Download Perfect Competition

Perfect Competition
Lecture by: Jacinto Fabiosa
Fall 2005
Market Structure
• Sellers want to sell at the highest possible price
– Buyers seek lowest possible price
– All trade is voluntary
• When we observe buyers and sellers in action
– See that different goods and services are sold in vastly
different ways
• When economists turn their attention to
differences in trading they think immediately about
market structure
– Characteristics of a market that influence behavior of
buyers and sellers when they come together to trade
2
Factors Considered
• To determine structure of any particular
market, we begin by asking
– How many buyers and sellers are there in the
market?
– Is each seller offering a standardized product,
more or less indistinguishable from that offered
by other sellers
• Or are there significant differences between the
products of different firms?
– Are there any barriers to entry or exit, or can
outsiders easily enter and leave this market?
3
Classification of Market Structure
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly
4
The Three Requirements of Perfect
Competition
• Large numbers of buyers and sellers, and
– Each buys or sells only a tiny fraction of the
total quantity in the market
• Sellers offer a standardized product
• Sellers can easily enter into or exit from
market
5
A Large Number of Buyers and
Sellers
• In perfect competition, there must be many
buyers and sellers
– How many?
• Number must be so large that no individual decision
maker can significantly affect price of the product by
changing quantity it buys or sells
6
A Standardized Product Offered by
Sellers
• Buyers do not perceive significant
differences between products of one seller
and another
– For instance, buyers of wheat do not prefer one
farmer’s wheat over another
7
Easy Entry into and Exit from the
Market
• Entry into a market is rarely free—a new seller must
always incur some costs to set up shop, begin production,
and establish contacts with customers
– But perfectly competitive market has no significant barriers to
discourage new entrants
• Any firm wishing to enter can do business on the same terms as firms
that are already there
• In many markets there are significant barriers to entry
– Legal barriers
– Existing sellers have an important advantage that new entrants can
not duplicate
• Brand loyalty enjoyed by existing producers would require a new
entrant to wrest customers away from existing firms
– Significant economies of scale may give existing firms a cost
advantage over new entrants
8
Easy Entry into and Exit from the
Market
• Perfect competition is also characterized by
easy exit
– A firm suffering a long-run loss must be able to
sell off its plant and equipment and leave the
industry for good, without obstacles
• Significant barriers to entry and exit can
completely change the environment in
which trading takes place
9
Is Perfect Competition Realistic?
• Assumptions market must satisfy to be perfectly
competitive are rather restrictive
• In vast majority of markets, one or more of assumptions of
perfect competition will, in a strict sense, be violated
– Yet when economists look at real-world markets, they use perfect
competition more often than any other market structure
• Why is this?
– Model of perfect competition is powerful
– Many markets—while not strictly perfectly competitive—come
reasonably close
• We can even—with some caution—use model to analyze
markets that violate all three assumptions
• Perfect competition can approximate conditions and yield
accurate-enough predictions in a wide variety of markets
10
The Perfectly Competitive Firm
• When we examine a competitive market
from a distance, we get one view of what is
occurring
– When we closely examine the individual
competitive firm, we get an entirely different
picture
• In learning about competitive firm, must also
discuss competitive market in which it
operates
11
The Competitive Industry and Firm
12
Goals and Constraints of the
Competitive Firm
• Perfectly competitive firm faces a cost
constraint like any other firm
• Cost of producing any given level of output
depends on
– Firm’s production technology
– Prices it must pay for its inputs
13
The Demand Curve Facing a
Perfectly Competitive Firm
• Demand curve facing Small Time Gold
Mines
– It’s horizontal, or infinitely price elastic
• Why should this be?
– In perfect competition output is standardized
– No matter how much a firm decides to produce,
it cannot make a noticeable difference in
market quantity supplied
• So cannot affect market price
14
The Demand Curve Facing a
Perfectly Competitive Firm
• Means Small Time has no control over the
price of its output
– Simply accepts market price as given
• In perfect competition, firm is a price taker
– Treats the price of its output as given and beyond its
control
• Since a competitive firm takes the market
price as given
– Its only decision is how much output to produce
and sell
15
Cost and Revenue Data for a
Competitive Firm
• For a competitive firm, marginal revenue at
each quantity is the same as the market
price
• For this reason, marginal revenue curve
and demand curve facing firm are the same
– A horizontal line at the market price
16
Profit Maximization in Perfect
Competition
17
The Total Revenue and Total Cost
Approach
• Most direct way of viewing firm’s search for
the profit-maximizing output level
• At each output level, subtract total cost from
total revenue to get total profit at that output
level
– Total Profit = TR - TC
18
The Marginal Revenue and Marginal
Cost Approach
• Firm should continue to increase output as long
as marginal revenue > marginal cost
• Remember that profit-maximizing output is found
where MC curve crosses MR curve from below
• Finding the profit-maximizing output level for a
competitive firm requires no new concepts or
techniques
19
Measuring Total Profit
• Start with firm’s profit per unit
– Revenue it gets on each unit minus cost per unit
• Revenue per unit is the price (P) of the firm’s output, and cost
per unit is our familiar ATC, so we can write
– Profit per unit = P – ATC
• Firm earns a profit whenever P > ATC
– Its total profit at the best output level equals area of a
rectangle with height equal to distance between P and
ATC, and width equal to level of output
• A firm suffers a loss whenever P < ATC at the best
level of output
– Its total loss equals area of a rectangle
• Height equals distance between P and ATC
• Width equals level of output
20
Measuring Profit or Loss
21
The Firm’s Short-Run Supply Curve
• A competitive firm is a price taker
– Takes market price as given and then decides how
much output it will produce at that price
• Profit-maximizing output level is always found by
traveling from the price, across to the firm’s MC
curve, and then down to the horizontal axis, or
– As price of output changes, firm will slide along its MC
curve in deciding how much to produce
• Exception
– If the firm is suffering a loss large enough to justify
shutting down
• It will not produce along its MC curve
• It will produce zero units instead
22
Short-Run Supply Under Perfect
Competition
23
The Shutdown Price
• Price at which a firm is indifferent between producing and
shutting down
• Can summarize all of this information in a single curve—
firm’s supply curve
– Tells us how much output the firm will produce at any price
• Supply curve has two parts
– For all prices above minimum point on its AVC curve, supply curve
coincides with MC curve
– For all prices below minimum point on AVC curve, firm will shut
down
• So its supply curve is a vertical line segment at zero units of output
• For all prices below $1—the shutdown price—output is
zero and the supply curve coincides with vertical axis
24
Competitive Markets in the ShortRun
• Short-run is a time period too short for firm
to vary all of its inputs
– Quantity of at least one input remains fixed
• Let’s extend concept of short-run from firm
to market as a whole
• Conclusion
– In short-run, number of firms in industry is fixed
25
The (Short-Run) Market Supply
Curve
• Once we know how to find supply curve of each
individual firm in a market
– Can easily determine the short-run market supply curve
• Shows amount of output that all sellers in market will offer at
each price
– To obtain market supply curve sum quantities of output supplied
by all firms in market at each price
• As we move along this curve, we are assuming
that two things are constant
– Fixed inputs of each firm
– Number of firms in market
26
Deriving The Market Supply Curve
27
Short-Run Equilibrium
• How does a perfectly competitive market
achieve equilibrium?
– In perfect competition, market sums buying and
selling preferences of individual consumers and
producers, and determines market price
• Each buyer and seller then takes market price as
given
– Each is able to buy or sell desired quantity
• Competitive firms can earn an economic
profit or suffer an economic loss
28
Perfect Competition
29
Short-Run Equilibrium in Perfect
Competition
(a)
Market
(b)
Firm
Dollars
Price
per
Bushel
MC ATC
S
$3.50
$3.50
d1
Loss per
Bushel
at p = $2
2.00
D1
2.00
Profit per
Bushel
at p = $3.50
d2
D2
400,000
700,000 Bushels
per Year
4,000
7,000
Bushels
per Year
30
Profit and Loss and the Long Run
• In a competitive market, economic profit and loss are the
forces driving long-run change
– Expectation of continued economic profit (losses) causes outsiders
(insiders) to enter (exit) the market
• In real world entry and exit occur literally every day
– In some cases, we see entry occur through formation of an entirely
new firm
– Entry can also occur when an existing firm adds a new product to
its line
• Exit can occur in different ways
– Firm may go out of business entirely, selling off its assets and
freeing itself once and for all from all costs
– Firm switches out of a particular product line, even as it continues
to produce other things
31
From Short-Run Profit to Long-Run
Equilibrium
• As we enter long-run, much will change
– Economic profit will attract new entrants
• Increasing number of firms in market
– As number of firms increases, market supply curve will shift
rightward causing several things to happen
» Market price begins to fall
» As market price falls, demand curve facing each firm
shifts downward
» Each firm—striving as always to maximize profit—will
slide down its marginal cost curve, decreasing output
32
From Short-Run Profit to Long-Run
Equilibrium
• This process of adjustment—in the market and
the firm—continues until…well, until when?
– When the reason for entry—positive profit—no longer
exits
– Requires market supply curve to shift rightward enough,
and the price to fall enough
• So that each existing firm is earning zero economic profit
• In a competitive market, positive economic profit
continues to attract new entrants until economic
profit is reduced to zero
33
From Short-Run Profit To Long-Run
Equilibrium
34
From Short-Run Loss to Long-Run
Equilibrium
• What if we begin from a position of loss?
– Same type of adjustments will occur, only in the
opposite direction
• In a competitive market, economic losses
continue to cause exit until losses are reduced to
zero
• When there are no significant barriers to exit
– Economic loss will eventually drive firms from the
industry
• Raising market price until typical firm breaks even again
35
Distinguishing Short-Run from LongRun Outcomes
• In short-run equilibrium, competitive firms
can earn profits or suffer losses
– In long-run equilibrium, after entry or exit has
occurred, economic profit is always zero
• When economists look at a market, they
automatically think of short-run versus longrun
– Choose the period more appropriate for
question at hand
36
The Notion of Zero Profit in Perfect
Competition
• We have not yet discussed plant size of
competitive firm
• The same forces—entry and exit—that
cause all firms to earn zero economic profit
also ensure
– In long-run equilibrium, every competitive firm
will select its plant size and output level so that
it operates at minimum point of its LRATC curve
37
Perfect Competition and Plant Size
• llustrates a firm in a perfectly competitive market
– But panel (a) does not show a true long-run equilibrium
– How do we know this?
• In long-run typical firm will want to expand
• Why?
– Because by increasing its plant size, it could slide down its
LRATC curve and produce more output at a lower cost per unit
– By expanding firm could potentially earn an economic profit
• Same opportunity to earn positive economic profit will attract
new entrants that will establish larger plants from the outset
• Entry and expansion must continue in this market
until the price falls to P*
– Because only then will each firm—doing the best that it
can do—earn zero economic profit
38
Perfect Competition and Plant Size
39
A Summary of the Competitive Firm
in the Long-Run
• Can put it all together with a very simple
statement
– At each competitive firm in long-run equilibrium
• P = MC = minimum ATC = minimum LRATC
• This equality is satisfied when the typical firm
produces at point E
– Where its demand, marginal cost, ATC, and LRATC
curves all intersect
• In perfect competition, consumers are getting the
best deal they could possibly get
40
A Change in Demand
• Short-run impact of an increase in demand is
– Rise in market price
– Rise in market quantity
– Economic profits
• What happens in long-run after demand curve
shifts rightward?
– Market equilibrium will move from point A to point C
• Long-run supply curve
– Curve indicating quantity of output that all sellers in a
market will produce at different prices
• After all long-run adjustments have taken place
41
An Increasing-Cost Industry
42
An Increasing-Cost Industry
NEW EQUILIBRIUM
Firm
Market
Price
per
Unit
Dollars
MC
B S1
PSR
S2
C
SLR
P2
P1
A
B
PSR
C
ATC1
P2
P1
ATCdSR= MRSR
A
d2= MR2
d1= MR1
D2
D1
Q1
QSR Q2
Output
per
Period
q1 q2 qSR
Output
per
Period
43
Increasing, Decreasing, and
Constant Cost Industries
• Increase in demand for inputs causes price
of those inputs to rise
• This type of industry (which is the most
common) is called an increasing cost
industry
– Entry causes input prices to rise
• Shifts up typical firm’s ATC curve
– Raises market price at which firms earn zero economic
profit
» As a result, long-run supply curve slopes upward
44
Increasing, Decreasing, and
Constant Cost Industries
• Other possibilities
– Industry might use such a small percentage of total inputs that—
even as new firms enter—there is no noticeable effect on input
prices
• Called a constant cost industry
– Entry has no effect on input prices, so typical firm’s ATC curve stays put
» Market price at which firms earn zero economic profit does not
change
» Long-run supply curve is horizontal
– Decreasing cost industry, in which entry by new firms actually
decreases input prices
• Entry causes input prices to fall
– Causes typical firm’s ATC curve to shift downward
» Lowers market price at which firms earn zero economic profit
» As a result, long-run supply curve slopes downward
45
Market Signals and the Economy
• In real world, demand curves for different goods and
services are constantly shifting
• As demand increases or decreases in a market, prices
change
• Economy is driven to produce whatever collection of
goods consumers prefer
• In a market economy, price changes act as market signals,
ensuring that pattern of production matches pattern of
consumer demands
– When demand increases, a rise in price signals firms to enter
market, increasing industry output
– When demand decreases, a fall in price signals firms to exit
market, decreasing industry output
46
Market Signals and the Economy
• Market signal
– Price changes that cause firms to change their
production to more closely match consumer demand
• No single person or government agency directs
this process
– This is what Adam Smith meant when he suggested
that individual decision makers act for the overall
benefit of society
• Even though, as individuals, they are merely trying to satisfy
their own desires
• As if guided by an invisible hand
47
Using the Theory: Changes in
Technology
• Competitive markets ensure that technological advances
are turned into benefits for consumers
• One industry that has experienced especially rapid
technological changes in the 1990s is farming
• Let’s see what happens when new, higher-yield corn
seeds are made available
– Suppose first that only one farm uses the new technology
• In long-run, economic profit at this farm will cause two
things to happen
– All other farms in market will have a powerful incentive to adopt
new technology—to plant the new, genetically engineered seed
themselves
– Outsiders will have an incentive to enter this industry with plants
utilizing the new technology
• Shifting market supply curve rightward and driving down the market
price
48
Using the Theory: Changes in
Technology
• Can draw two conclusions about technological
change under perfect competition
– All farms in the market must use the new technology
– Gainers are consumers of corn, since they benefit from
the lower price
• Impact of technological change
– Under perfect competition, a technological advance
leads to a rightward shift of market supply curve,
decreasing market price
• In short-run, early adopters may enjoy economic profit, but in
long-run, all adopters will earn zero economic profit
• Firms that refuse to use the new technology will not survive
49
Using the Theory: Changes in
Technology
• Technological advances in many
competitive industries have spread quickly
– Shifting market supply curves rapidly and
steadily rightward over the past 100 years
• While this has often been hard on individual
competitive firms it has led to huge rewards for
consumers
50
Technological Change in Perfect
Competition
(b) Firm
(a) Market
Price
per
Bushel
Dollars
per
Bushel
S1
S2
ATC1
A
ATC2
d1 = MR1
$3
$3
B
2
2
d2 = MR2
D
Q1
Q2
Bushels
per Day
1000
Bushels
per Day
51