Perfect Competition Jeremy Wong & Cynthia Ji. A market where no participants are large enough to...

Perfect CompetitionJeremy Wong & Cynthia Ji

• A market where no participants are large enough to set the price of a product

• Many conditions exist for a perfectly competitive market

• Therefore there are few if any, truly competitive markets• Mainly used as a benchmark for other market structures

• Let’s take a look at some of the conditions of a perfectly competitive market!

What is Perfect Competition?

Large number of buyers and sellersConditions

Buyers Sellers

Homogenous/identical products (e.g. no brand loyalty)

Conditions

Example: All window cleaning solutions are the sameBrand A = Brand B = Brand C = Brand D

No barriers to entry and exit from marketConditions

A company can easily enter into a market for a product and just as easily leave that market.

No advantages for established firmsConditions

Firm A (left)

Firm B (below)

Although well established, Firm B does not have any advantages over Firm A

No power to set the market priceConditions

No one firm has market power, the ability to influence the price of a product.

Price determined by industry supply and demand

As a result, the industry demand will be downward sloping demand curve but the firm’s demand will be perfectly elastic (horizontal line).

Suppliers only supply a small portion of the total industry output

Conditions

Example: Manufacturers only have a small market share in the Luxury Automotive Industry

Example: Consumers will know all the available prices for a MacBook Pro

Consumers and producers have perfect market knowledge

Conditions

The aim of firms is to maximize profitConditions

Total Revenue (TR) – Amount of money that a firm makes by selling its products (TR=Price x Quantity)Ex: A firm sells 200 apples for $2 each. The total revenue from selling apples would be 200 multiplied by 2 for a TR of $400.

Average Revenue (AR) – How much revenue a firm receives for a typical unit sold (total revenue divided by number of units sold)Ex: A firm makes $400 from selling 100 widgets. Their average revenue would be 400 divided by 100 to give an AR of $4.

Definitions

Average Total Cost (ATC) – Total cost of producing all units divided by the number of units produced. Includes the opportunity cost of producing the good.Ex: It costs $200 to produce 100 gadgets. By dividing 200 by 100, we get an ATC of $2.

Definitions

• Normal Profit – Exists when total revenue is equal to total costs (minimum profit needed to run the business and the long term profit for perfectly competitive markets). Opportunity cost is not considered.

• Economic/Abnormal Profit – When total revenue is greater than total costs, it is the difference between these two values (can only be achieved in the short term in a perfectly competitive market)

Definitions

Marginal Revenue (MR)•The additional revenue generated by increasing product sales by 1 unit•Calculation:__change in total revenue__ change in output quantity•In perfect competition, MR = AR = Price = Demand

Producers can’t set price but can determine how much of a product to produce in order to maximize profit.

Marginal Revenue = Marginal Cost

Maximizing Profit

Marginal Cost (MC)•The change in the total cost that arises when quantity produced changes by 1 unit•Calculation:___change in total cost___change in output quantity

In a perfectly competitive market, marginal revenue is the same as the average revenue per unit:

Marginal Revenue# of Units Total

RevenueMarginal Revenue

1 15 15

2 25 10

3 30 5

# of Units Total Revenue

Marginal Revenue

1 15 15

2 30 15

3 45 15

There can be a positive economic profit which is maximized at the point where MC=MR

Short run profit

Figure 1 Profit Maximization for a Competitive Firm

Copyright © 2004 South-Western

Quantity0

Costsand

Revenue

MC

ATC

AVC

MC1

Q1

MC2

Q2

The firm maximizesprofit by producing the quantity at whichmarginal cost equalsmarginal revenue.

QMAX

P = MR1 = MR2 P = AR = MR

• When MR > MC increase Q• When MR < MC decrease Q• When MR = MC profit maximized

How to calculate profit:Profit=qe(P-ATC)

How to maximize profit:Short run profit

Figure 5 Profit as the Area between Price and Average Total Cost

Copyright © 2004 South-Western

(a) A Firm with Profits

Quantity0

Price

P = AR = MR

ATCMC

P

ATC

Q(profit-maximizing quantity)

Profit

Figure 5 Profit as the Area between Price and Average Total Cost

Copyright © 2004 South-Western

(b) A Firm with Losses

Quantity0

Price

ATCMC

(loss-minimizing quantity)

P = AR = MRP

ATC

Q

Loss

Economic profit = 0Long run profit

• More firms will enter the market• Supply increases, price decreases• Profit decrease and Marginal Revenue decrease• Average Total Cost = Marginal Revenue

If economic profit is less than 0:• Firms will leave the market• Supply decreases, price increases• Profit increase and Marginal Revenue increase• Average Total Cost = Marginal Revenue

Why is economic profit 0?If economic profit is greater than 0:

Long run profit

Why Stay if No Economic Profit is made?• Profit=total revenue – total cost• Total cost include all the opportunity cost of the firm

• The long-run market supply curve is horizontal at this price.

• In a zero-profit equilibrium, the revenue compensates the time and money the owners spent to keep the business going

• Normal profit is still being made

Market Supply with Entry and Exit

Copyright © 2004 South-Western

(a) Firm’s Zero-Profit Condition

Quantity (firm)0

Price

(b) Market Supply

Quantity (market)

Price

0

P = minimumATC

Supply

MC

ATC

Shutdown – A firm’s short run decision to stop production for a period of time due to market conditions.Exit – A firm’s long run decision to leave the market entirely

Variable Costs – Expenses that change depending on the amount of output.Fixed Costs – Stays the same no matter the amount of output.

Shutting Down or Exiting

Decision to Shut Down in the Short Run• A firm shuts down its revenue is less than the variable cost of production.

• Shut down ifTotal Revenue < Total Variable Cost

• Converting this into per unit comparison:• Shut down if

•Price < Average Variable Cost

The Competitive Firm’s Short Run Supply Curve

Copyright © 2004 South-Western

MC

Quantity

ATC

AVC

0

Costs

Firmshutsdown ifP< AVC

Firm’s short-runsupply curve

If P > AVC, firm will continue to produce in the short run.

If P > ATC, the firm will continue to produce at a profit.

Short run supply curve• The short run supply curve for the firm is the portion of its marginal cost curve that lies above average variable cost since the firm would shutdown once price falls below the average variable cost.

Decision to Exit in the Long Run• The firm exits if the revenue it would get from producing is less than its total cost.

• Exit if Total Revenue < Total Cost

• Converting this into per unit comparison:• Exit if Price < Average Total Cost

Decision to Enter in the Long Run• A firm will enter the industry if such an action would be profitable.

• Enter if TR > TC

• Converting this into per unit comparison:• Enter if P > ATC

Figure 4 The Competitive Firm’s Long-Run Supply Curve

Copyright © 2004 South-Western

MC = long-run S

Firmexits ifP < ATC

Quantity

ATC

0

CostsFirm’s long-runsupply curve

Firmenters ifP > ATC

• The long run supply curve for the firm is the marginal cost curve above the minimum point of its average total cost curve since the firm would exit the market once price falls below average total cost.

Long run supply curve

Shift in Demand in the Short Run and Long Run• An increase in demand raises price and quantity in the short run.

• Firms earn profits because price now exceeds average total cost.

• In the long run, the increase in supply will push the equilibrium point to the original price with increased quantity.

An Increase in Demand in the Short Run and Long Run

Firm

(a) Initial Condition

Quantity (firm)0

Price

Market

Quantity (market)

Price

0

DDemand, 1

SShort-run supply, 1

P1

ATC

Long-runsupply

P1

1Q

A

MC

An Increase in Demand in the Short Run and Long Run

Copyright © 2004 South-Western

MarketFirm

(b) Short-Run Response

Quantity (firm)0

Price

MC ATCProfit

P1

Quantity (market)

Long-runsupply

Price

0

D1

D2

P1

S1

P2

Q1

A

Q2

P2

B

An Increase in Demand in the Short Run and Long Run

Copyright © 2004 South-Western

P1

Firm

(c) Long-Run Response

Quantity (firm)0

Price

MC ATC

Market

Quantity (market)

Price

0

P1

P2

Q1 Q2

Long-runsupply

B

D1

D2

S1

A

S2

Q3

C

Allocative Efficiency – The firm produces only goods that are most desirable and high in demand (P=MC)

Efficiency

• Productive Efficiency – The firm produces goods at the lowest possible cost which is a point on the Production Possibilities Curve (production at minimum ATC)

Short run Long runEconomic Profit

Yes No

Productively Efficient

No Yes

Allocatively Efficient

Yes Yes

Comparing short run and long run

QUIZ

a) Increasing its outputb) Decreasing its outputc) Increasing its priced) Increasing its resources

Which of the following is not a valid option for a perfectly competitive firm?

Question 1

a) Increasing its outputb) Decreasing its outputc) Increasing its priced) Increasing its resources

Which of the following is not a valid option for a perfectly competitive firm?

Question 1

a) Economic profitb) Allocative efficiencyc) Productive efficiencyd) Normal profit

In the long run, a perfectly competitive firm will achieve all but which of the following?

Question 2

a) Economic profitb) Allocative efficiencyc) Productive efficiencyd) Normal profit

In the long run, a perfectly competitive firm will achieve all but which of the following?

Question 2

a) Always earning an economic profitb) Always productively efficientc) Always allocatively efficientd) Always experiencing an economic loss

If the price a firm receives for its product is equal to the marginal cost of producing that product, the firm is:

Question 3

a) Always earning an economic profitb) Always productively efficientc) Always allocatively efficientd) Always experiencing an economic loss

If the price a firm receives for its product is equal to the marginal cost of producing that product, the firm is:

Question 3

a) Earning an economic profitb) Productively efficientc) Dominating the other firms in the marketd) Not producing enough output

A firm that is producing at the lowest possible average cost is always:

Question 4

a) Earning an economic profitb) Productively efficientc) Dominating the other firms in the marketd) Not producing enough output

A firm that is producing at the lowest possible average cost is always:

Question 4

a) Earn an economic profitb) Increase its price if it is experiencing an

economic lossc) Produce the quantity where its marginal cost

equals its marginal revenued) Produce at the productively efficient level of

output

A perfectly competitive firm should always:Question 5

a) Earn an economic profitb) Increase its price if it is experiencing an

economic lossc) Produce the quantity where its marginal

cost equals its marginal revenued) Produce at the productively efficient level of

output

A perfectly competitive firm should always:Question 5

a) A total profit of $2b) A total profit of $2000c) A price greater than its marginal costd) An economic loss

If a profit maximizing perfectly competitive firm is selling 1000 units at a price $10 and its average total cost is $8, the firm is experiencing:

Question 6

a) A total profit of $2b) A total profit of $2000c) A price greater than its marginal costd) An economic loss

If a profit maximizing perfectly competitive firm is selling 1000 units at a price $10 and its average total cost is $8, the firm is experiencing:

Question 6

a) Price will increaseb) Other firms will enter the marketc) Other firms will leave the marketd) Demand will decrease

Which is most likely to happen if a perfectly competitive firm is experiencing an average revenue greater than its average cost?

Question 7

a) Price will increaseb) Other firms will enter the marketc) Other firms will leave the marketd) Demand will decrease

Which is most likely to happen if a perfectly competitive firm is experiencing an average revenue greater than its average cost?

Question 7

a) Firms will enter the market, price will decreaseb) Firms will enter the market, price will increasec) Firms will exit the market, price will decreased) Firms will exit the market, price will increase

If a perfectly competitive firm is experiencing an economic loss, which of the following will happen?

Question 8

a) Firms will enter the market, price will decreaseb) Firms will enter the market, price will increasec) Firms will exit the market, price will decreased) Firms will exit the market, price will

increase

If a perfectly competitive firm is experiencing an economic loss, which of the following will happen?

Question 8

a) Earn an economic profit, be allocatively efficient, be productively efficient

b) Not earn an economic profit, be allocatively efficient, be productively efficient

c) Not earn an economic profit, not be allocatively efficient, be productively efficient

d) Not earn an economic profit, not be productively efficient, be allocatively efficient

A perfectly competitive firm that is in long run equilibrium will

Question 9

a) Earn an economic profit, be allocatively efficient, be productively efficient

b) Not earn an economic profit, be allocatively efficient, be productively efficient

c) Not earn an economic profit, not be allocatively efficient, be productively efficient

d) Not earn an economic profit, not be productively efficient, be allocatively efficient

A perfectly competitive firm that is in long run equilibrium will

Question 9

a) Experience an economic lossb) Experience an economic profit and produce more

in the short runc) Experience an economic profit and produce less

in the short rund) Experience no economic profit in the short run

A perfectly competitive firm produces widgets in the long run. The market demand for widgets suddenly increases. The firm will

Question 10

a) Experience an economic lossb) Experience an economic profit and produce

more in the short runc) Experience an economic profit and produce less

in the short rund) Experience no economic profit in the short run

A perfectly competitive firm produces widgets in the long run. The market demand for widgets suddenly increases. The firm will

Question 10

a) Rb) Sc) Td) Ue) J

The firm maximizes profit at which output?

Question 11

a) Rb) Sc) Td) Ue) J

The firm maximizes profit at which output?

Question 11

a) Less than $15b) $50c) Above $60d) Between $50

and $60e) $60

The firm’s shutdown price is

Question 12

a) Less than $15b) $50c) Above $60d) Between $50

and $60e) $60

The firm’s short run shutdown price is

Question 12