Chapter 5&6 Revenue and Perfect Competition Chapter 5&6 Revenue and Perfect Competition

Chapter 5&6Revenue and Perfect

Competition

Chapter 5&6Revenue and Perfect

Competition

RevenueRevenue

• We have looked at Production and then We have looked at Production and then Cost so we have anaylsed our technical Cost so we have anaylsed our technical capabilities and the costs of producing capabilities and the costs of producing output, 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 we get for an Now we have to examine what we get for an additional unitadditional unit

REVENUEREVENUE

• Thus we need to defining 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 defining 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.

– average revenue (AR)

– marginal revenue (MR)

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

REVENUEREVENUE

• Defining total, average and marginal revenue

• Revenue curves when firms are price takers (horizontal demand curve)



– total revenue (TR)

• Defining total, average and marginal revenue

• Revenue curves when firms are price takers (horizontal demand curve)



– total revenue (TR)

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

When is a firm a price taker?When is a firm a price taker?

• PERFECT COMPETITIONPERFECT COMPETITION

• Assumptions– firms are price takers

– freedom of entry

– identical products

– perfect knowledge

• PERFECT COMPETITIONPERFECT COMPETITION

• Assumptions– firms are price takers

– freedom of entry

– identical products

– perfect knowledge

Short-run equilibrium of industry and firm under Short-run equilibrium of industry and firm under perfect competitionperfect 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)


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

At Qe how much does 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)*Q


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 …………….raw, materials and …………….

• An appropriate return for the entrepreneur An appropriate return for the entrepreneur for his or her labour, capital invested and for his or her labour, capital invested and riskrisk

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

• (AR – AC)*Q =(AR – AC)*Q =

• 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

PERFECT COMPETITIONPERFECT COMPETITION

– Produce where MR = MC

– Under perfect Competition P = MR

– So MR= P = MC

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

– What is this firm’s supply curve in the Short-Run?

– Produce where MR = MC

– Under perfect Competition P = MR

– So MR= P = MC

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

– What is this firm’s supply curve in the Short-Run?

Deriving the short-run supply curveDeriving 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)


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)


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)



O O

S

D


P £

Q (millions)

P

(b) (b) Firm Firm

ARD = AR= MR

MC

Q

AC

AC

Q (thousands)

Supernormal Profit

So supernormal profits attract more firms to the So supernormal profits attract more firms to the industry. industry.

O O

S

D


P

£

Q (millions)

P

(b) (b) Firm Firm

ARD = AR= MR

MC

Q

AC

AC

Q (thousands)

Before 100* QBefore 100* Qee at every price at every price

now 110 * Qnow 110 * Qee at every price at every price

So supernormal profits attract more firms to the So supernormal profits attract more firms to the industry. industry.

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

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

– Since AR=AC and

– (AR-AC)*Q=0




– Since AR=AC and

– (AR-AC)*Q=0

So the LONG RUN Equilibrium under Perfect So the LONG RUN Equilibrium under Perfect Competition requires that AR=P=MR=MC=ACCompetition requires 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

..and quantity and price rise. ..and quantity and price rise.

O O

D


P

£

Q (millions)

P

(b) (b) Firm Firm

D = AR= MR

MC

Qe

AC

Q (thousands)

S1

Pe Pe

D1

In particular, each existing firm supplies more, In particular, each existing firm supplies more, up along its SR Supply curve, the MC curve.up along its SR Supply curve, the MC curve.


O O

D


P

£

Q (millions)

P

(b) (b) Firm Firm

D = AR= MR

MC

Qe

AC

Q (thousands)

S1

Pe Pe

D1



O O

D


P

£

Q (millions)

P1

(b) (b) Firm Firm

D = AR= MR

MC

Qe

AC

Q (thousands)

S

Pe Pe

D1


Q1


O O

D


P

£

Q (millions)

P1

(b) (b) Firm Firm

D = AR= MR

MC

Qe

AC

Q (thousands)

S

Pe Pe

D1

Bu again we have Supernormal profitsBu again we have Supernormal profits

Q1

O O

D


P

£

Q (millions)

P1

(b) (b) Firm Firm

D = AR= MR

MC

Qe

AC

Q (thousands)

S

Pe Pe

D1

So more firms enter, pushing the S curve out to So more firms enter, pushing the S curve out to SS11

Q1

S1

O O

D


P

£

Q (millions)

P2

(b) (b) Firm Firm

D = AR= MR

MC

Qe

AC

Q (thousands)

S

Pe Pe

D1

When will firms stop entering?When will firms stop entering?When all supernormal profits have gone.When all supernormal profits have gone.

That is, when the price returns to PThat is, when the price returns to Pee

Q2

S1

O O

D


P

£

Q (millions)

(b) (b) Firm Firm

D = AR= MR

MC

Qe

AC

Q (thousands)

S

Pe Pe

D1

When will firms stop entering?When will firms stop entering?When all supernormal profits have gone.When all supernormal profits have gone.

That is, when the price returns to PThat is, when the price returns to Pee

..and firm output is back at Q..and firm output is back at Qee

S1





– 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 RunWhat happened to Supply here in the Long Run

S1

LRS

P

Q O

Various long-run industry supply curves under perfect competitionVarious long-run industry supply curves under perfect competition

S1

D1

a

(a) Constant industry costs(a) Constant industry costs

P

Q O


S1

D1D2

a

b


P

Q O


S1

D1

S2

D2

a

b

c


P

Q O


Long-run S

S1

D1

S2

D2

a

b

c


P

Q O

S1

D1

D2

a

b


(b) Increasing industry costs: external diseconomies of scale(b) Increasing industry costs: external diseconomies of scale

P

Q O

S1

D1

S2

D2

a

b

c



P

Q O

Long-run S

S1

D1

S2

D2

a

b

c



P

Q O

S1

D1 D2

a

b


(c) Decreasing industry costs: external economies of scale(c) Decreasing industry costs: external economies of scale

P

Q O

S1

D1

S2

D2

a

b

c



P

Q O

Long-run S

S1

D1

S2

D2

a

b

c








• Incompatibility of economies of scale with perfect competition





• Incompatibility of economies of scale with perfect competition

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

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

= FC – (P-AVC)

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 we can’t cover variable costs, so better to close down and only lose FC


• Advantages of perfect competition

– P = MC

– production at minimum AC

– only normal profits in long run

– responsive to consumer wishes: consumer sovereignty

– competition efficiency

– no point in advertising

• Advantages of perfect competition

– P = MC

– production at minimum AC

– only normal profits in long run

– responsive to consumer wishes: consumer sovereignty

– competition efficiency

– no point in advertising


• (ALLEGED) Disadvantages of perfect competition

– insufficient profits for investment

– lack of product variety

– lack of competition over product design and specification

• Not really valid set of criticisms

• (ALLEGED) Disadvantages of perfect competition

– insufficient profits for investment

– lack of product variety

– lack of competition over product design and specification

• Not really valid set of criticisms


• Disadvantages of perfect competition

– There are none

• Except perhaps….

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

– Recall assumptionsfirms are price takers OKfreedom of entry and exit iffyidentical products Few examplesperfect knowledge iffy

• Disadvantages of perfect competition

– There are none

• Except perhaps….

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

– Recall assumptionsfirms are price takers OKfreedom of entry and exit iffyidentical products Few examplesperfect knowledge iffy

Documents

Chapter 5&6 Revenue and Perfect Competition Chapter 5&6 Revenue and Perfect Competition