ Market Marginal Marginal

day Price Cost Revenue

0 $5

1 5

2 5

3 5

4 5

5 5

6 5

7 5

8 5

9 5

10 5

11 5

$5 $5

3 5

2 5

1 5

2 5

3 5

4 5

5 5

6 5

7 5

8 5

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Using Marginal Analysis to Determinethe Profit-Maximizing Rate of Production

Marginal Revenue

– The change in total revenues divided by the change in output

Marginal Cost

– The change in total cost divided by the change in output

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Using Marginal Analysis to Determine the Profit-Maximizing

Rate of Production

Profit maximization occurs at the rate of output at which marginal revenue equals marginal cost.

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Short-Run Profits

To find out what our competitive individual flash memory producer is making in terms of profits in the short run, we have to determine the excess of price above average total cost.

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Short-Run Profits

From Figure 24-2 previously, if we have production and sales of seven flash drives, TR = $35, TC = $30, and profit = $5.

Now we take info from column 6 in panel (a) and add it to panel (c) to get Figure 24-3.

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•Profits are maximized where MR = MC

•This occurs at Q = 7.5 units

Measuring Total Profits

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Short-Run Profits

Graphical depiction of maximum profits

– The height of the rectangular box represents profits per unit.

– The length represents the amount of units produced.

– When we multiply these two quantities, we get total economic profits.

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•Losses are minimized where MR = MC

•This occurs at Q = 5.5 units

Minimization of Short-Run Losses

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Short-Run ProfitsShort-run average profits are determined by

comparing ATC with P = MR = AR at the profit-maximizing Q.

In the short run, the perfectly competitive firm can make either economic profits or economic losses.

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The Short-Run Shutdown Price

What do you think?

– Would you continue to produce if you were incurring a loss?

• In the short run?

• In the long run?

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As long as the loss from staying in business is less than the loss from shutting down, the firm will continue to produce.

A firm goes out of business when the owners sell its assets; a firm temporarily shuts down when it stops producing, but is still in business.

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As long as the price per unit sold exceeds the average variable cost per unit produced, the earnings of the firm’s owners will be higher if it continues to produce in the short run than if it shuts down.

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Short-Run Break-Even Price– The price at which a firm’s total revenues equal its total

costs– At the break-even price, the firm is just making a

normal rate of return on its capital investment (it’s covering its explicit and implicit costs).

Short-Run Shutdown Price– The price that just covers average variable costs– It occurs just below the intersection of the marginal

cost curve and the average variable cost curve.

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Short-Run Shutdown and Break-Even Prices

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The Meaning of Zero Economic Profits

Question– Why produce if you are not making a profit?

Answer– Distinguish between economic profits and

accounting profits.– Remember when economic profits are zero a

firm can still have positive accounting profits.

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The Supply Curve for a Perfectly Competitive Industry Question

– What does the short-run supply curve for the individual firm look like?

Answer– The firm’s short-run supply curve is its

marginal cost curve at and above the point of intersection with the average variable cost curve.

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The Individual Firm’s Short-Run Supply Curve

•Given the price, the quantity is determined where MC = MR

•Short-run supply = MC above minimum AVC

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The Supply Curve for a Perfectly Competitive Industry

The Industry Supply Curve

– The locus of points showing the minimum prices at which given quantities will be forthcoming

– Also called the market supply curve

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Deriving the Industry Supply Curve

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The Supply Curve for a Perfectly Competitive Industry Factors that influence the industry supply

curve (determinants of supply)

– Firm’s productivity

– Factor costs• Wages, prices of raw materials

– Taxes and subsidies

– Number of sellers

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Price Determination Under Perfect Competition

Question

– How is the market, or “going,” price established in a competitive market?

Answer

– This price is established by the interaction of all the suppliers (firms) and all the demanders.

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Price Determination Under Perfect Competition

The competitive price is determined by the intersection of the market demand curve and the market supply curve.

– The market supply curve is equal to the horizontal summation of the supply curves of the individual firms.

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Pe and Qe determined by

the interaction of the industry S and market D

Pe is the price

the firm must take

Industry Demand and Supply Curves and the Individual Firm Demand Curve

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Industry Demand and Supply Curves and the Individual Firm Demand Curve

•Given Pe, firm produces qe where MC = MR

If AC = AC1, break-even

•If AC = AC2, losses

•If AC = AC3, economic profit

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The Long-Run Industry Situation: Exit and Entry

Profits and losses act as signals for resources to enter an industry or to leave an industry.

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Signals

– Compact ways of conveying to economic decision makers information needed to make decisions

– An effective signal not only conveys information but also provides the incentive to react appropriately.

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Exit and entry of firms

– Economic profits

• Signal resources to enter the market

– Economic losses

• Signal resources to exit the market

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Allocation of capital and market signals

– Price system allocates capital according to the relative expected rates of return on alternative investments.

– Investors and other suppliers of resources respond to market signals about their highest-valued opportunities.

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Tendency toward equilibrium (note that firms are adjusting all of the time)

– At break-even, resources will not enter or exit the market.

– In competitive long-run equilibrium, firms will make zero economic profits.

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Long-Run Industry Supply Curve

– A market supply curve showing the relationship between prices and quantities after firms have been allowed time to enter or exit from an industry, depending on whether there have been positive or negative economic profits

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Long-Run Equilibrium

In the long run, the firm can change the scale of its plant, adjusting its plant size in such a way that it has no further incentive to change; it will do so until profits are maximized.

In the long run, a competitive firm produces where price, marginal revenue, marginal cost, short-run minimum average cost, and long-run minimum average cost are equal.

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Long-Run Firm Competitive Equilibrium

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Competitive Pricing: Marginal Cost Pricing

Market Failure

– A situation in which an unrestrained market operation leads to either too few or too many resources going to a specific economic activity

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Issues and Applications: The Big Rush to Provide Digital Snaps in a Snap

The photography industry brings in about $85 billion in revenues each year.

Since 2000, the majority of those revenues have been earned from the sale of digital cameras and related digital photography products and services.

During the mid-2000s, a rapidly growing part of the digital photography business has been the market for digital photo printing services.

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Issues and Applications: The Big Rush to Provide Digital Snaps in a Snap

The demand for digital photo printing services increased, and the market clearing price rose from 15 to about 19 cents.

Numerous firms entered the industry causing market supply to increase and the market clearing price declined from 19 cents to about 12 cents.

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Short-Run and Long-Run Adjustments in the Digital

Photo Printing Industry

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Summary Discussion of Learning Objectives

The characteristics of a perfectly competitive market structure

1. Large number of buyers and sellers

2. Homogeneous product

3. Buyers and sellers have equal access to information

4. No barriers to entry and exit

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How a perfectly competitive firm decides how much to produce

– Economic profits are maximized when marginal cost equals marginal revenue as long as the market price is not below the short-run shutdown price, where the marginal cost curve crosses the average variable cost curve.

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The short-run supply curve of a perfectly competitive firm – The rising part of the marginal cost curve above

minimum average variable cost

The equilibrium price in a perfectly competitive market– A price at which the total amount of output supplied by

all firms is equal to the total amount of output demanded by all buyers

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Incentives to enter or exit a perfectly competitive industry

– Economic profits induce entry of new firms.

– Economic losses will induce firms to exit the industry.

Documents

Chapter 24 Perfect Competition. 2 Learning Objectives Identify the characteristics of a perfectly competitive market structure Discuss the process