Download on to Perfect Competition

Week 7 – Perfect Competition – the short run
for the firm and the industry
(Note in Handbook – there is no Week 8!)
Perfect Competition – the main model for
microeconomics
- the firm in SR
- the industry in SR
- the firm in LR
- the industry in LR
- the dynamics of SR and LR adjustments
to a “shock” – how does equilibrium change
in SR and LR
1
Perfect Competition
1.
Many buyers, many sellers
(price takers)
2. Homogeneous good (no brand
loyalty)
3. Free entry and exit (no
barriers to competition)
4. Perfect information (no
mistakes)
The closer the situation to this ideal, the
better this model will apply to a real-world
situation
Examples?
2
How does individual PC firm behave?
It faces market price (no control). It has
known best-practice technology, can buy
inputs at same price as other firms. Wants to
maximize profit.
What does its demand curve look like? (and
why?)
P
The perfectly competitive
firm
3
q
Because individual PC firm has no power over
price, D curve is horizontal (perfectly
elastic). PC firm is a “price taker”
TR = P x q
If P is a constant (to the firm), its marginal
revenue is
MR = dTR/dq = d(P x q)/dq = P
MR = P
4
How does the individual PC firm behave?
Must choose amount of inputs and output to
maximize profit.
What about its costs?
SR and LR story.
In SR, costs probably look typical…
5
Cost per
unit
quantity
MC
AC
AVC
0
Quantity
produced
per unit of
time
6
Simplified a bit…
Cost per
unit
quantity
MC
AC
AVC
0
7
Quantity
produced
per unit of
time
Remember, cost curves (and cost functions) in
economics include all opportunity
costs…including those that accountants don’t
count (a normal return on money invested in
the firm, labour of family members and of the
owner, etc.)
8
PC firm will try to maximize profit. It can’t
change its cost curves. It can’t push up the
price. It can’t distinguish its product from
others by advertising/marketing/product
innovation.
All it can do is choose the profit-maximizing
output!
П = TR – TC
Max q П = dTR/dq = dTC/dq = 0
i.e., MR – MC = 0 or MR = MC
i.e., choose the output at which MR = MC
9
Profit-maximizing supply decision by PC firm
when P = P0
Cost per
unit
quantity
MC
AC
P0
AVC
0
10
Quantity
produced
per unit of
time
What happens to firm’s supply decision at
different possible prices?
Cost per
unit
quantity
MC
AC
P0
AVC
P1
P2
P3
P4
0
11
Quantity
produced
per unit of
time
Supply curve of individual PC firm is ?
Why?
Breakeven price?
Shut-down price?
12
Supply curve of PC industry in SR is?
If MC = 2 + .1q
And there are 1000 identical firms in the PC
industry
1000q = Q
or q = Q/1000 = .001Q
For firm, supply function is P = MC (above
AVC, of course)
Industry supply function is P = MC with
substitution for q
P = 2 + .1(.001Q)
Or P = 2 + .0001Q (SR Industry Supply Curve)
Limitation on function: must be above minAVC
13
Algebraic example
Market Demand: P = 154 - .06Q
Total cost function of each PC firm:
TC = 3q2 + 10q + 432
FC = 384
So, TVC = 3q2 + 10q + 48
MC =
AC =
AVC=
Where does AC reach minimum?
14
Where does AVC reach minimum?
Therefore, supply curve of individual PC firm
in this industry is?
If there are 100 identical firms in industry
then PC industry supply curve is?
15
Therefore, for PC industry in SR
Demand: P = 154 - .06Q
Supply: P = 10 + .06Q
SR equilibrium where D and S intersect
Q0* = 1200, Po* = $82
Each PC firm in this industry produces?
16
The firm and industry graph together
P
P
Industry
Supply - SR
A
Industry
Demand
q
Q
PC FIRM - SR
PC INDUSTRY - SR
17
The dynamics of the SR…what happens when
Demand increases?
P
P
Industry
Supply - SR
Industry
Demand
q
Q
PC FIRM - SR
PC INDUSTRY - SR
18
The dynamics of the SR…what happens when
Demand decreases?
P
P
Industry
Supply - SR
Industry
Demand
q
Q
PC FIRM - SR
PC INDUSTRY - SR
19
The dynamics of the SR…what happens when
costs increase?
P
P
Industry
Supply - SR
Industry
Demand
q
Q
PC FIRM - SR
PC INDUSTRY - SR
20
Extend previous algebraic example
Before:
Market Demand: P = 154 - .06Q
Total cost function of each PC firm:
TC = 3q2 + 10q + 432
FC = 384
Therefore, for PC industry in SR
Demand: P = 154 - .06Q
Supply: P = 10 + .06Q
SR equilibrium where D and S intersect
Q0* = 1200, Po* = $82
Now:
Demand shifts up to P = 226 - .06Q.
How does the PC firm and industry respond in
SR? How are resources reallocated in
economy to respond to additional demand?
21
The new demand will change SR industry
equilibrium…
Raising the market price…
The rising market price is what calls forth
new supply behaviour by each firm
22
…which increases profit of the firm
The market reallocates resources “as if by an
invisible hand” (Adam Smith, 1776)
23
Final example: What happens (in the SR) if an
excise tax is levied on a PC industry?
P
P
Industry
Supply - SR
Industry
Demand
q
Q
PC FIRM - SR
PC INDUSTRY - SR
24