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Chapter 8 Perfect Competition © 2009 South-Western/ Cengage Learning An Introduction to Perfect Competition • Market structure determinants – Number of buyers/sellers – Product’s degree of uniformity – Ease of entry into the market – Forms of competition among firms • Industry – All firms supplying output to a market 2 •2 Perfectly Competitive Market Structure • Theoretical construct, difficult to find in the real world • Many buyers and sellers • Commodity; standardized product • Fully informed buyers and sellers • No barriers to entry • Individual buyer or seller – No control over price – Price takers •3 Demand Under Perfect Competition • Market price – Determined by market supply and and demand • Demand curve facing one supplier – Horizontal line at the market price – Perfectly elastic • The individual firm is a price taker •4 Exhibit 1 Market equilibrium and a firm’s demand curve in perfect competition (b) Firm’s demand (a) Market equilibrium $5 D Price per bushel Price per bushel S $5 d 0 5 10 15 Bushels of 1,200,000 Bushels of wheat per day wheat per day Market price ($5)- determined by the intersection of the market demand and market supply curves. A perfectly competitive firm can sell any amount at that price. The demand curve facing the perfectly competitive firm - horizontal at 5 the market price. 0 Short Run Profit Maximization • Maximize economic profit – Quantity at which total revenue (TR) exceeds total cost (TC) by the greatest amount • Profit = TR – TC – If TR > TC: economic profit – If TC > TR: economic loss – If TC = TR: zero economic profit, normal profit •6 Short Run Profit Maximization • Marginal revenue (MR) = P = AR (perfect competition) • Marginal cost (MC)—upward sloping • Maximize economic profit: – Increase production as long as each additional unit adds more to MR than MC • Golden rule – Expand output: MR>MC – Contract output: MR < MC – Stop when MC=MR •7 Exhibit 3 Short-run profit maximization Total dollars Total cost $60 (a)Total revenue minus total cost TR: straight line, slope=5=P TC increases with output Max Economic profit: where TR exceeds TC by the greatest amount Maximum economic profit = $12 48 15 0 Dollars per bushel Total revenue (=$5 × q) 5 7 10 12 15 e $5 4 Bushels of wheat per day Marginal cost Average total cost (b) Marginal cost equals marginal revenue d = Marginal revenue MR: horizontal line at P=$5 = Average revenue Profit Max Economic profit: at 12 bushels, where MR=MC a 0 5 7 10 12 15 Bushels of wheat per day 8 SHORT RUN PROFIT MC = MR MC Cost Market sales price = marginal revenue (MR) P1 ATC Total Economic Profit = (P1 – C1) x Q1 C1 AVC Q1 QUANTITY 9 Minimizing Short-Run Losses • Total Cost (TC) = Fixed cost (FC) + Variable cost (VC) • Shut down in short run: pay fixed cost • If TC<TR: economic loss – Produce if TR>VC (P>AVC) • Revenue covers variable costs and a portion of fixed cost • Loss < fixed cost – Shut down if TR<VC (P<AVC) • Loss = FC •10 Exhibit 5 Short-run loss minimization Total revenue (=$3 × q) Total dollars Total cost $40 30 TC>TR; loss Minimize loss: 10 bushels Minimum economic loss = $10 15 0 5 10 15 Marginal cost Dollars per bushel (a)Total revenue minus total cost $4.00 3.00 2.50 0 Bushels of wheat per day Average total cost (b) Marginal cost equals marginal revenue Average variable cost Loss 5 e 10 d = Marginal revenue = Average revenue 15 Bushels of wheat per day MR=MC=$3; ATC=$4 P=$3; P>AVC Continue to produce in short run 11 SHORT RUN LOSS--PRODUCE MC Cost ATC ATC1 Economic Loss – C1 > P1 P1 MC=MR Market price –Marginal Revenue (MR) AVC AVC1 Q1 Quantity SHORT RUN LOSS—SHUT DOWN MC Cost ATC Loss on fixed cost AVC Loss on average variable cost P1 Market price – marginal revenue MC = MR QUANTITY Firm and Industry Short-Run S curves • Short-run firm supply curve – Upward sloping portion of MC curve – Above minimum AVC curve • Short-run industry supply curve – Horizontal sum of all firms’ short-run supply curves •14 Exhibit 6 Summary of short-run output decisions Break-even Firm’s short run S curve Marginal cost point 5 p5>ATC, q5, economic profit d5 Average total cost 4 p4=ATC, q4, normal profit d4 Average variable cost 3 ATC>p3>AVC, q3, loss <FC d3 2 p2=AVC, q2 or 0, loss=FC d2 1 d1 p1<AVC, shut down, Shutdown q1=0,loss=FC point Dollars per unit p5 p4 p3 p2 p1 0 q1 q2 q3 q4 q5 Quantity per period 15 Exhibit 7 Aggregating individual supply to form market supply Price per unit (a) Firm A (b) Firm B SA (c) Firm C SB (d) Industry, or market, supply SC SA + SB + SC = S p’ p’ p’ p’ p p p p 0 10 20 0 Quantity per period 10 20 0 Quantity per period 10 20 Quantity per period 0 30 60 Quantity per period 16 Firm Supply and Market Equilibrium • Short run, perfect competition – Market converges to equilibrium P and Q based on market supply and demand – Options available to the firm • Max profit • Min loss • Shuts down temporarily •17 Exhibit 8 (a) Firm MC = s ATC $5 4 d AVC Profit (b) Industry, or market Price per unit Dollars per unit Short-run profit maximization and market equilibrium ∑ MC = S $5 D 0 5 10 12 Bushels of wheat per day Market price $5 determines the perfectly elastic demand curve (and MR) facing the individual firm. 0 Bushels of 1,200,000 wheat per day S = horizontal sum of the supply curves of all firms in the industry Intersection of S and D: market price $5 18 Perfect Competition in the Long Run • Long run – Firms enter/exit the market – Firms adjust scale of operations • Until average cost is minimized – All resources are variable •19 Perfect Competition in the Long Run • Economic profit in short run – New firms enter market in long run – Existing firms expand in long run – Market supply increases—supply curve shifts to the right • P decreases • Economic profit disappears • Firms break even—price decreases to the minimum of the ATC curve •20 Perfect Competition in the Long Run • Economic loss in short run – Some firms exit the market in long run – Some firms reduce scale in long run – Market supply decreases—supply curve shifts to the left • P increases • Economic loss disappears • Firms break even--price increases to the minimum of the ATC curve •21 Zero Economic Profit in the Long Run • Firms enter, leave, change scale • Market: – supply shifts; price changes • Firm – d(P=MR=AR) shifts – Long run equilibrium • MR=MC =ATC=LRAC • Normal profit • Zero economic profit •22 Exhibit 9 Long-run equilibrium for a firm and the industry (a) Firm (b) Industry, or market S ATC LRAC e p d Price per unit Dollars per unit MC p D 0 q Quantity per period 0 Q Quantity per period Long run equilibrium: P=MC=MR=ATC=LRAC. No reason for new firms to enter the market or for existing firms to leave. As long as the market demand and supply curves remain unchanged, the industry will continue to 23 produce a total of Q units of output at price p. Long-Run Adjustment to a Change in D • Effects of an Increase in Demand – Short run • market demand increases, P increases • Firms increase quantity supplied • Economic profit – Long run • • • • New firms enter the market Market supply increases, P decreases Firm’s horizontal demand curve decreases Normal profit •24 Exhibit 10 Long-run adjustment to an increase in demand (a) Firm (b) Industry, or market S d’ ATC LRAC p’ Profit p d Price per unit Dollars per unit MC S’ b p’ a c p S* D’ D 0 q q’ Quantity per period 0 Qa Qb Qc Quantity per period Increase in D to D’ moves the market equilibrium point from a to b; firm’s demand increases to d’; economic profit in short run. Long run: new firms enter the industry; supply increases to S’; price drops back to p; firm’s demand drops back to d 25 Long-Run Adjustment to a Change in D • Effects of a Decrease in Demand – Short run • Market demand decreases, P decreases • Firms decrease quantity supplied • Economic loss – Long run • • • • Firms exit the market Market supply decreases, P increases Firm’s demand curve increases Normal profit •26 Exhibit 11 Long-run adjustment to a decrease in demand (a) Firm (b) Industry, or market S’’ ATC LRAC d p p’’ 0 Loss q’’ d’’ q Quantity per period Price per unit Dollars per unit MC g a S* p p’’ 0 S f Qg Qf D’’ Qa D Quantity per period Decrease in D to D’’ moves the market equilibrium point from a to f; firm’s demand decreases to d’’; economic loss in short run. Long run: firms exit the industry; supply decreases to S’’; price increases back to p; firm’s demand rises back to d 27 The Long-Run Industry Supply Curve • Short run – Change quantity supplied along MC curve • Long run industry supply curve S* – Perfectly horizontal at the minimum of the ATC curve (break even price) • Constant-cost industries – LRAC doesn’t shift with output – Long run S* curve for industry: straight horizontal line •28 Increasing Cost Industries – Average costs increase as output expands • Effects of an increase in demand – Short run • Market demand increases; P increases; • Firms increase output; Economic profit – Long run • New firms enter the market; • Market: supply increases; price decreases • Firm: MC and ATC increase (shift upward), higher minimum of ATC curve •29 Exhibit 12 An increasing-cost industry (a) Firm (b) Industry, or market MC S pc b ATC’ db ATC dc pa da pb c a Price per unit Dollars per unit MC’ S* b pb pc S’ a c pa D’ D 0 q qb Quantity per period 0 Qa Qb Qc Quantity per period D increases to D’, new short-run equilibrium: point b. Higher price pb; firm’s demand curve shifts up (db); economic profit, which attracts new firms. Input prices go up, MC and ATC curves shift up. Market S increases to S’; new price pc, firm’s demand curve shifts 30 down to dc; normal profit. Perfect Competition and Efficiency • Productive efficiency: Making Stuff Right – Produce output at the least possible cost • Min point on LRAC curve • P = min average total cost in long run • Allocative efficiency: Making the Right Stuff – Produce output that consumers value most • Marginal benefit = P = Marginal cost • Allocative efficient market •31 What’s So Perfect About Perfect Competition? • Consumer surplus • Consumers pay less (P) than they are willing to pay (along D curve) • Producer surplus • Producers are willing to accept less (along S curve; MC) than what they are receiving (P) • Gains from voluntary exchange • Consumer and producer surplus • Productive and allocative efficiency • Maximum social welfare •32 Exhibit 13 Dollars per unit Consumer surplus and producer surplus for a competitive market $10 6 5 Consumer surplus: area above the market-clearing price ($10) and S below the demand. Consumer surplus e Producer surplus m 0 Producer surplus: area above the short-run market supply curve and below the market-clearing price 100,000 200,000 120,000 D At p=$5: no producer surplus; the price just covers each firms AVC. At p=$6: producer surplus is the area between $5, $6, and S curve. Quantity per period 33