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Perfect Competition (Ch. 10) Claudia Garcia-Szekely © 2 0 0 1 C l a u d i a G a r c i a - S z e k e l y 1

P ERFECT C OMPETITION (C H. 10) Claudia Garcia-Szekely ©2001ClaudiaGarcia-Szekely 1

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Perfect Competition (Ch. 10)Claudia Garcia-Szekely

©2001C

laudiaG

arcia-Szekely

1

“THE MARKET IS THE WORST SYSTEM OF ECONOMIC AND SOCIAL DEVELOPMENT – EXCEPT FOR ALL THE OTHERS THAT HAVE BEEN TRIED FROM TIME TO TIME.”

Sir Winston Churchill2

MES: SMALLEST PLANT WITH LOWEST ATC IN THE LONG RUNMES: The smallest plant that prevents the firm from being “priced out” of the industry by firms with lower costs.

Only firms with plants with the lowest cost will survive in the long run.

3

500,000

SRATC1

SRATC2

SRATC3

SRATC4SRATC5

SRATC6

SRATC7

LRATC

MES

Total Market Demand = 3,000,000150,000

# of surviving Firms = 3,000,000/500,000 = 6 firms each selling 500,000# of surviving Firms = 3,000,000/150,000 = 20 firms each one sells 150,000

10,000

# of surviving Firms = 3,000,000/10,000 = 300 firms each sells 10,000

The smaller the size of the

MES, the larger the number of firms that can successfully compete and survive in the

industry

The smaller the size of the

MES, the more competitive the

industry is.

The larger the size of the

MES, the more concentrated

the industry is.

Perfect Competition Arises WhenThe minimum efficient scale is small relative to Market demand.

©2001C

laudiaG

arcia-Szekely

5

In a Perfectly Competitive Industry

There are many firms: no single firm can affect the price

Firms are price takers. There are many buyers: no single

buyer can affect the price Buyers are price takers.

All firms sell identical products. Established firms have no advantages

over new firms.

6

Price is Determined by the Market

7

S

D

Q

PAll firms

Sell at thisprice

Each firm produces only a tiny fraction(q) of this total Q

Sum of all firms’ output

Total Market Demand

Perfectly competitive firms are price takers

Each firm produces only small portion of the total supply

Buyers know all prices from all firms in the market

8

A firm wouldn’t increase price above market price

Because

Lose all its customers to the competition

A firm would not decrease its price

Because

It can sell all it wants at market price

d

Demand as perceived by each firm is perfectly elastic at the market price

Perfectly Competitive Firms are Price Takers

9

S

D

Q

P d

q1

P

Given the price determined by the market

PC firms decide how many units to produce at the

market price.

q2 q3

Which output level is

best?

Total Revenues

Total Revenues =

10

Price x Quantity Sold

TR

quantity

TR

q TRPrice

5 30 150

5 10 50

5 20 100

10

50

20

100

30

150

TRPrice

$7

$7

70

140

210

70

140

210

TR’

As the price increases, TR line becomes steeper

$7

11

dP = $5

1 2 3 4 5 6

Quantity purchased

Price

Quantity purchased

TRTR

1 2 3 4 5 6

5

10

15

20

25

305

5

5

5

5

MRMR = $5

1 2 3 4 5 6Q

MR

In PC markets:

MR = Price

Total Revenue /Total Cost view

12

Total Revenues

Total Costs

TR,TC

Output

Revenues (TR)- Total Costs (TC)

Profit or Loss = Profit

Total Revenues

Total Costs

Loss

Firms want to maximize Profits

Total

Rev

enue

sTot

al C

osts

Total

Rev

enue

s

Total

Cos

ts

TR,TC

-Total Costs (TC)

=Profit (Loss)

Total Revenues

All these output levels generate

losses.

LossesAll these output levels generate

Profits.

Profits

All these output levels

generate Losses.

14

Total

Rev

enue

sTot

al C

osts

Total

Rev

enue

s

Total

Cos

ts

TR,TC

Firm must produce more than q0 to

offset these losses

Firm chooses the output level that

maximizes profits

Profit

The largest distance between

TR and TCoccurs when TR and TC have the same slope.

TR

TC

q0

Losse

s

Total Profits are Maximized when MR = MC

15

Total

Rev

enue

s

Total

Cos

ts

TR,TC

Slope of TC = Slope

of TRMC = MR

Profit Maximizing Output Level q*

Choose output where MC= MR to maximize profit

TRTC

Slope = MC

Slope = MR

MC = MR: Maximize Profit

MAX Profit

q*

Price determines Profit/Loss

Total

Rev

enue

sTot

al C

osts

Total

Rev

enue

sTotal

Cos

ts

TR,TC

Output

Losse

s

Profits

If Price Decreases

Slope of TR line decreases

If the price continues to drop, there will be NO output level that generate a profit, only loss.

For all these output levels the firm makes a profit: chooses the output with the largest profit.

ProfitsProfitsProfitsProfitProfit

Choosing q where MR = MC Maximize profit or Minimize Loss

TR

TC

Slope = MC

Slope = MR

Loss

Loss

Loss

Loss

q*

MC = MR TR = TC Loss = zero

Choose q where MC = MR to Minimize Loss

TR less than TC: Economic Losses

At q*, the slope of TC (MC) = Slope of TR (MR) But the firm does not make a profit

TR

TC

Slope = MC

Slope = MR

q*

Smallest Loss

Loss

LossLoss

Loss

Choose q where MC = MR to Minimize Loss

Marginal Revenue (MR): Additional revenue from selling one more unit.

20

MR

Q

MR = Price = $5In PC markets, the

additional Revenue the firm gets from selling one more

unit is the price per unit

In PC markets, the additional Revenue the firm gets from selling one more

unit is the price per unit

5

PROFIT PER UNIT = MR-MCPROFIT PER UNIT = PRICE - MC

21

MR, MC

Q

MR= Price = $5

MC = Cost per unit

Negative: Loss

Positive: Profit

Number of Units (Q) Profit Per Unit = MR – MCTotal Profit

= Sum of Per unit profit.

1234567891011

Fill in the values in the table using the information in the next slide

Price - MC

P = $5 MR=$5

MC9

8

6

3

21 2

3

8

11

7

4

4 111 2 3 5 6 7 8 9 10 12 13 14

Loss = $5 - $9 = -4Loss = $5 - $8 = -3

Loss = $5 - $6 = -1Loss = $5 - $5 = 0

Profit = $5 - $3 = +2Profit = $5 - $2 = +3

Profit = $5 - $1 = +4Profit = $5 - $2 = +3

Profit = $5 - $3 = +2

5 5Profit = $5 - $5 = 0

Profit = $5 - $4 = +1

Loss = $5 - $7 = -2

Loss = $5 - $8 = -3

Loss = $5 - $11 = -6

P = 5 MR

MC

9

8

6

32 1 2

3

8

11

7

4

4 11

If The firm produces more than 11 units, profits will shrink as losses start to accumulate…

-2

-3

-6

1 2 3 5 6 7 8 9 10 12 13 14

Profit maximizing output level

-4

-3

-1

+2+3 +4 +3 +2 +1

Number of Units (Q) Profit Per Unit = Price – MCTotal Profit is sum of

per unit profit

1 5 - 9= - 4 -4

2 5 - 8 = - 3 -7

3 5 - 6 = - 1 -8

4 5 - 5 = 0 -8

5 5 – 3 = +2 -6

6 5 – 2 = +3 -3

7 5 – 1 = + 4 +18 5 – 2 = +3 +4

9 5 – 3 =+2 +6

10 5 – 4 = +1 +7

11 5 – 5 = 0 +712 5 - 7 = -2 +5

13 5 - 8 = -3 +2

14 5 - 11 = -6 -4

Max per unit

profit at q = 7

Max TOTAL profit at q=

11

Always choose output at the maximum TOTAL profit

Never choose output at the maximum PER UNIT profit

26

Per unit view

Total view

Profit maximizing output level

Total

Rev

enue

sTot

al C

osts

Total

Rev

enue

s

Total

Cos

tsTR,TC

Output

Losse

s

Profit

s

1 2 313

5 67

8

9

10411

12 14

11

27

Total

Rev

enue

sTotal

Cos

tsTR,TC

Slope of TC = Slope

of TRMR = MC

The output level where the Total Profit is largestIs the same as the output level where per unit profit is zero

TRTC

CHOOSING THE OUTPUT LEVEL THAT MAXIMIZES PROFIT

Choose q* at the point where MC = MRSince MR = PriceChoose q* where MC = Price

28

29

MC

AVCATC

P=MR

q*

Profit Max Output level

P

Marginal Revenue /Marginal Cost view

ATC less than Price: Economic Profit

30

© 2001 Claudia Garcia-Szekely

MC

AVC

ATC

P=MR

ATCAVC

q*

Profit Max Output level

VC

FC

TC

AVC x Q = VC

AFC x Q = FCATC x Q = TC

PTR

P x Q = TRTR – TC = Profit

ATC = Price: Zero Economic Profit

MC

AVC

ATC

P = MRP

q* Profit Max Output level

AVC

VC

ATC = P

TC = TR No loss or profit

TC TR = TC

MC

AVC

ATC

P = MRP

q* Profit Max Output level

AVC

VC

ATC

TC larger than TR

TC

ATC larger than Price: Loss

LOSS

TR

SHUT DOWN

Firm continues to pay all the fixed costs in order to KEEP the plant.Produces zero units.Variable Cost= ZERO Total Cost = Fixed CostTotal Revenue = ZEROLoss = TR (0) – TC (FC) = FC.

33

If by producing q*, the firm generates a loss larger than the FC, the firm should

shut down to minimize the loss

MC

AVC

ATC

P = MRP

q* Profit Max Output level

AVCVC

ATC

FCLOSS < FC

TR

Loss if the firm produces q* is smaller than the FC Loss if the firm produces q* is smaller than the FC ATC larger than

P P larger than AVC

ATC larger than P P larger than

AVC

Revenues cover all VC and some of

FC

Revenues cover all VC and some of

FC

MC

P=MR

ATC

AVC

q*

Profit Max Output

PRevenues are NOT enough to

pay for ALL the VCRevenues are NOT enough to

pay for ALL the VC

Loss if the firm produces q* is larger than the FCLoss if the firm produces q* is larger than the FC

VC

TCTC FC

TR

Loss = + some of the

Loss

P less than ATC P less than AVCP less than ATC P less than AVC

MC

P=MR

ATC

AVC

q*

Profit Max Output level

=P

Loss if the firm produces q* is equal

to FC

Loss if the firm produces q* is equal

to FC

VC

TCTC FC

TR

Loss =

Revenues are enough to cover only

the VC

Revenues are enough to cover only

the VC

P less than ATC P =AVC

P less than ATC P =AVC

Loss

TR

TC

q*

VC

Firm should produce at a loss

Loss less than FC

FC

TC larger than TR TR larger than VCTC larger than TR TR larger than VC

TR

TC

q*

VC

Firm is indifferent

Loss = FCFC

TC larger than TR TR = VC

TC larger than TR TR = VC

TR

TC

q*

VCFirm should shut down

Loss greater than FCFC

TC larger than TR TR less than VC

TC larger than TR TR less than VC

40

41

P0

P1

P2

P3

P4

q0 q1

q2

q3 q4

P Qs short run

P0q0

P1 q1

P2 q2

P3q3 

P4 q4 

MR

MRMRMR

Choose output where: MC = MR = Price

As long as Price > AVC

Choose output where: MC = MR = Price

As long as Price > AVC

MC

MR

If Price < AVC

The firm should shut down

If Price < AVC

The firm should shut down

42

Minimum AVC is the shutdown point.

The firm minimizes its losses by producing zero units.

Shut Down

P

Shutdown PriceShutdown Price

AVC

If Price < AVC

Producing at MC=MR will generate losses greater than fixed costs. The firm should shut down

If Price < AVC

Producing at MC=MR will generate losses greater than fixed costs. The firm should shut down

The Short Run Supply Curve

Shut Down

MCMC Above AVC = Supply in the short run To determine the

quantity supplied in the short run choose

q where:

Price = MC.

= Shut down point = minimum

AVC

If price < shut down price then

the quantity supplied = 0

Produce at

MR=MC

AVC

2

46

8

14

5060

70

80 100

P

Typical Firm’s

qs short run

10,000Firms Market Supply

2

4  

6  

8  

14  

MR

MRMRMR80

1M

800,000

700,00070

60 or 0

0600,000

Or 0

0

P =

Shutdown Price100

In the Long Run firms EXIT the industry if they are incurring losses

EXIT

P

EXIT Price = Min ATC

MC = Supply in the long run

If price > exit price choose q where

Price = MC.

If price > exit price choose q where

Price = MC.

If price < exit price quantity supplied = 0.

If price < exit price quantity supplied = 0.

P

q

If price = ATC Firm is indifferent

ATC

46

Long-Run Adjustment

If firms in an industry are earning economic profits, firms will enter and the industry expands.

If firms in an industry are earning economic losses, firms will exit and the industry contracts.

If firms in an industry are earning normal profits, expect no further entry or exit.

Firms enter attracted by profits: Supply shifts right

P0MR0

ATC

MC

Profit

D

S0

S1

P1 MR1

q0q1

Zero Profit

Price drops

Firms will enter until profits are zero

Firms will enter until price = Min ATC

q0

q0

Firms exit due to Loss: Supply shifts left

P0 MR0

ATC

MC

Loss

D

S0

S1

P1

MR1

q0 q1

Zero Loss / Profit

Firms will exit until Losses/profits are zero

Firms will exit until price = Min ATC

Perfectly Competitive Firms earn only Normal

Profits ( Zero Economic Profits)

in the long run

An industry is not in equilibrium if:

Firms have an incentive to change their output level

Firms have an incentive to enter or exit the industry.

Firms have an incentive to expand or contract the plant size

51

Firms have an incentive to change their output level if:

1. They are not maximizing profits.

Firm should produce more Firm should produce less

MR > MCMC

MR

q0

MR < MCMC

q1

52

Firms have an incentive to change their plant if:

2. They are not minimizing LRATC.

Firm should Expand to Plant 5 Firm should Contract to Plant 5

LRATC

Min

ATC

sratc5

sratc1

q0 q1

LRATC

sratc5

sratc1

q0

Min

ATC

q1

Firms have an incentive to enter or exit an industry if

New Firms will ENTER the industry

Some Firms will EXIT the industry

ATC

Economic Profits

MC

MRProfit

q0

Economic Losses

MC

ATC

Loss

q0

MR

Conditions for Equilibrium In the Long Run

1. Firms must be maximizing Profits

MR = MC

2. Firms must be Minimizing Long Run Costs

SRATC = LRATC

3. Firms must be earning Zero Economic Profit

(No entry, No exit)

P = ATC

MR = MC MC

MR

q0

LRATCSRATC

ATCMC

P

Long Run Equilibrium Condition

MR = MC = Price = SRATC = LRATC

Max Profit Zero Economic Profit/Loss

Min Cost

No change in Output No entry/exit No change in plant size

Competition forces firms to be efficient

P0MR0

ATC

MC

D

S0

S1

P1 MR1

q1

Price drops

Firms will produce at the lowest ATC

Firms will enter until price = Min ATC

No Excess Capacity

When firms expand Supply shifts right

MC

SRATC1

SRATC2

SRATC3

LRACP0

D

S0

S1

P1

Price drops

Firms will expand until they minimize the LRATC

Firms produce with the lowest

cost plant

58

MC

SRATC1

SRATC2 SRATC3

LRAC

Price = ATC

Consumers in perfe

ctly

competitive markets p

ay the

lowest possib

le price

Price