Download Unit 2.3.2 Perfect Competition

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Unit 2.3.2 Perfect Competition
Unit Overview
Unit 2.3.2 - Perfect competition
• Assumptions of the model
• Demand curve facing the industry and the firm in perfect competition
• Profit-maximizing level of output and price in the short-run and long-run
• The possibility of abnormal profits/losses in the short-run and normal profits in
the long-run
• Shut-down price, break-even price
• Definitions of allocative and productive efficiency
• Efficiency in perfect competition
Blog posts: "Perfect competition"
Blog posts: "Profit maximization"
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Perfect Competition
Characteristics of Perfectly Competitive markets
Discussion question:
What will happen to the price of pizza when YOU demand more pizza?
What about when you and your closest friends demand more pizza?
Explain what will happen and why?
Discussion:
Clearly, nothing will happen to the price of pizza when you or your closest friends
demand more pizza. You pay the price that the market has determined.
Similarly, in a purely competitive market, nothing will happen to the price of a
product when one firm (or a few firms) begin supplying more output.
• Firms in perfectly competitive markets are price takers. No individual firm
exerts enough market power to influence the price. Firms must adjust to the
market price, they cannot charge anything above the market price, or demand for
their output will fall to ZERO.
• In other words, purely competitive firms face a perfectly elastic demand curve!
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Perfect Competition
Characteristics of Perfectly Competitive markets
Many sellers: means that there are enough so that a single seller has no
impact on price by its decisions alone.
Standardized products: The products in a purely competitive market are
homogeneous or standardized; each seller’s product is identical to its
competitor’s.
Price-takers: Individual firms must accept the market price; they are price
takers and can exert no influence on price.
Freedom of entry and exit: means that there are no significant obstacles
preventing firms from entering or leaving the industry.
Pure competition is rare in the real world, but the model is important.
>>The model helps analyze industries with characteristics similar to pure competition.
>>The model provides a context in which to apply revenue and cost concepts
developed in previous chapters.
>>Pure competition provides a norm or standard against which to compare and
evaluate the efficiency of the real world.
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Perfect Competition
Demand as seen by a PC seller
Why study pure competition if actual purely competitive markets do not exist?
• Purely competitive markets represent allocative efficiency. The operation of a
purely competitive economy provides a “standard, or norm” for evaluating the
efficiency of the real-world economy.
The individual firm will view its demand as perfectly elastic.
• The demand curve is not perfectly elastic for the industry: It only appears that way
to the individual firm, since it must charge the market price no matter what quantity
it produces. Purely competitive firms are price takers!!!
What happens if the firm increases its output? >>Market price stays same
Lowers its output? >>SAME equilibrium price!
Definitions of average, total, and marginal revenue:
• Average revenue (AR) is the price per unit for each firm in pure competition. AR=P
• Total revenue (TR) is the price multiplied by the quantity sold. TR = PQ
• Marginal revenue (MR) is the change in total revenue that results from selling 1
more unit of output. MR will also equal the unit price in conditions of pure
competition.
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Perfect Competition
Demand as seen by a PC seller
P
Perfectly Competitive Industry
Sindustry P
Pe
Perfectly Competitive Firm
DfirmMR=AR=P
Dindustry
Q
Q
A PC firm is a price taker:
• The price faced by each firm is determined by market supply and demand
• Since price equals average revenue, the firm's demand curve also represents
the firm's average revenue at each level of output.
• Since the firm can sell as much as it wants at Pe, the marginal revenue equals
the price. Therefore: MR = D = AR = P
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Perfect Competition
Profit Maximization - Total Revenue and Total Cost
Costs and Revenues
Profit =
Total Revenue - Total Cost
Total Revenue = Price x Quantity
TR
TC
Since the price a PC firm receives is
constant at all levels of the firm's output,
TR increases at a constant rate with output.
Max
profit!
Profit maximization:
Economic Profit = TR - TC. The firm wants to
produce the level of output at which the
vertical distance between TR and TC is
greatest.
Break even points:
Break even point
Break even point
Profit-max point
Q
Normal profit: the minimum level of profit
needed just to keep an entrepreneur operating
in his current market. If he does not earn
normal profit, an entrepreneur will direct his
skills towards another market.
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TR and TC are equal, meaning the firm is
earning a normal profit but zero economic
profits.
Economic profit: also called "super-normal
profits". When revenues exceed all costs and
normal profit. Firms are attracted to
industries where economic profits are being
earned
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Perfect Competition
Profit maximization: Marginal Revenue = Marginal Cost
A firm will maximize its profits when it produces at the point where its marginal
cost of production is equal to its marginal revenue.
MR = MC
• This maximizes profits because any time the last unit produced brings more
additional revenue (MR) than it incurs in additional cost (MC), the firm can
increase its profits by producing that unit
• On the other hand, if the last unit produced incurs a more additional cost (MC)
than it brings in additional revenue, then the firm's profits will decline if it
produces that unit.
Conclusion: When MR>MC at the margin, the firm will profit by producing more.
When MC>MR at the margin, the firm will profit more by producting less. Only
when MC=MR is the firm doing the best it possibly can!
• This rule applies only when producing is preferable to shutting down. If MR<AVC,
the firm would be better off shutting down.
• The rule applies to all market structures
• In pure competition, the rule can also be stated as the P=MC rule, since marginal
revenue equals price in a purely competitive market.
Practice Profit-maximization: Rainbow book Activity 28
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Perfect Competition
Profit maximization: MR = MC
A firm will produce where MR = MC:
P
Shoe Market
Sindustry
P/C
Shoe Firm
Pe
MC
MR=D=AR=P
P1
MR=D=AR=P1
D1
Dindustry
Q
Q2 Q1
Q
The profit-maximizing level of output by the firm depends on the price
determined by the market
1) Pe is determined by the total market supply and demand.
2) The firm faces its own marginal cost curve
3) The firm will choose to produce at the level of output where the MC equals MR
4) If MR falls because of falling demand, profit maximizing level of output for the firm falls
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Perfect Competition
Profit maximization: MR = MC
Profit-maximizing case:
Shoe Market
P
Sindustry
P/C
Shoe Firm
MC
ATC
AVC
Pe
MR=D=AR=P1
ATC
Dindustry
Qe
Q
Profit = TR - TC
• No TR and TC curves in the firm diagram, but
there is AR and ATC
Per unit profit = AR - ATC
• To determine the amount of a PC firm's profit,
subtract ATC from AR at the profit-maximizing
level of output.
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Q
Is the firm above earning
economic profits?
Yes, because average revenue is
greater than average cost!
Total profits = (AR - ATC) x Q
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Perfect Competition
Quick Quiz
A firm in perfect competition is producing at the profit
maximizing output, but making a loss. Using diagrammatic
analysis, explain how this is possible.
(Total 10 points)
The profit maximizing output is where MC = MR. If, at this output, AC is greater than AR,
the firm will make a loss in the short run. Answers should illustrate this point using the
standard perfect competition diagram.
Providing the above is clearly and accurately explained and illustrated, nothing further
would be required for full marks. It would be extremely difficult to fully answer this
question without the use of a diagram, and a maximum of [6 marks] should be awarded if
there is no appropriate diagrammatic illustration.
[10 marks]
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Perfect Competition
Profit maximization: MR = MC
Loss-minimizing case:
P
PC Industry
P/C
Sindustry
PC Firm
MC
ATC
AVC
ATC
Pe
MR=D=AR=P1
Dindustry
Q
Qf
Q
If the firm's costs increase or the price it can sell for decreases,
AR - ATC is negative,
it may be in a situation where it must minimize losses.
meaning the firm is
• ATC > AR, the firm is losing money on each unit it produces.
experiencing losses
• The AR is still greater than AVC, meaning the firm can cover its
variable costs in the short-run
• The firm will remain open as long as it can cover its variable
Total loss = (ATC-AR) x Qs
costs
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Perfect Competition
Profit maximization: MR = MC
Shut-down scenario:
P
MC
PC Industry
ATC
PC Firm
P/C
AVC
Sindustry
ATC
Loss
AVC
Pe
MR=D=AR=P1
Dindustry
Q
Qf
Q
If the supply in the industry increases or demand falls, or if the firm's costs increase,
it may be in a situation where it would be better off shutting down.
Why shut down? Because at every level of output, the firm's average variable cost is
higher than its average revenue. This firm is not even earning enough revenue to pay its
workers or pay for raw materials! The firm MUST SHUT DOWN!
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Perfect Competition
Long-run Equilibrium
Discussion Question:
How will the existence of economic profits in a purely competitive market
affect the total supply in that market?
Remember, FIRMS ARE PROFIT SEEKERS!
Answer:
Because there are NO BARRIERS TO ENTRY, new firms will enter a market
where profits are being earned. As new firms enter, market supply will shift
out, lowering the market price faced by firms, eliminating economic profits.
Question:
How will the existence of economic losses among the firms in a purely
competitive market affect the total supply in the market?
Answer:
Because firms are loss averse, and there are NO BARRIERS TO EXIT,
some firms will leave the industry, reducing market supply, increasing
the price, eliminating losses for the remaining firms!
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Perfect Competition
Long-run Equilibrium
Entry eliminates profits:
P
PC Industry
PC Firm
Sindustry P/C
MC
ATC
AVC
P1
MR=D=AR=P
economic profit
Dindustry
Q
Qf
Q
The firm above is earning economic profits because AR > ATC at its current
level of output.
• What will happen to the firm's profits in the long-run? Why?
• Illustrate the long-run changes that will occur on the graphs
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Perfect Competition
Long-run Equilibrium
Exit eliminates losses:
P
PC Industry
P/C
Sindustry
PC Firm
MC
ATC
AVC
ATC
Pe
MR=D=AR=P1
AVC
Dindustry
Q
Qf
Q
The firm above is losing money becaues AR < ATC at its current level of
output.
• What will happen to the firm's losses in the long-run? Why?
• Illustrate the long-run changes that will occur on the graphs
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Perfect Competition
Long-run Equilibrium
Long-run equilibrium in PC:
P
PC Industry
SindustryP/C
PC Firm
MC
ATC
AVC
P1
MR=D=AR=P
Dindustry
Q
Qf
Q
The industry above is earning in long-run equlibirum:
• Why?
• How would an increase in demand affect the industry? A decrease?
• How would an increase in the firms' costs affect the industry? A decrease?
Practice SR and LR Equilibrium: Rainbow book Activity 29
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Perfect Competition
Marginal Cost as the firm's Supply Curve
PC firms adjust their output in response to changes in price.
A PC firm will shut down
when MR falls below AVC.
When MR is above AVC, the
firm will increase its output
as price increases according
to its upward sloping MC
curve.
The MC curve above AVC
shows a direct relationship
between Price (AR) and
quantity supplied.
The MC curve above AVC
IS THE INDIVIDUAL FIRM'S
SUPPLY CURVE!
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PC Firm
P
MC
MR4
P4
Firm's Supply curve
P3
MR3
AVC
P2
MR2
P1
MR1
Q
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Perfect Competition
Marginal Cost as the firm's Supply Curve
Points to understand about the MC curve as the firm's short-run supply curve
The MC increases as ouput increases
because of diminishing marginal returns
Since the MC increases at higher level of
ouput, firms require a higher prices in
order for them to increase output, so
they can maintain the MR=MC level and
maximize profits.
PC Firm
P
MC
Firm's Supply curve
In other words, the MC curve represents
the relationship between price and
quantity supplied. This is a direct
relationship (demonstrating the law of
supply!)
AVC
Q
What would cause the firm's supply (MC) curve to shift?
Changes in the prices of variable inputs: For example, a higher minimum wage will shift
the cost curve of a firm employing minimum wage workers UP. This corresponds to a
leftward shift of the firm's supply curve.
Improvements in technology will shift MC down: since better technology makes all
workers more productive (shift the MP and AP curves up, thus the MC and AVC curves
down). This corresponds with an outward shift of the firm's supply curve
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Perfect Competition
Marginal Cost and Market Supply
P
PC Firm
MC
Firm's Supply curve
P
AVC
$5
MR=AR
x200=
PC Market with 200
identical firms
S=MC
$5
D
10
Q
2000
Q
From the firm to the market - Marginal Cost = Supply:
• 200 identical firms making an identical product with identical costs
• Each firm produces the profit maximizing level of output based on where the
price equals its MC
• Equilibrium output in the market is found at the intersection of market
supply and market demand.
• Total quantity supplied equals the product of the individual firms' output
multiplied by the number of firms
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Perfect Competition
Allocative and Productive Efficiency
Discuss:
"Purely competitive markets are clearly undesirable. Firms in such
markets are doomed to earning NO profits, so how could such a market
be good for society?"
Firms in purely competitive industries:
Why are they winners?
Why are they losers?
Consumers in purely competitive industries:
Why are they winners?
Why are they losers?
Practice graphing PC: NCEE workbook Activity 31
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Perfect Competition
Allocative and Productive Efficiency
In long-run equilibrium, purely competitive firms will produce at the level of
output where the price equals firms' marginal cost and its minimum average
total cost. This represents
Productive Efficiency: P= minimum ATC
Interpretation: The firms are using resources to their maximum
efficiency by producing their output at the lowest possible
average total cost. Competition forces firms to use resources as
efficiently as possible.
Allocative Efficiency: P = MC
Interpretation: The right amount of output is being produced. There
is neither under nor over-allocation of resources towards a good in a
purely competitive industry. If the price were higher than the
marginal cost, this is a signal that more output is desired, if price
were lower than marginal cost, the signal from buyers to sellers is
that less output is desired. Only when P = MC is the right amount of
output being produced.
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Perfect Competition
Allocative and Productive Efficiency
Price as a signal from consumers to producers:
• If the price of a lattes goes up, it is a signal to producers that consumers wants
more lattes, so more resources should be allocated towards the production of
lattes.
• As firms produce more lattes, their MC will increase until P = MC once more. Only
then have the right amount of lattes been produced! ALLOCATIVE EFFICIENCY is
achieved when P = MC!
Discussion Questions:
Allocative Efficiency: Is P = MC good for society? Why or why not?
Productive Efficiency: Is P = min. ATC good for society? Why or why not?
Are ZERO economic profits bad for firms? Why or why not?
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Perfect Competition
Practice Free Response Question
Luigi's, a typical profit-maximizing pizzeria, is operating in a perfectly
competitive industry that is in long-run equilibrium.
(a) Draw correctly labeled side-by-side graphs for the pizza market and for
Luigi's and show each of the following.
(i) Price and output for the market
(ii) Price and output for Luigi's
(b) Assume that pizza is a normal good and that consumer income falls.
Assume that Luigi's continues to produce. On your graphs in part (a), show
the effect of the derease in income on each of the following in the short run.
(i) Price and output for the industry
(ii) Price and output for Luigi's
(iii) Area of loss or profit for Luigi's
(c) Following the decrease in consumer income, what must be true for Luigi's
to continue to produce in the short run?
(d) Assume that the market adjusts to a new long-run equilibrium. Compare
the following between the initial and the new long-run equilibrium.
(i) Price in the industry
(ii) Output of a typical firm
(iii) The number of firms in the dairy industry
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Perfect Competition
Practice problems
Describe the situation in the market below and firm below.
• Show the firm's i) MR, ii) Output, iii) Economic profit or loss
• Assuming this is a PC market, describe and illustrate the long run adjustments that will restore
this market to Equilibrium. Show on the graphs, for both the industry and the firm, the price and
output after long-run adjustments
P
Industry
MC
Sindustry P
Pe
Firm
ATC
AVC
MR=D=AR=P1
Dindustry
Q
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Perfect Competition
Practice problems
Describe the situation in the market below and firm below.
• Show the firm's i) MR, ii) Output, iii) Economic profit or loss
• Assuming this is a PC market, describe and illustrate the long run adjustments that will restore
this market to Equilibrium. Show on the graphs, for both the industry and the firm, the price and
output after long-run adjustments
P
Industry
Sindustry P
Firm
MC
ATC
AVC
Pe
MR=D=AR=P1
Dindustry
Q
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Perfect Competition
Practice problems
Describe the situation in the market below and firm below.
• Show the firm's i) MR, ii) Output, iii) Economic profit or loss
• Assuming this is a PC market, describe and illustrate the long run adjustments that will restore this
market to Equilibrium. Show on the graphs, for both the industry and the firm, the price and output
after long-run adjustments
MC
P
Industry
Sindustry
P
Pe
Firm
ATC
AVC
MR=D=AR=P1
Dindustry
Q
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Perfect Competition
Practice problems
Describe the situation in the market below and firm below. Assume price of a close
substitute drops. Illustrate the changes that will occur in this market:
• Show the new industry price and output
• Show the new firm price and output
P
Industry
Sindustry P
Firm
MC
ATC
AVC
Pe
MR=D=AR=P1
Dindustry
Q
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Perfect Competition
Practice problems
Describe the situation in the market and firm below. Assume this product is featured in
a new movie and consumers' tastes shift towards it overnight. Illustrate the changes
that will occur in this market:
• Show the new industry price and output
• Show the new firm price and output
P
Industry
Sindustry P
Pe
Firm
MC
ATC
AVC
MR=D=AR=P1
Dindustry
Q
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Perfect Competition
Unit 2.3.2 Quiz
1.Distinguish between normal profits and economic profits. Explain why
firms in a perfectly competitive market are likely to earn only normal
profits in the long-run.
2. What is meant by economic efficiency? How do purely competitive
markets assure that economic efficiency is achieved?
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