CHAPTER 12 Competition

CHAPTER 12Competition

Competition What is perfect competition? How are price and output determined

in a competitive industry? Why do firms enter and leave an

industry? How do changes in demand and

technology affect an industry? Why is perfect competition

economically efficient?

Perfect Competition Perfect competition arises when:

There are many firms, each selling an identical product.

There are many buyers. There are no restrictions on entry into

the industry. Firms in the industry have no advantage

over potential new entrants. Firms and buyers are completely

informed about other firms’ prices.

The Firm Has No Control Over the Price It Charges

Since each firm produces a small fraction of total industry output and the products are identical, no firm has any control over price.

Firms are price takers in perfectly competitive markets. A price taker is a firm that cannot influence the price of a good or service.

Elasticity of Industryand Firm Demand

A price taker firm faces a demand curve that is perfectly elastic (horizontal) because the product from firm A is a perfect substitute for the product from firm B.

However, the market demand curve will still slope downward; elasticity will be positive, but not infinite.

Competition inthe Real World

In reality, there are no markets that are absolutely perfectly competitive.

However, competition in some industries is so fierce that the model of perfect competition predicts extremely well how firms will behave.

Examples are computers, soft drinks, TVs, DVD players, potato chips, etc.

Economic Profit and Revenue Total revenue (TR)

Value of a firm’s sales TR = P Q

Marginal revenue (MR) Change in total revenue resulting from a one-

unit increase in quantity sold. MR = TR/ Q

Average revenue (AR) Total revenue divided by the quantity sold —

revenue per unit sold. AR = TR/Q = PxQ/Q = P

In perfect competition, Price = MR = AR

Economic Profit and Revenue

Suppose Cindy sells her sweaters in a perfectly competitive market.

What are Cindy’s TR, MR, and AR?

Demand, Price, and Revenuein Perfect Competition

Quantity Price Marginal Average sold (P) Total revenue revenue (Q) (dollars revenue AR = TR/Q

(sweaters per TR = P ´ Q (dollars per (dollars per day) sweater) (dollars) additional sweater) per sweater)

QTRMR /

8 25 200

QTRMR /

8 25 200

9 25 225

QTRMR /

8 25 200

9 25 225

10 25 250

QTRMR /

8 25 200 -

9 25 225

10 25 250

QTRMR /

8 25 200 -

9 25 225 25

10 25 250

QTRMR /

8 25 200 -

9 25 225 25

10 25 250 25

QTRMR /

8 25 200 - 25

9 25 225 25

10 25 250 25

QTRMR /

8 25 200 - 25

9 25 225 25 25

10 25 250 25

QTRMR /

8 25 200 - 25

9 25 225 25 25

10 25 250 25 25

QTRMR /

Demand, Price, and Revenue

in Perfect Competition

Quantity (thousandsof sweaters per day)

Quantity (sweaters per day) Quantity (sweaters per day)

0 9 20 0 10 20 0 9 20

25 225

Sweater Industry

Cindy’s demand,average revenue, andmarginal revenue

Cindy’s total revenue

0 9 20 0 10 20 0 9 20

25 225

Sweater Industry

0 9 20 0 10 20 0 9 20

25 225

Sweater Industry

Cindy’sdemandcurve

0 9 20 0 10 20 0 9 20

25 225

Sweater Industry

Cindy’s total revenue

Cindy’sdemandcurve

Economic Profit and Revenue

The firm’s goal is to maximize economic profit.

Total cost is the opportunity cost — including normal profit.

The Firm’s Decisions inPerfect Competition

A firm’s task is to make the maximum economic profit possible, given the constraints it faces.

In order to do so, the firm must make two decisions in the short-run, and two in the long-run.

Short-run A time frame in which each firm has a

given plant and the number of firms in the industry is fixed

Long run A time frame in which each firm can

change the size of its plant and decide whether to leave or stay in the industry.

In the short-run, the firm must decide:

Whether to produce or to shut down.

If the decision is to produce, what quantity to produce.

Price is not a decision because firm is a price taker.

In the long-run, the firm must decide: Whether to increase of decrease its

plant size Whether to stay in the industry or leave

itWe will first address the short-

Total Revenue, Total Cost,and Economic Profit

Quantity Total Total Economic (Q) revenue cost profit (sweaters (TR) (TC) (TR – TC)

Per day) (dollars) (dollars) (dollars)

0 0 221 25 452 50 663 75 854 100 1005 125 1146 150 1267 175 1418 200 1609 225 18310 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 452 50 663 75 854 100 1005 125 1146 150 1267 175 1418 200 1609 225 18310 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 663 75 854 100 1005 125 1146 150 1267 175 1418 200 1609 225 18310 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 854 100 1005 125 1146 150 1267 175 1418 200 1609 225 18310 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 1005 125 1146 150 1267 175 1418 200 1609 225 18310 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 1146 150 1267 175 1418 200 1609 225 18310 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 1267 175 1418 200 1609 225 18310 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 126 247 175 1418 200 1609 225 18310 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 126 247 175 141 348 200 1609 225 18310 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 126 247 175 141 348 200 160 409 225 18310 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 126 247 175 141 348 200 160 409 225 183 4210 250 21011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 126 247 175 141 348 200 160 409 225 183 4210 250 210 4011 275 24512 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 126 247 175 141 348 200 160 409 225 183 4210 250 210 4011 275 245 3012 300 30013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 126 247 175 141 348 200 160 409 225 183 4210 250 210 4011 275 245 3012 300 300 013 325 360

0 0 22 -221 25 45 -202 50 66 -163 75 85 -104 100 100 05 125 114 116 150 126 247 175 141 348 200 160 409 225 183 4210 250 210 4011 275 245 3012 300 300 013 325 360 -35

Quantity (sweaters per day)

0 4 9 12

Revenueand Cost

0 4 9 12

Revenueand Cost

0 4 9 12

Revenueand Cost

0 4 9 12

Economicloss

Economicprofit =TR - TC

Revenueand Cost

4 9 12-20

Quantity (sweaters per day)Profit/

Economic profit/loss

4 9 12-20

Profitmaximizing quantity

Profit/loss

Economicprofit

Economicloss

Economic profit/loss

4 9 12-20

Profit/loss

ay) MR>MC MR<MCMR=MC

Break-even Output An output at which total cost equals

total revenue is called a break-even point.

Even though economic profit is zero at break-even output, the firm still earns a normal profit.

Remember, normal profit is part of total (opportunity) cost.

0 4 9 12

Breakeven Points

4 9 12-20

ay) Breakeven Point Breakeven Point

Profit/loss

Marginal Analysis Using marginal analysis, a

comparison is made between a units marginal revenue and marginal cost.

Marginal Analysis If MR > MC, the extra revenue from selling

one more unit exceeds the extra cost. The firm should increase output to increase

profit If MR < MC, the extra revenue from selling

one more unit is less than the extra cost. The firm should decrease output to increase

profit If MR = MC economic profit is maximized.

Profit-Maximizing Output Marginal Marginal revenue cost

Quantity Total (MR) Total (MC) Economic(Q) revenue (dollars per cost (dollars per

profit(sweaters (TR) additional (TC) additional

(TR – TC)per day) (dollars)sweater) (dollars sweater) (dollars)

7 175 141 34 8 200 160 40 9 225 183 4210 250 210 4011 275 245 30

-252525

7 175 141 34 8 200 160 40 9 225 183 4210 250 210 4011 275 245 30

-192327

-252525

7 175 141 34 8 200 160 40 9 225 183 4210 250 210 4011 275 245 30

-192327

-25252525

7 175 141 34 8 200 160 40 9 225 183 4210 250 210 4011 275 245 30

-19232735

-25252525

7 175 141 34 8 200 160 40 9 225 183 4210 250 210 4011 275 245 30

-19232735

-25252525

Profit-Maximizing Output

Quantity (sweaters per day) 8 9 10

MR = AR = P25

MCProfit-maximizationpoint

Loss from10th sweater

Profit from9th sweater

Economic Profitin the Short Run

Maximizing economic profit does not guarantee that profits will be positive.

Economic profit can be positive, negative or zero.

To calculate total profit, we must subtract total cost from total revenue.

Price, Average Total Cost, and Profit

Price is total revenue per unit, or average revenue (P=AR=TR/Q)

Average total cost is total cost per unit (ATC=TC/Q).

Profit = TR - TC Profit per unit=(TR-TC)/Q=TR/Q-TC/Q = (P - ATC) That means we can calculate total

profit as (P - ATC)xQ.

Profits and Losses in the Short-Run

As we indicated, at short-run equilibrium firms may: Earn a profit Break even Incur an economic loss.

Profits and Losses in the Short-Run

If price equals average total cost (P=ATC), a firm breaks even.

If price exceeds average total cost (P>ATC), a firm makes an economic profit.

If price is less than average total cost (P<ATC), a firm incurs an economic loss.

Quantity (millions of chips per year)

Three Possible Profit Outcomes in the Short-Run

30.00MC ATC

Possible Outcome OneP=ATC

AR = MR = P

MC ATCBreak-evenpoint

Possible Outcome OneP=ATCProfits=(P-ATC)xQ=(20-20)x8 = 0

30.00MC ATC

Possible Outcome Two

AR = MR = P

MC ATCPossible

Outcome TwoP>ATC

Profits=(P-ATC)xQ=(25-20.33)x9=4.67x9=42

AR = MR = P

MC ATCPossible

Outcome TwoP>ATC

Profits=(P-ATC)xQ=(25-20.33)x9=4.67x9=42

Economic Profit

30.00MC ATC

Possible Outcome Three

30.00MC ATC

AR = MR = P

Profits=(P-ATC)xQ=(17-20.14)x7=-22

30.00MC ATC

AR = MR = P

Profits=(P-ATC)xQ=(17-20.14)x7=-22Economic Loss

Three Possible Profit Outcomes in the Short-run

The Firm’s Short-Run Supply Curve

Fixed costs must be paid in the short-run.

Variable-costs can be avoided by laying off workers and shutting down.

Firms shut down if price falls below the minimum of average variable cost.

A Firm’s Supply Curve

Quantity (sweaters per day)7 9 10

MR1=P1=25

MR2=P2=31

MR0=P0=17

Shutdown point

)MC = Supply

MR1=P1=25

MR2=P2=31

MR0=P0=17

)S = MC

The Firm’s Short-Run Supply Curve

A perfectly competitive firm’s short-run supply curve shows how its profit-maximizing output varies as market price changes.

Since price must equal marginal cost, the marginal cost curve is also the supply curve.

However, only the portion of the marginal cost curve above the minimum average variable cost curve is relevant.

Temporary Plant Shutdown A firm cannot avoid incurring its fixed

costs but it can avoid variable costs. A firm that shuts down and produces no

output incurs a loss equal to its total fixed cost.

A firm’s shutdown point is the level of output and price where the firm is just covering its total variable cost.

In other words, if its losses are bigger than its fixed costs, the firm will shut down.

Production Decisions When price is below the minimum

point of the AVC curve, the firm will shut down and supply zero output.

When price is above the lowest point of the AVC curve, the firm will produce the level of output where price equals marginal cost.

The short-run supply curve is therefore the MC curve above the AVC curve.

Output, Price, and Profitin the Long Run

In short-run equilibrium, a firm might make an economic profit, incur an economic loss, or break even (make a normal profit). Only one of these situations is a long-run equilibrium.

In the long run either the number of firms in an industry changes or firms change the scale of their plants.

Economic Profit and Economic Loss as Signals

If an industry is earning above normal profits (positive economic profits), firms will enter the industry and begin producing output.

This will shift the industry supply curve out, lowering price and profit.

Economic Loss as a Signal If an industry is earning below

normal profits (negative economic profits), some of the weaker firms will leave the industry.

This shifts the industry supply curve in, raising price and profit.

Long-Run Adjustments Forces in a competitive industry

ensure only one of these situations is possible in the long-run.

Competitive industries adjust in two ways: Entry and exit Changes in plant size

Entry and Exit The prospect of persistent profit or

loss causes firms to enter or exit an industry.

If firms are making economic profits, other firms enter the industry.

If firms are making economic losses, some of the existing firms exit the industry.

Entry and Exit This entry and exit of firms influence

price, quantity, and economic profit.

Let’s investigate the effects of firms entering or exiting an

industry.

Quantity (thousands of sweaters per day)6 7 8 9 10

Entry and Exit

Quantity (thousands of sweaters per day)6 7 8 9 10

Entry and ExitImportant Points

As new firms enter an industry, the price falls and the economic profit of each existing firm decreases.

As firms leave an industry, the price rises and the economic loss of each remaining firm decreases.

Long-Run Equilibrium Long-run equilibrium occurs in a

competitive industry when firms are earning normal profit and economic profit is zero.

Economic profits draw in firms and cause existing firms to expand.

Economic losses cause firms to leave and cause existing firms to scale back.

Long-Run Equilibrium So in long-run equilibrium in a

competitive industry, firms neither enter nor exit the industry and firms neither expand their scale of operation nor downsize.

Long-Run Equilibrium In long-run equilibrium, firms will be

earning only a normal profit. Economic profits will be zero.

Firms will neither enter nor exit the industry.

In long run equilibrium, P=MC and P=ATC. Thus, P=MC=ATC.

Because MC=ATC, ATC must be at its minimum.

Changing Tastes and Advancing Technology

What happens in a competitive industry when a permanent change in demand occurs?

A Decrease in Demand

Quantity

0 Quantity

Industry Firm

Quantity

Industry Firm

Quantity

Industry Firm

q1Q0Q1

Quantity

0 Quantity

Industry Firm

Quantity

Industry Firm

Quantity

Industry Firm

Quantity

Industry Firm

q1Q0Q1

Summary

Technological change New technology allows firms to produce

at lower costs.• This causes their cost curves to shift downward.

Firms adopting the new technology make an economic profit.• This draws in new technology firms

Old technology firms disappear, the price falls, and the quantity produced increases.

A competitive industry is rarely in a long-run equilibrium.

What happens in a competitive industry when there is a permanent increase or decrease in the demand for its product?

What happens in a competitive industry when technological change lowers its production costs?

A Permanent Changein Demand

A permanent decrease in demand will cause the short-run equilibrium price and quantity to fall.

In the long run, firms will leave the industry (because economic profits are negative), raising price enough to restore a normal level of profit.

The difference is the number of firms in the industry.

A Permanent Increasein Demand

The increase in demand causes industry price and profits to rise.

Firms enter the industry, increasing market supply and eventually lowering price to its original level.

However there are now more firms in the industry.

Technological Change Technological improvements lower

average cost of production. Most technological improvements

cannot be implemented without investment in new plant and equipment.

This means it takes time for a technological advance to spread through an industry.

Technological Change and Equilibrium Price

A technological improvement that affects all firms will shift the industry supply curve down and to the right.

Firms now earn economic profits and new firms enter the industry.

This this drives down equilibrium price and raises industry output.

Technological Change and Equilibrium Profit

Implementing a technological improvement causes the marginal cost curve for each firm to shift down and to the right.

Economic profits are not affected in the long run.

The firms that survive in the long run are those that adopted the new technology early.

CHAPTER 12 Competition

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