Chapter 06 - Competition

8/9/2019 Chapter 06 - Competition

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Chapter 6

Competition

(Perfect Competition and Monopoly)

Firms compete with one another toattract customers by:

1. Cutting Prices

2. Other means

Two types of Competition

1. Price Competition: Reducing the prices of

their products below the prices ofcompeting firms for boosting sales andprofits.


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2. Non-Price Competition: Creating a demandby Advertising and through both pre andpost sale activities.

Market Structure refers to certain marketcharacteristics that influence the firmspricing and output behavior.

Markets differ from one another due todifferences in the:

1. Number of Buyers and Sellers

2. Nature of the Product

3. Influence over Price4. Freedom for Entry and Exit

In Markets where there are a Largenumber of small buyers and sellers,individual firms have little control overprice.

By Differentiating its product, a firm cangain some control over price.

If it is easy for new firms to enter an

industry, existing firms may have littlefreedom in their pricing decisions.


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Single firm

product hasno closesubstitutes

Few firms

Similar orDifferentiatedProducts

Many firms

DifferentiatedProducts

Large Numberof firms

Identicalproducts

MonopolyOligopolyMonopolisticCompetition

PerfectCompetition

Market Structures and Characteristics

Effectivebarriers toentry

Significantcontrol overprice

Somebarriers toentry

Substantial controlover price

Freedom ofentry and exit

Small controlover marketprice

No barriers toentry and exit

No controlover marketprice

MonopolyOligopolyMonopolisticCompetition

PerfectCompetition

Market Structures and Characteristics


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Perfect Compet itionImplies complete absence of rivalry among

the firms.Individual economic units are very small

relative to the total market.

Actions of one unit have no impact onothers.

Units do not have to consider the effect oftheir activities on other participants in themarket.

PC in economic theory has a oppositemeaning to the everyday usage of the term.

Characteristics:Large number of buyers and sellers in the

market.

No single seller is able to exert influenceover price.

Sellers are price takers, offer their productat market determined price.

Individual buyer and seller is an insignificantplayer in the market.

Homogeneous or identical products in themarket- product is totally undifferentiated.


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Free Entry and Exit.

Uniform price in the market.

Buyers have full knowledge about the natureof the product and the prices charged.

Determination of Market Price

(Equilibrium Price)

No single entity can affect price.

Aggregate effect of the participants isconsidered.

Interaction of supply and demand

determines equilibrium price and quantity tobe exchanged.

ExcessDemand

130757.53

ExcessDemand

1208084

ExcessDemand

100858.55

Equilibrium909096

Excesssupply

80959.57

Excesssupply

70100108

ImpactMarketDemand

Mkt. Supply(10 firms)

Single FirmPrice($)/Unit

Market Supply and Demand Schedule

The Equilibrium P rice is $ 6 at which the quantity dem anded equalsquantity supplied.


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SD

Price per unit( $ )

7.00

Pe

4.00

D

S

080 Qe 95 Quantity

E

The Equilibrium Price Pe is determined bythe intersection of the S and D curves.

If the price is > Pe, there is excess S leadingto fall in price.

If the price is < Pe, there is excess Dleading to rise in price.

AR and MR of a Firm

For a firm P=AR=MR, since the price is

constant.As the firms are Price-takers, demand curve

is perfectly elastic.


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101050510

101040410

101030310

101020210

101010110

--0010

MRARTRDeman

d

Price

TR, AR and MR of a Perfectly Competitive Firm

MR is the same as the AR as the Price remains constant.

D S

DS

Industry Firm

P

00

Quantity( a )

X

Quantity( b )

Price

AR/MR


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As a price taker, the firm faces aPerfectly Elastic demand curve.

The demand curve is also known as ARand MR curve.

Role of Single Firm

No significant impact on the marketprice so far output decisions of

individual producers are concerned.

Equilibrium Analysis

In a Purely Competitive market thereare Three types of Equilibrium.

1.The Firm

2.The Industry

3.The Market


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A Firm reaches Equilibrium when MR = MC.

An Industry attains Equilibrium when thereis neither Entry of new firms into theindustry nor Exit of old firms from it. (Onlywhen each firm is able to make only normalprofit and reaches its break-even point).

The Market reaches Equilibrium when QD

equals QS for sale.

Equilibrium of a FirmA Firm is said to be in equilibrium when it

earns Maximum Profits.

There will be no incentive for the firm tochange either its output or the price of itsproducts, i.e., the firm finds no incentive forchange.

The Two Approaches to study Equilibrium

Analysis are:1.Total Revenue -Total Cost Approach

2.Marginal Revenue Marginal Cost Approach


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If TR < TVC at all output levels, the Profit-maximizing strategy is to Shut down and

absorb the loss due to the TFC, which cannot be avoided in the short run.

If there are output levels at which the TR >TVC, the firm should produce where thevertical distance between the TR and TC isat Maximum.

The firm will be in equilibrium when it

produces 650 units of output, as it earnsmaximum profit.

If TR > TC, then > 0; if TR = TC then =0; and if TR< TC, then < 0.

To maximize profits, the firm can choosethat level of Q at which the differencebetween TR and TC is maximum, i.e., theprofit maximizing output is Qe and themaximum profit is MK.


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Output0

Costand

Revenue

Total CostMaximumProfit

Total revenue

Q e

MR-MC Approach

Equilibrium output is that level of outputwhen the firms MR equals MC.

MR is the addition to the TR as a result of aunit increase in sales of a firm.

MC is the addition to the TC as a result of aunit increase in the output of a firm.

Maximum profits occur for the firm at thatlevel of output where its MR = MC, i.e. 650units.


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Thus, the profit maximizing output isdetermined where the extra revenue

generated by selling the last unit just equalsthe MC of producing that unit.

Beyond equilibrium level of Q, MC > MR andless than that level MR > MC.

Profit will be maximum at the Q where MR =MC.

Profit function can be = TR TC, tomaximize total profit, the first ordercondition requires that d/ dq = 0.

d/ dQ = dTR/ dQ dTC/ dQ = 0

dTR/ dQ = dTC/ dQ

That is MR = MC.

Again when total profit is maximum,marginal profit is 0.

Marginal Profit is the difference between MRand MC and when MR = MC, marginal profitis 0 and total profit is maximum, means thefirm does not gain by expanding its outputfurther.


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In Perfect Competition, the demand curvefaced by a firm is horizontal at the price

determined by industry supply & demandforces.

Hence, P = MR = AR.

The first order condition for profitmaximizing is MC = MR = AR = P.

Equality of MR with MC is just a necessaryand not a sufficient condition of maximization.

The second order condition for profitmaximization requires d2/ dq2 < 0.

d 2TR/dQ 2 d 2TC/ dQ2 < 0

or, d 2TR/dQ 2 < d 2TC/ dQ2

Slope of MR curve should be less than theslope of the MC curve.

In perfect competition, MR = P which isconstant.

Second order condition implies that the

slope of MC curve should be positive or theMC must be rising.

MC curve has to intersect the MR curvefrom below.


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L K

MC

P

0 Q1 Q 0 X

Quantity

Y

Cost/Revenue

MR= AR

As seen, point K can be considered as theequilibrium point since it satisfies both thefirst and second condition.

Issues

1.Should a firm produce at a given marketprice?

2.How much should it produce?

1.A firm will produce at any level of outputif TR TVC or ARAVC or P AVC, i.e., TRexceeds or at least equal to TVC.


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2. A level of Q at which a firm earnsmaximum profits (given perfectly elastic

demand curve) would be the one thatsatisfies the following two conditions:

MR = MC and MC cuts MR from below.

Shut down Decisions

Refers to a Short run decision not toproduce anything during a specific period oftime due to adverse market conditions.

Exit refers to a Long run decision to leavethe market.

If a firm has to shut down it has to bear itsFixed Cost.

A firm will decide to shut down if the priceof its product is less than the AVC, i.e., TR< TVC or P < AVC.

The lowest point of the AVC curve is calledthe shut down point.

SR Equilibrium of a FirmIs attained at a level of Q which satisfies the

conditions: MR = MC and MC cuts MR frombelow.


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In SR equilibrium, a firm may find itself anyof the situations: losses or profits or breaks

even. A firm suffers losses, if at the equilibrium

level of Q, its AC > AR or P.

Equilibrium point : E

Equilibrium output: OQ

Average Revenue: QE

Average Cost : QK

Loss per unit : QK QE = EKTotal Loss : EK OQ = Area PEKT

K

MC

AC

AR = MRP

T

0 XQ

Y

Quantity

Cost/Revenue

E


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A firm earns profits if at the equilibriumoutput AR > AC.

Average Revenue : QE Average Cost : QK

Profit per unit : QE QK = EK

Total Profit : EK OQ = Area PEKT

A firm breaks even when at the equilibriumQ its AR = AC.

Average Revenue : QE

Average Cost : QE

X

Y

0Q

Quantity

KT

P

M C

AR = MR

E

AC

Cost/Revenue


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M C AC

E AR = MR

P

Y

X0

QuantityQ

Cost/Revenue

A firm will continue to produce at theequilibrium level of output when AR AVC,otherwise the firm will shut down.


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Y

X

Q

0

P

M CAC

AVC

AR = MR

K

E

Cost/Revenue

Quantity

1099077676054473930209TC

109876543210Q

Class Assignment: 1

A perfectly Competitive firm has the following costschedule.

If the market price is 13$, what output will the firm choose to produceto maximize profits? What is the maximum profit?

Suppose the market price falls to 6$, how much will the firm choose toproduce now and what will be its profit?


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Long-run Equilibrium

Key to LR equilibrium is entry and exit offirms.

An Entry-attracting Price: When firms earnabnormal profits (AR > AC), new firmsenter the industry.

Supply level goes up, price level falls and allfirms earn zero profit.

An Exit-inducing Price: When firms incurlosses, exit of firms occur.

Supply level goes down, price levelincreases and firms are in the zero profitequilibrium.

Break-even Price: Neither an attraction fornew firms to enter the industry nor forexisting firms to exit.

The industry will be zero profit equilibrium.

LR equilibrium of a perfectly competitiveindustry obtains when all the firms are inzero-profit equilibrium.

When the industry is in equilibrium, each

firm not only earns zero profits but producesat the lowest point on its LAC curve.

Resources are used most efficiently toproduce goods at minimum cost.


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Since firms also earn zero profits, consumerspurchase the commodity at the lowest

possible price.

LACLMCFirm's Equilibrium

YY

E P = MR

P

Cost/Revenue

0 X

Q

PPrice

SS

DD

QX

Industry's Equilibrium

E

0

Y

Class Assignment: 2A firm produces output at a constant MC of$6 and has no fixed costs. The demandposition of the firm is given below:

204

156108

510

012

QD (units)Price $


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Determine the firms profit-maximizingoutput, price and profit.

Show that by producing more or less outputthe firm would decrease its profit.

Explain what happens to MR when output israised from 15 to 20 units.

MONOPOLYSingle Producer and a unique product.

Entry as well as exit totally prohibited.

No substitute of the product in the market .

Number of buyers could be large, small orjust one.

No difference between the industry and the

firm.Demand curve facing the monopolist firm is

one faced by the purely competitiveindustry which slopes downward.


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Implies that more could be sold only at thelower price.

Firm is a price-maker.AR and MR of Monopoly Firm

The MR curve of the monopoly firm placedbelow the AR curve.

SR and LR Equilibrium of the Firm

Profit in both periods

Loss only in SR

Normal profit in both periods

N

P

ARX

Q

M R Quantity

0

Y

Demand curve ( D )

Revenue


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W

M C

E A R

A C

AbnormalProfits

Z

T

Y

QM R Quantity ( a )

X0

Price/Cost/Revenue K

M C

K

NormalProfits

A C

A RM R

Q Quantity( b )

X0

T

Price/Cost/Revenue

Y


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M CA CLoss

U

K

A R

X

M R

Q

Quantity ( c )

0

T

N

E

Price/Cost/Revenue

Y

Monopolygains

LMC

LAC

A R

M R

Q0 X

Y

T

K

J

N

E

MR = MC

Equilibrium

Quantity

Revenueand

Cost


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Class Assignment: 3

Suppose that the total cost equation for a

monopolist is given by TC = 500 + 20Q2 ,

Let the demand equation be P = 400 -20Qand the total revenue equation is

TR = 400Q -20Q2.

What is the profit maximizing price andquantity?

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Chapter 06 - Competition