Download q {Corn(Bushels per week)}

Firms in their Environment:Market Structure
• Classified according to three conditions:
1. Number of firms in the Market (Industry)
2. Product differentiation
(Are firms products identical or slightly different)
3. Ease of Entry into and Exit from the industry
• There are 4 Market Structures to study:
Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly(few firms)
• We will start with Perfect Competition, then move to the
opposite extreme(no competition) Monopoly.
• The latter two lie between Perfect competition and
Monopoly in terms of competitiveness and are
sometimes called imperfect competition.
Examples of Perfectly competitive
markets
• There are not many markets or industries that are
perfectly competitive…
…agricultural markets(corn, wheat, fruit, vegetables) and
other commodity markets come closest….
...Stock and Bond markets also are very competitive.
Why have a theory that has few “real”
industries to study?
• If is an “as if” theory. It shows how firms behave as
industries get closer to competitive conditions.
• It also shows the benefits to the consumer and the
economy of competitive conditions
Competitive Markets and the
Competitive Firm (Perfect Competition)
4 Assumptions that make up Competitive markets
1. There are many buyers and sellers.
No individual seller is very large and makes up only a
small part of total market share.
2. The industry produces a homogeneous product.
Each firm produces an identical product
3. Information on prices, technology, and profit
opportunities are freely available
4. There is free entry and exit into and out of the industry.
New firms find it easy to enter and compete with existing
firms. Failing firms find it easy to quit producing
Implications from the 4 assumptions of
Perfect Competition
1.
Many small firms are producing the
exact same product
(Products of different firms are perfect substitutes)
• No single firm can affect market supply
If a firm attempted to raise price, then consumers
would not buy any goods from that firm and
purchase them from other firms...
…each firm is a Price taker:
A firm takes the market price as given and decides
how much to produce based on this price that is
determined in the market.
Implications from the 4 assumptions
2. Firms will not pay attention to production decisions
made by other firms…
...since every firm is a price taker and small
(compared to the entire market), no individual firm
can affect the market share or profitability of
another firm.
3. A distinction must be made between the
market(industry) and the individual firm...
…a firm is small enough that it can sell all it desires at
a constant price (This comes from being a price taker)
• Therefore, the demand curve faced by a single firm
is perfectly elastic at the market price.
How Perfect Competition Arises
•When firm’s minimum efficient scale is small
relative to market demand so there is room for
many firms in the industry.
•When each firm is perceived to produce a good or
service that has no unique characteristics
(a commodity), so consumers don’t care which firm
they buy from.
Price (per Bushel)
Price (per Bushel)
S
The firm will sell all it can at the
given market price.
$12
$12
D
500,000
Q {Corn
(Bushels
per week)}
Competitive market
d
q {Corn
(Bushels
per week)}
A representative firm 500
in the market
• Price is determined in the market by the interactions of ALL
buyers and sellers (Demand & Supply)…
…since a single firm is small it cannot control the price it
charges…
… it can’t raise price(lose all it’s customers) and it has no
incentive to lower price (because it can’t sell much more)...
Profit maximization by a competitive firm
The competitive firm only has control over how
much OUTPUT to produce; it’s Price to charge is
determined in the market.
Question: How does the firm determine the amount
of output that will maximize:
Economic profit =
Total Revenue (TR) - Total cost(TC)
Price (per Bushel)
Economic profit = Total Revenue (TR) - Total cost(TC)
Firm wants the gap between TR and TC to be at it’s greatest.
Now we need to discuss the revenue of the competitive firm...
Total revenue = Price x quantity. What is average revenue(AR)?
$12
d = price =AR = MR
The firm earns $12 from selling the 51st unit.
Marginal revenue =($612 - $600) / (51 -50) = $12 / 1 = $12
Additional revenue from selling one more unit of the good
Implication: Marginal revenue is equal to the price of the good!
Because the competitive firm does not have to lower
price to sell more goods
50 51
500
q{Corn(Bushels per week)}
Average revenue = Total revenue/quantity; price x quantity/quantity
Average revenue = Price ! Average revenue is the price of the good.
How much additional revenue will this firm earn by selling the next
unit of this good? (From 50 to 51 bushels per week)
Marginal revenue(MR) is the additional revenue gained from selling
the next unit of the good (MR = change in TR / change in q)
Price (per Bushel)
Economic profit = Total Revenue (TR) - Total cost(TC)
To determine the profit maximizing
MC output level we need to add the
Marginal cost curve to our graph.
$12
d = price = AR = MR
Profit will increase as long as MR > MC.
It declines if MC > MR.
$4.25
$4
100 101
500
q {Corn(Bushels per week)}
Consider an output level of 100. MR > MC for this level of output
Should this firm produce the next unit of the good? YES! Why?
MR for the 101st unit is $12, but MC is only $4.25
The next unit of the good adds more to revenue than to cost which
means that Total profit is GETTING LARGER.
Price (per Bushel)
Economic profit = Total Revenue (TR) - Total cost(TC)
MC
$12
Firms expand output
because it adds to profit
MR = MC means firms are
making as much profit as
possible.
d = price = AR = MR
Going beyond MR=MC causes profit
to decrease and firms cut output.
250
500
q {Corn(Bushels per week)}
Profit will increase as long as MR > MC
Profit will decline if MC > MR.
Profit will be maximized when MR = MC!
Since P = MR for a competitive firm: P = MC!
How do we determine how much profit the firm makes?
Price (per Bushel)
Economic profit = Total Revenue (TR) - Total cost(TC)
How much profit
the firm makes MC
depends on the
market price.
$12
$10
A
}
Can compare Price
(AR) to Average cost
(ATC) at the profit
maximizing level of
AVC
output
d = price = AR =MR
ATC
B
Profit per unit
(Average profit)
= $2
250
Total Revenue =$3,000
Total Cost
= $2,500
Total Profit
= $500
q {Corn(Bushels per week)}
500
At 250, the ATC is $10(per bushel) and the price is $12(per bushel)
Profit per unit = (P - ATC). In this case($12 - $10) or $2 per bushel.
Total profit = Profit per unit x number of units = $500
This firm makes an Economic profit of $500
($500 better than the firm’s next best alternative)
It is possible for a competitive firm to make
an Economic profit in the SHORT RUN.
In the SHORT RUN a competitive firm may
earn an Economic profit,
but depending on price it could:
• Make a normal profit (zero economic profit)
• Make an economic loss
(But continue to operate in the short run)
• Make an economic loss
(But shut down immediately in the short run)
Show each possibility with
our graph of the firm
Price (per Bushel)
A Competitive Firm making a NORMAL PROFIT
ATC
MC
P = MC
AVC
P =ATC
Total Revenue =$1,900
Total Cost
= $1,900
Total Profit
= $0
$12
$9.50
A
d = price = AR =MR
Profit per unit(average profit) = $0
200
500
q {Corn(Bushels per week)}
If the market price is $9.50 instead of $12 this firm:
1) Will now produce 200 bushels of corn instead of 250 (P =MC)
2) Will now make a normal profit since P = ATC at the profit
maximizing level of output
Notice that when the firm makes a normal profit it is producing
output at minimum ATC.
A Competitive Firm making an Economic Loss,
but operating.
ATC
MC
Price (per Bushel)
Total Revenue =$1,440
Loss per unit =$2
(If operate)
AVC
Total Costs
= $1,800
Economic Loss = $360
$12
$10
Economic Loss }
$8
A
180
d = price = AR =MR
500
q {Corn(Bushels per week)}
If the market price is $8 then this firm:
1) Will produce 180 bushels of corn (P =MC)
2) Will make an Economic Loss since P < ATC at the profit
maximizing level of output
If this firm is doing worse than their next best alternative why do
they operate in the short run under the above circumstances?
A Competitive Firm making an Economic Loss,
but operating.
ATC
MC
Price (per Bushel)
Total Revenue =$1,440
Loss per unit =$2
(If operate)
AVC
}
180
= $1,800
Economic Loss = $360
Total Fixed Cost =$540
( Loss if shut down)
$12
$10
Economic Loss }
$8
A
$7
Total Costs
d = price = AR =MR
AFC =$3
500
q {Corn(Bushels per week)}
Because they have FIXED COSTS in the short run!
If a firm shuts down it must still PAY it’s fixed costs.
Which loss is smaller: Operating or paying FIXED COSTS?
In this case, Operating losses are smaller than Fixed Costs, so it will
be better for this firm to operate in the short run.
How will the firm know when to shut down in the short run?
A Competitive Firm making an Economic Loss,
but operating.
ATC
MC
Price (per Bushel)
Total Revenue =$1,440
Loss per unit =$2
(If operate)
AVC
}
180
= $1,800
Economic Loss = $360
Total Fixed Cost =$540
( Loss if shut down)
$12
$10
Economic Loss }
$8
A
$7
Total Costs
d = price = AR =MR
AFC =$3
500
Total
variable = $1,260
cost
q {Corn(Bushels per week)}
Notice: When the firm operates it earns revenue, but it also
incurs variable costs.
Is total revenue greater than total variable costs?
YES! With some revenue left over to pay off some of the fixed costs.
This is shown on the graph in two ways:
1) Loss per unit(if operate){$2} is less than AFC{$3}
2) Price (AR) is greater than AVC
Price (per Bushel)
The Shut-Down Point
MC
ATC
Total Revenue
AVC
$10.13
=
Total
variable
cost
Shut Down point (P = AVC)
$8
$6.75
d = price = AR =MR
160
500
q {Corn(Bushels per week)}
At the point where P = AVC, Operating losses = Fixed costs.
If price were to fall any further, Operating losses > Fixed costs
and the firm would shut down immediately to minimize losses.
When P = AVC, P = MC. Which means MC = AVC...
...AVC will be at it’s minimum.
Price (per Bushel)A Competitive firm that Shuts Down in the Short Run
Total Costs = $1,605
ATC
Loss per unit = $4.70
MC
Total Revenue = $900
(If operate)
AFC = $3.60
AVC
$10.70
<
Total Variable
cost = $1,065
Total Fixed Cost =$540
( Loss if shut down)
Total Economic
Operating Loss = $705
$7.10
Shut Down point (P = AVC)
d = price = AR =MR
$6
150
500
q {Corn(Bushels per week)}
This is a case of price being too low to produce any output.
Operating losses > Fixed cost and this firm will produce
nothing.
It will take a loss of $540 (Fixed cost) rather than $705
The Supply curve for the firm and
the industry
• Just as we used consumer theory to derive a
demand curve, we can use perfect competition to
derive a supply curve.
• Remember the law of Supply:
As the price of a good increases firms are willing
and able to make more of the product available
for sale.
Is this true for a perfectly competitive firm?
Price (per Bushel)
= SUPPLY CURVE
MC
$14
$12
$9.50
$8
$6.75
160 200 270
180 250
The Supply Curve
A firm will maximize
profit when P =MC.
ATC
AVC When price increases the
firm responds by
producing more, because
it it PROFITABLE to do
so.
What is the supply
curve for the firm?
It is the MC curve above
the Shut down point!
500
q{Corn(Bushels per week)}
$6.75 is the lowest price that will start this firm to produce in the
short run.
If the price of the good(determined in the market) increases, how
does the firm respond? It will increase production to where P = MC.
This firm is willing and able to produce more output as the price of
the good increases. This is exactly the same as the Law of Supply!
Price (per Bushel)
= SUPPLY CURVE
MC
ATC
AVC
$14
The Supply Curve
A firm will maximize
profit when P =MC.
The MC curve (above the
AVC curve) is the
SUPPLY CURVE for the
firm.
$12
$9.50
$8
$6.75
160 200 270
180 250
500
q{Corn(Bushels per week)}
The reason the Supply curve is upward sloping (a positive
relationship) is because MC rises as output increases...
…the firm needs a higher price to produce more because MC
increases. Why is the MC curve shaped that way?
Because of diminishing Marginal returns!
Market S =
Sum of all firms MC $
$
MC
$
MC
$10
$8
AVC
90,000 95,000 Output
Industry or Market
200 220
Output
A firm in Industry
AVC
235 260 Output
A firm in the Industry
The market supply curve is the SUM of ALL FIRMS
marginal cost curves above the AVC curve
The competitive firm and Industry in the
LONG RUN
There are 3 conditions that must be met for a
competitive firm(and industry) to be in long run
equilibrium:
1) There is no incentive for any new firm to enter or
any existing firm to exit.
2) There is no incentive to change the amount of output
produced by the firm
3) No firm has an incentive to change it’s scale of
operations.
Using our theory of
Perfect Competition how are these 3 conditions met?
Price (per Bushel)
Price (per Bushel)
S
S’
Condition 1)
MC
ATC
$12
$12
Economic profit
$9.50
d=
MR
d’
$9.50
D
Q(Corn)
500,000 560,000
q (Corn)
200 250
500
A representative firm
Competitive market
Suppose firms in this industry are making economic profit
Assumption 4 states there is free entry and exit...
…new firms will have an Incentive to Enter the Industry (to gain
economic profit) Existing firms have no cost or information advantage
New firms entering the market shift the Supply curve to the right
and cause the market price to DECLINE.
Firms enter as long as economic profit can be made
Firms stop entering when there is zero economic profit (Normal Profit)
Price (per Bushel)
Price (per Bushel)
S’
Condition 1)
MC
S
ATC
AVC
$9.50
$9.50
Economic Loss
$8
$8
D
Q(Corn)
560,000 600,000
d’
d=
MR
q (Corn)
180 200
500
A representative firm
Competitive market
If firms in an industry are making economic losses, some firms will
have an incentive to EXIT the industry in the LONG RUN
(Doing worse than their next best alternative)
As firms EXIT the industry the market supply curve shifts to the left
and the market price starts rising.
Enough firms must EXIT the industry so there is no longer any
incentive for remaining firms to EXIT.
This occurs when remaining firms are making a NORMAL profit
Price (per Bushel)
Price (per Bushel)
Condition 1) & 2)
S’
MC
ATC
AVC
$9.50
d’
$9.50
D
q (Corn)
Q(Corn)
560,000
Competitive market
200
A representative firm
500
Condition 1(firms have no incentive to enter or exit the
industry) is met when firms in that industry make NORMAL
PROFIT.
This means that P = ATC in the long run
Moreover, condition 2 is met; Firms have no incentive to
change output:
Firms maximize profit when
P = MC in the long run(& short run)
Price (per bushel)
Condition 3)
Here is the situation from the previous slide except we now
add the LRAC curve: This firm is not in long run equilibrium..
MC1 SRATC
1
MC2
$9.50
d
SRATC2
LRAC
0
200
450
q(corn)
…the firm has an incentive to expand their scale of operations to
MAKE MORE PROFIT.
At the price of $9.50 this firm(and others like it) can lower costs by
expanding plant size…
...but it can’t last because other existing firms will have an incentive to
do the same thing…
…and new firms will enter too in response to the ECONOMIC profit to
be made...
Price (per bushel)
Condition 3)
This drives down the market price until no further
incentive remains to enter…
MC1 SRATC
1
MC2
$9.50
d
SRATC2
E
$3.50
0
200
380
LRAC
d’
450
q(corn)
...Firms in the industry make only NORMAL profit (P = SRATC)
Firms also are maximizing profit ( P = MC)
At point E, MC = SRATC, which means that SRATC is
minimized
MC = SRATC = LRAC which means that LRAC is also
minimized
Price (per bushel)
Condition 3)
Condition 3
(firm has no incentive to change scale of operations)
is satisfied when....
MC2
SRATC2
LRAC
$3.50
0
E
380
…the cost of production will be as low as possible.
This is true at point E:
P = MC = SRATC = LRAC
Firms are: Maximizing profit = Normal profit =
Minimizing costs
d’
q(corn)
Applying the theory of
Perfect Competition
Responses to Demand changes
• Long run Industry Supply curve(LRIS)
• How does a perfectly competitive industry respond to
changes in the economy?
• Are firms responsive to consumers wants?
• How do prices respond in the short and long runs to
changes in demand?
• It depends on what happens to costs for firms in an
industry.
• Depending on the size of the INDUSTRY in the economy
costs may stay the same, rise, or even fall.
• In the LONG RUN this will effects the price that will be
charged.
Price (per Bushel)
Now Consumers
want more of this
product...
B
$11
$9.50
A
Price (per Bushel)
Point A is in Long
run equilibrium
S
S’
$11
MC
B
ATC
d’
Economic Profit
C
d
$9.50
A =C
D
D’
Q(Corn
200240
in
thousands)
Competitive market
A representative firm
560
600 640
q (Corn)
500
Assume that costs for the Firm and Industry don’t change as Market
output changes (COSTS ARE CONSTANT)
Firms respond to the higher price by moving up their MC curve to
produce more and make Economic profit (This is a SR equilibrium)
This price increase is temporary because new firms will enter to get
the economic profit. The supply curve increases…...
Price MUST return to the previous level because it is the only price
where firms make a normal profit, etc.
Price (per Bushel)
Price (per Bushel)
Point A is in Long
run equilibrium
S
$11
$9.50
S’
B
A
LRIS
MC
B
ATC
C
d
$9.50
A =C
D
D’
Q(Corn
200
in
thousands)
Competitive market
A representative firm
560
640
q (Corn)
500
By connecting points A & C (both long run equilibrium) we get….
…a Long Run Industry Supply curve(LRIS)
This curve shows how the INDUSTRY responds to changes in
Demand in the LONG RUN.
This is a case where costs don’t change, hence it is called…
…a CONSTANT COSTS INDUSTRY
Price (per Bushel)
Price (per Bushel)
S
S’
LRACB
B
$11
LRACA
LRIS
C
$10.25
C
$9.50
A
A
D’
D
560
615
Competitive market
Q(Corn
in thousands)
q (Corn)
A representative firm 500
INCREASING COSTS INDUSTRY
Per unit costs increase as Industry output expands…
Industry may be a large portion of the economy and when
demand for resources increases, it bids up the price of resources.
Price (per Bushel)
Price (per Bushel)
S
LRACB
B
LRACA
$11
S’
$9.50
$9
A
LRIS
C
A
C
D
560
D’
Q(Corn
665in thousands)
Competitive market
q (Corn)
A representative firm 500
DECREASING COSTS INDUSTRY
Per unit costs decline as Industry output expands…why?
Perhaps costs of inputs fall because producing parts for this
industry is cheaper if produced in bulk.
Computer chips became cheaper as more computers were built.
Changes in Technology
How does a competitive firm
and Industry react to
an improvement in technology?
Price (per Bushel)
S1
S’ S’’
Price (per Bushel)
LRAC1
S2
LRAC2
$12
$12
$9
$9
…until it reaches the new
minimum average costs.
D
Q1
Q2
Q(Corn)
q (Corn)
500
Competitive market
A representative firm
Here is a firm and an Industry with a given technology (LRAC1)
• Suppose that a single firm starts to use a new corn seed that needs
less fertilizer to grow; this lowers cost of production…..
…the LRAC curve will shift downward, reflecting the lower costs.
That firm will enjoy economic profit…temporarily.
Since information is freely available, other firms will have an
incentive to do the same thing, new firms enter, and….
Insight: Anything that changes the cost of production in a
competitive industry will be passed along as a price change.
Evaluating
Perfect Competition
Efficiency
Two types of Efficiency
a) Allocative efficiency...a condition that makes it
impossible to improve the satisfaction received by
consumers (Maximizing Consumer Surplus)
• For allocative efficiency to occur the maximum price
the consumer is willing to pay for a good would be
just equal to what it cost the producer to make it.
b) Productive efficiency...producing the good at the lowest
possible opportunity cost.
P
r
I
c
e
PE
Supply = MC(Marginal Cost)Allocative
Consumer
Surplus
Consumer surplus will
be as great as possible
under competitive
conditions
Efficiency
Maximum price the
consumer is willing to
pay for a good would be
just equal to what it cost
the producer to make it.
Demand = MB(Marginal Benefit)
QE
Quantity
MB = what a consumer would give up to get the next unit of the good
MC = the opportunity cost of producing the next unit of the good
In equilibrium, P = MC (Profit Maximization) …Under Perfect
Competition price is equal to the cost of producing the good.
Also, P = MB in equilibrium (shown by the intersection of the
demand curve and the price line.
P = MC = MB : Consumers are paying just what it costs to produce
the good in perfect competition: Allocative efficiency
P
r
I
c
e
PE
Supply = MC(Marginal Cost)Allocative
Efficiency
P = MC = MB
Maximum price the
consumer is willing to
pay for a good would be
just equal to what it cost
the producer to make it.
Consumer
Surplus
Producer
Surplus
Demand = MB(Marginal Benefit)
QE
Quantity
Producer Surplus: The difference between the price of the good and
the cost to produce the good (MC).
The yellow shaded area represents the gain from ALL producers in
the competitive market.
Under Perfectly competitive conditions the sum of Consumer
surplus and producer surplus is at it’s Maximum.
P
r
I
c
e
MB1
Supply = MC
Allocative Efficiency
Maximum price the
consumer is willing to
pay for a good would be
just equal to what it cost
the producer to make it.
PE
MC1
Demand = MB(Marginal Benefit)
Q1
QE
Quantity
Allocative Efficiency implies competitive markets will produce the
amount of the good that consumers desire.
Example: If MB1 > MC1 consumers and producers can be made
better off producing more of the good.
On the other hand: If MB < MC consumers and producers can be
made better off producing less of the good.
A net loss in Consumer or Producer surplus from under or
overproduction is called a Deadweight loss
Price
LRAC
Productive Efficiency
MC
S
Price
Costs
SRATC
PE
d
D
QE
Quantity
Competitive market
qe
A representative firm
quantity
Competitive firms must produce at lowest average costs in
long run equilibrium because free entry or exit of firms
forces them to do so.
P = MC = SRATC = LRAC
which makes LRAC & SRAC at their minimum
Competitive markets are productively efficient.
Limitations of Competitive Markets
a) It is only and “as if” theory. There are not very
many perfectly competitive markets.
b) Standardized products may not be preferable for
consumers.
Consumers may be willing to pay more for
differentiated(Slightly different) goods.
c) Economic profit may be needed to encourage
firms to engage in Research and Development.
d) Some products may require large firms to take
advantage of economies of scale.
Coming Next: Market Failure
• Monopoly & Imperfect Competition:
Firms having some control over their price
• Public Goods: Goods or services that benefit
more than one person at a time and no person
can be exclude from consuming them
Example: National Defense, Fire, Police, etc
• Externalities: Costs or benefits from an activity
imposed or bestowed on person(s) not involved
with that activity
Examples: Pollution, vaccinations