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Chapter 8: Perfect Competition: Definition: Market Structure: The characteristics of a market that influence how trading takes place. By market structure, we mean all the characteristics of a market that influence the behavior of buyers and sellers when they come together to trade. The structure of any particular market can be determined by the answers to the following three questions: 1. How many buyers and sellers are there in the market? 2. Is each seller offering a standardized product, more or less indistinguishable from that offered by other sellers, or are there significant differences between the products of different firms? 3. Are there any barriers to entry or exit, or can outsiders easily enter and leave this market? The four basic types of markets are: 1) Perfect competition 2) Monopoly 3) Monopolistic competition 4) Oligopoly The focus of this chapter is perfect competition. What is Perfect Competition? In economics, the term “competition” describes a situation of diffuse, impersonal competition in a highly populated environment. Definition: Perfect competition: A market structure in which there are many buyers and sellers, the product is standardized, and sellers can easily enter or exit the market. The Three Requirements of Perfect Competition: Perfect competition is a market structure with three important characteristics: 1. There are large numbers of buyers and sellers, and each buys or sells a tiny fraction of the total quantity in the market. 2. Sellers offer a standardized, homogenous product.. 3. Sellers can easily enter into or exit from the market. In a perfectly competitive market, each buyer and seller is a price taker. A Large Number of Buyers and Sellers: In a perfectly competitive market, the number of buyers and sellers is so large that no individual decision maker can significantly affect the price of the product by changing the quantity it buys or sells. Examples: Wheat, cotton, gold, silver, stocks, bonds. A Standardized Product Offered by Sellers: In perfectly competitive markets, buyers do not distinguish considerable differences of the products of one seller to another. Buyers see the products in perfectly competitive markets essentially as identical. The manufacturers of Wheaties have no preference of Bob’s wheat over Andy’s. Easy Entry and Exit from the Market: Easy entry into a market does not mean a free entry—the new entrant must incur some overhead costs, yet a perfectly competitive market has no significant barriers to discourage new entrants. Some markets do have barriers to entry, often imposed by the government; for example, the number of taxicabs licensed to operate in New York City is fixed by the local government. Zoning laws are another government imposed barrier to entry. Existing sellers’ market dominance can also create barriers to entry without any government action. Consumer brand loyalty and significant economies of scale often give existing firms a cost advantage over new entrants. Perfect competition also requires easy exit: A firm suffering a long run loss must be able to sell off its plant and equipment and leave the industry for good, without obstacle. If shutting down the plant requires intense union litigation, the capital equipment too specialized to be immediately sold, or if significant barriers to exit arise, then the firm will not conform to the assumptions of perfect competition. The Perfectly Competitive Firm: Goals and Constraints of the Competitive Firm: A perfectly competitive firm faces a cost constraint like any other firm. The cost of producing any given level of output depends on the firms’ production technology and the prices it must pay for its inputs. The Competitive Industry Industry and and The Competitive Firm Firm (a) (a) Market Market Price Price per per Ounce Ounce (b) (b) Firm Firm Price Price per per Ounce Ounce SS $400 $400 $400 $400 DD Ounces Ouncesof of Gold Goldper perDay Day Demand Demand Curve Curve Facing Facing the theFirm Firm Ounces Ouncesof of Gold Goldper perDay Day In panel (a), the market supply and demand curves intersect to determine a market price of $400 per ounce. The typical firm in panel (b) can sell all it wants at that price. The demand curve facing the competitive firm is a horizontal line at the market price. The Demand Curve Facing a Perfectly Competitive Firm: Panel (b) of the figure above shows the demand curve facing the perfectly competitive firm Small Time Gold Mines. Note that the shape of the demand curve is horizontal, or infinitely price elastic. This tells us that no matter how much gold Small Time produces, it will always sell it at the same price: $400 per ounce. In perfect competition, the firm is a price taker—it treats the price of its output as given. Definition: Price taker: Any firm that treats the price of its product as given and beyond its control. Cost and Revenue Data for Small Time Gold Mines: (1) (2)Price (3) Total (4) (5) Total Output (per troy revenue Marginal cost (troy ounce) Revenue ounces per day) 0 $400 $0 $550 $400 1 $400 $400 $1,000 $400 2 $400 $800 $1,200 $400 3 $400 $1,200 $1,250 $400 4 $400 $1,600 $1,350 $400 5 $400 $2,000 $1,500 $400 6 $400 $2,400 $1,750 $400 7 $400 $2,800 $2,100 $400 8 $400 $3,200 $2,550 $400 9 $400 $3,600 $3,100 $400 10 $400 $4,000 $3,750 (6) Marginal cost (7) Profit -$550 $450 -$600 $200 -$400 $50 -$50 $100 $250 $150 $500 $250 $650 $350 $700 $450 $650 $550 $500 $650 $250 Because Small Time Gold mines is a perfectly competitive firm—a price taker—its price per ounce remains constant at $400, no matter how many ounces it produces. Marginal revenue remains constant at $400. Why? Price remains constant at $400 and each time the firm produces another ounce of gold, total revenue increases by $400. The The Perfectly Perfectly Competitive Competitive Firm Firm (a) (a) Dollars Dollars $2,800 $2,800 TR TR TC TC Ma Maximum ximum Profit Profit per perDa Dayy ==$700 $700 2,100 2,100 550 550 Slope Slope==400 400 11 22 33 44 55 66 77 88 99 10 10 Ounces Ouncesof of Gol Golddper perDDaayy (b) (b) Dollars Dollars MC MC $400 $400 dd==MR MR 11 22 33 44 55 66 77 88 99 10 10 Ounces Ouncesof of Gol Golddper perDDaayy Panel (a) shows a competitive firm’s total revenue (TR) and total cost (TC) curves. TR is a straight line with slope equal to the market price. Profit is maximized at 7 ounces per day, where the vertical distance between TR and TC is greatest. Panel (b) shows that profit is maximized where the marginal cost (MC) curve intersects the horizontal demand (d) and marginal revenue (MR) curves. Small Time’s total revenue and marginal revenue is plotted above. Notice that the total revenue (TR) curve in panel (a) is a straight line that slopes upward—each time output increases by one unit, TR rises by the same $400 we considered with marginal revenue. Therefore the slope of the TR curve is equal to the price of output. Marginal revenue is constant at $400 (market price); therefore it is represented above by a horizontal line. Recall that marginal revenue is the additional revenue the firm earns from selling an additional unit of output. This brings up a very important point: For a competitive firm, marginal revenue at each quantity is the same as the market price. For this reason, the marginal revenue curve and the demand curve facing the firm are the same—a horizontal line at the market price. It is especially important to notice that in panel (b) the horizontal line is labeled “d = MR”—since this line is both the firm’s demand curve (d) and its marginal revenue curve (MR). Finding the Profit Maximizing Output Level: (recall chapter 7) Competitive firms, like all firms, want to maximize profits, and to do so it will use the principles demonstrated in chapter 7 (the TR/TC approach and the MR/MC approach) For the following examples refer to the table and figure above. 1. The total revenue and total cost approach: Recall that in the total revenue and total cost approach, profit is calculated by subtracting TR – TC at each output level. Recall also that profit is maximized by finding the output level with the highest profit. At 7 ounces per day, Small Time Gold Mines maximizes profit at $700 per day. You should be able to use the graph in panel (a) of figure 2 above to verify that the greatest distance between the TR and TC curves occurs when the firm is producing 7 (troy) ounces of gold per day and indeed their profit is $700. 2. The marginal revenue and marginal cost approach: Recall that in the MR and MC approach, the firm should continue to increase output as long as marginal revenue is greater than marginal cost. Notice how the firm keeps producing more as long as MR>MC, when producing more will raise profit; however, once the firm is producing 7 units, MR<MC, thus further increasing output will reduce profit. Examine (b) of figure 2 and find the output levels where the MR and MC curves intersect. Notice how the MC intersects the MR curve twice. However, we can rule out the first crossing point because there, the MC curve crosses the MR curve from above. Remember that the profit maximizing output is found where the MC curve crosses the MR curve from below. The profit maximizing output level for competitive firms only requires you top use what you learned in chapter 7—however, Ned’s Beds, the firm we examined in chapter 7 did not operate under perfect competition. As a result, both its demand curve and its marginal revenue curve sloped downward. Small Time, however, operates under perfect competition, so its demand and MR curves are the same horizontal line. Measuring Total Profit: We already know that the vertical distance between the TR and TC curves gives us a firm’s profit. Now we will learn another way to measure profit: Profit per unit = P - ATC Measuring Measuring Profit Profit or or Loss Loss (b) (b)Economic EconomicLoss Loss (a) (a)Economic EconomicProfit Profit Dollars Dollars Dollars Dollars ATC ATC Prof Profitit per per MC MC Ounce Ounce $100 $100 Loss Lossper per Ounce Ounce $100 $100 dd==MR MR $400 $400 300 300 ATC ATC $300 $300 200 200 11 22 33 44 55 66 77 88 99 10 10 Ounces Ouncesof of per Gold Gold perDay Day MC MC dd==MR MR 11 22 33 44 55 66 77 88 99 10 10 Ounces Ouncesof of per Gold Gold perDay Day The competitive firm in panel (a) produces where marginal cost equals marginal revenue, or 7 units of output per day. Profit per unit at that output level is equal to revenue per unit ($400) minus cost per unit ($300) or $100 per unit. Total profit (indicated by the blue shaded rectangle) is equal to profit per unit times the number of units sold, $100*7 = $700. In panel (b), the firm faces a lower market price of $200 per ounce. The best it can do is produce 5 ounces per day and suffer a loss by the red area. It loses $100 per ounce on each of those 5 ounces produced, so the total loss is $500—the area of the red-shaded rectangle. A firm earns a profit whenever P>ATC. Its total profit at the best output level equals the area of a rectangle with height equal to the distance between P and ATC, and width equal to the level of output. A firm suffers a loss whenever P<ATC at the best level of output. Its total loss equals the area of a rectangle with height equal to the distance between P and ATC, and width equal to the level of output. The Firm’s Short-Run Supply Curve: How does a competitive firm maximize profit when market price changes in the short run? Short Supply Curve Curve Short--Run Run Supply (b) (b) (a) (a) Dollars Dollars Price Price per perBushe Bushel l $3 $3.50 .50 MC MC dd1 ==MR 1 MR11 ATC ATC 22.50 .50 22.00 .00 dd2 ==MR 2 MR22 AVC AVCd = MR d33 = MR33 2.50 2.50 2.00 2.00 11.00 .00 00.50 .50 dd4 ==MR 4 4 MR 4 dd5 ==MR MR5 1.00 1.00 0.50 0.50 5 1,000 1,000 2,000 2,000 4,000 4,000 5,000 5,000 5 7,000 7,000 Bushels Bushels per perYear Year Firm’s Firm’s Su Supply pply Curve Curve $3.50 $3.50 2,000 2,000 4,000 4,000 5,000 5,000 7,000 Bushels 7,000 Bushels per perYear Year Panel (a) shows a typical competitive firm facing various market prices. For prices between $1 and $3.50 per bushel, the profit maximizing quantity is found by sliding along the MC curve. Below $1 per bushel, the firm is better off shutting down, because P<AVC, so TR<TVC. Panel (b) shows that the firms supply curve consists of two segments. Above the shutdown price of $1 per bushel it follows the MC curve; below that price it is synchronized with the vertical axis. The figure above shows ATC, AVC, and MC curves for a competitive producer of wheat. Note that there are five different demand curves that the firm could face. Market Price Demand curve Profit Maximizing level (MC = MR) $3.50 d1 7,000 bushels per year $2.50 d2 5,000 $2.00 d3 4,000 $1.00 d4 2,000 Indifferent $0.50 d5 1,000 [ALWAYS SHUT DOWN] As the price of output changes, the firm will slide along its MC curve in deciding how much to produce. Recall: 1. AVC * Q = TVC 2. A firm should never shut down when TR>TVC 3. A firm should always shut down when TR<TVC Definition: Shutdown Price: The price at which a firm is indifferent between producing and shutting down. [The firm will] shut down at a price any lower and stay open at any price higher. For all prices above the minimum point on the AVC curve, the firm will stay open and will produce the level of output at which MR = MC. For these prices, the firm slides along its MC curve in deciding how much output to produce. But for any price below the minimum AVC, the firm will shut down and produce zero units. Definition: Firm’s supply curve: A curve that shows the quantity of output a competitive firm will produce at different prices. The competitive firm’s supply curve has two parts. For all the prices above the minimum point on its AVC curve, the supply curve coincides with the MC curve. For all prices below the minimum point on the AVC curve, the firm will shut down, so its supply curve is a vertical segment at zero units of output (see graph above). In the short run, the number of firms in the industry is fixed. The Short-Run Market Supply Curve: Definition: Market Supply Curve: A curve indicating the quantity of output that all sellers in a market will produce at different prices. To obtain the market supply curve, we add up all the quantities of output supplied by all firms in the market at each price. The market supply curve of panel (b) is obtained by adding up the quantities of output supplied by all the firms in the market at each price, as shown in panel (a). The Market Supply Supply Curve Curve The Market (b) (b) Market Market (a) (a) Firm Firm Price Price per perBushel Bushel Firm’s Firm’s Supply Supply Curve Curve $3.50 $3.50 Price Price per perBushel Bushel $3.50 $3.50 2.50 2.50 2.00 2.00 2.50 2.50 2.00 2.00 1.00 1.00 0.50 0.50 1.00 1.00 0.50 0.50 2,000 2,000 4,000 4,000 5,000 5,000 7,000 Bushels 7,000 Bushels per perYear Year Market Market Supply Supply Curve Curve 700,000 400,000 400,000 700,000Bushels Bushels per 500,000 200,000 200,000 500,000 perYear Year Short Equilibrium Short--Run Run Equilibrium (a) (a) Market Market (b) (b) Firm Firm Dollars Dollars Price Price per per Bushel Bushel SS MC MC ATC ATC $3.50 $3.50 $3.50 $3.50 2.00 2.00 DD11 2.00 2.00 dd11 Loss Lossper per Bushel Bushel at atpp==$2 $2 Profit Profitper per Bushel Bushel atatpp==$3.50 $3.50 dd22 DD22 400,000 400,000 700,000 700,000 Bushels Bushels per perYear Year 4,000 4,000 7,000 7,000 Bushels Bushels per perYear Year Short Run Equilibrium (in perfect competition)—An Example In panel (a) demand curve D1 intersects supply curve S to determine a market price of $3.50 per bushel. The firm in panel (b) takes that price as given, produces 7,000 bushels per year—determined at the intersection of its marginal cost curve with the horizontal demand curve, d1—and earns a short run profit. If the market demand curve shifts left to D2, the market price falls to $2 per bushel. The typical firm then reduces production to 4,000 bushels per year and suffers a short run loss. Let’s take a look at two possible short-run equilibria in the wheat market: 1. Suppose market demand is represented by curve D1, as illustrated in panel (a). The short run equilibrium price would be $3.50. Each firm would face the horizontal demand curve d1, and, as plotted in panel (b), would decide to produce 7,000 bushels, and with 100 firms 7,000*100 = 700,000 bushels. Note that the price is $3.50; thus each firm will earn an economic profit because P>ATC. 2. Now let the market demand curve be D2, and equilibrium price will equal $2.00. Each firm would then face the horizontal demand curve d2, and would produce 4,000 bushels. Equilibrium market quantity would then be 400,000 bushels with 100 firms and each firm would suffer an economic loss since P<ATC. Thus, in the short run equilibrium, competitive firms can earn an economic profit or suffer an economic loss. In perfect competition, the market sums up the buying and selling preferences of individual consumers and producers, and determines the market price. Each buyer and seller then takes the market price as given, and each is able to buy or sell the desired quantity. Competitive Markets in the Long Run: In the short run, we know that the number of firms in a perfectly competitive is fixed; however, in the long run entry and exit can occur. Profit and Loss and the Long Run: In a competitive market, economic profit and loss are the forces driving long run change. The expectation of continued economic profit causes outsiders to enter the market; the expectation of continued economic losses causes firms in the market to exit. Long-Run Equilibrium: From Short-Run Profit to Long-Run Equilibrium: Assume the market for wheat is in short-run equilibrium at $4.50 per bushel and the equilibrium price lays above the ATC curve per bushel for a given firm. With P>ATC the firm will earn an economic profit in the short run. Attracted to economic profit, new firms enter the market and increase overall market production effectively causing the market supply curve to shift rightward: 1. The market price will fall. 2. As the market price falls, the marginal revenue and demand curve for the firm shift further downward. 3. Attempting to maximize profit, the firm will decrease output and slide down its marginal cost curve. New entrants will continue to shift the market supply rightward until the market supply shifts so far rightward such that each existing firm is earning zero economic profit. In a competitive market, positive economic profit continues to attract new entrants until economic profit is reduced to zero. From Short Run Loss to Long-Run Equilibrium: In a competitive market, economic losses continue to cause exit unit the losses are reduced to zero. The Notion of Zero Profit in Perfect Competition: Definition: Normal Profit: Another name for zero economic profit In the long run, every competitive firm will earn normal profit—that is, zero economic profit. Perfect Competition and Plant Size: In the long-run equilibrium, every competitive firm will select its plant size and output level so that it operates at the minimum point of its LRATC curve. Competitive Competitive Markets Markets in in the the Long Long Run Run (a) (a) (b) (b) Dollars Dollars Dollars Dollars LRA LRATC TC LRA LRATC TC MC MC11ATC1 ATC1 PP11 MC MC2ATC 2ATC22 dd11 ==MR MR11 PP* * qq11 Output Output per per Period Period EE dd22==MR MR22 qq* * Output Output per per Period Period The firm in panel (a) faces a price of P1, and produces quantity q1. It earns zero profit because price equal average cost. In the long run, the firm will want to expand. By sliding down the LRATC curve, it could produce more output at a lower cost per unit and earn an economic profit. In turn, economic profit will attract entry, and that will reduce the market price. The firm’s long-run equilibrium position is shown in panel (b). The firm earns zero profit by operating at minimum LRATC. Summary: The Perfectly Competitive Firm in the Long Run At each competitive firm in the long run, P = MC = Minimum ATC = minimum LRATC. Producing goods at the minimum average cost means that firms are producing at the lowest possible cost per unit, which results in economic efficiency. A Change in Demand: A Change in Demand INI TIA L EQUILIB RIU M (b) Firm (a) Marke t Price per Unit Dollars S1 MC ATC1 P1 P1 A d1 = MR1 A D1 NEW EQUI LIBRI U M (c) Marke t Price per Unit Output per Period (d) Firm Dollars B MC S1 S2 P SR SLR C P2 P1 q1 Output per Period Q1 B P SR C P2 P1 A A dSR = MRSR ATC2 ATC1 d2 = MR2 d1 = MR 1 D2 D1 Q1 Q SR Q 2 Output per Period q1 q2 qSR Output per Period At point A in panel (a), the market is in long run equilibrium. The typical firm in panel (b) earns zero economic profit. If demand increases market price rises. Individual firms increase output and earn an economic profit at point B. Profit attracts entry, increasing market supply and driving up ATC. When long run equilibrium is reestablished at point C in panel (c), price is higher, but the typical firm again earns zero economic profit. The long-run market supply curve is and upward sloping line found by connecting points like A and C in panel (c). The long run supply curve shows the relationship between market price and market quantity produced after all long-run adjustments have taken place. An increasing cost industry in which the long-run supply curve slopes upward because each firm’s ATC curve shifts upward as industry output increases. A constant cost industry is an industry in which the long-run supply curve is horizontal because each firm’s ATC curve is unaffected by changes in industry output. A decreasing cost industry is an industry in which the long run supply curve slopes downward because each firm’s ATC curve shifts downward as industry output increases. In a market economy, price changes act as market signals, ensuring that the pattern of production matches the pattern of consumer demands. When demand increases, a rise in price signals firms to enter the market, increasing industry output. When demand decreases, a fall in price signals firms to exit the market, decreasing industry output.