Download Lesson III-2: Perfect Competition, Chapter 13

Overview
Overview
BA 210 Lesson III.2 Perfect Competition
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Lesson overview
Chapter 13 Perfect Competition
What is Perfect Competition?
Finding Profit Maximizing Quantity
Exiting an Industry
Entering an Industry
Long-Run Competitive Equilibrium
Summary
Review Questions
BA 210 Lesson III.2 Perfect Competition
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What is Perfect Competition?
What is Perfect Competition?
BA 210 Lesson III.2 Perfect Competition
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What is Perfect Competition?
• A price-taking producer is a producer whose actions have no
effect on the market price of the good it sells.


Example: Farmer Smith producing apples.
Counter Example: Apple Inc. producing personal computers.
• A price-taking consumer is a consumer whose actions have no
effect on the market price of the good he buys.


Example: You buying apples, or you buying personal computers.
Counter Example: Microsoft buying the services of computer scientists.
• A perfectly competitive market is a market in which all
producers and consumers are price-takers.


Example: The apple market.
Counter Example: The personal computer market.
• A perfectly competitive industry is an industry in which
producers are price-takers.
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What is Perfect Competition?
Two Necessary Conditions for Perfect Competition
1) For an industry to be perfectly competitive, it must contain
many producers, none of whom have a large market share.
 A producer’s market share is the fraction of the total
industry output accounted for by that producer’s output.
2) An industry can be perfectly competitive only if consumers
regard the products of all producers as equivalent.
 A good is a standardized product, also known as a
commodity, when consumers regard the products of
different producers as the same good. That is, products
of different producers are perfect substitutes.
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What is Perfect Competition?
Free Entry and Exit
• There is free entry and exit into and from an industry when new
producers can easily enter into or leave that industry.
• Free entry and exit ensure:
 that the number of producers in an industry can adjust to
changing market conditions, and,
 that producers in an industry cannot artificially keep other firms
out.
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What is Perfect Competition?
Preview of Perfect Competition Implications
What effect did cancer have on the cigarette industry?
• Demand down, so price, quantity, and profit
down (according to demand-supply analysis).
• But, profit down makes some producers quit.
• As some producers quit, industry supply down.
• As industry supply down, price and profit start
back up.
• Adjustment continues until producers stop
leaving, which means profits have to be back to
where they started.
• Remaining producers thus regain profits in the
long run.
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What is Perfect Competition?
What effect do higher gas prices have on the
hybrid-car industry?
• Demand up, so price, quantity, and profit down
(according to demand-supply analysis).
• But, profit up makes some producers enter the
industry.
• As producers enter, industry supply up.
• As industry supply up, price and profit start
back down.
• Adjustment continues until producers stop
entering, which means profits have to be back
to where they started.
• Producers thus back to original profits in the
long run.
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What is Perfect Competition?
Since few producers are perfectly competitive, why learn
about perfect competition?
• Many small businesses are almost perfectly
competitive.
• Gives an extreme environment to compare with
monopolies.
• Illuminates the danger of competition to producer
profits, and the importance of product differentiation to
reduce competition and maintain profits.
 Chevron with Techron (an additive for cleanliness)
 Standard Oil “Put a tiger in your tank”
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Finding Profit Maximizing Quantity
Finding Profit Maximizing Quantity
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Finding Profit Maximizing Quantity
Setting Price to Match the Competition
$
$
S
Pe
Df
D
Market for Apples
QM
Farmer Jennifer and
Jason’s Tomatoes
BA 210 Lesson III.2 Perfect Competition
Qf
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Finding Profit Maximizing Quantity
Production and Profits
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Finding Profit Maximizing Quantity
Using Marginal Analysis to Choose the Profit-Maximizing Quantity
of Output
• Marginal revenue is the change in total revenue generated by an
additional unit of output.
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Finding Profit Maximizing Quantity
The Optimal Output Rule
• The optimal output rule says that profit is maximized by
producing the quantity of output at which the marginal cost of
the last unit produced is equal to its marginal revenue.
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Finding Profit Maximizing Quantity
Short-Run Costs for Jennifer and Jason’s Farm
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Finding Profit Maximizing Quantity
Marginal Analysis Leads to Profit-Maximizing Quantity of
Output
• The price-taking firm’s optimal output rule says that a pricetaking firm’s profit is maximized by producing the quantity of
output at which the marginal cost of the last unit produced is
equal to the market price.
• The marginal revenue curve shows how marginal revenue
varies as output varies.
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Finding Profit Maximizing Quantity
The Price-Taking Firm’s Profit-Maximizing Quantity of Output
Price, cost of
bushel
$24
Market
price
MC
Optimal
point
20
18
16
E
MR = P
12
8
6
0
1
2
3
4
5
6
Profit-maximizing
quantity
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Quantity of
tomatoes
(bushels)
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Finding Profit Maximizing Quantity
Setting Quantity
• General rule, set Q where MC(Q) = MR(Q).
• Since, MR(Q) = constant market price P, equate MC(Q) = P to
set Q.
Calculating Profit
• P = P x Q – C(Q) = (P – C(Q)/Q) x Q = (P – ATC) x Q.
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Exiting an Industry
Exiting an Industry
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Exiting an Industry
Calculating Profit
Profit = (Pe - ATC)  Qf*
MC
$
ATC
AVC
Pe = Df = MR
Pe
ATC
Qf*
BA 210 Lesson III.2 Perfect Competition
Qf
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Exiting an Industry
Should this Firm Sustain Short Run Losses or Shut Down?
Profit = (Pe - ATC)  Qf* < 0
ATC
MC
$
AVC
ATC
Pe
Loss
Pe = Df = MR
Qf*
BA 210 Lesson III.2 Perfect Competition
Qf
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Exiting an Industry
Shutdown Decision Rule
• A profit-maximizing firm should continue to operate (sustain
short-run losses) if its operating loss is less than its fixed costs
(really sunk cost), since fixed cost is the loss if shut down.


Operating loss P = PQ – TC > -FC, or PQ > TC – FC = VC.
P > VC/Q = AVC.
• Decision rule (if you expect current conditions to persist):
 Continue operating as long as P > AVC.
• On graph, P > min AVC.
• 9/11 made ATA bankrupt years later.
• Bankruptcy throughout a recession (not all at once).


Operate or not (it does not matter) if P = min AVC
Immediate shut down if P < AVC.
• On graph, P < min AVC.
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Exiting an Industry
Firm’s Short-Run Supply Curve
Profit maximization MC = P and the shutdown rule imply the
firms short-run (FC > 0) supply is MC above Min AVC.
ATC
MC
$
AVC
P min AVC
Qf*
BA 210 Lesson III.2 Perfect Competition
Qf
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Exiting an Industry
WorldCom files largest bankruptcy ever
Nation's No. 2 long-distance company in Chapter 11 -- largest with $107
billion in assets.
July 22, 2002: 10:35 AM EDT
By Luisa Beltran, CNN/Money staff writer
NEW YORK (CNN/Money) - WorldCom, the nation's No. 2 long-distance
phone company, filed for Chapter 11 bankruptcy protection late Sunday,
nearly one month after it revealed that it had improperly booked $3.8 billion in
expenses.
WorldCom, crushed by its $41 billion debt load, made its filing in the
Southern District of New York. With $107 billion in assets, WorldCom's
bankruptcy is the largest in United States history, dwarfing that of Enron Corp.
The Houston-based energy trader listed $63.4 billion in assets when it filed
Chapter 11 late last year. WorldCom's non-U.S. units were not included in the
filing.
Bankruptcy had long been expected for WorldCom (P > AVC).
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Entering an Industry
Entering an Industry
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Entering an Industry
Short-Run Market Supply Curve
• The number of firms is fixed in the short run (because capital is fixed).
• The market or industry supply curve is the horizontal summation of each
individual firm’s supply at each price.
P
Firm 1
Market
Firm 2
P
P
S1
S2
SM
15
5
10
18
Q
20
25
Q
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43Q
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Entering an Industry
Long Run Adjustments if profits are positive
• If firms are price takers but if there were barriers to entry,
profits will persist.
• If the industry is perfectly competitive, not only are firms price
takers but there is free entry into the industry.
 Firms producing clones enter the market if profits are
positive.
 For example, the profitability of the iPhone in 2007
prompted clones to enter the market, including the
Samsung Instinct, Sony Xperia, Deeda Pi, LG Voyager, LG
Vu, ….
 There is now a difference between a short-run equilibrium
and a long-run equilibrium.
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Entering an Industry
The Short-Run Market Equilibrium
Price, cost of
bushel
$26
Short-run industry
supply curve, S
22
Market
price
E
MKT
18
D
14
Shut-down
price
10
0
200
300
400
500
600
700
Quantity of tomatoes (bushels)
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The Long-Run Market Equilibrium
(a) Market
Price, cost
of bushel
S
1
E
MKT
$18
S
2
(b) Individual Firm
S
3
Price, cost
of bushel
$18
E
A
D
MKT
16
MC
16
ATC
D
B
C
MKT
D
14
0
500
750
1,000
Quantity of tomatoes (bushels)
Breakeven
price
14.40
14
C
0
3
BA 210 Lesson III.2 Perfect Competition
Y
Z
4 4.5 5
6
Quantity of tomatoes (bushels)
29
The Effect of an Increase in Demand in the Short Run and the
Long Run
(a) Existing Firm Response
to Increase in Demand
Price,
cost
Price
An increase in
demand raises
price and
profit.
$18
14
0
Y
(b) Short-Run and
Long-Run Market
Response to Increase in
Demand
Long-run
industry
supply
S curve, LRS S
1
2
MC
ATC
Y
MKT
X
MKT
X
Quantity
0
QXQY
(a) Existing Firm Response
to New Entrants
Price,
cost
Higher industry
output from new
entrants drive
price and profit
back down.
MC
Y
Z
D
Z
MKT 2
D
1
QZ Quantity
ATC
0
Quantity
Increase in output from new entrants
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Comparing the Short-Run and Long-Run Industry Supply Curves
Price
Short-run industry supply
curve, S
Long-run
industry supply
curve, LRS
The long-run industry supply curve is
always perfectly flat – but the shortrun industry supply curve has
positive slope.
Quantity
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Long-Run Competitive Equilibrium
Long-Run Competitive Equilibrium
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Long-Run Competitive Equilibrium
Features of Long Run Competitive Equilibrium
• P = MC


The one and only socially-efficient output.
For example, P = $2 and MC = $1 for candy is socially inefficient.
• There is some consumer willing to buy another candy for $2.
• There is a firm that can produce and distribute another candy for
$1.
• Society would be better off is we changed plans and the firm
produced and sold the extra candy for $1.50.
– The consumer gains $.50 surplus; the producer, $.50 surplus.
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Long-Run Competitive Equilibrium
Features of Long Run Competitive Equilibrium
• P = minimum AC
 Price depends solely on cost.
 Why does a Mercedes cost more to consumers than a
Honda?
 Any long-run difference in price is from a difference in
production cost.
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Summary
Summary
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Summary
Summary of exit (shut down) and entry conditions
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Review Questions
Review Questions
 You should try to answer some of the following questions
before the next class.
 You will not turn in your answers, but students may request
to discuss their answers to begin the next class.
 Your upcoming cumulative Final Exam will contain some
similar questions, so you should eventually consider every
review question before taking your exam.
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Review Questions
Follow the link
http://faculty.pepperdine.edu/jburke2/ba210/PowerP3/Set9Answers.pdf
for review questions for Lesson III.2
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BA 210
Introduction to Microeconomics
End of Lesson III.2
BA 210 Lesson III.2 Perfect Competition
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