Download Perfect Competitive Market

Perfect Competition
Sometimes referred to as Pure
Competition or just The
Competitive Firm
Market Structure

The specific market structure
determines their pricing and output
production.
Background on Markets
When economists analyze the production
decisions of a firm, they take into account
the structure of the market in which the
firm is operating.
Four Different Market Structures:
 Perfect Competition
 Monopoly
 Monopolistic Competition
 Oligopoly
Market Model Price/Output
Market economy has 4 models and they all
vary from one seller to many sellers…
None is “typical.”
Each unique and attempting to operate with
his “self-interest” in mind.
Each will work towards MC=MR
(Profit Maximizing point and loss minimizing
point.)
Market structure
characteristics
All four market structures have four distinguishing
characteristics:
 The number and size of the firms in the market.
 The ease with which firms may enter and exit the
market.
 The degree to which firms’ products are
differentiated.
 The amount of information available to both
buyers and sellers regarding prices, product
characteristics and production techniques.
Characteristics of Pure Competition
(1) There
are many sellers and many buyers,
none of which is large in relation to total
sales or purchases.
(2) Each firm produces and sells a
homogeneous product.
(3) Buyers and sellers have all relevant
information with respect to prices, product
quality, sources of supply, and so on.
(4) There is easy entry into and exit from the
industry.
Perfect Competitive Market
There are very few if any competitive
markets.
 Why teach about a non-existent form
of competition?
 Many firms actually function as
purely competitive.

Questions to answer:
When is a firm making a profit?
 What are the unique characteristics of
competitive firms?
 How much output will a competitive
firm produce?
 When will competitive firm maximize
profits?
 When will the competitive firm shut
down?

A Perfectly Competitive Firm is
a Price Taker – Why?

A seller that does not have the
ability to control the price of the
product it sells; it takes the price
determined in the market.
Competitive Markets
If an industry is profitable, it lures in
new firms and existing firms expand.
Supply shifts right.
 This causes price to fall and profits to
decline.


23-10
Some firms, both old and new, fail and
close.
The Demand Curve of the
Perfect Competitor

Question


If the perfectly competitive firm is a
price taker, who or what sets the
price?
Answer - The Market
The Demand Curve continued

The perfectly competitive firm is a
price taker, selling a homogenous
commodity with perfect substitutes.

Will sell all units for $5

Will not be able to sell at a higher
price

Will face a perfectly elastic demand
curve at the going market price
The Demand Curve for a
Producer of Secure Digital Cards
How Much Should the
Perfect Competitor
Produce? (cont'd)
Profit p = Total revenue (TR) – Total cost (TC)
TR = P x Q
TC = TFC + TVC
P determined by the market in perfect competition
Q determined by the producer to maximize profit
Profit Maximization
Take a personal look?
How many of you owned a computer 15 years
ago?
 How many own a compact disc player today?
 How many have discarded the VCR in favor of a
another digital tool?
 Do you own an Ipod?
 Do you own an IPhone?
 Do you own an Ipad?
 Do you own a Blackberry?
 Do you own a graphing calculator?
 Did your parents have a graphing calculator?
 How did your parents type project papers for
economics class?
Competition has brought the above changes
about.

Price Taker Discussion
When there are many firms, all producing and
selling the same product using the same inputs
and technology, competition forces each firm to
charge the same market price for its good.
 Because each firm sells the same homogeneous
product, no single firm can increase the price
that it charges above the price charged by other
firms in the market (without losing business.)
 No single firm can affect the market price by
changing the quantity of output it suppliesbecause many firms- each firm is small in size.
Demand Curve
Individual firm/industry



The perfect competitor faces a horizontal or
perfectly elastic demand curve.
The demand curve is identical to the
Marginal Revenue Curve (because the firm
can sell as much as it wants to sell at
market price.) It is not necessary to lower
the price to sell more.
The demand curve for the entire industry
slopes downward (this is a result of
aggregate entries and exits into the market.)
Demand Curve


Market Demand
Curves vs. Firm
Demand Curves
While the actions of
a single competitive
firm are negligible,
the unified actions
of many such firms
are not.

The individual
firm’s equilibrium
quantity of output
will be completely
determined by the
amount of output
the individual firm
chooses to supply
Profit Maximization
$18
Marginal cost
Price or Cost (per bushel)
16
14
p = MC
MRB
Profits decreasing
Price (= MR)
12
10
Profits increasing
8
Profit-maximizing
rate of output
6
4
2
0
MCB
1
2
3
4
5
Quantity (bushels per day)
6
7
Profit Maximization
SHORT RUN





In the short-run, individual firm may make profit
or loss
In long run will break even
You can always tell if the firm is making a profit
or loss by looking at the DEMAND CURVE AND
THE ATC CURVE
If the demand curve is ABOVE the ATC curve
at any point the firm will make a profit.
If the demand curve is always BELOW the
ATC curve the firm will lose money.
Profit Maximization when the
• In the short run, the price
Firm is a Price Taker
taker
Price
will expand output until
p = MC
marginal
revenue (price) is just equal to
Profit
marginal cost.
B
P
• This will maximize the firm’s
profits (rectangle BACP).
C
A
• When P > MC then the firm can
make more on the next unit sold
than it costs to increase output
for that unit. In order for the
firm to maximize its profits it
P > MC
increases output until MC = P.
• When P < MC then the firm
made less on the last unit sold
than it cost for that unit. In
order for the firm to maximize
its profits it decreases output
until MC = P.
ATC
d (P = MR)
P < MC
decrease q
Increase q
0
MC
q
Output
/ Time
Operating
• In the graph to the right, the firm
operates at an output level where
p = MC, but here ATC > MC
resulting in a loss for the firm.
• The magnitude of the firm’s
short-run losses is equal to the
size of the of the rectangle BACP1
• A firm experiencing losses but
covering its average variable costs
will operate in the short-run.
• A firm will shutdown in the
short-run whenever price falls
below average variable cost (P2).
• A firm will shutdown in the
long-run whenever price falls
below average total cost.
PriceMC
ATC
Loss
AVC
C
P1
A
B
d (P = MR)
P2
p = MC
0
q
Output
/ Time

For the perfect competitor in the LR,
the most profitable output is at the
minimum point of its ATC curve.

The firm is forced to operate at peak
efficiency and that is why it operates at the
minimum of its ATC curve.. Not anything to
do with virtue------- just competition.
Price Quantity
$8
8
8
8
8
8
8
8
8
1
2
3
4
5
6
7
8
9
Total
Revenue
$ 8
16
24
32
40
48
56
64
72
Total Revenue
Total Revenue
$96
88
80
72
64
56
48
40
32
24
16
8
0
Total revenue
pe= $8
1 2 3 4 5 6 7 8 9 10 11 12
Quantity
Most profitable point for
any firm
Profit maximization is where
MC = MR
Efficiency:
A firm operates at peak efficiency when
it produces its product at the lowest
possible cost… That would be at the
MINIMUM POINT OF ITS ATC
CURVE – the break even point.
Profit-Maximization Rule
Profit is maximized by producing the
quantity of output at which MR = MC.
 For Perfect Competition, profit is
maximized when P = MR = MC*


* This condition is unique for perfect
competition and does not hold for other
market structures.
Realization
Marginal Cost
 A firm’s goal is not to maximize
revenues, but to maximize profits.
 Marginal revenue is compared to marginal
costs to determine the best level of output.


What an additional unit of output brings in
is its marginal revenue (MR).
Remember… Firm Demand Curve is
Different from Industry’s Demand Curve
Price
Price
Market
Supply
Individual firms must
take the market price.
P
Demand for
Single Firm
P
Market
Demand
Output / Time
Output / Time
Entry and Exit
•
It is easy to enter or exit an industry in perfect
competition.
–
–
If more firms enter (lured in by economic profits),
the market supply curve shifts right and price
falls.
As price falls, economic profits decrease and
approach zero.
•
•
•
•
Entry will cease.
Some firms could be making losses by this time.
Many will cut back output or exit.
If so, the supply curve shifts back to the left and the
price rises.
23-31
Long Run

In the long run there is time for firms to
enter or leave the industry. This factor
ensures that the firm will make ZERO
profits in the long run.
Short- vs. Long-Run
Equilibrium
23-33
Profit
- what kind is it???




Pure Profit -an amount above that
necessary to keep the owner in the
industry… is not considered part of total
cost
Pure profit is the residual after all costs
(including normal profit) have been met
Pure profit will attract other firms into
the market
Normal Profit will not induce firms into
the market- nor are they low enough to
force others to leave.. Breaking even..
Long Run

In the LR, no firm will accept losses.

It will simply close up shop and go
out of business.

But also remember – one firm leaving
the industry WILL NOT affect market
price.
Market Entry
23-36
Profit Squeeze
23-37
Factor Costs
Factor costs mean wages, rent and interestare far the most important determinants of
whether costs are falling, constant or
increasing.
 Usually factor costs will eventually rise
which makes every industry an increasing
costs industry. Example: as more and more
land is used by an expanding industry, rent
will be bid up…
Time influences supply: Whether industry
is in SR or LR …all can adjust in LR if
desire to do so.

LR Continued



If one firm is losing money, presumably others
are too.
When enough firms go out of business, industry
supply declines which pushes price up…
This price rise is reflected in a new demand
curve for the individual firm.
P
D1
D2 S2 S1
NPI
OP I
Q
OPI = Original Price for individual ; NPI = new price for individual
Rules for Entry and Exit

If P > ATC, economic profits exist.


If P < ATC, economic losses exist.


Enter the industry or expand capacity.
Reduce capacity (or exit if P < AVC).
If P = ATC, economic profits are zero.

Maintain existing capacity (no entry or
exit).
23-40
Lower Costs: Improve Profits and
Stimulate Output
•
•
•
If a firm lowers its costs
of production, it will
encourage increases in
output.
The cost curves fall,
and MC appears to shift
right.
Profit maximization
occurs at point J before
and point N after the
reduced costs take
effect.
23-41
The Decision to Shut Down
in the Short Run

Firms can’t always make
a profit



Ski resort in summer
Surf shop in winter
Shutting down


Firm will shut down if it
cannot cover variable costs
Shutting down is not the
same as going out of
business and exiting the
industry
Shutdown point for a firm




A firm compares total revenue with total cost
to see what its profit or loss is.
Remember there are fixed and variable costs.
Fixed costs have to be paid whether
operating or not.
Suppose: a firm’s total cost is $300,000 at a
certain level of output. $200,000 made up of
variable costs,such as labor and raw
materials and $100,000made up of fixed costs
such as interest payments, taxes, and rent.
Shutdown Continued
If the firm’s total revenue is $240,000 it is
clearly taking a loss. The difference
between TR and TC in this case is
$60,000.
 Notice that the total revenue of $240,000
pays all of the firms variable costs
($200,000) and also pays $40,000 of its
fixed cost. If the firm were to shut down on
the other hand, its loss would total
$100,000- the amount of the fixed cost.

Shutdown

If competition drives price below AVC
for a firm, it will shut down and exit the
industry.
If the exiting firm has inventory, it will
dump that inventory on the market at
a reduced price.
 This will cause the industry price to
drop further, possibly causing losses
for other industry firms.

23-45
The Competitive Process
(this is the market- not the
individual)
•
•
•
Competitive forces drive the product’s
price down, making it more affordable to
more consumers. Thus the market
expands.
Also, competitive forces spur firms to
improve quality, add features, and look
for lower costs.
This is the market mechanism at work.
–
Market mechanism: the use of market
prices and sales to signal desired outputs
(or resource allocations).
23-46
Shutdown Continued
As long as a firm can cover ALL of its variable
cost by remaining in operation, it will do so.
 ****It’s shutdown point will be where TR no
longer covers TVC.
Shutdown: when MR falls below the firm’s
minimum AVC. When a firm shuts down, it does
not necessarily leave the industry. Shutdown is a
SR response…and is based on fixed costs of
established plant and variable costs of operating
it.

Profit
Maximization and
Loss
Minimization for
the Perfectly
Competitive Firm:
Three Cases I


In Case 1, TR TC and
the firm earns profits.
It continues to
produce in the short
run.
Profit Maximization and
Loss Minimization for the
Perfectly Competitive
Firm: Three Cases II


In Case 2, TR < TC
and the firm takes a
loss.
It shuts down in the
short run because it
minimizes its losses by
doing so; it is better to
lose $400 in fixed costs
than to take a loss of
$450.
Profit Maximization and
Loss Minimization for the
Perfectly Competitive
Firm: Three Cases III


In Case 3, TR < TC and
the firm takes a loss.
It continues to produce in
the short run because it
minimizes its losses by
doing so; it is better to
lose $80 by producing
than to lose $400 in fixed
costs by not producing.
What Should a Perfectly
Competitive Firm Do in the Short
Run?


The firm should produce in the short run as long
as price (P) is above average variable cost
(AVC).
It should shut down in the short run if price is below
average variable cost.
Long-run Equilibrium
• The two conditions necessary for long-run equilibrium in a
price-taker market are depicted here.
• First, the quantity supplied and the quantity demanded must
be equal in the market, as shown below at P1 with output Q1.
• Second, the firms in the industry must earn zero economic
profit (that is, the “normal market rate of return”) at the
established market price (P1 below).
Price
Price
Ssr
MC ATC
P1
d
P1
D
Firm
q1
Output
Market
Q1
Output
The Lure of Profits




In competitive markets, economic profits attract
new entrants.
Low entry barriers permit new firms to enter
competitive markets.
The entry of new firms shifts the market supply
curve to the right.
As long as economic profits are available in
short-run competitive equilibrium, new entrants
will continue to be attracted.
p = MC

Short-run competitive equilibrium:
Signaling
Profits and losses act as
signals to firms
 Signals

Convey information about
the profitability of various markets
 Positive profits

• A signal of profitability. More firms will enter the
industry.

Negative profits (losses)
• A signal that resources could be doing better
elsewhere. Firms will exit the industry.
The Competitive Process

If economic profits are high, consumers are
willing to pay more than the opportunity cost
of resources to acquire a product.



It signals they want more of that industry’s
goods.
Profit-seeking producers respond by
producing more to satisfy consumer
demand.
This is allocative efficiency: the industry will
end up producing the right output mix.
23-55
The Competitive Process

If economic profits are negative (losses),
consumers are unwilling to pay the opportunity
cost of resources to acquire a product.



It signals they want fewer of that industry’s goods.
Profit-seeking producers respond by producing
less to satisfy a waning consumer demand.
This is also allocative efficiency: the industry will
end up producing the right output mix.
23-56
A Shift of Market Supply
Any short-run equilibrium will not
last.



As supply increases, price drops, to the minimum
of ATC.
Once at minimum of ATC, there are no longer
economic profits to attract firms to enter.
In long-run equilibrium, entry and exit cease, and
zero economic profit (i.e., normal profit) prevails.

Long-run equilibrium:
p =MC =minimum ATC
Short- vs. Long-Run
Equilibrium
PRICE OR COST
MC
pS
qS
QUANTITY
ATC
Long-run equilibrium
(p = MC = ATC)
PRICE OR COST
Short-run equilibrium
(p = MC)
MC
pS
pL
qL
QUANTITY
ATC
Long-Run Rules for Entry
and Exit
Price Level Result for typical firm
Market Response
P > ATC
Profits
New firms enter
industry, Existing firms
expand
P < ATC
Loss
Firms exit industry,
Existing firms contract
P = ATC
Break even
No exit or entry,
Existing firms maintain
current capacity
Technology improvements noted below
PRICE (per computer)
Old MC New MC
Old ATC
New ATC
J
$700
N
R
0
430
600
QUANTITY (computers per month)
Two terms to remember
PRODUCTIVE EFFICIENCY
ALLOCATIVE EFFICIENCY
Allocative Efficiency

The market mechanism works best in
competitive markets.

Market mechanism - The market
mechanism is the use of market prices and
sales to signal desired output.
Allocative efficiency means that we are
producing the right output mix.
 The price signal the consumer gets in a
competitive market is an accurate
reflection of opportunity cost.

Production Efficiency

Production efficiency means that we
are producing at minimum average total
cost.

Efficiency (production) – Maximum
output of a good from the resources used
to produce it.
When competitive pressure on prices is
carried to the limit, the products in
question are also produced at the least
possible cost.
 Society is getting the most it can from its
available (scarce) resources. This market
model is the best “buy” for consumers.

Reality of Attaining a Profit







The sequence of events common to a competitive market
situation includes the following.
High prices and profits signal consumers’
demand for more output.
Economic profit attracts new suppliers.
The market supply shifts to the right
Prices slide down the market demand curve.
A new equilibrium is reached with increased
quantities being produced and sold and the
economic profit approaching zero.
Producers experience great pressure to keep
ahead of the profit squeeze by reducing costs.
Profits Are The Bottom Line
Kiley studies profits a lot