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Perfect Competition Sometimes referred to as Pure Competition or just The Competitive Firm Market Structure (there are 4) (what is it?) A specific environment the firm operates in which influences decisions on pricing and output. Background on Markets When economists analyze the production decisions of a firm, they take into account the structure of the market in which the firm is operating. Four Different Market Structures: Perfect Competition Monopoly Monopolistic Competition Oligopoly Market Model Price/Output Market economy… varies from one seller to many sellers… None is “typical.” Each unique and attempting to operate with his “self-interest” in mind. Look at the “Models” for the 4 market categories… How does each determine the price to charge and the output to produce? Market structure characteristics All four market structures have four distinguishing characteristics: The number and size of the firms in the market. The ease with which firms may enter and exit the market. The degree to which firms’ products are differentiated. The amount of information available to both buyers and sellers regarding prices, product characteristics and production techniques. The Theory of Perfect Competition is based on 4 assumptions : (1) There are many sellers and many buyers, none of which is large in relation to total sales or purchases. (2) Each firm produces and sells a homogeneous product. (3) Buyers and sellers have all relevant information with respect to prices, product quality, sources of supply, and so on. (4) There is easy entry into and exit from the industry. Perfect Competitive Market Why teach about a non-existent form of competition? Questions to answer: What are profits? What are the unique characteristics of competitive firms How much output will a competitive firm produce A Perfectly Competitive Firm is a Price Taker 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. Distinction in terminology Speak of “the firm” we are referring to the individual firm. Speak of the “market,” we are referring to the industry. We mean all the firms in the aggregate. The Demand Curve of the Perfect Competitor Question If the perfectly competitive firm is a price taker, who or what sets the price? The Demand Curve of the Perfect Competitor The perfectly competitive firm is a price taker, selling a homogenous commodity with perfect substitutes. Will sell all units for $5 Will not be able to sell at a higher price Will face a perfectly elastic demand curve at the going market price Figure 24-1 The Demand Curve for a Producer of Secure Digital Cards How Much Should the Perfect Competitor Produce? (cont'd) Profit p = Total revenue (TR) – Total cost (TC) TR = P x Q TC = TFC + TVC P determined by the market in perfect competition Q determined by the producer to maximize profit Figure 24-2 Profit Maximization, Panel (a) Take a personal look? How many of you owned a computer 15 years ago? How many still own a compact disc player today? How many have discarded the VCR in favor of a DVD? Do you own an Ipod? Do you own an IPhone? Do you own an Ipad? Do you own a Blackberry? Do you own a graphing calculator? Did your parents have a graphing calculator How did your parents type project papers for economics class? Competition & technology advancement has brought the above changes about. Price Taker Discussion When there are many firms, all producing and selling the same product using the same inputs and technology, competition forces each firm to charge the same market price for its good. Because each firm sells the same homogeneous product, no single firm can increase the price that it charges above the price charged by other firms in the market (without losing business.) No single firm can affect the market price by changing the quantity of output it suppliesbecause many firms- each firm is small in size. Cannot change the amount of sand. Demand Curve Individual firm/industry The perfect competitor faces a horizontal or perfectly elastic demand curve. The demand curve is identical to the Marginal Revenue Curve (because the firm can sell as much as it wants to sell at market price.) It is not necessary to lower the price to sell more. The demand curve for the entire industry slopes downward (this is a result of aggregate entries and exits into the market.) Price Taker’s Demand Curve • The market forces of supply and demand determine price. • Price takers have no control over the price that they may charge in the market. If such a firm was to offer their good/service at a price above that established by the market they would buy elsewhere. Price Price Market Supply Individual firms must take the market price. P Demand for Single Firm Price is determined in the market. P Market Demand Output / Time Output / Time Demand Curve Market Demand Curves vs. Firm Demand Curves While the actions of a single competitive firm are negligible, the unified actions of many such firms are not. The individual firm’s equilibrium quantity of output will be completely determined by the amount of output the individual firm chooses to supply SHORT RUN In the short-run, individual firm may make profit or loss In long run will break even You can always tell if the firm is making a profit or loss by looking at the DEMAND CURVE AND THE ATC CURVE If the demand curve is ABOVE the ATC curve at any point the firm will make a profit. If the demand curve is always BELOW the ATC curve the firm will lose money. Price Quantity $8 8 8 8 8 8 8 8 8 1 2 3 4 5 6 7 8 9 Total Revenue $ 8 16 24 32 40 48 56 64 72 Total Revenue Total Revenue $96 88 80 72 64 56 48 40 32 24 16 8 0 Total revenue pe= $8 1 2 3 4 5 6 7 8 9 10 11 12 Quantity Most profitable point for any firm Profit maximization is where MC = MR Efficiency: A firm operates at peak efficiency when it produces its product at the lowest possible cost… That would be at the MINIMUM POINT OF ITS ATC CURVE – the break even point. Profit-Maximization Rule Profit is maximized by producing the quantity of output at which MR = MC. For Perfect Competition, profit is maximized when P = MR = MC* * This condition is unique for perfect competition and does not hold for other market structures. Realization Marginal Cost A firm’s goal is not to maximize revenues, but to maximize profits. Marginal revenue is compared to marginal costs to determine the best level of output. What an additional unit of output brings in is its marginal revenue (MR). Profit Maximization $18 Marginal cost Price or Cost (per bushel) 16 14 p = MC MRB Profits decreasing Price (= MR) 12 10 Profits increasing 8 Profit-maximizing rate of output 6 4 2 0 MCB 1 2 3 4 5 Quantity (bushels per day) 6 7 Profit Maximization when the • In the short run, the price Firm is a Price Taker taker will expand output until marginal revenue (price) is just equal to marginal cost. • This will maximize the firm’s profits (rectangle BACP). Price MC p = MC Profit P • When P > MC then the firm can C make more on the next unit sold than it costs to increase output for that unit. In order for the firm to maximize its profits it increases output until MC = P. • When P < MC then the firm made less on the last unit sold than it cost for that unit. In order for the firm to maximize 0 its profits it decreases output until MC = P. ATC B d (P = MR) A P > MC P < MC decrease q Increase q q Output / Time Marginal Revenue / Marginal Cost Approach Marginal Marginal Revenue Cost Profit Output (MR) (MC) (TR - TC) 0 1 2 .. . 8 9 10 11 12 13 14 15 16 17 18 19 20 21 ---5 5 .. . 5 5 5 5 5 5 5 5 5 5 5 5 5 5 ---$ 4.80 $ 3.95 .. . $ 1.50 $ 1.25 $ 1.00 $ 1.25 $ 1.75 $ 2.50 $ 3.50 $ 4.75 $ 6.00 $ 7.25 $ 8.25 $ 9.50 $ 13.00 $ 17.00 - 25.00 - 24.80 - 23.75 .. . - 8.00 - 4.25 - .25 3.50 6.75 9.25 10.75 11.00 10.00 7.75 4.50 0.00 - 8.00 - 20.00 • We can show the relationship between the TR/TC and the MR/MC approach. • Below, low levels of output deliver marginal revenue to the firm greater than the marginal cost of increased output. • After some point, though, additional units cost more than their marginal revenue. • Profit is maximized where P = MR = MC. • Both the TR/TC and the MR/MC method yield the same profit maximizing output, q=15 Price and Cost Per Unit 9 7 5 MC Profit Maximum P = MR = MC MR 3 1 Output Level 2 4 6 8 10 12 14 16 18 20 22 Operating • In the graph to the right, the firm operates at an output level where p = MC, but here ATC > MC resulting in a loss for the firm. • The magnitude of the firm’s short-run losses is equal to the size of the of the rectangle BACP1 • A firm experiencing losses but covering its average variable costs will operate in the short-run. • A firm will shutdown in the short-run whenever price falls below average variable cost (P2). • A firm will shutdown in the long-run whenever price falls below average total cost. PriceMC ATC Loss AVC C P1 A B d (P = MR) P2 p = MC 0 q Output / Time Where is pure profit? Normal Profit? • Given Pe, firm produces qe where MC = MR If AC = AC1, break-even • If AC = AC2, losses • If AC = AC3, economic profit Long Run In the long run there is time for firms to enter or leave the industry. This factor ensures that the firm will make ZERO profits in the long run. Terminology Check Pure Profit (attracts individual firms into the market) Zero or Normal Profit (can still make a decent living, but cannot go to Germany for vacation.) Firms not attracted at this profit level. Going into Business- Pure Competition in 60 seconds http://www.youtube.com/watch?v=nv9 gzUUU7Mk Long Run In the LR, no firm will accept losses. It will simply close up shop and go out of business. But also remember – one firm leaving the industry WILL NOT affect market price. LR Continued If one firm is losing money, presumably others are too. When enough firms go out of business, industry supply declines which pushes price up… This price rise is reflected in a new demand curve for the firm. P D1 D2 S2 S1 Q MC ATC $60 $50 MR (D) For the perfect competitor in the LR, the most profitable output is at the minimum point of its ATC curve. The firm is forced to operate at peak efficiency and that is why it operates at the minimum of its ATC curve.. Not anything to do with virtue------- just competition. Remember… Firm Demand Curve is Different from Industry’s Demand Curve Price Price Market Supply Individual firms must take the market price. P Demand for Single Firm P Market Demand Output / Time Output / Time Point of Fact For virtually every industry---- a firm will be able to lower its ATC if it can expand up to a certain point. If it expands beyond that point… ATC will rise. Two concepts: Increasing and Decreasing costs. The third alternative is constant costs. Economies of Scale Economies of scale COST (dollars per unit) Constant returns to scale Diseconomies of scale ATC3 ATC1 ATCS ATCS m1 c c 0 QM RATE OF OUTPUT (units per period) 0 ATCS ATC2 m2 QM RATE OF OUTPUT (units per period) m3 c 0 QM RATE OF OUTPUT (units per period) The Long-Run Industry Situation: Exit and Entry (cont'd) Constant-Cost Industry An industry whose total output can be increased without an increase in longrun per-unit costs Its long-run supply curve is horizontal. The Long-Run Industry Situation: Exit and Entry (cont'd) Increasing-Cost Industry An industry in which an increase in industry output is accompanied by an increase in long-run per unit costs Its long-run industry supply curve slopes upward. The Long-Run Industry Situation: Exit and Entry (cont'd) Decreasing-Cost Industry An industry in which an increase in industry output leads to a reduction in long-run per-unit costs Its long-run industry supply curve slopes downward. Decreasing Cost Industry Decreasing cost industry can lower ATCs by increasing output – thus taking advantage of “economies of scale” examples such as discounts from buying or selling large quantities, declining average fixed cost as output expands, and lower costs resulting from specialization Increasing Cost Industry Increasing Cost Industries “diseconomies of scale” overwhelm economies of scale. These diseconomies drive costs up, pushing firms into the rising segment of their ATC curves. (examples would be managerial inefficiencies, cost of maintaining a huge bureaucracy, difficulties of communication among various branches, also diminishing returns.) Factor Costs Factor costs mean wages, rent and interestare far the most important determinants of whether costs are falling, constant or increasing. Usually factor costs will eventually rise which makes every industry an increasing costs industry. Example: as more and more land is used by an expanding industry, rent will be bid up… Time influences supply: Whether industry is in SR or LR …all can adjust in LR if desire to do so. Katrina Cottages Profit - what kind is it??? Pure Profit -an amount above that necessary to keep the owner in the industry… is not considered part of total cost Pure profit is the residual after all costs (including normal profit) have been met Pure profit will attract other firms into the market Normal Profit will not induce firms into the market- nor are they low enough to force others to leave.. Breaking even.. Basic Info As long as MR is greater than MC the firm will find an advantage in increasing its production. Rule is: The most profitable point for any firm is the point at which MC = MR. The firm can improve its profit position by increasing its output up to the point where MC crosses MR. Shutdown point for a firm A firm compares total revenue with total cost to see what its profit or loss is. Remember there are fixed and variable costs. Fixed costs have to be paid whether operating or not. Suppose: a firm’s total cost is $300,000 at a certain level of output. $200,000 made up of variable costs,such as labor and raw materials and $100,000made up of fixed costs such as interest payments, taxes, and rent. Shutdown Continued If the firm’s total revenue is $240,000 it is clearly taking a loss. The difference between TR and TC in this case is $60,000. Notice that the total revenue of $240,000 pays all of the firms variable costs ($200,000) and also pays $40,000 of its fixed cost. If the firm were to shut down on the other hand, its loss would total $100,000- the amount of the fixed cost. There may be instances where the firm can pay all fixed and part of variable. In those cases, it is possible the firm will opt for that. BUT…. For the most part, and for you to remember… if firm can pay variable and part of fixed, they will continue to operate. Shutdown Continued As long as a firm can cover ALL of its variable cost by remaining in operation, it will do so. ****It’s shutdown point will be where TR no longer covers TVC. Shutdown: when MR falls below the firm’s minimum AVC. When a firm shuts down, it does not necessarily leave the industry. Shutdown is a SR response…and is based on fixed costs of established plant and variable costs of operating it. Profit Maximization and Loss Minimization for the Perfectly Competitive Firm: Three Cases I In Case 1, TR TC and the firm earns profits. It continues to produce in the short run. Profit Maximization and Loss Minimization for the Perfectly Competitive Firm: Three Cases II In Case 2, TR < TC and the firm takes a loss. It shuts down in the short run because it minimizes its losses by doing so; it is better to lose $400 in fixed costs than to take a loss of $450. Profit Maximization and Loss Minimization for the Perfectly Competitive Firm: Three Cases III In Case 3, TR < TC and the firm takes a loss. It continues to produce in the short run because it minimizes its losses by doing so; it is better to lose $80 by producing than to lose $400 in fixed costs by not producing. What Should a Perfectly Competitive 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. Long-run Equilibrium • The two conditions necessary for long-run equilibrium in a price-taker market are depicted here. • First, the quantity supplied and the quantity demanded must be equal in the market, as shown below at P1 with output Q1. • Second, the firms in the industry must earn zero economic profit (that is, the “normal market rate of return”) at the established market price (P1 below). Price Price Ssr MC ATC P1 d P1 D q1 Firm Q1 Output Market Output The Lure of Profits In competitive markets, economic profits attract new entrants. Low entry barriers permit new firms to enter competitive markets. The entry of new firms shifts the market supply curve to the right. As long as economic profits are available in short-run competitive equilibrium, new entrants will continue to be attracted. p = MC Short-run competitive equilibrium: A Shift of Market Supply Any short-run equilibrium will not last. As supply increases, price drops, to the minimum of ATC. Once at minimum of ATC, there are no longer economic profits to attract firms to enter. In long-run equilibrium, entry and exit cease, and zero economic profit (i.e., normal profit) prevails. Long-run equilibrium: p =MC =minimum ATC Short- vs. Long-Run Equilibrium PRICE OR COST MC pS qS QUANTITY ATC Long-run equilibrium (p = MC = ATC) PRICE OR COST Short-run equilibrium (p = MC) MC pS pL qL QUANTITY ATC Long-Run Rules for Entry and Exit Price Level Result for typical firm Market Response P > ATC Profits New firms enter industry, Existing firms expand P < ATC Loss Firms exit industry, Existing firms contract P = ATC Break even No exit or entry, Existing firms maintain current capacity Further Supply Shifts With strong competition, often the only way for a firm to improve profitability is to reduce costs. Cost reductions can be accomplished through technological improvements. This might increase productivity. Technological improvements are illustrated by a downward shift of the ATC and MC curves. Technology improvements noted below PRICE (per computer) Old MC New MC Old ATC New ATC J $700 N R 0 430 600 QUANTITY (computers per month) Allocative Efficiency The market mechanism works best in competitive markets. Market mechanism - The market mechanism is the use of market prices and sales to signal desired output. Allocative efficiency means that we are producing the right output mix. The price signal the consumer gets in a competitive market is an accurate reflection of opportunity cost. Production Efficiency Production efficiency means that we are producing at minimum average total cost. Efficiency (production) – Maximum output of a good from the resources used to produce it. When competitive pressure on prices is carried to the limit, the products in question are also produced at the least possible cost. Society is getting the most it can from its available (scarce) resources. This market model is the best “buy” for consumers. Reality of Attaining a Profit The sequence of events common to a competitive market situation includes the following. High prices and profits signal consumers’ demand for more output. Economic profit attracts new suppliers. The market supply shifts to the right Prices slide down the market demand curve. A new equilibrium is reached with increased quantities being produced and sold and the economic profit approaching zero. Producers experience great pressure to keep ahead of the profit squeeze by reducing costs. Profits Are The Bottom Line