Download 1 Unit 6. Firm behaviour and market structure: perfect competition

Unit 6. Firm behaviour and market structure: perfect competition
Learning objectives:
 to determine short-run and long-run equilibrium, both for the profitmaximizing individual firm and for the industry;
 to explain the equilibrium relationships among price, marginal and
average revenues, marginal and average costs, and profits;
 to understand the adjustment process to long-run equilibrium.
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Questions for revision:
The relationships among the short-run and long-run costs: total,
average and marginal;
Total and marginal revenue;
The profit-maximizing rule;
Market supply and the law of supply;
Market equilibrium;
Efficiency of a competitive market;
Tax incidence and dead weight loss.
6.1. Product markets: characteristics and types. Perfect competition as
a market structure
Supply
A commonly used classification of market structures is based on
quantity of producers and consumers.
Many
Many
Perfect competition
Demand
A group
Oligopsony
A group
Oligopoly
Bilateral oligopoly
Single
Monopoly
Monopoly bounded
by oligopsony
Single
Monopsony
Monopsony bounded
by oligopoly
Bilateral monopoly
Based on: von Stackelberg H. Grundlagen der theoretischen
Volkswirtschaftslehre. 2. Auflage. – Bern: A. Francke AG. Verlag; Tübingen: J.C.B.
Mohr (Paul Siebeck), 1951; Euken W. Gründsätze der Wirtschaftspolitik. – Tübingen:
Möhr, 1960.
We are going to study perfect competition, monopoly, monopolistic
competition and oligopoly at product markets. The following table
summarizes the typical features of these market structures.
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Perfect Competition
Imperfect Competition
Monopolistic Competition Monopoly and Oligopoly
Many buyers and sellers
Many buyers and sellers
One or few sellers (large)
Firms are too small to affect
price
Can affect price
Can affect price
Identical (homogeneous)
products
Goods are close substitutes
Homogeneous or
heterogeneous goods
Free entry and exit
Free entry and exit
Big entry costs
Zero profits in the long run
Zero profits in the long run
Profits can be positive
Under perfect competition each market participant is too small to
affect the market price: firms are price-takers. Producers have no market
power. Prices are considered by the firms as exogenous parameters set by
market equilibrium.
Under perfect competition all firms produce an identical
(homogeneous) good. There is free entry of firms to the market and free
exit from the market. There is perfect mobility of factors of production.
6.2. Perfectly competitive firm and industry: profit maximization and
supply in short run
A competitive firm can sell as much as it wants at the market price
P . It cannot sell anything at a higher price. A firm cannot influence the
market price which is set by market equilibrium. Its demand curve (D) is
horizontal (see the figure below).
A firm’s average revenue is equal to marginal revenue and both
coinside with market price:
MR=AR=P.
For a competitive firm the profit-maximizing rule is reduced to
equation of marginal costs and market price. So, a competitive firm will
supply the product according to the rule:
P=MC(Q).
*
2
PR,
TR,
TC
break-even
points
TC
Profit maximization
by a competitive firm
in short run
TR
0
PR
P,
MC,
AC
Q*
Q
MC
AC
MR=AR=D
P
0
Q1
Q*
break-even outputs
Q
In short run a firm won’t immediately shut down, even if it bears
losses. If market price is higher than the minimum of AVC, the firm would
continue operating because it would cover a part of fixed cost that would be
losses if it shuts down (see the figure below).
Thus, a competitive firm will supply the product in short run
according to the rule P=MC(Q) if MC⩾AVCmin.
P,
SAC,
SMC,
AVC
Short run output decision and supply
SMC
SAC
AVC
Economic
loss
P
shutdown
price
0
shutdown output
shutdown
point
Q*
Q
In the short run equilibrium market price equates the quantity
demanded to the total quantity supplied by the given number of firms in the
industry when each firm produces on its short-run supply curve. Short-run
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industry supply curve is a horizontal sum of the SRS curves of individual
(existing) firms (see the figure below).
Industry supply in short run
AVC, Firm 1
AVC, Firm 2
P
Industry
P, MC
P, MC MC2 AVC
2
MC1
AVC1
S=∑MC
Р2
Р2
S=MC1
Р1
Р1
Q1+Q2 Q
Q2
Q 0 Q0 Q1
0
Q0 Q1 Q 0
6.3. Firm and industry in long run
In the long run a firm (producer) makes decisions: 1) whether it
wants to be in the market; and, if so, 2) how much output to produce.
Decision 2 is determined by the rule: MR=P=LRMC. Decision 1 is subject
to the obvious inequality: price must exceed or at least be equal to average
cost.
A competitive firm will supply the product in long run according to
the rule P=MC(Q) if MC≥ACmin.
Suppose that market price exceeds minimum LRAC, and a typical
firm is making economic profit. It will attract new firms to the market.
Entrance of the new firms will shift industry supply curve to the right,
equilibrium market quantity of sales will go up, and equilibrium price will
go down. This will go on until market price falls to the minimum of LRAC
curve. Hence, in long run economic profit of a representative firm is zero.
Thus, in long run equilibrium market price will be set at the point
where LRMC is equal to minimum LRAC of a representative firm:
P=LRMC=LRAC.
In LR equilibrium market price equates the quantity demanded to
the total quantity supplied when each firm produces on its long-run supply
curve, and the marginal firm makes only normal profits:
P  MR  LMC  SMS , P  LAC  SAC .
The following set of side-by-side graphs are used to derive the
long-run supply curve for an increasing-cost industry and a typical firm.
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P
Market equilibrium
Equilibrium of a firm
P,
MC,
SRS
∑LMC AC
D
SMC
SAC
LMC
LAC
1
E
P
E
Pf
MR=AR
m
Q 0
Qm
0
Q
Qf
Competitive equilibrium
in long run: firm and industry
m
f
Suppose that initially the perfectly competitive industry and a
representative firm are in long-run equilibrium (E). Industry equilibrium
price and quantity are labeled Pm and Qm respectively. The firm’s
equilibrium price and quantity are labeled Pf and Qf respectively. ∑LMC is
the horizontal sum of long run supply curves of all the firms in the market.
Assume an increase in demand for the product of the industry that yields a
shift in market demand curve to the right (or up). The new short-run
industry equilibrium price and quantity are labelled Pm2 and Qm2
respectively. The new short-run profit-maximizing price and quantity for
the typical firm are labelled Pf2 and Qf2 respectively (see the figure below).
Equilibrium market price and quantity of sales, as well as output of each
firm go up. In the short run the equilibrium moves from E to E2.
Market equilibrium
P
P,
∑LMC1 MC,
SRS1
AC
D2
D1
Equilibrium of a firm
SMC1
LMC1
Short run
economic profits
E2
Pm2
LAC1
E2
Pf2
MR2=AR2
E
Pm
0
E
Pf
Qm Qm2
SAC1
Qm 0
Qf Qf2
MR=AR
Qf
A shift in demand and a new equilibrium in short run
A typical firm in the market makes positive economic profits in the
short run (the shaded area in the figure above), that attracts new firms to the
industry. As the industry adjusts to a new long-run equilibrium the number
of firms goes up.
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A growth of output in an increasing-cost industry expands the
demand for factors of production and pushes up their prices. As a result a
firm’s average total cost curve shifts upward (see the figure below).
Entrance of new firms shifts down short-run supply curve. In the
long run equilibrium moves from E2 to E′. The new long-run equilibrium
price Pf′ will be lower than its former short-run equilibrium level Pf2 but
higher than the initial price Pf because in an increasing cost industry the
rising factors’ prices shift upward a firm’s average total cost curve (its
minimum is now above the former one), and the entrance of new firms to
the market will continue until the market price falls down to the new LAC
minimum (see the figure below). The quantity of the good sold and bought
in the market will go up.
The long-run industry supply curve connects all long-run
equilibrium points (LRS curve in the figure below). Industry long-run
supply curve is flatter than the short-run supply curve.
Market equilibrium
P
P, MC, AC Equilibrium of a firm
SMC1
SMC2 LMC
∑LMC SRS2
2
∑
LMC
LMC2
1
SRS11
LRS
E2
Pf2
E′ E2
D2
D1
Pm2
Pm′
Pm
0
E
E′
Qm Qm2 Qm′
Pf′
Pf
E
Qm 0
Qf=Qf′ Qf2
SAC2
SAC1
2LAC
2
LAC1
MR′=AR′
MR=AR
MR2=AR2
Qf
Long run market supply: increasing-cost industry
In a decreasing-cost industry input prices go down with an increase
in output, and the long-run supply curve is downward-sloping.
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P
Market equilibrium
SRS1
Pm2
Pm
E2
E
P, MC, AC Equilibrium of a
SMC2 SAC1
firm
∑LMC1
SMC1 LMC1
LMC2 SAC2
∑LMC2
Short run
SRS2
LAC1
economic
profits
LAC2
Pf2
E2
Pf
Pf′
LRS
D2
E′
Pm′
E
E′
MR=AR
MR′=AR′
MR2=AR2
D1
0
Qm Qm2
Qm′
Qf=Qf′ Qf2
Qm 0
Long run market supply: decreasing-cost industry
Qf
In a constant-cost industry input prices do not change with output,
and the long-run supply curve is horizontal.
Market equilibrium
P
P, C Equilibrium of a firm
∑LMC1
D2
SAC
SMC
∑LMC2
SRS1
LMC
Short run
D1
SRS2
economic
LAC
profits
E2
Pf2
Pm2
E
MR2=AR2
E
2
LRS
E′
Pf
Pm
E=E′
MR=AR
0
Qm Qm2
Qm′
Qf=Qf′Qf2
Qm 0
Long run market supply: constant-cost industry
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Qf