Download Chapter 8: Competitive Firms and Markets

Chapter 8:
Competitive Firms and Markets
• We learned firms’ production and cost functions.
• In this chapter, we study how firms use those
information to reach the most efficient outcome
and how market equilibrium is determined.
What is competition?
• Economists are concerned with the intensity of
competition in market because of its effect on
the equilibrium.
• Various types of market structure:
Perfect
competition
Monopoly/
Monopsony
Oligopoly/ Oligopsony
• Market is “perfectly competitive” when each firm
in the market is a “price-taker,” i.e., nobody can
affect the equilibrium price.
• A firm in a competitive market faces a
horizontal demand curve.
– The firm’s action does not influence the price.
Firm level
Market level
P
P
Smarket
S’firmA
S’’firmA
P*
P
DfirmA
Dmarket
0
Q
0
q
• Factors that make markets perfectly competitive:
–
–
–
–
Identical products
Free entry and exit
Both buyers and sellers know the prices
Low transaction costs (costs of search, negotiation,
monitoring, and enforcement)
• Examples: wheat market, stock exchange
• Perfect competition is the extreme case, but is
useful to consider the various real-world market
structures.
Profit Maximization
• A firm’s profit function:
 (q)  R(q)  C (q)  pq  C (q)
• The firm maximizes its profit by choosing q.
• The maximum profit is obtained at q where the
distance between revenue and cost curves are
the greatest. This occurs when their slopes are
equal, i.e., the optimum condition is:
dR(q) dC (q)

 p  MC
dq
dq
Competition in the SR
• Two-step decision
– Optimum condition:
– Shutdown option:
(better shut down if profit is
less than the loss from FC)
p  MC (q )
   FC
pq  VC  FC   FC
pq  VC or
p  AVC
• Thus, SR firm supply curve is MC above AVC.
• What happens to optimum production level
– if the price of output increases?
– If the price of inputs increase?
SR Shut-down Decision
SR Supply Curve
When factor prices change…
• SR market supply is the horizontal sum of firm’s
supply curves:
S ( p)   Si ( p) i  1, 2,..., n
• SR competitive market equilibrium:
Dmarket(p) = Smarket(p)
With 5 identical firms
With 2 different firms
SR Market Equilibrium
(5 identical firms)
With different firms
P
P
P
MC
AC
MC
AVC
MC
AC
AVC
AVC
P*
q
Firm A
q’
Firm B
q
q’
Firm C
q
SR Profit Maximization
• In SR, a firm’s profit function is:
 (q)  R(q )  C (q )
 pf ( L, K )  wL  r K
• Optimum condition:
dR(q) dC (q)

dq
dq
df ( L, K )
p
 w or
dL
pMPL  w
Value of Marginal Product = Factor Price
Competition in LR
• In LR, no fixed factor, so only the optimal
condition matters.
• LR firm supply curve is MC above AC as:
  R(q)  C (q)  0 
C (q)
p
 AC
q
• LR supply curve is more elastic than SR supply
curve as fixed factor can be replaced in LR.
• LR market supply curve is the horizontal
sum of firm supply as in SR.
• LR market supply curve is horizontal if:
– Free entry and exit of firms
– All firms have identical costs
– Constant input prices
If all conditions hold
Free entry & exit, identical firms,
but increasing-cost market:
Free entry & exit, identical firms,
but decreasing-cost market
LR market supply with trade
• An importing country’s supply is the sum of its
own + import supply curves.
r
o
S
(
p
)

S
(
p
)

D
( p)
• Residual supply curve:
– The quantity that the market supplies that is not
consumed by other demanders at any given price.
Cf) Similar concept:
• Residual Demand Curve: the market
demand that is not met by other sellers at
any given price. Dr(p) = D(p) – So(p)
LR Competitive Equilibrium
Zero Profits for Competitive firms in LR
• Zero economic profits in LR under three assumptions
because all firms operate at their minimum LRAC.
• Positive profits exist even in LR when some inputs are
scarce fixed factors at industry level (not firm level as in
SR), e.g., superior oil well, fertile land, and exceptional
management ability.
• These are called economic rents and positive profits are
returns to these factors.
• If we consider these rents as costs, then there is no
profit in the LR.
Economic Rent
LR Profit Maximization
• In LR, a firm’s profit function is:
 (q)  pf ( L, K )  wL  rK
• Optimum condition: MPV = factor price
df ( L, K )
p
 w or pMPL  w
dL

df ( L, K )
p
 r or pMPK  r
dK
w
r
p

MPL MPK
• Solution to the above leads to factor demand
functions:
L*  L( p, w, r ) and
K *  K ( p, w, r )