Perfect Competition and Efficiency - WordPress.com · Chapter 8 Perfect Competition ... (perfect substitutes) ... 8-28 Entry and Exit in Perfect Competition:

Copyright © 2011 Pearson Addison-Wesley. All rights reserved.

Chapter 8 Perfect Competition and Efficiency

Copyright © 2011 Pearson Addison-Wesley. All rights reserved. 8-2

Short Run Production Function for Vennari's Pizza: shows output produced by different quantities of variable inputs (labor), holding capital and other inputs fixed.

Total Product of Labor (TPL) and Marginal Product of Labor (MPL), With Capital (K) fixed

Laborers: 0 1 2 3 4 5 6 7 8

Quantity (TPL)=(Output of Pizzas)

0 10 25 35 40 43 44 44 43

Marginal Product of Labor:MPL= ΔQ/ΔL

--- 10 15 10 5 3 1 0 -1

Total Variable Cost: TVC=W*L(W=$6)

0 6 12 18 24 30 36 42 48

Marginal Cost of a PizzaMC=ΔTVC/ΔQ

--- .60 .40 .60 1.20 2.00 6.00 ∞ ∞


•  When laborers specialize in a particular task, productivity increases because of – Gains in skill & dexterity – Less time spent switching jobs – Mechanization associated with repetitive tasks

LAW OF SPECIALIZATION:


•  As you increase the amount of one input, holding other inputs constant, the Marginal Product of the input will eventually decline –  i.e., each additional input adds less and less to

your output –  Examples:

•  Fertilizer for a Farmer: adding more and more fertilizer to a certain field

•  Also works for additional tractors, laborers, water, other inputs

LAW OF DIMINISHING RETURNS


Graph of a Production Function:

L

Q

TPL

l

l

Max MPL

Max Q

A

B


Relationship between productivity and costs:

L

Q

TPL

l

l

Max MPL

Max Q

A

B

Q1

Q2

Al

lB

MCP

QQ1 Q2


Other firm costs: Average Variable Cost

•  Total Variable Costs = Total Labor costs •  Average Variable Costs: AVC=TVC/Q •  AVC is driven by MC:

–  when MC<AVC, AVC falls –  each new unit costs less than the average to produce –  when MC>AVC, AVC rises –  each new unit costs more than the average to produce


Q

MC, AVC

MC

AVC

MC<AVC; AVC falls as Q increases

MC>AVC; AVC rises as Q increases

●

●


Average Fixed Cost

•  Total Fixed Costs (TFC): must be paid in short run, even if you don't produce –  GM must pay mortgage on plant even if they decide

to shut down –  Must pay rent on your lease, property taxes, etc.

•  Average Fixed Costs: AFC=TFC/Q –  AFC falls as Q increases –  With a higher Q the firm is able to spread its capital

costs over more units •  GM has $4 billion in fixed costs: what would P

of Car be if they only made 1?


AFC

Q

AFC

AFC always falls as Q increases


q1

q2

avc

atc

mc

p

q

•

•

b

a

q q Q1 Q2

Average (Total) Cost = AC = AVC + AFC

From 0 to Q1, AC falls quickly (both AVC and AFC are falling).

From Q1 to Q2, AC falls slowly (AFC falls more than AVC rises).

From Q2 on, AC rises (AVC rises quickly).


The MARGINAL COST Curve is the firm's SHORT RUN SUPPLY CURVE

•  Marginal Cost is the cost of producing an additional unit–  includes explicit (accounting) costs

•  like wages, cost of capital and other inputs–  also includes implicit (opportunity) costs


One implicit cost: a firm must earn a normal profit on the investment tied up in the company

•  For example, a company worth $1 million must generate $100,000 in profit a year to stay in business. –  The invisible hand of the market means that, if this investment

could earn a higher return elsewhere, people will pull their money out

–  So businesses must earn a NORMAL PROFIT just to stay in business (otherwise it will lose investors)

•  Thus in economics, earning a normal profit is an imperative for business –  So a normal profit is considered part of the normal costs of

production for the firm.


Other examples of implicit costs

•  Suppose you own your own business, but you could earn $40,000 working for someone else.–  $40,000 is the OPPORTUNITY COST of running your

own business (what you give up).–  Economists include this $40,000 in the costs of production

because•  if you earn a profit on your business of less than $40,000, you

should quit and go to work for someone else.

•  So Marginal Cost is the cost of producing an additional unit, including a normal profit.


Supply Curves tell us at what price suppliers will provide a certain quantity

•  And Marginal Cost (MC) tells us how much each unit costs to produce, including a normal profit.

•  So MC tells us how much businesses are willing to sell stuff for.

•  And therefore, MC is the firm's SUPPLY CURVE


MC

Q

P

p1

q1

p2

q2

l

l

NOTE: producers ignore the downward-sloping part of MC because they always make more money by producing more as costs fall.

At P1, producers will supply q1. They won’t produce more than q1 because MC>P after q1 (would lose money on those units).

At p2, producers will supply q2,

MC as the firm’s supply curve


So, the firm’s Supply curve is the upward-sloping portion of the MC curve.


q1

q2

AVC

AC

MC

$

Q

•

•

b

a

The Complete Picture:

• The firm uses Price and Marginal Cost to determine what quantity to produce.

• The cost curves then determine how much money the firm is making or losing at that price.


Perfect Competition

•  Characteristics: –  Large Number of Small Firms: firms are so small relative to

size of the market, they can't influence it. –  Easy Entry and Exit in the long run: new firms can enter to

take advantage of higher prices, profits; firms with losses will exit.

–  Product Homogeneity: products are basically identical (perfect substitutes)

•  For example, wheat, corn, and other farm products –  Firms are Price Takers: can’t raise price above the market

price, and no reason to lower price because they can sell their entire crop at the market price.


Price is determined by the market p

q

S

D

Q

P

D

MARKET 1 FIRM

Producers and consumers know the prices, so no one will sell for less than the market price, and no one will buy for more than the market price.


Profit Maximization

•  Produce as long as Marginal Revenue (MR) is greater than or equal to Marginal Cost (MC) –  It is profitable to produce a unit if it makes you more than it

costs –  MR � MC

•  MR=Change in Total Revenue/Change in Quant. –  MR=ΔTR/ΔQ –  When P is fixed, P=MR (perfect competition only) –  Always get same amount for each unit you sell

•  But IF P fell, MR would fall as Q increased

Q P=MR TR TC ATC MC PROFIT (TR-TC) 0 15 0 5 --- --- -5 1 15 15 15 15 10 0 2 15 30 23 11.5 8 7 3 15 45 33 11 10 12 4 15 60 45 11.25 12 15 5 15 75 60 12 15 15 6 15 90 84 14 24 6

• Total Cost (TC) always increases, but it increases faster after Q=2. • MC decreases up to Q=2, then increases; the firm's supply curve would start at Q=2.

• Average Total Cost (AC) decreases at first, when MC<AC; after Q=4, MC>AC, so AC rises.

• Total Variable Cost isn't on here, but we could find it by subtracting TFC from TC; when Q=0, all costs are fixed costs (no Labor costs).

• Profits increase when MR>MC; profits decrease when MC>MR; Profits stay the same when MC=MR, BUT MC includes a normal profit, so it is always better to produce where MC=MR.

Graphing the same information

Q

0

5

10

15

20

25

0 1 2 3 4 5 6

MC

P=MR=D AC Economic Profit

Q P=MR TR TC ATC MC Profit 0 15 0 5 --- --- -5 1 15 15 15 15 10 0 2 15 30 23 11.5 8 7 3 15 45 33 11 10 12 4 15 60 45 11.25 12 15 5 15 75 60 12 15 15 6 15 90 84 14 24 6


•  Normal profit occurs when TR=TC (TC includes a normal profit). –  So when TR>TC, this is an above normal, or economic profit.

•  In the long run, firms would enter this industry to take advantage of excess profits. –  This would increase market supply and drive down the market

price until the firm earns a NORMAL profit.

•  So under Perfect Competition, firms can only earn economic profits temporarily, and will earn a normal profit in the long run.

The firm in this example was making an economic profit (above normal)


SHORT RUN shut down condition: a firm should shut down if LOSS > TFC

•  If Loss < TFC, would lose TFC if you shut down, so shutting down would cost more than staying open. –  Note: if these losses continue, will have to shut down in

long run. •  If Loss > TFC, better off shutting down and only

losing TFC. –  Note: if P increases, the firm may reopen, but otherwise

it will shut down in the long run. •  If Loss = TFC, then you are indifferent. This

occurs at the minimum point on the AVC curve.


Short Run Shut Down Condition

•  Here, P=AVC, so TR=TVC, and

•  TR-TC=TFC •  LOSS=TFC •  If P falls lower

then the firm should definitely shut down in the short run.

•  If P is any higher, the firm should stay open in the short run.

Q

$

AVC

AC

MC

P=MR

Q1

P

AC1

Loss=TFC


All Possible Short Run Cases:

•  P>P2 : Economic Profit.

•  P = P2 : Normal Profit.

•  P1<P<P2 : Loss, but stay open in the short run.

•  P<P1 : shut down in the short run.

Q

$

AVC

AC=LAC

MC=LMC

P1

P2


Entry and Exit in Perfect Competition:

•  In the SHORT RUN, firms produce where P=MR=MC.

•  In the LONG RUN, firms will enter or exit to take advantage of economic profit or to run away from economic losses.


FIGURE 8.11 Deriving Long-Run Average Costs


FIGURE 8.12 Typical Long-Run Average Cost Curve


FIGURE 8.13 The Firm in the Long Run


FIGURE 8.14 The Effect of Entry in the Long Run


FIGURE 8.15 Long-Run Equilibrium in Competition

Economic Profit causes firms enter, Market Supply increase, Market Price falls until firms earn a Normal Profit. A Normal Profit occurs at the minimum AC, where TR=TC.


Losses & Exiting in the Long Run

$

MR=P

Q

LAC

LMC

Q1

AC1

Economic Loss

Q

$

P1 P1

Market Firm

S1

D

This firm is losing money. In the long run, some firms will go out of business. FIRMS EXIT, decreasing market supply, and increasing market price until the remaining firms earn a NORMAL PROFIT.

S2

Q2

P2

Q1 Q2

MR2=P2


Shut Down Condition:

•  LONG RUN: eventually some firms will shut down if earning an economic loss – Any profit less than a normal profit means that the

firm should move resources into a more profitable area.


All Possible Long Run Cases

•  P>P2, firms enter, P falls to P2.

•  P<P2, firms exit, P rises to P2

•  So in the long run, all firms earn a normal profit at the market price.

Q

$

LAC

LMC

P2


Perfect Competition Problem

•  Given the following information, draw a graph showing a perfectly competitive firm in the short run. Discuss what will happen in the long run and also show this on the graph. Assume AC=LAC; MC=LMC.

•  P=$5, AC=$4, AVC=$3, Qfirm=1000, Qmarket=1million

Example 1: a firm earning economic profit

•  Step 1: Draw the D curve above AC to indicate economic profit; draw S=D at the market price in the market graph.

$

Q

P

Q

MC

AC AVC

5 D=P

S

D

Firm Market

Step 2

•  Find the profit maximizing quantity in the firm graph where P=MC and use the quantity given in the problem; also use the market quantity given in the problem.

$

Q

P

Q

MC

AC AVC

5 D=P

S

D

Firm Market

1000 1m

Step 3

•  Use the profit maximizing Q to find AC and AVC at that quantity.

$

Q

P

Q

MC

AC AVC

5 D=P

S

D

Firm Market

1000 1m

4 3

Step 4: Long Run

•  In the long run, the economic profit causes new firms to enter, increasing market supply, decreasing market price until firms earn a normal profit (at a price just below $4 in this graph).

$

Q

P

Q

MC

AC AVC

5 D=P

S

D

Firm Market

1000 1m

4

3 3.90 D2

S2

q2 q2

Table for a perfectly competitive firm

Q TC TVC MC AC AVC P TR0 10,000$ 20$

100 11,000 20200 11,800 20300 12,500 20400 13,300 20500 14,300 20600 15,500 20700 16,900 20800 18,500 20900 20,300 20

1,000 22,300 201,100 24,600 201,200 27,200 201,300 30,200 201,400 33,700 201,500 37,900 20

What are TFC? Compute TVC.


Q TC TVC MC AC AVC P TR0 10,000$ $0 20$

100 11,000 1,000 20200 11,800 1,800 20300 12,500 2,500 20400 13,300 3,300 20500 14,300 4,300 20600 15,500 5,500 20700 16,900 6,900 20800 18,500 8,500 20900 20,300 10,300 20

1,000 22,300 12,300 201,100 24,600 14,600 201,200 27,200 17,200 201,300 30,200 20,200 201,400 33,700 23,700 201,500 37,900 27,900 20

Compute MC = ΔTC/ΔQ



100 11,000 1,000 10 20200 11,800 1,800 8 20300 12,500 2,500 7 20400 13,300 3,300 8 20500 14,300 4,300 10 20600 15,500 5,500 12 20700 16,900 6,900 14 20800 18,500 8,500 16 20900 20,300 10,300 18 20

1,000 22,300 12,300 20 201,100 24,600 14,600 23 201,200 27,200 17,200 26 201,300 30,200 20,200 30 201,400 33,700 23,700 35 201,500 37,900 27,900 42 20

Compute AC = TC/Q; AVC = TVC/Q



100 11,000 1,000 10 110.0 10.0 20200 11,800 1,800 8 59.0 9.0 20300 12,500 2,500 7 41.7 8.3 20400 13,300 3,300 8 33.3 8.3 20500 14,300 4,300 10 28.6 8.6 20600 15,500 5,500 12 25.8 9.2 20700 16,900 6,900 14 24.1 9.9 20800 18,500 8,500 16 23.1 10.6 20900 20,300 10,300 18 22.6 11.4 20

1,000 22,300 12,300 20 22.3 12.3 201,100 24,600 14,600 23 22.4 13.3 201,200 27,200 17,200 26 22.7 14.3 201,300 30,200 20,200 30 23.2 15.5 201,400 33,700 23,700 35 24.1 16.9 201,500 37,900 27,900 42 25.3 18.6 20

Compute Total Revenue, TR = P * Q


Q TC TVC MC AC AVC P TR0 10,000$ $0 20$ $0

100 11,000 1,000 10 110.0 10.0 20 2,000 200 11,800 1,800 8 59.0 9.0 20 4,000 300 12,500 2,500 7 41.7 8.3 20 6,000 400 13,300 3,300 8 33.3 8.3 20 8,000 500 14,300 4,300 10 28.6 8.6 20 10,000 600 15,500 5,500 12 25.8 9.2 20 12,000 700 16,900 6,900 14 24.1 9.9 20 14,000 800 18,500 8,500 16 23.1 10.6 20 16,000 900 20,300 10,300 18 22.6 11.4 20 18,000

1,000 22,300 12,300 20 22.3 12.3 20 20,000 1,100 24,600 14,600 23 22.4 13.3 20 22,000 1,200 27,200 17,200 26 22.7 14.3 20 24,000 1,300 30,200 20,200 30 23.2 15.5 20 26,000 1,400 33,700 23,700 35 24.1 16.9 20 28,000 1,500 37,900 27,900 42 25.3 18.6 20 30,000

What is the profit maximizing level of output?

What is the firm’s profit or loss?


Q TC TVC MC ATC AVC P TR0 10,000$ $0 20$ $0

100 11,000 1,000 10 110.0 10.0 20 2,000 200 11,800 1,800 8 59.0 9.0 20 4,000 300 12,500 2,500 7 41.7 8.3 20 6,000 400 13,300 3,300 8 33.3 8.3 20 8,000 500 14,300 4,300 10 28.6 8.6 20 10,000 600 15,500 5,500 12 25.8 9.2 20 12,000 700 16,900 6,900 14 24.1 9.9 20 14,000 800 18,500 8,500 16 23.1 10.6 20 16,000 900 20,300 10,300 18 22.6 11.4 20 18,000

1,000 22,300 12,300 20 22.3 12.3 20 20,000 1,100 24,600 14,600 23 22.4 13.3 20 22,000 1,200 27,200 17,200 26 22.7 14.3 20 24,000 1,300 30,200 20,200 30 23.2 15.5 20 26,000 1,400 33,700 23,700 35 24.1 16.9 20 28,000 1,500 37,900 27,900 42 25.3 18.6 20 30,000

What is the profit maximizing level of output? Q=1000

What is the firm’s profit or loss? Loss = $2,300



100 11,000 1,000 10 110.0 10.0 20 2,000 200 11,800 1,800 8 59.0 9.0 20 4,000 300 12,500 2,500 7 41.7 8.3 20 6,000 400 13,300 3,300 8 33.3 8.3 20 8,000 500 14,300 4,300 10 28.6 8.6 20 10,000 600 15,500 5,500 12 25.8 9.2 20 12,000 700 16,900 6,900 14 24.1 9.9 20 14,000 800 18,500 8,500 16 23.1 10.6 20 16,000 900 20,300 10,300 18 22.6 11.4 20 18,000

1,000 22,300 12,300 20 22.3 12.3 20 20,000 1,100 24,600 14,600 23 22.4 13.3 20 22,000 1,200 27,200 17,200 26 22.7 14.3 20 24,000 1,300 30,200 20,200 30 23.2 15.5 20 26,000 1,400 33,700 23,700 35 24.1 16.9 20 28,000 1,500 37,900 27,900 42 25.3 18.6 20 30,000

What can we expect to happen in the long run? (Assume that AC=LAC, MC=LMC)

What price will the market tend towards in the long run?


Q TC TVC MC ATC AVC P TR0 10,000$ $0 20$ $0

100 11,000 1,000 10 110.0 10.0 20 2,000 200 11,800 1,800 8 59.0 9.0 20 4,000 300 12,500 2,500 7 41.7 8.3 20 6,000 400 13,300 3,300 8 33.3 8.3 20 8,000 500 14,300 4,300 10 28.6 8.6 20 10,000 600 15,500 5,500 12 25.8 9.2 20 12,000 700 16,900 6,900 14 24.1 9.9 20 14,000 800 18,500 8,500 16 23.1 10.6 20 16,000 900 20,300 10,300 18 22.6 11.4 20 18,000

1,000 22,300 12,300 20 22.3 12.3 20 20,000 1,100 24,600 14,600 23 22.4 13.3 20 22,000 1,200 27,200 17,200 26 22.7 14.3 20 24,000 1,300 30,200 20,200 30 23.2 15.5 20 26,000 1,400 33,700 23,700 35 24.1 16.9 20 28,000 1,500 37,900 27,900 42 25.3 18.6 20 30,000

What can we expect to happen in the long run? Firms exit, market supply decreases, market price increases until firms earn a normal profit at a price of about $22.30 (min. AC).



100 11,000 1,000 10 110.0 10.0 20 2,000 200 11,800 1,800 8 59.0 9.0 20 4,000 300 12,500 2,500 7 41.7 8.3 20 6,000 400 13,300 3,300 8 33.3 8.3 20 8,000 500 14,300 4,300 10 28.6 8.6 20 10,000 600 15,500 5,500 12 25.8 9.2 20 12,000 700 16,900 6,900 14 24.1 9.9 20 14,000 800 18,500 8,500 16 23.1 10.6 20 16,000 900 20,300 10,300 18 22.6 11.4 20 18,000

1,000 22,300 12,300 20 22.3 12.3 20 20,000 1,100 24,600 14,600 23 22.4 13.3 20 22,000 1,200 27,200 17,200 26 22.7 14.3 20 24,000 1,300 30,200 20,200 30 23.2 15.5 20 26,000 1,400 33,700 23,700 35 24.1 16.9 20 28,000 1,500 37,900 27,900 42 25.3 18.6 20 30,000

At what price would the firm shut down in the short run?

At what price would the firm shut down in the long run?



100 11,000 1,000 10 110.0 10.0 20 2,000 200 11,800 1,800 8 59.0 9.0 20 4,000 300 12,500 2,500 7 41.7 8.3 20 6,000 400 13,300 3,300 8 33.3 8.3 20 8,000 500 14,300 4,300 10 28.6 8.6 20 10,000 600 15,500 5,500 12 25.8 9.2 20 12,000 700 16,900 6,900 14 24.1 9.9 20 14,000 800 18,500 8,500 16 23.1 10.6 20 16,000 900 20,300 10,300 18 22.6 11.4 20 18,000

1,000 22,300 12,300 20 22.3 12.3 20 20,000 1,100 24,600 14,600 23 22.4 13.3 20 22,000 1,200 27,200 17,200 26 22.7 14.3 20 24,000 1,300 30,200 20,200 30 23.2 15.5 20 26,000 1,400 33,700 23,700 35 24.1 16.9 20 28,000 1,500 37,900 27,900 42 25.3 18.6 20 30,000

At what price would the firm shut down in the short run? Below $8.30 (minimum AVC).

At what price would the firm shut down in the long run? Below $22.30 (minimum AC) if other firms don’t exit.


FIGURE 8.1 Average Fixed Cost


TABLE 8.1 Marginal Cost and Average Variable Cost of a Pizza


FIGURE 8.2 Marginal Cost and Average Variable Cost


FIGURE 8.3 Average Cost Curve


FIGURE 8.4 Marginal Revenue Curve


FIGURE 8.5 Marginal Revenue, Marginal Cost, and Profit Maximization


FIGURE 8.6 Total Costs, Total Fixed Costs, and Total Variable Costs


TABLE 8.2 Pizzeria’s Costs at Possible Levels of Output


TABLE 8.3 Pizzeria’s Average and Marginal Costs


FIGURE 8.7 Average Fixed Costs (a), Average Variable Costs (b), Average Costs (b), and Marginal Costs (b)


FIGURE 8.8 Total Revenue (a) and Marginal Revenue (b)


TABLE 8.4 Data for a Firm’s Profit Maximization Decision


FIGURE 8.9 Profit Maximization


FIGURE 8.10 A Perfectly Competitive Firm Earning an Economic Profit (a), Earning a Normal Profit (b) and Incurring an Economic Loss (c)


FIGURE 8.10 (continued) A Perfectly Competitive Firm Earning an Economic Profit (a), Earning a Normal Profit (b) and Incurring an Economic Loss (c)


FIGURE 8.10 (continued) A Perfectly Competitive Firm Earning an Economic Profit (a), Earning a Normal Profit (b) and Incurring an Economic Loss (c)


FIGURE 8.16 Change in Costs


FIGURE 8.17 Change in Market Supply


FIGURE 8.18 Change in Demand


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Perfect Competition and Efficiency - WordPress.com · Chapter 8 Perfect Competition ... (perfect substitutes) ... 8-28 Entry and Exit in Perfect Competition: