Download Perfect Competition

C H AP T E R
P e rf e c t
EL E V E N
co m p e t i t i o n
Assume for the moment that you have completed your business training and that you are
working for some consulting firm. The first assignment you receive is to advise the
Tvelia Construction Corporation about the likelihood of success in that industry.
Assumptions:
1. You are the young executive on the rise.
2. You are concerned about future advancement.
3. You want to present an accurate and reliable forecast.
Assume that we know the Tvelia Construction Corp. is interested in building
small frame houses and their expected costs are:
Housing Units Total cost
Per Month
Per Month
0
$ 40,000.00
1
60,000.00
2
80,000.00
3
100,000.00
4
120,000.00
5
142,000.00
6
168,000.00
7
198,000.00
8
232,000.00
9
270,000.00
10
315,000.00
Questions:
1. What advice could you give them about their chance of success?
2. How many houses would they have to produce to make a profit?
Before you can answer these questions you probably would like to investigate the
market in which Tvelia Construction Corp. will be participating. Suppose you discover
that at some time there is a lot of similar construction firms while at other times there are
relatively few. Can you successfully formulate an analysis when the variables are
changing indiscriminately?
If you guess there is going to be few rival firms in the market when Tvelia
Construction Corp. enters, and there is not, then your report is incorrect. Your client
could suffer and your career definitely will! How can you protect both yourself and your
client?
Well one way to protect yourself is to formulate assumptions about the market
and base our study on those assumptions. Let’s assume the worse case (for us) exists.
This means that we discover a lot of competitors in the market. What does this imply?
Well as we have learned, everything is relative so we would like to know how much
competition exists.
Let’s assume that in this market the rivalry is so intense that the market drives the
price of a house to its lowest possible price. This means that there are so many producers
(sellers) in this market that one person alone cannot affect price. Now just to make this
competition even more intense lets also assume that each producer is manufacturing
exactly identical units. That is, there is no choice here. Given this we find the following:
S
P
$29,500
D
Q
As the consultant you now have all the facts to properly advise your client. How
many homes should be produced for this firm to maximize profits?
To make this calculation all the costs of production must be generated and
analyzed. From the data provided the following costs were computed:
O
0
1
TC
40
60
FC
40
40
VC
0
20
ATC
AFC
AVC MC
60
40
20
20
2
1.
2.
3.
4.
80
40
40
40
20
20
20
3
100 40
60
33
13
20
20
4
120 40
80
30
10
20
20
5
142
102 28
8
20
20
Assuming that your client wishes to maximize profits:
How many homes should be produced?
What will the profit be?
What does the demand curve for this firm look like?
Construct a graph that demonstrates the point at which profit is maximized.
40
Perfect Competition
What we have done here is to create a model that depicts the conditions that
would exist under perfect competition. Perfect competition is a market structure
characterized by a large number of buyers and sellers all engaged in the purchase and sale
of a homogeneous product, with perfect knowledge of market prices and quantities, no
discrimination, and perfect mobility of resources.
The assumption of this model are:
1. a large number of buyers and sellers;
2. homogeneous product;
3. freedom of entry and exit; and
4. perfect knowledge and mobility of resources.
Graphically the model appears as follows:
MC
ATC
AVC
P
Q
D=MR=P
As producers we were interested in knowing how many homes we should produce
to maximize our profits. From that complicated schedule of costs we see that profit is
maximized when 6 homes are produced. Can we find a way to show the point of profit
maximization graphically? Well we know that profit is simply total revenue minus total
costs. How much must we produce to maximize our profits?
Logically, we will only continue to produce if the benefits of producing a unit of
output exceed the costs. The benefits of production have, thus far, been measured by
looking at total revenue. However, it is more useful to know the amount of revenue each
unit of output contributes to total revenue. This can be calculated rather simply by
measuring the change in total revenue generated as output levels change. This is what
economists call marginal revenue. Thus by calculating marginal revenues and comparing
them to the marginal costs of production we can measure the benefits versus costs of
production.
Clearly the firm will produce units of output if the marginal revenue derived from
the sale of that unit is equal to or exceeds the costs of producing it. This is a rule known
as the profit maximizing rule. Profits will be maximized at the point where MR=MC.
Proof of the profit maximization rule:
1.
P=f(q) demand function
2.
TR=q x f(q) total revenue function
3.
C=b+ø(q) total cost function
4.
¶=q x f(q) - ø(q) profit=TR-TC
5.
d¶/dq=f’(q)-ø’(q) first derivative of equation 4
f’(q)=ø’(q) MR=MC
Now in the example we have constructed are we making a profit? What kind?
Normal or Economic? What will happen as a result of these economic profits? Other
business people will be encouraged to enter this industry, in search of the high rates of
return we are earning. Thus more competition is going to occur. This will drive prices
downward to the point where normal profits are being realized.
Change in supply resulting
in a loss
S1
S2
P5
MC
ATC
AVC
D=MR=P
P3
P3
D
Q
Q
If prices fall below this level the firm will suffer a loss and then must make a
decision of whether or not to go out of business. Generally firms that face this decision
have three choices:
1. Continue to operate in the short-run as long as AVC are being met. Some firms
realizing a loss will decide to stay in business as long as they can pay their work force
and their suppliers of raw materials. They do this with the hope that market conditions
will soon turn favorable and provide at least economic profits.
2. shut down temporarily until the market conditions change. Firms facing this scenario
have high variable costs and in an attempt to minimize those costs close their doors
temporarily with hope that other similar firms facing losses will leave the industry
leading to higher product prices. Once prices rise firms who have closed down will
reopen and charge the higher price for their product.
3. Go out of business. Firms that cannot meet any variable or fixed costs will go out of
business immediately. In this case neither supplier, workers or banks holding business
loans can be paid for services provided to the firm thus forcing the firm to go out of
business.
Losses force firms out of the
industry and price rises
S1
S3
S2
MC
D=MR=P
P4
P5
P4
P3
ATC
AVC
D
Q
Q
Normal Profit
MC
ATC
D=MR=P
P4
AVC
Q
We have constructed a model of perfect competition that depicts the costs of
production as well as the revenues (TR & MR) generated. We have observed that the
MR curve in this case also represents the demand curve for this product. As you recall
this demand curve demonstrates a series of prices and quantities at which demand exists.
But no-where have we indicated or implied the willingness and ability of the producer to
supply those goods. Where is the short-run supply curve in this model?
For a purely competitive industry the short run market supply curve is the
horizontal summation of the MC curves (above the level of AVC) for all the firms in the
industry. This can be said to be true because a supply curve is nothing more than a series
of prices and quantities at which supply exists, and, the MC curve shows the costs of
producing an additional unit. If an additional unit has been produced then supply has
increased by one unit. Furthermore, we make the observation that producers will be
willing to supply additional units only if they can meet their variable costs in the process.
Now, in the long run there may be adjustments in output and prices due to the
type of industry we are looking at. We know that for competitive industries the quantity
supplied will equal the quantity demanded at the market price. However, that long run
equilibrium can change if demand changes, allowing us to identify three different types
of industries that can exist. For example suppose there is an increase in demand that
causes price to be bid upward. This would result in economic profits and so more firms
will be attracted to the industry. If this leads to a return to the original price then factor
prices cost the same while output has increased. This is known as a constant cost
industry. In this case the long run supply curve is perfectly elastic.
Constant Cost Industry: Is one that does not experience increases in resource
prices or costs of production as new firms enter the industry. This happens when an
industry’s demand for resources is insignificant of the total demand for those resources
(i.e. unskilled labor.)
Increasing Cost Industry
S1
S2
LRS
P
D2
D1
Q
For some industries, however, the costs of production increase as output expands.
This we call an increasing cost industry.
Increasing Cost Industry: Is one that does experience increases in resource prices
and therefore increasing costs of production as new firms enter the industry. In this case
the industry’s demand for resources is a significant proportion of the total demand (i.e.
skilled labor).
Decreasing Cost Industry: Is one that experiences declining resource prices and
therefore falling costs of production as new firms enter the industry.
Decreasing Cost Industry
S1
S2
P
LRS
D2
D1
Q
Equilibrium conditions
under perfect competition.
MC=P=ATC=LRATC
1. MC=P Indicator of economic efficiency. This means that the value of the good to the
consumer is equal to the value of the resources used to produce that good. Therefore, the
MC=P condition is a standard of allocative efficiency. It measures the extent to which
the firm is making full utilization of its resources to fulfill the consumers preferences.
2. MC=MR Means that the firm is maximizing profit and there is no incentive for it to
alter its output.
3. MR=P Tells you the firm is selling in a perfectly competitive market.
4. MC=ATC Means the firm is operating at the minimum point on its ATC curve.
Therefore, the firm is incurring the least possible cost per unit given its current fixed
inputs.
5. MC=ATC=LRATC Indicates that the firm is producing the optimum output with the
optimum size plant. Therefore, the firm is allocating its resources in an efficient manner.
Favorable Features of Perfect Competition:
1. Consumer behavior is maximized. Meaning that consumers can get the most for the
least possible cost.
2. Our scarce resources are being allocated in the most efficient manner.
3. The high competition among employers for inputs and consumers for goods and jobs,
would cause factor owners to be paid their opportunity costs.
Unfavorable Features
1. May not address adequately all consumer desires.
2. Does not consider externalities and therefore my not contribute to social welfare.
3. Insufficient incentives for progress.
Our Farm Problem:
Applying the Perfectly Competitive Model
The problems that farmers have traditionally faced stem from four conditions:
1. Price and income inelasticities;
2. Highly competitive structure;
3. Rapid technological change; and
4. Resource mobility.
In regard to the price and income inelasticities we note that the demand for most
agricultural goods is relatively inelastic. Meaning that the demand for food is
unresponsive to price changes. In the same token the supply of most agricultural goods is
also inelastic. Crops cannot be instantly changed to meet the ever changing whims of the
consumer. Therefore, we know that crops cannot be increased during the growing season
in response to price changes.
Agricultural products are also income inelastic in demand. Income elasticity of
demand measures the percentage change in quantity demanded resulting from a one
percentage change in income. The income elasticity for farming products is somewhere
between 0.1 and 0.2 which implies that if income increases by 10% the demand for
agricultural products will increase by only 1 or 2%.
Now as a result of both price and income inelasticities, increases in the rate of
growth of farm production that exceed increases in the rate of growth of consumption
will cause a downward trend in farm prices and therefore farmers' incomes fall. Farmers
have thus been arguing that their incomes have been steadily decreasing over time and
they have been seeking special considerations from government in the form of tax
abatements or price supports.
Now this observation is correct but also somewhat misleading. Economists argue
that farmer’s incomes are actually substantially higher than reported because of:
1. Unreported income — estimates show that as much as 30% of the farmer’s income is
unreported.
2. Future Capital Gains - the soaring property values are not being included in the
farmers calculations of wealth.
3. Tax Benefits - that farmers have traditionally benefited from special considerations
under present tax laws. For example, over the years the farmer’s lobby has received
government support via:
a. price supports
b. surplus disposal
c. acreage curtailment
d. marketing quotas
e. direct payments
The issue according to the Reagan administration concerns the efficiency of the
above and the subsequent costs to society.