Chapter-6 Market Structure and Perfect Competition

8/2/2019 Chapter-6 Market Structure and Perfect Competition

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MARKET STRUCTURE


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Objectives

How Firms in Market Operate.

What are different Market Structures.

How price and quantity is determined.

What is profit maximizing output.

Supply curve of a perfectly competitive firm.


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Market Structures

Market structure is influenced by howa firm behaves:

Pricing ( how they decide the price)

Supply (how much they supply)

Barriers to Entry ( high or low)

Efficiency ( allocative efficiency)

Competition ( high or low)


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How do we know about market structure?

To determine structure of anyparticular market, we begin by askingHow many buyers and sellers are there in the

market? Is each seller offering a homogenous product?

Are there any barriers to entry or exit, or canoutsiders easily enter and leave this market?


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Different Market Structure

Perfect competition.

Imperfect competition

MonopolyOligopoly

Monopolistic


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Perfect Competition

Assumptions of Perfectly competitive market

Large Number of Buyers and Sellers

Homogenous Products

Full information

Each firm produces a small fraction of total output of an industry

Firms are price taker: decision is only about quantity

Free entry and free exit

No government intervention

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Perfect Competition

Each Firm Has Zero Market Power.

Market Power: the power an individual firm has to

influence the price in the market.

Price is fixed by the market ( not by the firm)


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Perfect Competition

Demand curve of the firm andindustry in Perfect Competition?


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Perfect Competition

Q

P

Market Supply

pe

p1

Market Demand


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Perfect Competition

MarketSupply

MarketDemand

Q

P

Firms Demand Curve

P

P* P*

Qf

Firms demand


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Figure 1: The Competitive Industry and Firm

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quantity

Price perOunce

D

$400

S

Market

DemandCurve Facing

the Firm

$400

Firm

1. The intersection of the market supplyand the market demand curve

3. The typical firm can sell all itwants at the market price

quantity

Price perOunce

2. determine the equilibriummarket price

4. so it faces a horizontaldemand curve


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The Firms Decisions in Perfect Competition

The competitive firm makes two decisions in the short run:1. Whether to produce or to shut down?

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

A firms long-run decisions are1. Whether to increase or decrease its plant size?

2. Whether to stay in the industry or leave it?

A perfectly competitive firm chooses the output thatmaximizes its economic profit.


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Profit maximization: Twoapproaches

Total revenue and total cost approach.

Marginal revenue and marginal costapproach.


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Total Revenue and Total costapproach


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Minimizing Short-Run Losses

15

$4.003.00

2.50

0 5 10 15

Marginal cost

Average total cost

d= Marginal revenue

= average revenue

Average variable costeLoss

Bushels of wheat per day

Dollarsper

bushel

b) Marginal Cost Equals Marginal Revenue

$40

30

15

0 5 10 15

Total costTotal revenue(= $3 q)

Minimum economicloss = $10

Bushels of wheat per day

(a) Total Cost and Total Revenue

TotaldollarsIn panel (a), Total revenue is lower

because of the lower priceTotal revenue now lies below thetotal cost curve at all output rates. The

vertical distance between the twocurves measures the loss at each rateof outputThe vertical distance is minimized atan output rate of 10 bushels where theloss is $10 per daySame result in panel bFirm will produce rather than shut

down if MR= MCat a rate of outputwhere price equals or exceeds averagevariable costAt point e, output is 10 bushels perday and the price of $3 exceeds theaverage variable cost of $2.50 Totaleconomic loss shown by shaded area


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Marginal Revenue and Marginal cost


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Short run profits and losses

Maximum profit is not always a positive economic profit.

To determine whether a firm is earning an economic

profit or incurring an economic loss, we compare thefirms average total cost, ATC, at the profit-

maximizing output with the market price.


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Short run supply curve

A perfectly competitive firms short-run supply curveshows how the firms profit-maximizing output variesas the market price varies, other things remaining thesame.

Because the firm produces the output at which marginalcost equals marginal revenue, and because marginalrevenue equals price, the firms supply curve is linkedto its marginal cost curve.

But there is a price below which the firm producesnothing and shuts down temporarily.


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Short run supply curve

The shutdown point is the output and price atwhich the firm just covers its total variable cost.

This point is where average variable cost is at

its minimum. It is also the point at which themarginal cost curve crosses the averagevariable cost curve.

If the price exceeds minimum average variablecost, the firm produces the quantity at whichmarginal cost equals price. Price exceedsaverage variable cost, and the firm covers all itsvariable cost and at least part of its fixed cost.


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Short run supply curve of the firm


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Summary of Short-Run Output Decisions

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q

1

0

Quantity per period

d1

A C

A VC

4

1

Marginal cost

p1

Shutdownpoint

2

q

2

p2 d

2

q

3

3p3 d

3

Break-evenpoint

q

4

p4 d

4

q

5

p5 5 d

5

Dollarsperunit

At p1, the firm will shutdown rather thanoperate because price isbelow average variablecost at all output rates.If the price is p3, thefirm will produce q3 to

minimize its loss while atp4, the firm will produceq4 to earn just a normalprofit: break-even pointAt p2, the firm isindifferent: shutdownpoint

If the price rises to p5,the firm will earn a short-run economic profit byproducing q5

The short-run supply curve is theupward-sloping portion of the

marginal cost curve beginning atpoint 2.


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Long run Adjustments

In short-run equilibrium, a firm may make aneconomic profit, make normal profit, or incur aneconomic loss.

Which of these states exists determines the furtherdecisions the firm makes in the long run.

In the long run, the firm may:

Enter or exit an industry

Change its plant size


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Effects of entry

As new firms enter anindustry, industry supplyincreases. The industrysupply curve shifts

rightward.

The price falls, the

quantity increases, andthe economic profit ofeach firm decreases.


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Effects of exit

As firms exit anindustry, industry supplydecreases. The industry

supply curve shiftsleftward.

The price rises, thequantity decreases, andthe economic profit ofeach firm increases.


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Changes in plant size

Firms change their plant size whenever doing sois profitable.

If average total cost exceeds the minimum long-

run average cost, firms change their plant sizeto lower costs and increase profits.

If the firms earn zero economic profit with the

current plant and the LRACcurve slopesdownward at the current output, the firm canincrease profit by expanding the plant. As theplant size increases, short-run supplyincreases, the price falls.


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Long-run equilibrium occurs when the firm is producingat the minimum long-run average cost and earning zeroeconomic profit.


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Long run equilibrium

Long-run equilibrium occurs in a competitiveindustry when:

(1) Economic profit is zero, so firms neither enternor exit the industry.

(2) Long-run average cost is at its minimum, sofirms dont change their plant size.


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Why Do Competitive Firms Stay inBusiness If They Make Zero Profit?

Remember that accounting (nominal)profit is positive even if economicprofit is zero.

The firm making zero economic profitmeans the firm is doing the best it canand there is no other alternative thatwill give better profit. If there was,current economic profit would benegative.


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Allocative Efficiency of perfect competition

Efficient allocation of resources ( no otherallocation that would allow someone to bemade better off while no one was made

worse off).Consumers & producers surplus.

Allocative efficiency: Sum of consumer

surplus and producers surplus is maximum.


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Documents

Chapter-6 Market Structure and Perfect Competition