Download Ch. 8: Perfect Competition

CHAPTER EIGHT
PERFECT COMPETITION
Four Basic Market Types
— How firms establish their price and output levels in order to achieve their
objective of profit maximization (or loss minimization)?
— The answer to this depends on the market structure in which the firm is
operating.
— Market structure refers to the number and the relative size of the firms in
an industry
— There are four main types of market structure: Perfect competition,
Monopoly, Monopolistic Competition, and Oligopoly
— It is important to note that: (1) these markets may change over time from
one structure to another, and (2) some real life markets may not fit well in
any of these four structures
— Perfect Competition
o Perfect competition refers to a market in which there are large
number of relatively small firms selling an identical (standardized)
product, and large number of buyers who are indifferent from whom
to buy.
o None of the buyers or sellers has market Power, which refers to the
ability to influence the market price of a good or service. Each firm is
a price taker.
o Very easy market entry and exit.
o Information is available to all.
o Non-price competition is not possible
Page 1 of 16
o Firm cannot earn positive economic profit in the long run.
o Examples: the markets for agricultural product (corn, wheat, coffee),
financial instruments (stocks, bonds, foreign exchange), precious
metals (gold, silver, platinum) and the global petroleum industry
— Monopoly
o Monopoly refers to one firm that produces the entire market supply of
a particular unique good or service that has no close substitutes.
o The firm is the industry
o It has market power. It is a price maker.
o It is very difficult or impossible for any other firm to enter this market.
o This firm makes high economic profit subject to regulations.
o Firm earn positive economic profit in the long run.
o Non-price competition is not necessary
o Examples of pure monopoly are not easy to find. Electricity and
water industry in some countries, patent laws sometimes provide
companies with temporary monopolies, a company that is so
dominant might be said to exhibit monopolistic status (such as
Microsoft)
— Monopolistic Competition
o Monopolistic competition is a market in which large number of
relatively small firms producing similar but differentiated products.
o There are many of monopolistic competitive firms in any given city or
area of the city. The start-up capital is relatively low, so it is fairly
easy to start these types of business. Each one tries its best to stand
out among its many competitors by differentiating its product.
o Each firm maintains some control of its own price.
o It is easy to enter or exit this market.
Page 2 of 16
o Non-price competition very important
o In the long run, economic profit of any firm in this type of markets is
zero.
o Examples: Small industries such as retail and service establishments
(restaurants, boutiques, luggage stores, shoe stores, stationary
stores, repair shops, laundries, beauty parlors)
— Oligopoly
o Oligopoly is a market in which a small number of firms producing all
or most of the market supply of a particular good or service.
o The product may be identical (standardized) or differentiated.
o This market is generally considered to be for large firms.
o It is difficult to enter this market.
o Non-price competition very important among firms selling
differentiated products
o Firms in this market can make positive economic profit based on
whether they compete with each other severely or they have some
kind of mutual agreements regarding prices, market share and
products.
o Examples: manufacturing sector, oil refining, certain types of
computer hardware and software, chemical and plastics, steel,
automobile, soft drinks, airline travel, banking industry, insurance
companies, telecommunications, etc
Page 3 of 16
Pricing and Output Decisions in Perfect Competition
— Perfectly competitive market exists when:
1. Each firm (seller/producer) is small relative to market demand ⇒ firm
cannot affect market demand.
2. No unique characteristics of each firm’s product ⇒ consumers are
indifferent about from which firm to buy.
— This implies that a firm in competitive market
1. Firm receives the same marginal revenue from the sale of each
additional unit of product; equal to the price of the product (MR=P)
2. Average revenue is also equal to price (AR=P)
3. No limit to the total revenue that the firm can gain in a perfectly
competitive market.
4. The firm’s objective is to maximize its profit in the short run. If it
cannot earn a profit, then it seeks to minimize its loss.
— The Basic Business Decision: entering a market on the basis of the
following questions:
o How much should we produce to maximize profit?
o If a loss rather than a profit is incurred, will it be worthwhile to
continue in this market in the long run (in hopes that we will
eventually earn a profit) or should we exit?
Market demand curve vs. firm demand curve
— It is important to distinguish between the market demand curve and the
demand curve facing a particular firm.
— The equilibrium market price is determined by the interaction of market
demand and market supply curves. The market demand curve for a
product is downward sloping (less than infinite). The market supply curve is
upward sloping
Page 4 of 16
— However, the demand curve facing the perfectly competitive firm is different.
— Since the output of each firm is such a very small share of this total output,
no individual firm can affect the market price and therefore is a price “taker”.
— The perfectly competitive firm faces a horizontal, perfectly elastic demand
curve (with price elasticity of demand equal to infinity).
— At a fixed price, the firm sells any quantity it wants. No matter of what is the
quantity sold the firm charges the same price, i.e., P = D
Market
P
Firm
P
S
P
P
D
D
Q
q
— Given the fixed price and the horizontal demand curve, the perfectly
competitive firm faces two decisions in the short run and two decisions in
the long run.
o Production decisions in SR: the firm has to decide on
a. Whether to produce or shut down temporarily?
b. If it is to produce, how much to produce? And how much profit will it
earn?
o Investment decisions in LR: the firm has to decide on
a. Whether to enter, stay or leave the industry
b. If the firm is already in the market, whether to expand or downsize
the plant
Page 5 of 16
SHORT RUN DECISION: THE PRODUCTION DECISION
— Since a competitive firm cannot affect market price (a price “taker), it has to
decide what is the amount of output that will maximize the firm's total
economic profit (or minimize loss)
— To find the amount of output that maximizes profit we can use the total
analysis or marginal analysis
Total Analysis approach:
— Profit is maximized at Q* where TR-TC is highest
— Compare the total revenue and total cost schedules and find the level of
output that either maximizes the firm’s profits or minimizes its loss.
— Total profit is less than TR
— TR = P * Q. Since a perfectly competitive firm can sell all of its output at
one price, the total revenue curve of a perfectly competitive firm is an
upward sloping straight line, with slope equal to market (equilibrium) price
(P*)
— In order to calculate profit, we also have to see how costs vary with the rate
of output in the short-run.
— TC is the opportunity cost of production, which includes normal profit.
— Total costs (TFC + TVC) increase as output expands. At first, they rise
slowly due to the increasing marginal returns, and then they increase more
quickly due to the diminishing marginal returns.
— Since profit depends on the difference between TR and TC, profit is
maximized when TR exceeds TC by the largest amount; i.e., where the
vertical distance between TR curve and TC curve is the largest.
— The point in which the curves have the largest vertical distance between
TR curve and TC curve is the profit-maximizing rate of output (point m).
Page 6 of 16
TC
TR
TR
Loss
Break-even
Points
R
Max Profit
C
Break-even
Points
Loss
0
Q
a
Q*
Profit
b
Max Profit
Profit
0
Loss
a
Q*
Q
b
Loss
Marginal Analysis approach:
— What an additional unit of output brings in revenue is its marginal revenue
(MR) and what it costs to produce is its marginal cost (MC).
— A firm that wants to maximize its profit (or minimize its loss) should produce
a level of output at which the additional revenue received from the last unit
is equal to the additional cost of producing that unit; i.e., MR=MC.
Page 7 of 16
P, MR,MC
MC
P = MCÖmaintain Q
P =MR =D
P > MCÖQ
P < MCÖQ
Q
Q*
— Since perfect competition structure implies MR=P, the MR=MC rule may be
restated as P=MC.
— Equating MR (or P) to MC shows us the efficient level of output. However,
this level of output does not tell us whether the firm is maximizing profit or
minimizing loss.
— To determine whether a firm is earning an economic profit or incurring an
economic loss, we compare the firm’s average total cost, ATC, at the profit
maximizing output with the market price.
— Profit = TR – TC = (P - AC) Q*
1. Total economic profit is maximized if P=MC above ATC (P > ATC)
2. Total economic profit is zero (normal profit) if P = MC = ATC ⇒
Break-even point @ minimum AC.
3. Total economic loss is minimized if P=MC below ATC (P < ATC)
1) Profit Maximization: Making Positive Economic Profit
— If ATC curve is added to the diagram, a profit-maximizing firm will produce
at the level of output (Q*) at which
P = MC > ATC
Page 8 of 16
MC
P, MR,Costs
ATC
C
P=5
A=3
P =MR=AR=D
B
0
Q
Q* = 20
— TR = P × Q = 5 * 20 = 100
— TC = ATC × Q = 3 * 20 = 60
— Total economic profit =TR –TC = (P-ATC) * Q= 2 * 20 = 40
— If a firm is receiving positive economic profits, the owners are receiving a
return on their investment that exceeds what they could receive if their
resources had been used in an alternative occupation.
2) Zero Economic Profit (Normal Profit)
— If P = MC = min ATC, firm is earning zero economic profit, i.e., is earning
normal profit (this is known also as break-even point)
MC
P, MR,Costs
ATC
P =MR =D
P
0
Q
Q*
— Total profit = (P – ATC) * Q, But since P = ATC then (P-ATC) = 0 ⇒ total
profit = 0
Page 9 of 16
3) Loss Minimization and the Temporary Shutdown Decision
— If P < ATC at the level of output at which MR = MC, the firm will incur
economic loss.
P, MR,Costs
MC
ATC
A=8
P =MR =D
P=5
0
Q*=20
Q
— Total economic profit = (P-ATC)*Q = -3 * 20 = -60 ⇒ Economic loss
— Now, with this loss, should the firm continue its operations?
— If the firm suffers a loss, what is the best action?
— Remember that: Profit = (P – ATC) * Q, and that ATC = AFC + AVC
Therefore, Profit = (P – AFC - AVC) * Q
— Remember also that fixed costs must be paid even if output = 0. Thus, if
the firm shuts down its operation it has to pay the fixed costs
— To determine this, we have to compare the firm's loss if it stays in business
with its loss if it shuts down.
— If the firm decides to shut down, its revenue will equal zero and its costs
will equal its fixed costs. (Remember, fixed costs must be paid even if the
firm shuts down.) Thus, the firm receives an economic loss equal to its
fixed costs if it shuts down.
— The firm will stay in business in the short run even if it receives an
economic loss as long as its loss is less than its fixed costs. This will occur
if the revenue received by the firm is large enough to cover its variable
costs and some of its fixed costs.
Page 10 of 16
— In mathematical terms, this means that the firm will stay in business as long
as TR = P x Q > TVC
— Contribution Margin (CM): the amount by which total revenue exceeds
total variable cost: CM = TR – TVC
— If the contribution margin is positive, the firm should continue to produce in
the short run in order to cover some of the fixed cost, otherwise it should
shutdown.
— Dividing both sides of the above expression by Q, we can say that the firm
will stay in business as long as P > AVC
— Consider the situation illustrated by the diagram below.
— In this case, losses are minimized in the short run at the level of output at
which MR = MC. This occurs at an output level of Q1.
— Since the level of average total cost (ATC) exceeds the market price (P1),
this firm receives economic losses.
— But as long as the price is greater than AVC this firm will choose to stay in
business in the short run. If the firm were to shut down, it would lose its
fixed costs. TFC =AFC * Q1 = ac *Q1
P, Costs
MC
c
ATC
AVC
b
P1
a
P2
P3
0
Q3
Q1
Q2
Page 11 of 16
Q
— A comparison of the firm's losses if it shuts down with its losses if it
continues to operate in the short run (bc *Q1) indicates that this firm will
receive lower losses if it decides to remain in business in the short run.
— If the firm produce the amount of output Q2 at price P2, it is producing at
the shut-down point where, P = MC = min AVC.
— The shutdown point is the output and price at which the firm just covers
its TVC, where P = MC = min AVC.
— Shutdown Point: the lowest price at which the firm would still produce.
— At the shutdown point, the price is equal to the minimum point on the AVC.
This is where selling at the price results in zero contribution margin.
— The loss of operation here is equal to the loss of shutting down (Loss =
TFC).
— Although firm is indifferent of producing or shutting down, many firms
continue to produce hoping for price improvement as well as to keep
customers from going to other producers, and to save the cost of
maintenance when it starts re-operating in the future.
— The minimum amount of output that the perfectly competitive firm could be
produced is Q2 where P = min AVC (shutdown point)
— A firm should shut down only if the losses from continuing production
exceeds fixed costs, i.e., a firm should shut down only if P < AVC (or TR <
TVC).
— Therefore, shutdown the firm at any level of output where P < AVC. This
possibility is illustrated in the diagram at P3
— If the price falls below the shutdown point, revenues fail to cover the fixed
costs and the variable costs. The firm would be better off if it shut down
and just paid its fixed costs.
— Note that a shutdown (a SR decision) does not necessarily mean a firm is
exiting the business. Leaving the business is a LR decision.
Page 12 of 16
— In LR, of course, firms will leave the industry if economic losses are
received (remember, there are no fixed costs in the long run.)
— Example:
What is the profit maximizing output for a perfectly competitive firm selling
its product at $10, with the following cost structure?
Q
TFC
TVC MC
4
10
19
5
10
25
6
10
34
7
10
45
8
10
57
The Firm Short-run Supply Curve
— For a competitive firm, MC defines the lowest price a firm will accept for a
given quantity of output.
— In this sense, the MC curve is the supply curve; it tells us how quantity
supplied respond to price.
— The supply curve is upward sloping because of increasing MC. If more
quantities needed to be produced price must increase to cover the rising
MC.
— Since the firm will shutdown if P falls below minimum AVC, the supply
curve does not exist below min AVC.
— Therefore, the MC curve, above the shutdown point (above the min AVC),
is the short run supply curve for a competitive firm.
Page 13 of 16
Pricing and Output Decisions in Perfect Competition in the LR
— In the long run, two adjustments are possible:
1. Existing firms may adjust plant size
2. Entry and exit of firms is possible
— Both actions will affect market supply and a new market price is
established
— Existence of economic profit:
1. Invites existing firms to expand plant size
2. invites entry of new firms
3. This shifts the supply curve to the right, decreases price and reduces
profits until economic profit is wiped out.
MC
S1
P
S2
P, MR,Costs
Sn
P1
P1
P2
ATC
P2
Pn
Pn
D
0
Q 0
Qn
Q2
Q1
— Economic loss causes exit of firms or shrink plant size which shifts the
supply curve to the left, increases price and reduces loss until it is
eliminated.
Page 14 of 16
Q
— Thus, the price in the competitive market in the long-run will settle at the
point where firms earn only normal profit (zero economic profit).
Observations in perfectly competitive markets:
— The earlier the firm enters a market, the better its chances of earning
above-normal profit (assuming a strong demand in the market).
— As new firms enter the market, firms that want to survive and perhaps
thrive must find ways to produce at the lowest possible cost, or at least at
cost levels below those of their competitors.
— Firms that find themselves unable to compete on the basis of cost might
want to try competing on the basis of product differentiation instead.
Page 15 of 16
Using Calculus:
— Total analysis: find Q* that maximize π by differentiating π function.
— Marginal analysis: set MR equal to MC and solve for Q* that maximize π .
— Example:
Given P = 170 - 5Q and TC = 40 +50Q + 5Q2.
Find optimal output level Q* that maximize π
1. A firm operating in perfectly competitive firm has the following total cost
function
TC = 6000 + 400Q – 20Q2 + Q3
a. What is the lowest (minimum) price at which the firm will shut down
in the SR?
b. If the market price is $310, what would be the profit maximizing firm
2. Given P = 170 -5Q
TC = 40 + 50Q + 5Q2
Find Q that will max profit
Page 16 of 16