Download Perfect Competition

Perfect Competition
Output Decisions: Revenues, Costs, and Profit Maximization
perfect competition An industry structure in which there are many firms,
each small relative to the industry, producing virtually identical products and in
which no firm is large enough to have any control over prices. In perfectly
competitive industries, new competitors can freely enter and exit the market.
homogeneous products Undifferentiated products; products that are
identical to, or indistinguishable from, one another.
The Theory of Perfect Competition
• Basics: A market structure is a firm’s particular
environment, the characteristics of which influence
the firm’s pricing and decision making.
• Perfect Competition Theory is a theory of market
structure.
Perfect Competition Assumptions
• There are many sellers and many buyers, none of which is large in
relation to total sales or purchases.
• Each firm produces and sells a homogeneous product.
• Buyers and sellers have all relevant information about prices,
product quality, sources of supply, and so forth.
• Firms have easy entry and exit.
– Both buyers and sellers are price takers.
– The number of firms is large.
– There are no barriers to entry.
– The firms' products are identical.
– There is complete information.
– Firms are profit maximizers
Output Decisions: Revenues, Costs, and Profit Maximization
Perfect Competition
FIGURE 8.9 Demand Facing a Single
Firm In a Perfectly Competitive Market
If a representative firm in a perfectly competitive market raises the price of its output
above $2.45, the quantity demanded of that firm’s output will drop to zero. Each firm
faces a perfectly elastic demand curve, d.
5 of 48
Output Decisions: Revenues, Costs, and Profit Maximization
Comparing Costs and Revenues to Maximize Profit
The Profit-Maximizing Level of Output
FIGURE 8.10 The Profit-Maximizing Level of Output for a Perfectly Competitive Firm
If price is above marginal cost, as it is at 100 and 250 units of output, profits can be increased by
raising output; each additional unit increases revenues by more than it costs to produce the
additional output. Beyond q* = 300, however, added output will reduce profits. At 340 units of output,
an additional unit of output costs more to produce than it will bring in revenue when sold on the
market. Profit-maximizing output is thus q*, the point at which P* = MC.
6 of 48
Output Decisions: Revenues, Costs, and Profit Maximization
Comparing Costs and Revenues to Maximize Profit
The Profit-Maximizing Level of Output
As long as marginal revenue is greater than
marginal cost, even though the difference between
the two is getting smaller, added output means
added profit. Whenever marginal revenue
exceeds marginal cost, the revenue gained by
increasing output by 1 unit per period exceeds the
cost incurred by doing so.
The profit-maximizing perfectly competitive firm
will produce up to the point where the price of its
output is just equal to short-run marginal cost—the
level of output at which P* = MC.
The profit-maximizing output level for all firms is
the output level where MR = MC.
7 of 48
Perfectly Competitive Firms are
Price Takers
• A price taker is 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.
• A firms is restrained from being anything but a price taker if
it finds itself one among many firms where its supply is
small relative to the total market supply, and it sells a
homogeneous product in an environment where buyers and
sellers have all relevant information.
Output Decisions: Revenues, Costs, and Profit Maximization
Comparing Costs and Revenues to Maximize Profit
A Numerical Example
TABLE 8.6 Profit Analysis for a Simple Firm
(1)
(2)
(3)
(4)
(5)
q
TFC
TVC
MC
P = MR
(6)
TR
(P x q)
$
$
$
0
$
-
15
0
(7)
TC
(TFC + TVC)
$
10
(8)
PROFIT
(TR - TC)
0
$ 10
$
-10
1
10
10
10
15
15
20
-5
2
10
15
5
15
30
25
5
3
10
20
5
15
45
30
15
4
10
30
10
15
60
40
20
5
10
50
20
15
75
60
15
6
10
80
30
15
90
90
0
9 of 48
The Demand Curve for a Perfectly
Competitive Firm is Horizontal!
•
The market , composed of all buyers and sellers, establishes
the equilibrium price.
• When the equilibrium price has been established, a single
perfectly competitive firm faces a horizontal demand curve
(perfectly elastic) at the equilibrium price. So, the firm is a
price taker; it takes the equilibrium price established by the
market and sells any and all quantities of output at this price.
• If a firm tries to charge a price higher than the equilibrium
price, it won’t be able to do so. This is because the firm sells
homogeneous product, its supply is small relative to the total
market supply, and all the buyers are well informed about
where they can obtain the product at the lowest price.
The Marginal Revenue Curve of a Perfectly Competitive
Curve is the Same as its Demand Curve
• The firm’s marginal revenue is the change in total
revenue that results from selling one additional
unit of output.
• Notice that marginal revenue at any output level
is always equal to the equilibrium price. For a
perfectly competitive firm, price is equal to
marginal revenue.
• The marginal revenue curve for the perfectly
competitive firm is the same as its demand curve.
The Demand Curve and the Marginal Revenue Curve
for a Perfectly Competitive Firm
Theory and Real World Markets
• A market that does not meet the assumptions of
perfect competition may nonetheless approximate
those assumptions to such a degree that it behaves as if
it were a perfectly competitive market. If so, the theory
of perfect competition can be used to predict the
market’s behavior.
• (in reality, the number of sellers may not be large
enough for every firm to be a price taker, but the firm’s
control over price may be negligible. Similarly buyers
may not have all relevant information concerning prices
and quality, again it may be negligible)
Perfect Competition in the Short Run
• The firm will continue to increase its quantity
of output as long as marginal revenue is
greater than marginal cost.
• The firm will stop increasing its quantity of
output when marginal revenue and marginal
cost are equal
• The Profit – Maximization Rule: Produce the
quantity of output at which MR=MC
• In perfect competition, P = MR = MC
The Quantity of Output the Perfectly
Competitive Firm Will Produce
The firm’s demand
curve is horizontal
at the equilibrium
price. Its demand
curve is its
marginal revenue
curve. The firm
produces that
quantity of output
at which MR=MC
Allocative efficiency and perfect competition
• Resource Allocative Efficiency: the situation
occurs when produce the quantity of output
at which price equals marginal cost: P = MC.
• Producing a good until price equals marginal
cost ensures that all units of the good are
produced that are of greater value to buyers
than the alternative goods that might have
been produced. (example)
Profit Maximization and Loss Minimization for the
Perfectly Competitive Firm: Three Cases
Profit Maximization and Loss Minimization
for Perfect Competition
• A firm produces in the short run as long as price is
above average variable cost.
• A firm shuts down in the short run if price is less than
average variable cost.
• A firm produces in the short run as long as total
revenue is greater than total variable costs.
• A firm shuts down in the short run if total revenue is
less than total variable costs.
What Should a 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.
Perfectly Competitive Firm’s Short-Run
Supply Curve
• Only a price above average
variable cost will induce
the firm to supply output.
• The Short-Run supply
curve is that portion of the
firm’s marginal cost curve
that lies above the average
variable cost curve.
Deriving the Market (Industry) Supply Curve
22
Perfect Competition In The Long Run
The following conditions characterize long run equilibrium:
1. Economic profit is Zero: Price is equal to short-run
average total cost (SRATC).
If P > SRATC → positive economic profit → entry
If P < SRATC → loss → exit
2. Firms are producing the quantity of output at which
Price is equal to Marginal Cost (MC) or MR=MC
3. No firm has an incentive to change its plant size to
produce its current output; that is, SRATC=LRATC at the
quantity of output at which P=MC. (if SRATC > LRATC
then firm has an incentive to change the plant size)
Long-Run Competitive Equilibrium
24
Long Run Competitive Equilibrium
Exists When The Following Occur
• There is no incentive for firms to enter or exit
the industry
• There is no incentive for firms to produce more
or less output.
• There is no incentive for firms to change plant
size.
Condition: P = MC = SRATC = LRATC.
The Perfectly Competitive Firm and Resource
Allocative Efficiency
For the perfectly
competitive firm,
P=MR. Also, the
firm maximizes
profits or
minimizes losses
by producing
that quantity of
output at which
MR=MC.
Because P=MR and MR=MC, it follows that
P=MC, that is the perfectly competitive firm
exhibits resource allocative efficiency.
The Revenue of a Competitive Firm
• Total revenue (TR)
TR = P x Q
• Average revenue (AR)
TR
=P
AR =
Q
• Marginal revenue (MR):
The change in TR from
selling one more unit.
27
∆TR
MR =
∆Q
ACTIVE LEARNING
1
Calculating TR, AR, MR
Fill in the empty spaces of the table.
Q
P
TR
0
$10
n/a
1
$10
$10
2
$10
3
$10
4
$10
AR
MR
$40
$10
5
$10
$50
28
ACTIVE LEARNING
1
Answers
Fill in the empty spaces of the table.
Q
P
TR = P x Q
0
$10
$0
AR =
TR
Q
MR =
∆TR
∆Q
n/a
$10
1
2
3
$10
$10
$10
Notice that
$20
$10
MR = P
$10
$30
$10
$10
$10
$10
$10
4
$10
$40
$10
$10
5
$10
$50
$10
29
Profit
Maximization
(continued from earlier exercise)
At any Q with
MR > MC,
increasing Q
raises profit.
At any Q with
MR < MC,
reducing Q
raises profit.
FIRMS IN
COMPETITIVE
Q
TR
TC
0
$0
$5
–$5
1
10
9
1
2
20
15
5
3
30
23
7
4
40
33
7
5
50
45
30
Profit MR MC
5
Profit =
MR – MC
$10 $4
$6
10
6
4
10
8
2
10
10
0
10
12
–2
Profit-Maximizing Level of Output
• Since profit is the difference between total revenue and total
cost, what happens to profit in response to a change in output
is determined by marginal revenue (MR) and marginal cost
• (MC).
A firm maximizes profit when MC = MR.
• Marginal revenue (MR) – the change in total revenue
associated with a change in quantity.
• Marginal cost (MC) -- the change in total cost
associated with a change in quantity.
• Since a perfect competitor accepts the market price
as given, for a competitive firm, marginal revenue is
price (MR = P).
• Thus, the profit-maximizing condition of a competitive
firm is MC = MR = P
Costs Relevant to a Firm
Profit Maximization for a Competitive Firm
Total
P = MR Output Total Cost Marginal Average
Total Cost Revenue
Cost
35.00
35.00
35.00
35.00
35.00
35.00
35.00
4
5
6
7
8
9
10
118.00
130.00
147.00
169.00
199.00
239.00
293.00
14.00
12.00
17.00
22.00
30.00
40.00
54.00
29.50
26.00
24.50
24.14
24.88
26.56
29.30
140.00
175.00
210.00
245.00
280.00
315.00
350.00
Profit
TR-TC
22.00
45.00
63.00
76.00
81.00
76.00
57.00
Determining Profits Graphically
MC
MC
MC
Price
Price
Price
65
65
65
60
60
60
55
55
55
ATC
50
50
50
ATC
45
45
45
40
40 D
A
P = MR 40
P = MR
Loss
35
35
35
P = MR
Profit
30
30
30
B ATC
AVC
25
25 C
25
AVC
AVC
E
20
20
20
15
15
15
10
10
10
5
5
5
0
0
0
1 2 3 4 5 6 7 8 910 12
1 2 3 4 5 6 7 8 9 10 12
1 2 3 4 5 6 7 8 9 10 12
Quantity
Quantity
Quantity
(b) Zero profit case
(a) Profit case
(c) Loss case
Irwin/McGraw-Hill
© The McGraw-Hill Companies, Inc., 2000
Shutdown vs. Exit
• Shutdown:
A short-run decision not to produce anything
because of market conditions.
• Exit:
A long-run decision to leave the market.
• A key difference:
– If shut down in SR, must still pay FC.
– If exit in LR, zero costs.
FIRMS IN
COMPETITIVE
34
A Firm’s Short-run Decision to Shut Down
• Cost of shutting down: revenue loss = TR
• Benefit of shutting down: cost savings = VC
(firm must still pay FC)
• So, shut down if TR < VC
• Divide both sides by Q:
• So, firm’s decision rule is:
TR/Q < VC/Q
Shut down if P < AVC
35
The Shutdown Point
• The firm will shut down if it cannot cover average variable costs.
– A firm should continue to produce as long as price is greater than
average variable cost.
– Once price falls below that point it makes sense to shut down
temporarily and save the variable costs.
– The shutdown point is the point at which the firm will gain more by
shutting down than it will by staying in business.
– As long as total revenue is more than total variable cost, temporarily
producing at a loss is the firm’s best strategy since it is taking less of a
loss than it would by shutting down.
The Shutdown Decision
MC
Price
60
ATC
50
40
Loss
P = MR
30
AVC
20
$17.80
A
10
0
2
4
6
8 Quantity
The Irrelevance of Sunk Costs
• Sunk cost: a cost that has already been
committed and cannot be recovered
• Sunk costs should be irrelevant to decisions;
you must pay them regardless of your choice.
• FC is a sunk cost: The firm must pay its fixed
costs whether it produces or shuts down.
• So, FC should not matter in the decision to
shut down.
39