Download Firms in perfectly competitive markets

Chapter 3
Perfect Competition
Outline.

Firms in perfectly competitive markets

The Short-Run Condition for Profit Maximisation

Adjustments in the long run

Applying the Perfect Competitive Model
The goal of profit maximisation

Firms' main objective is to maximise profit.

This assumption is not specific to perfect competition: it is
made whatever the type of market structure that is considered

Economic profit is defined as the difference between total
revenues and total costs. Total costs include opportunity
and implicit costs.
Example A firm produces 100 units of output per week
using 10 units of capital and 10 units of labour. The
capital belongs to the firm. The weekly price of each
factor is 10$ per unit and output sells for 2,5$ per unit.

Total revenue per week is 250$.
Total cost is 100$ spent on labour (explicit cost) + 100$
spent on capital (opportunity cost)

Economic profit is 250 – 200 = 50$

The goal of profit maximisation (ctd)

If the opportunity cost of the resources
owned by the firm are considered as
generating a normal profit, the economic
profit is the profit in excess to this normal
profit

Economists assume that the goal of firms
is to maximise profit .

Simplifying assumption

Numerous challenges

Idea: firms do their best to maximse profit
The four conditions for perfect
competition

Four conditions
1.
2.
3.
4.

Firms sell a standardised product
Firms are price-takers: every individual firm
considers the market price as given
Factors of production are perfectly mobile in
the long run
Firms and consumers have perfect
information
Do they make sense?


In most cases, strictly speaking: NO
But can tell us something
Outline.

The Short-Run Condition for Profit
Maximisation

Adjustments in the long run

Applying the Perfect Competitive Model
Maximising profit in the short run

Example: Assume that a firm is characterised by
the short-run total cost curve we saw in Chapter
2.



This firm experiences first increasing and then
decreasing returns to is variable input.
Assume that it can sell its product at a price P0 =
18$/unit.
One characteristic of the competitive firm is that
it considers the market price as given .

So, the total revenue of the firm is given by:
TR = P0.Q

The profit of the firm is given by:
P = TR – TC
Maximising profit in the short run (ctd1)

The firm's problem is to maximise profit
P = TR – TC = P0.Q - TC

First-order condition:
d
dTC
 P0 
dQ
dQ
 P0  MC

Second-order condition:
d 2
d 2TC
dMC

0




0
2
2
dQ
dQ
dQ

dMC
0
dQ
Maximising profit in the short run (ctd2)

The firm maximises its profit when choosing a level of
production such that its marginal revenue is strictly equal
to its marginal cost
dTR dP0Q
MR 

 P0
dQ
dQ
The shut-down condition

The market price must exceed the minimum
value of the average variable cost. Otherwise the
firm will do better, in the short-run, if shutting
down .

Under perfect competition, the average revenue is:
AR 

TR P0 Q

 P0
Q
Q
If P0 is lower than the minimum of the average variable
cost curve, losses are minimum if the firm shuts down
The shut-down condition (ctd1)
The shut-down condition (ctd2)

The 2 rules :

(i) price equals marginal cost on the rising portion of the marginal cost
curve and

(ii) price must exceed the minimum value of the average variable cost
curve
define the short-run supply curve of the perfectly competitive
firm.

Note that

For P below the minimum of the AVC, the firm will supply 0 output

For P between the minimum of the AVC and the minimum of the ATC,
the firm will provide positive output


In this range of prices, the firm will lose money (make negative profits)
because
(P – ATC).Q = P < 0
But covers its variable costs and even makes some money on top of it:
(P – AVC).Q > 0
The short-run competitive industry
supply

For any given level of price, it is the sum
of the amounts that firms are willing to
supply at this price.

When firms are identical:



If each firm has a supply curve Qi = a + b.P
If there are n firms in the industry
The total industry supply is just:
Q = n Qi = n.a + n.b.P
The short-run competitive industry
supply (ctd)

For an industry composed of 2 firms:
The short-run competitive equilibrium
Positive Profits
The short-run competitive equilibrium
Negative profits
Efficiency of the short-run competitive
equilibrium

Competitive markets result in allocative
efficiency, i.e. they fully exploit the possibilities
for mutual gains through exchange
The producer surplus

The firm's gain compared with the
alternative of producing nothing (D) is:
D = (P – ATC).Q* - (-FC)

Producer surplus:
[P – (ATC – FC/Q*)].Q* = [P – AVC].Q*

because AVC = ATC – FC/Q

It is the difference between what the firm actually gets
(P.Q*) and the minimum it was requiring to supply a
positive output (AVC.Q*)
The producer surplus (ctd)
The aggregate producer surplus on the
market
Outline.

Adjustments in the long run

Applying the Perfect Competitive Model
The long-run market equilibrium

In the long run, all inputs are variable so that a
firm will choose to go out of business if it cannot
earn a "normal" profit in its current industry

In the long run
 If firms in an industry make positive economic profits,
other firms are going to enter this industry. This will
drive the market price down because supply is going to
increase.

If firms make negative profits, the opposite movement
will take place.
The long-run market equilibrium (ctd)
Allocative Efficiency

This long-run market equilibrium has a
number of nice efficiency properties:

The equilibrium price is equal to the long-run
and short-run marginal cost so that all
possibilities for mutually beneficial trade are
exhausted.

All producers earn only a normal rate of profit.
 All these properties define what is called
allocative efficiency.
The long-run competitive industry
supply curve

With U-shaped LAC curves
Changing input prices and long-run
supply

So far, we have assumed that input prices did not
vary with the amount of output produced

However, for a number of very large industries,
the amount of inputs purchased constitutes a
substantial share of the market


When this happens, the price of inputs increases as
output rises. This generates a pecuniary diseconomy.

In this case, the long-run curve is upward sloping even if
individual LAC curves are U-shaped
These are called increasing cost industries
Increasing cost industries
Decreasing cost industries

In some cases, an increase in the volume
of output may reduce the price of inputs.

This is the case if the increase in the demand
for the input creates an incentive for
innovation resulting in lower production costs
for those inputs (e.g. computers).

In this case there is a pecuniary economy and
the long-run industry supply curve is
downward sloping.

These are called decreasing cost industries.
The elasticity of supply

The price elasticity of supply is the percentage
change in supply in response to a given change in
prices
s 
DQ P DQ / Q

DP Q DP / P
The elasticity of supply (ctd)

So, it can be re-written as:
1 P
 
Slope Q
s

In the short-run the supply curve is upward
sloping so that the elasticity of supply will be
positive.

For industries with a long-run horizontal supply
curve, the elasticity is infinite.
Outline.

Applying the Perfect Competitive Model
The perfect competitive model: to what
extent is it useful (useless)?

No industries strictly satisfy the 4
conditions of perfect competition

Still, it may be a useful tool, in particular
because its long-run properties apply in a
large number of industries

Example:decrease in the number of small
family farms which are increasingly
replaced by large corporate ones.
Corporate and Family Farms
Price support policies


In this particular case, resource mobility is
far from being perfect.

Many farmers are strongly attached to their
land

 Programs supporting the price of
agricultural products
These programs have failed miserably
The failure of price support programs
Changes in the EC policy

As a way of protecting the long-term viability of
family farms the agricultural price support could
not have been more ill-conceived.

More efficient ways to aid family farmers would have
been a reduction in income taxes or even, more directly,
cash grants.

This is actually what the European Commission has
realised recently.
"Severing the link between subsidies and production
(usually termed decoupling’) will enable EU farmers to
be more market-orientated. They will be free to produce
according to what is most profitable for them while still
enjoying a required stability of income".