Chapter 5&6 Main Lecture on Revenue and Perfect Competition Chapter 5&6 Main Lecture on Revenue and Perfect Competition

Chapter 5&6Main Lecture on Revenue and Perfect Competition

Chapter 5&6Main Lecture on Revenue and Perfect Competition

RevenueRevenue

• We have looked at Production and then We have looked at Production and then Cost so we have analysed a firm’s Cost so we have analysed a firm’s technical capabilities and the costs of technical capabilities and the costs of producing output, producing output,

• on average on average

• and at the margin (one more unit)and at the margin (one more unit)

• Now we have to examine what the firm Now we have to examine what the firm earns from producing an additional unitearns from producing an additional unit

REVENUEREVENUE

• …thus we need to define total, average and marginal revenue

• We start by examining revenue curves when firms are price takers

• By this we mean that firms are small relative to the total market and that they do not have much influence over the price charged.

• In such a market if they raise price people will go elsewhere…

• … and if they reduce price (even if it were profitable) they would not be able to cope with the resultant demand.

• …thus we need to define total, average and marginal revenue

• We start by examining revenue curves when firms are price takers

• By this we mean that firms are small relative to the total market and that they do not have much influence over the price charged.

• In such a market if they raise price people will go elsewhere…

• … and if they reduce price (even if it were profitable) they would not be able to cope with the resultant demand.

RevenueRevenue

• That is, they perceive the price they can That is, they perceive the price they can receive as constant.receive as constant.

• So as far as they are concerned the So as far as they are concerned the demand curve is demand curve is horizontal.

• That means they believe:

• They can sell as much as they want at the going price.

Deriving a firm’s Deriving a firm’s ARAR and and MRMR: price-taking firm: price-taking firm

O O

Pri

ce (

£)

AR

, MR

(£

)

Q (millions) Q (hundreds)

Pe

S

D

(a) The market (b) The firm

O O

Pri

ce (

£)

AR

, MR

(£

)

Pe

S

D

Q (millions) Q (hundreds)

(a) The market (b) The firm

Deriving a firm’s Deriving a firm’s ARAR and and MRMR: price-taking firm: price-taking firm

Total revenue for a price-taking firmTotal revenue for a price-taking firm

0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200

TR

(£

)

Quantity

Quantity(units)

0200400600800

10001200

Price

5555555

0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200

TR

(£

)

Quantity

Quantity(units)

0200400600800

10001200

Price

5555555

TR(£)

0100020003000400050006000


0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200

TR

(£

)

Quantity

Quantity(units)

0200400600800

10001200

Price

5555555

TR(£)

0100020003000400050006000


TR

0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200

TR

(£

)

Quantity


TR

0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200

TR

(£

)

Quantity

Quantity(units)

0200400600800

10001200

Price = AR= MR (£)

5555555

TR(£)

0100020003000400050006000


AR=TR/Q

0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200

TR

(£

)

Quantity

Quantity(units)

0200400600800

10001200

Price = AR= MR (£)

5555555

TR(£)

0100020003000400050006000


AR=TR/Q

5555555

0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200

TR

(£

)

Quantity

Quantity(units)

0200400600800

10001200

Price = AR= MR (£)

5555555

TR(£)

0100020003000400050006000


AR=TR/Q

5555555

MR

0

1000

2000

3000

4000

5000

6000

0 200 400 600 800 1000 1200

TR

(£

)

Quantity

Quantity(units)

0200400600800

10001200

Price = AR= MR (£)

5555555

TR(£)

0100020003000400050006000


AR=TR/Q

5555555

MR

5555555

£5

Mathematics of Revenue:Mathematics of Revenue:

QPTR .

Average Revenue PQ

QP

Q

TR

.

Total Revenue

Marginal Revenue

When P is constant P

Q

QPd

dQ

TRd).()(

Price Taking FirmsPrice Taking Firms

• So in conclusion: When a firm is a price So in conclusion: When a firm is a price taker, MR and AR are constant and equal to taker, MR and AR are constant and equal to the price of the output.the price of the output.

VERY Short-run equilibrium of industry and firm VERY Short-run equilibrium of industry and firm under perfect competitionunder perfect competition

O O

S

D

(a) (a) Industry Industry

P £

Q (millions)


O O

S

D


P £

Pe

Q (millions)


O O

S

D


P £

Pe

(b) (b) Firm Firm

ARD = AR= MR

Q (millions) q (thousands)


O O

S

D


P £

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR= MR

MC

qe

q (thousands)

Very Short-run equilibrium of industry and firm Very Short-run equilibrium of industry and firm under perfect competitionunder perfect competition

O O

S

D


P £

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR= MR

MC

qe

AC

AC

q (thousands)At what level of output should

the firm Produce?

O O

S

D


P £

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR= MR

MC

qe

AC

AC

q (thousands)

Produce where MR = MCProduce where MR = MC

RULE ALWAYS HOLDSRULE ALWAYS HOLDS

At Qe how much profit does the firm make?

O O

S

D


P £

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR= MR

MC

qe

AC

AC

q (thousands)

O O

S

D


P £

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR= MR

MC

qe

AC

AC

q (thousands)


O O

S

D


P £

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR= MR

MC

Qe

AC

AC

Q (thousands)Area =

(AR-AC)*Qe


Supernormal ProfitsSupernormal Profits

• What was included in total costs when we What was included in total costs when we drew the TC and AC curves?drew the TC and AC curves?

• We included the cost of capital, labour, and We included the cost of capital, labour, and raw materials and also:raw materials and also:

• ……an appropriate return for the an appropriate return for the entrepreneur for his or her labour, capital entrepreneur for his or her labour, capital invested, and riskinvested, and risk

• So what does the yellow area represent?So what does the yellow area represent?

• (AR – AC)*Q(AR – AC)*Qee = =

Supernormal profitSupernormal profit

O O

S

D


P £

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR= MR

MC

Qe

AC

AC

Q (thousands)

Supernormal Profit

Supernormal profitSupernormal profit

PERFECT COMPETITIONPERFECT COMPETITION

– Produce where MR = MC

– Under perfect Competition P = MR

– So MR= P = MC

– possible supernormal profits = (AR-AC)*Q

– Produce where MR = MC

– Under perfect Competition P = MR

– So MR= P = MC

– possible supernormal profits = (AR-AC)*Q

Very Short-run equilibrium of industry and firm Very Short-run equilibrium of industry and firm under perfect competitionunder perfect competition

O O

S

D


P £

Q (millions)

P

(b) (b) Firm Firm

ARD = AR= MR

MC

Qe

AC

AC

Q (thousands)

Supernormal Profit

Supernormal profits will attract Supernormal profits will attract aa more firms to the more firms to the industry. industry.

O O

S

D


P

£

Q (millions)

P

(b) (b) Firm Firm

ARD = AR= MR

MC

Qe

AC

AC

Q (thousands)

Before S = n* QBefore S = n* Qee

now Snow S = (n+a) * Q= (n+a) * Qee

So Supply curve moves out!So Supply curve moves out!

O O

S

D


P

£

Q (millions)

P

(b) (b) Firm Firm

ARD = AR= MR

MC

Q

AC

AC

Q (thousands)

S1

Qe Q1

Price fallsPrice falls

O O

S

D


P

£

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR= MR

MC

Qe

AC

AC

Q (thousands)

S1

O O

S

D


P

£

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR= MR

MC AC

AC

Q (thousands)

S1

.. And a new LONG RUN equilibrium is established at .. And a new LONG RUN equilibrium is established at PPee,Q,Qee

O O

S

D


P

£

Q (millions)

P

(b) (b) Firm Firm

ARD = AR= MR

MC

Qe

AC

AC

Q (thousands)

S1

Pe


• Short-run supply curve of industry

• Long-run equilibrium of the firm

– all supernormal profits competed away because new firm enter

– Since AR=AC in long-run equilibrium:

(AR-AC)*Q=0

So there is NO supernormal profits.



– all supernormal profits competed away because new firm enter

– Since AR=AC in long-run equilibrium:

(AR-AC)*Q=0

So there is NO supernormal profits.

LONG RUN Equilibrium under Perfect Competition LONG RUN Equilibrium under Perfect Competition requires that AR=P=MR=MC=ACrequires that AR=P=MR=MC=AC

O O

D


P

£

Q (millions)

(b) (b) Firm Firm

D = AR= MR

MC

Qe

AC

Q (thousands)

S1

Pe Pe

Suppose now demand falls. Suppose now demand falls.

O O

D1


P

£

Q (millions)

P0

(b) (b) Firm Firm

MC

Qe

AC

Q (thousands)

S1

P1

Pe

D0

What happens to supply now?What happens to supply now?

Suppose now demand falls. Suppose now demand falls.

O O

D1


P

£

Q (millions)

P0

(b) (b) Firm Firm

MC

Qe

AC

Q (thousands)

S1

P1

Pe

D0

Our same MR = MC rule applies, but there is Our same MR = MC rule applies, but there is one more considerationone more consideration

RecallRecall

• In the short run, capital is fixed while labor In the short run, capital is fixed while labor may vary. So TC=FC+VC (Fixed Costs and may vary. So TC=FC+VC (Fixed Costs and Variable Costs). Variable costs=labour Variable Costs). Variable costs=labour costs.costs.

• AVC (average variable), is equal to:AVC (average variable), is equal to:

labour costs/Qlabour costs/Q

The rest of the firms costs are The rest of the firms costs are fixed costsfixed costs (costs to capital equipment). Those are the (costs to capital equipment). Those are the ones which, in the short run, the firm ones which, in the short run, the firm cannot escape.cannot escape.

O O

D1

P

£

P0

MC

Q1

ACS1

P1

Pe

D0


We need to check where the AVC curve lies. Why?

AVC

In this case P > AVC so will continue to produce.

By doing so, cover AVC and make some contribution to covering Fixed Costs

Q0

O O

D1

P

£

P0

MC

Q1

ACS1

P1

Pe

D0


We need to check where the AVC curve lies. Why?

AVC

But overall making a (supernormal) loss

= (AC-P)Q < 0

Q0

O O

D1

P

£

P0

MC

Qe

ACS1

P1

Pe

D0

What if P is below AVC?What if P is below AVC?

AVC

In this case the firm can’t cover variable costs, so better to close down (lay of all workers) and

only lose FC

To sum up: Let’s derive the short-run supply curveTo sum up: Let’s derive the short-run supply curve

O O


P £

P1

Q (millions)

(b) (b) Firm Firm

D1 = MR1

Q (thousands)

MC

Q1

a

D1

S

O O


P £

P1

Q (millions)

D1

(b) (b) Firm Firm

D1 = MR1

MC

Q2

a

P2

D2 = MR2b

S

D2

Q (thousands)

Deriving the short-run supply curveDeriving the short-run supply curve

O O


P £

P1

Q (millions)

S

D1

(b) (b) Firm Firm

D1 = MR1

MC

Q3

a

P2

D2 = MR2

D2

b

P3

D3 = MR3

D3

c

Q (thousands)

Deriving the short-run supply curveDeriving the short-run supply curve

AVC

O O


P £

P1

Q (millions)

S

D1

(b) (b) Firm Firm

D1 = MR1

S

a

P2

D2 = MR2

D2

b

P3

D3 = MR3

D3

c

Q (thousands)

Deriving the short-run supply curveDeriving the short-run supply curve“equals” the MC curve until p=AVC“equals” the MC curve until p=AVC

AVC


• Short-run supply curve of industry is equal to MC curve (as long as the price is above AVC)


– all supernormal profits competed away

– long-run industry supply curve

• Short-run supply curve of industry is equal to MC curve (as long as the price is above AVC)



– long-run industry supply curve

O O

D


P

£

Q (millions)

(b) (b) Firm Firm

D = AR= MR

MC

Qe

AC

Q (thousands)

S

Pe Pe

D1

What happened to Supply here in the Long Run What happened to Supply here in the Long Run ??

MC=P=AC (so AC at minimum)MC=P=AC (so AC at minimum)

S1

LRS





– long-run industry supply curve (horizontal at minimum AC)




– long-run industry supply curve (horizontal at minimum AC)


• Advantages of perfect competition

– production at minimum AC (which is efficient)

– only normal profits in long run (no supernormal profits)

– responsive to consumer wishes: consumer sovereignty (demand influences price and so firms’ actions)

– competition efficiency

• Advantages of perfect competition

– production at minimum AC (which is efficient)

– only normal profits in long run (no supernormal profits)

– responsive to consumer wishes: consumer sovereignty (demand influences price and so firms’ actions)

– competition efficiency


• Disadvantages of perfect competition

– There really are none

• Except perhaps….

– Disadvantage is that it may not be a valid version of reality

– Perfect competition rests on the following assumptions

firms are price takers ? (small r.t. market)freedom of entry and exit ? (depends on product)identical products OK approximation

(typically)

• Disadvantages of perfect competition

– There really are none

• Except perhaps….

– Disadvantage is that it may not be a valid version of reality

– Perfect competition rests on the following assumptions

firms are price takers ? (small r.t. market)freedom of entry and exit ? (depends on product)identical products OK approximation

(typically)

Documents

Chapter 5&6 Main Lecture on Revenue and Perfect Competition Chapter 5&6 Main Lecture on Revenue and Perfect Competition