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Perfect Competition
Tutorial 8
Firm’s Output Choice
 Economists assume ALL firms maximize economic profits,   R  C
 As shown by the cost functions developed in the last chapter, total costs
depends on quantity of output of the firm.
 To see how a firm’s revenue depends on its output level, we must look at
the demand for the firm’s product, which is highly related to the market
structure in which the firm is operating.
-
Perfect Competition
Monopoly
Monopolistic Competition
Oligopoly
Page 2
Perfect Competition
 Characteristics of perfectly competitive markets:
- Large numbers of small buyers and sellers: price takers
- Homogeneous products
- Perfect information
- Free entry and exit
Page 3
Demand Curve facing a Competitive Firm
p
p
S
Marginal revenue: additional
revenue obtained by producing
one more unit of output.
pe
d = p = MR
D
Qe
Market
Q
q
Individual Firm
Page 4
Short-run Output Decision
p
p
SMC
S
MC = MR
At q1 , p > MC
pe
At q2 ,p < MC
d = p = MR
D
Qe
Market
Q
q2
q1
q*
Individual Firm
q
Page 5
Short-run Output Decision
 To find the profit of the firm:
  TR  TC
 To show the profit in a per-unit diagram, it is often convenient to represent the
profit as
C
  pq   q  ( p  AC )  q
q
SMC
P
SAC
p*
p = MR
π
AC*
q*
q
Page 6
Short-run Shutdown Decision
 What if the firm is making economic loss?
- Keep on Production
- Shut down
 Which one to choose? Depending on market price
 Shutdown: Do not produce temporarily.
- Loss = TFC
 Case 1: When SAC > P > AVC
SAC x q > P x q > AVC x q
TC > TR > TVC
Economic Loss = TC – TR < TC – TVC (= TFC)
 Case 2: When SAC > AVC > P
SAC x q > AVC x q > P x q
TC > TVC > TR
Economic Loss = TC – TR > TC – TVC (= TFC)
 The firm will shut down only if its revenues cannot cover its variable cost
Page 7
Short-run Shutdown Decision
p($)
SMC
SAC
AC
AVC
Loss
AFC
FC
p*
p = MR
TR – VC
AVC
q*
q
Page 8
Firm’s Short-run Supply Curve
 The firm’s supply curve shows
how much it will produce at
various output prices.
 The positively-sloped
segment of the firm’s SMC
curve above the point of
minimum AVC, therefore, is
the firm’s short-run supply
curve.
o For prices below this level, the
firm will choose to shut down,
so this price level is called the
shut-down price.
p($)
SMC
C
p2
B
p1
p0
AVC
A
q
q0 q1 q2
Page 9
Short-run Market Supply Curve
 The short-run market supply curve is derived by horizontal summing all the
individual firms’ supply curves:
p
p
p
S1
S2
SS
p2
p1
q1
q3
Firm 1
q
q2
q4
Firm 2
q
Q
q 1 + q2
q3 + q4
Market
Page 10
Short-run Competitive Market Equilibrium
 The market equilibrium occurs when the quantity demanded by all consumers
equals the total quantity supplied by all the firms in the market. That is,
Qd  Qs
p
p
SS
SMC
SAC
p*
p = MR
D
Q*
Market
Q
q*
Individual Firm
q
Page 11
Long-run Output Choice and Firm’s Supply Curve
 In the long run, a firm may adapt all of its inputs, such as adjusting plant size (capital
employed), to fit market condition. Therefore, we should use the firm’s long-run cost
functions for long-run analysis.
 As firm will exit the market if it makes an economic loss in the long run. Therefore,
the firm’s long-run supply curve is its long-run marginal cost curve above
the minimum of its long-run average cost curve
p($)
SMC1
SMC2
LMC
LAC
E
p1
SAC1
q1
MR
SAC2
q2
q
Page 12
Free Entry and Long-run Competitive Market
Equilibrium
 In the long run, new firms can enter the industry.
- New firms enter when π > 0.
- Existing firms exit when π < 0.
p
p
SS0
MC
SS1
SMC
SAC
p1
AC
p2
D1
Q1
Market
Q2
Q
q2
q
q1
Individual Firm
Page 13
Comparative statics analysis
 Increase in Demand:
p
p
SS1
SS2
SMC
SAC
p2
AC
p1
D2
D1
Q1 Q2
Market
Q3
Q
q1
q
q2
Individual Firm
Page 14
Comparative statics analysis: Long run
 The long-run market supply curve can be derived indirectly by
connecting the long-run equilibrium before and after the increase in
market demand.
- Why not derive it by horizontal summation of all firms’ long-run supply curve?
p
S
E2
E1
D1
D2
Q
Page 15
Comparative statics analysis: Long run
 Long-run Market Supply Curve
p
p
SS1
SS2
SMC
SAC
p2
AC
LS
p1
D2
D1
Q1 Q2
Market
Q3
Q
q1
q
q2
Individual Firm
Page 16
Comparative statics analysis: Long run
 The long-run market supply curve can be derived indirectly by
connecting the long-run equilibrium before and after the increase in
market demand.
- Why not derive it by horizontal summation of all firms’ long-run supply curve?
 The long-run supply curve is horizontal at price equal to the minimum
long-run average cost .
- Free entry and exit always drive price to this level (zero profit)
- Constant-cost industry: It is assumed that entry of new firms will have no
effect on input prices
Page 17
Discussion Question 2: Beijing’s Silk Market
(Xiushui Market)
 The Silk Street attracts approximately 20,000 visitors daily (from 9am to 9pm) on
weekdays and between 50,000 and 60,000 on weekends as of 2006.Many of the
stalls have over the years gained local and international reputation for selling
counterfeit luxury designer brands at relatively low prices.
Page 18
Discussion Question 2: Beijing’s Silk Market (Xiushui
Market)
 In an opinion piece published in The Wall Street Journal on 17 June,
2008, Chinese Vice-Premier Wang Qishan mentioned that Beijing’s Silk
Market has gone “through rectification and has since become a
distribution centre of famous brands”. But in reality, many stalls have
carried on selling counterfeit luxury designer brands despite growing
pressures from the Chinese government and famous brand name
companies.
“True, there is not much shouting or
pulling at customers walking down
the aisles full of handbag and shoe
stalls. But if you are caught looking
at a bag for more than two seconds,
a saleslady quickly hisses at you:
“ Want Gucci?” …”
Page 19
Discussion Question 2: Beijing’s Silk Market (Xiushui
Market)

According to the article, the problem persists because of weak enforcement
of the intellectual property law.

“In reality the cost of proving a criminal charge is very high,” said National
Copyright Administration deputy director – general Xu Chao. “It’s very difficult,
hence the limited number of criminal arrests.”
(Source: SCMP, July 7, 2008)
a. Consider the counterfeiters industry, which is highly competitive. Suppose the
government runs a confiscation program to arrest the counterfeiters from time
to time. The program can only arrest limited number of counterfeiters. What
would happen to the profits and prices of the remaining firms, which were not
arrested in short run?
b. What would be the long run adjustment in the market after the confiscation
program? Is this kind confiscation program an effective way to deal with the
piracy problem?
Page 20
Effects of the Confiscation Program
Market
P
Individual Firm
S2
P ($)
S1
SMC
LMC
LAC
SAC
P2
MR2
P1
MR1
D
Q2
Q1
Q
q1 q2
q
Page 21
Discussion Question 2
c. Many people suggested other measures to be more effective, e.g.
educating the youngsters about the importance of protecting the
intellectual property rights were more effective ways to deal with piracy
in long run. Do you agree?
Page 22
Effects of Successful Education
Market
Individual Firm
S2
P
P ($)
S1
SMC
LMC
LAC
SAC
P1
MR1
P2
MR2
D2
Q3
Q2
Q1
D1
Q
q 2 q1
q
Page 23
Discussion Question 3: Fishermen in HK
 A report published in Hong Kong Economics Times on 11 June 2008 concerns
the fishing market in Hong Kong. It is reported that the diesel price increased by
2.4 times in a year, which raised the cost of fishing significantly. How would this
regulation affect the market and individual fishermen in the short run and long
run?
(Source: Hong Kong Economic Times, 11 June, 2008)
Page 24
Short-run Effects of Increase in (Variable) Cost
Market
Individual Firm
P
P ($)
S2
S1
SMC2
SMC1
SAC2
SAC1
P2
LAC2
LAC1
MR2
P1
MR1
D
Q2
Q1
Q
q2
q1
q
Page 25
Discussion Question 3: Fishermen in HK
 If p < AVC, some fishermen may shutdown
 “Because of the high diesel price, some fishermen’s two-day revenues of $4000
can only cover the diesel costs. Therefore, some of them have stopped
fishing for some time,” said Mr. Lai.
Page 26
Long-run Effects of Increase in Cost
Market
Individual Firm
P
P ($)
S2
S2
S1
SMC2
SMC1
SAC2
P3
SAC1
P2
LAC2
LAC1 MR3
MR2
P1
MR1
D
Q3 Q2
Q1
Q
q2 q3 q1
q
Page 27
Discussion Question 3: Fishermen in HK
 Starting from this year, some of the fishermen started to sell their boats to stop
losses. Starting from January, 30 boats were sold in this year.
 It leads to higher fish prices. Some of the fish prices rise by about 25%.
Page 28
Discussion Question 4
Suppose the book-printing industry is competitive and begins in a long-run
equilibrium.
a. Hi-Tech Printing Company employs an extra-ordinary manager that
sharply reduces the cost of administrative costs (i.e. fixed cost in the
short run). What happens to Hi-Tech’s profits and the price of books in
short run? Will it attract new firms to enter the market in long run?
b. Suppose you were the owner of Hi-Tech. What is the maximum amount
that you would offer to keep the extra-ordinary manager to your own
firm?
Page 29
Discussion Question 4
p
Economic rent is the returns that
p
are derived from extraordinarily
productive inputs, which is scarce.
SMCB
SMCA
SAC1A
SACB
p1
A
SAC A2
qA
Individual Firm A
Q
qB
q
Typical Firm B
Page 30