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Perfect Competition. Assumptions of Perfect Competition. Homogeneous or identical products – every seller’s product is the same as every other seller’s product. Many small independent firms Easy entry & exit into the industry – all resources are perfectly mobile. - PowerPoint PPT Presentation
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Perfect Competition
Assumptions of Perfect Competition
1. Homogeneous or identical products – every seller’s product is the same as every other seller’s product.
2. Many small independent firms
3. Easy entry & exit into the industry – all resources are perfectly mobile.
4. Firms, consumers, & resource owners have perfect knowledge of relevant economic & technical data.
The perfectly competitive firm is a price taker that sells its product at the market price. Why?
If the firm tried to charge more than the market price, it would lose all its business to its competitors who sell the identical product.The firm can sell as much as it wants at the market price, since it is very small relative to the market. The firm, therefore, has no incentive to charge less than the market price.
Since the perfectly competitive firm always sells its product for the market price, the demand curve for its product is horizontal at the market price.
P
Q
D
Consider a perfectly competitive firm whose product sells for $10. The firm’s costs are as shown below.
Quantity of output
(Q)
Price (P)
Total Revenue
(TR)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Total Cost (TC)
Total Profit
()
Marginal Revenue
(MR)
Marginal Cost (MC)
0 10 12 0
1 10 12 2
2 10 12 3
3 10 12 5
4 10 12 8
5 10 12 13
6 10 12 23
7 10 12 38
8 10 12 69
Total Revenue is TR = PQ
Quantity of output
(Q)
Price (P)
Total Revenue
(TR)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Total Cost (TC)
Total Profit
()
Marginal Revenue
(MR)
Marginal Cost (MC)
0 10 0 12 0
1 10 10 12 2
2 10 20 12 3
3 10 30 12 5
4 10 40 12 8
5 10 50 12 13
6 10 60 12 23
7 10 70 12 38
8 10 80 12 69
Total Cost is TC = TFC + TVC.
Quantity of output
(Q)
Price (P)
Total Revenue
(TR)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Total Cost (TC)
Total Profit
()
Marginal Revenue
(MR)
Marginal Cost (MC)
0 10 0 12 0 12
1 10 10 12 2 14
2 10 20 12 3 15
3 10 30 12 5 17
4 10 40 12 8 20
5 10 50 12 13 25
6 10 60 12 23 35
7 10 70 12 38 50
8 10 80 12 69 81
Profit is = TR –TC
Quantity of output
(Q)
Price (P)
Total Revenue
(TR)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Total Cost (TC)
Total Profit
()
Marginal Revenue
(MR)
Marginal Cost (MC)
0 10 0 12 0 12 -12
1 10 10 12 2 14 -4
2 10 20 12 3 15 5
3 10 30 12 5 17 13
4 10 40 12 8 20 20
5 10 50 12 13 25 25
6 10 60 12 23 35 25
7 10 70 12 38 50 20
8 10 80 12 69 81 -1
Marginal Revenue is MR =ΔTR/ΔQ .
Quantity of output
(Q)
Price (P)
Total Revenue
(TR)
Total Fixed Cost (TFC)
Total Variable Cost (TVC)
Total Cost (TC)
Total Profit
()
Marginal Revenue
(MR)
Marginal Cost (MC)
0 10 0 12 0 12 -12 ---
1 10 10 12 2 14 -4 10
2 10 20 12 3 15 5 10
3 10 30 12 5 17 13 10
4 10 40 12 8 20 20 10
5 10 50 12 13 25 25 10
6 10 60 12 23 35 25 10
7 10 70 12 38 50 20 10
8 10 80 12 69 81 -1 10
For a perfectly competitive firm, MR is constant & equal to the price of the product.
Marginal Cost is MC =ΔTC/ΔQ
Quantity of output
PriceTotal
Revenue
Total Fixed Cost
Total Variable
Cost
Total Cost
Total Profit
Marginal Revenue
Marginal Cost
0 10 0 12 0 12 -12 --- ---
1 10 10 12 2 14 -4 10 2
2 10 20 12 3 15 5 10 1
3 10 30 12 5 17 13 10 2
4 10 40 12 8 20 20 10 3
5 10 50 12 13 25 25 10 5
6 10 60 12 23 35 25 10 10
7 10 70 12 38 50 20 10 15
8 10 80 12 69 81 -1 10 31
Notice that when Q = 6, MR=MC
Quantity of output
PriceTotal
Revenue
Total Fixed Cost
Total Variable
Cost
Total Cost
Total Profit
Marginal Revenue
Marginal Cost
0 10 0 12 0 12 -12 --- ---
1 10 10 12 2 14 -4 10 2
2 10 20 12 3 15 5 10 1
3 10 30 12 5 17 13 10 2
4 10 40 12 8 20 20 10 3
5 10 50 12 13 25 25 10 5
6 10 60 12 23 35 25 10 10
7 10 70 12 38 50 20 10 15
8 10 80 12 69 81 -1 10 31
and profit is at its maximum.
Notice also that at that profit-maximizing output, price is equal to marginal cost
P=MC
Quantity of output
PriceTotal
Revenue
Total Fixed Cost
Total Variable
Cost
Total Cost
Total Profit
Marginal Revenue
Marginal Cost
0 10 0 12 0 12 -12 --- ---
1 10 10 12 2 14 -4 10 2
2 10 20 12 3 15 5 10 1
3 10 30 12 5 17 13 10 2
4 10 40 12 8 20 20 10 3
5 10 50 12 13 25 25 10 5
6 10 60 12 23 35 25 10 10
7 10 70 12 38 50 20 10 15
8 10 80 12 69 81 -1 10 31
P = MC because for the perfectly competitive firm, P = MR & for the profit-maximizing firm, MR = MC.
Quantity of output
PriceTotal
Revenue
Total Fixed Cost
Total Variable
Cost
Total Cost
Total Profit
Marginal Revenue
Marginal Cost
0 10 0 12 0 12 -12 --- ---
1 10 10 12 2 14 -4 10 2
2 10 20 12 3 15 5 10 1
3 10 30 12 5 17 13 10 2
4 10 40 12 8 20 20 10 3
5 10 50 12 13 25 25 10 5
6 10 60 12 23 35 25 10 10
7 10 70 12 38 50 20 10 15
8 10 80 12 69 81 -1 10 31
On a graph, the perfectly competitive firm making a positive economic profit looks like
this. The horizontal demand curve lies above the minimum of the ATC curve.
$
Quantity
MC ATC
D = MRP
Q*
Sometimes the best the firm can do is break even (make zero economic profits). This occurs when the price (& the demand curve) are at the minimum of the ATC curve.
$
Quantity
MC ATC
AVC
D = MRP
What if the demand curve lies below the minimum of the ATC curve but above the
minimum of the AVC curve?
$
Quantity
MC ATC
AVC
D = MRP
Then the firm will have an economic loss.
However, the firm will still operate. If the firm were to shut down & produce nothing,
its loss would equal its fixed cost.But since the price is greater than the variable
costs per unit (AVC), by operating the firm will be able to cover its variable costs & part of its fixed costs.
So its loss would be smaller than the amount of fixed cost.
So it pays to operate, as long as the price is above the minimum of the average variable cost.
Mathematically, the situation works like this:
P > AVC So, PQ > AVC (Q),[Now since AVC = TVC / Q , AVC (Q) = TVC.]So, PQ > TVCTR > TVCTR – TC > TVC – TC > TVC – TC > – TC + TVC > -1(TC – TVC) > – TFC
If the firm produced nothing, = TR – TC
= TR – (TVC+TFC )
= 0 – (0+TFC)
= – TFC
So the firm does better by operating than by shutting down.
If the price equals the minimum value of the AVC curve, the firm will lose the same amount if it shuts down or if it operates.
$
Quantity
MC ATC
AVC
D = MRP
However, if the price is below the minimum of the AVC curve,
the firm is unable to cover even the variable costs, & it should shut down.
It would lose more by operating than by shutting down.
Consequently, the minimum of the AVC curve is called the shutdown point.
Graphically, the firm’s horizontal demand curve lies below the minimum of the AVC curve:
$
Quantity
MC ATC
AVC
D = MRP
So we have these five possible cases:
1. Positive economic profits
2. Break even
3. Operate at a loss
4. Lose same amount if operate or shutdown
5. Shutdown
$
Quantity
MC ATC
AVCP1
P2
P3
P4
P5
Using this information and the fact that the firm maximizes profits by producing where MR = MC, we can determine the firm’s short run supply curve.
If the price is P1, the firm produces output Q1, where MR = MC.(The numbering of the prices in the upcoming slides does not correspond to the numbering in our 5 case discussion.)
$
Quantity
MCATC
AVC
P1 D1 = MR1
Q1
If the price is P2, the firm produces output Q2 .
$
Quantity
MCATC
AVC
P2 D2= MR2
Q2
If the price is P3, the firm produces output Q3.
$
Quantity
MC ATC
AVC
P3
Q3
D3 = MR3
If the price is P4, the firm produces output Q4.
$
Quantity
MC ATC
AVC
P4
Q4
D4 = MR4
If the price is P5, the firm produces output Q5 (or shuts down – it loses the same amount either way).
$
Quantity
MC ATC
AVC
P5
Q5
D5 = MR5
So in determining the quantity the firm would supply at each price, we have actually traced out the points of the MC curve above the minimum of the AVC curve.
$
Quantity
MC ATC
AVC
So this is the firm’s short run supply curve.
Price
Quantity
S
To determine the industry or market short run supply curve, horizontal sum the individual firms’ supply curves.
Price
Quantity
S2 S3 S4 S5S1
Industry supply curve
That means that for each price, we add the amounts all the firms are willing to supply.
Price
10 20 30 40 50 150
S2 S3 S4 S5S1
Industry supply curve
25
Quantity
For example, if there are five firms who at a price of $25 will supply 10, 20, 30, 40, & 50 units each, the total supplied by the industry at that price is 10 + 20 + 30 + 40 + 50 = 150 .
How do perfectly competitive firms & industries adjust to changes in demand conditions &
what are the implications for the long run market supply curve?
Let’s start with the simplest case, which is the constant cost industry.
Constant Cost Industry
an industry in which costs of production remain constant as industry output expands
S
D
P0
P
QQ*
Market
Start with the market.
S
D
P0
P
QQ*
Market Firm
Put in a typical firm in long run equilibrium (zero profits).
q* q
MCATC
D= MRP0
P
S
D
P0
P
QQ*
Market Firm
q* q
MCATC
D= MR
Suppose demand increases.
D’
P0
S
D
P0
P
QQ* Q1
Market Firm
q* q1 q
MC ATC
D= MR
Price rises and profits are made.
D’
P0
P1 D1= MR1P1
S
D
P0
P
QQ*Q1
Market Firm
q* q1 q
MCATC
D= MR
New firms enter the industry, increasing supply.
D’
P0
P1 D1= MR1P1
S’
S
D
P0
P
QQ* Q1 Q2
Market Firm
q* q
MCATC
D= MR
Price falls to original level, & profits return to zero.
D’
P0
P1 D1= MR1P1
S’
The Long Run Supply Curve
The initial market point and the final one are long run equilibrium points and therefore are on the long run supply curve for this industry.
(The middle point - the black one - is not on the long run supply curve, since it is not a long run equilibrium point.)
For a constant cost industry, the long run supply curve is a horizontal line.
S
D
P0
P
QQ* Q1 Q2
Market
The Long Run Supply Curve
D’
P1
S’
long run supply curve
Increasing Cost Industry
an industry in which costs of production increase as industry output expands
S
D
P0
P
QQ*
Market
Start with the market.
S
D
P0
P
QQ*
Market Firm
q* q
MCATC
D= MR
Put in a typical firm in long run equilibrium (zero profits).
P0
P
S
D
P0
P
QQ*
Market Firm
q* q
MCATC
D= MR
Suppose demand increases.
D’
P0
S
D
P0
P
QQ* Q1
Market Firm
q* q1 q
MCATC
D= MR
Price rises and profits are made.
D’
P0
P1 D1= MR1P1
S
D
P0
P
QQ*Q1
Market Firm
q* q1 q
MCATC
D= MR
New firms enter the industry, increasing supply.
D’
P0
P1 D1= MR1P1
S’
However, as industry output expands, demand for the inputs rises. The prices of the inputs increase, and therefore production costs increase.
So we see an upward shift in the cost curves.
S
D
P0
P
QQ*Q1
Market Firm
q* q1 q
MC1
ATC
D= MR
Cost curves shift upward.
D’
P0
P1 D1= MR1P1
S’
MC
ATC1
The market supply curve shifts to the right just enough, so that the equilibrium price will be at the minimum of the new ATC curve and we have zero profits.
So the price rises and then falls but not to the original price level.
S
D
P0
P
QQ*Q1
Market Firm
q2 q* q1q
MC1
ATC
D= MR
D’
P0
P1D1= MR1P1
S’
MC
ATC1
D2 =MR2P2P2
The new long run equilibrium price is higher than the original price.
The Long Run Supply Curve
The initial market point and the final one are long run equilibrium points and therefore are on the long run supply curve for this industry.
For a increasing cost industry, the long run supply curve is upward sloping.
S
D
P0
P
QQ*Q1
Market
D’
P1
S’
P2
long run supply curve
The Long Run Supply Curve
Decreasing Cost Industry
an industry in which costs of production fall as industry output expands
S
D
P0
P
QQ*
Market
Start with the market.
S
D
P0
P
QQ*
Market Firm
q* q
MCATC
D= MR
Put in a typical firm in long run equilibrium (zero profits).
P0
P
S
D
P0
P
QQ*
Market Firm
q* q
MCATC
D= MR
Suppose demand increases.
D’
P0
S
D
P0
P
QQ* Q1
Market Firm
q* q1 q
MCATC
D= MR
Price rises and profits are made.
D’
P0
P1 D1= MR1P1
S
D
P0
P
QQ*Q1
Market Firm
q* q1 q
MCATC
D= MR
New firms enter the industry, increasing supply.
D’
P0
P1 D1= MR1P1
S’
As industry output expands, area infrastructure (such as roads and bridges) improves and therefore costs of transporting inputs and outputs decrease.
So we see an downward shift in the cost curves.
S
D
P0
P
QQ*Q1
Market Firm
q* q1 q
MCATC
D= MR
Cost curves shift downward.
D’
P0
P1 D1= MR1
S’
P1
The market supply curve shifts to the right just enough, so that the equilibrium price will be at the minimum of the new ATC curve and we have zero profits.
So the price rises and then falls to below the original price level.
S
D
P0
P
QQ*Q1
Market Firm
q* q1 q2 q
MCATC
D= MR
The new long run equilibrium price is lower than the original price.
D’
P0
P1 D1= MR1
S’
D2= MR2P2
P1
P2
The Long Run Supply Curve
The initial market point and the final one are long run equilibrium points and therefore are on the long run supply curve for this industry.
For a decreasing cost industry, the long run supply curve is downward sloping.
S
D
P0
P
QQ*Q1 Q2
Market
The Long Run Supply Curve
D’
P1
S’
P2 long run supply curve
We have seen that in long run equilibrium, the perfectly competitive firm always operates
at the minimum of its SR ATC curve.
In LR equilibrium, it will also be at the minimum of its LR ATC. Why?
When the firm is maximizing LR profits, MR = LR MC.
Since for a perfectly competitive firm, P=MR, P = LR MC.
But since the firm has zero economic profits, P = LR ATC.So LR MC must equal LR ATC. Where does that
occur?At the minimum of the LR ATC.
So in LR equilibrium, a perfectly competitive firm operates at the minimum of both the SR & LR ATC curves, where those curves intersect the LR & SR MC curves.
q* q
LR MC
LR ATC
D= MRP0
P
SR ATC
SR MC
