Perfect Competition

1
Perfect Competition

• Sometimes referred to as Pure Competition or just
  The Competitive Firm

2
Market Structure

• The particular environment of a firm, the
  characteristics of which influence the firms
  pricing and output decisions.

3
Background on Markets

• When economists analyze the production decisions
  of a firm, they take into account the structure
  of the market in which the firm is operating.
• Four Different Market Structures
• Perfect Competition
• Monopoly
• Monopolistic Competition
• Oligopoly

4
The Theory of Perfect Competition I

• A theory of market structure based on four
  assumptions
• There are many sellers and many buyers, none of
  which is large in relation to total sales or
  purchases.
• Each firm produces and sells a homogeneous
  product.
• Buyers and sellers have all relevant information
  with respect to prices, product quality, sources
  of supply, and so on.
• There is easy entry into and exit from the
  industry.

5
Perfect Competitive Market

• Why teach about a non-existent form of
  competition?
• Questions to answer
• What are profits?
• What are the unique characteristics of
  competitive firms
• How much output will a competitive firm produce

6
A Perfectly Competitive Firm is a Price Taker

• A seller that does not have the ability to
  control the price of the product it sells it
  takes the price determined in the market.

7
Market Model Price/Output

• Market economy varies from one seller to many
  sellers
• None is typical.
• Each unique and attempting to operate with their
  self-interest in mind.
• Look at the Models for the 4 market categories
  How does each determine the price to charge and
  the output to produce?

8
Market structure characteristics

• All four market structures have four
  distinguishing characteristics
• The number and size of the firms in the market.
• The ease with which firms may enter and exit the
  market.
• The degree to which firms products are
  differentiated.
• The amount of information available to both
  buyers and sellers regarding prices, product
  characteristics and production techniques.

9
Take a personal look?

• How many of you owned a computer 10 years ago?
• How many own a compact disc player today?
• How many have discarded the VCR in favor of a
  DVD?
• Do you own an Ipod?
• Do you own an IPhone?
• Do you own a graphing calculator?
• Did your parents have a graphing calculator
• How did your parents type project papers for
  economics class?
• Competition has brought the above changes about.

10
Price Taker Discussion

• When there are many firms, all producing and
  selling the same product using the same inputs
  and technology, competition forces each firm to
  charge the same market price for its good.
• Because each firm sells the same homogeneous
  product, no single firm can increase the price
  that it charges above the price charged by other
  firms in the market (without losing business.)
• No single firm can affect the market price by
  changing the quantity of output it supplies-
  because many firms- each firm is small in size.

11
Demand CurveIndividual firm/industry

• The perfect competitor faces a horizontal or
  perfectly elastic demand curve.
• The demand curve is identical to the Marginal
  Revenue Curve (because the firm can sell as much
  as it wants to sell at market price.) It is not
  necessary to lower the price to sell more.
• The demand curve for the entire industry slopes
  downward (this is a result of aggregate entries
  and exits into the market.)

12
Price Takers Demand Curve

• The market forces of supply and demand determine
  price.

• Price takers have no control over the price
  that they may charge in the market. If such
  a firm was to offer their good/service at a
  price above that established by the market,
  then consumers would simply buy elsewhere.

• Thus, the demand for the product of the firm is
  perfectly elastic. Only at the market price
  will there be any demand.

13
Demand Curve

• Market Demand Curves vs. Firm Demand Curves
• While the actions of a single competitive firm
  are negligible, the unified actions of many such
  firms are not.

• The individual firms equilibrium quantity of
  output will be completely determined by the
  amount of output the individual firm chooses to
  supply

14
SHORT RUN

• In the short-run individual firm may make profit
  or loss
• In long run will break even
• You can always tell if the firm is making a
  profit or loss by looking at the DEMAND CURVE AND
  THE ATC CURVE
• If the demand curve is ABOVE the ATC curve at any
  point the firm will make a profit.
• If the demand curve is always BELOW the ATC curve
  the firm will lose money.

15
Total Revenue
16
Most profitable point for any firm

• Profit maximization is where
• MC MR
• Efficiency
• A firm operates at peak efficiency when it
  produces its product at the lowest possible cost
  That would be at the MINIMUM POINT OF ITS ATC
  CURVE the break even point.

17
Profit-Maximization Rule

• Profit is maximized by producing the quantity of
  output at which MR MC.
• For Perfect Competition, profit is maximized when
  P MR MC
• This condition is unique for perfect
  competition and does not hold for other market
  structures.

18
Realization

• Marginal Cost
• A firms goal is not to maximize revenues, but to
  maximize profits.
• Marginal revenue is compared to marginal costs to
  determine the best level of output.
• What an additional unit of output brings in is
  its marginal revenue (MR).

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Profit Maximization
p MC
MRB
Profit-maximizing rate of output
MCB
20
Profit Maximization when the Firm
is a Price Taker

• In the short run, the price taker will expand
  output until marginal revenue (price) is just
  equal to marginal cost.

Price

• This will maximize the firms profits
  (rectangle BACP).

B

• When P gt MC then the firm can make more on
  the next unit sold than it costs to increase
  output for that unit. In order for the
  firm to maximize its profits it increases
  output until MC P.

• When P lt MC then the firm made less on the
  last unit sold than it cost for that unit. In
  order for the firm to maximize its
  profits it decreases output until MC P.

Output/ Time
q
0
21
Marginal Revenue / Marginal Cost Approach

• We can show the relationship between the
  TR/TC and the MR/MC approach.

• Below, low levels of output deliver marginal
  revenue to the firm greater than the
  marginal cost of increased output.

----
----
- 25.00
5
4.80
- 24.80

• After some point, though, additional units
  cost more than their marginal revenue.

5
3.95
- 23.75
.

• Profit is maximized where P MR MC.

.
.
.
.

• Both the TR/TC and the MR/MC method yield the
  same profit maximizing output, q15

1.50
- 8.00
5
- 4.25
5
1.25
Price and CostPer Unit
- .25
5
1.00
9
5
1.25
3.50
5
6.75
1.75
7
5
9.25
2.50
MR
5
10.75
3.50
5
11.00
5
4.75
5
10.00
6.00
3
5
7.25
7.75
4.50
5
8.25
1
5
0.00
9.50
- 8.00
5
13.00
Output Level
- 20.00
17.00
5
10
8
4
2
6
12
14
16
18
20
22
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Operating

• In the graph to the right, the firm operates
  at an output level where p MC, but here ATC
  gt MC resulting in a loss for the firm.

Price
with Short-Run Losses

• The magnitude of the firms short-run losses
  is equal to the size of the of the rectangle
  BACP1

• A firm experiencing losses but covering its
  average variable costs will operate in the
  short-run.

B

• A firm will shutdown in the short-run
  whenever price falls below average variable
  cost (P2).

• A firm will shutdown in the long-run whenever
  price falls below average total cost.

Output/ Time
q
0
23
Long Run

• In the long run there is time for firms to enter
  or leave the industry. This factor ensures that
  the firm will make ZERO profits in the long run.

24
Long Run

• In the LR, no firm will accept losses.
• It will simply close up shop and go out of
  business.
• But also remember one firm leaving the industry
  WILL NOT affect market price.

25
LR Continued

• If one firm is losing money, presumably others
  are too.
• When enough firms go out of business, industry
  supply declines which pushes price up
• This price rise is reflected in a new demand
  curve for the firm.
• P D1 D2 S1

S2
Q
26
ATC
MC
60
MR (D)
50
27

• For the perfect competitor in the LR, the most
  profitable output is at the minimum point of its
  ATC curve.
• The firm is forced to operate at peak efficiency
  and that is why it operates at the minimum of its
  ATC curve.. Not anything to do with virtue-------
  just competition.

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Remember Firm Demand Curve is Different from
Industrys Demand Curve
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Point of Fact

• For virtually every industry---- a firm will be
  able to lower its ATC if it can expand up to a
  certain point.
• If it expands beyond that point ATC will rise.
• Two concepts Increasing and Decreasing costs.
• The third alternative is constant costs.

30
Economies of Scale
31
Decreasing Cost Industry

• Decreasing cost industry can lower ATCs by
  increasing output thus taking advantage of
  economies of scale
• examples such as discounts from buying or selling
  large quantities, declining average fixed cost as
  output expands, and lower costs resulting from
  specialization

32
Increasing Cost Industry

• Increasing Cost Industries diseconomies of
  scale overwhelm economies of scale.
• These diseconomies drive costs up, pushing firms
  into the rising segment of their ATC curves.
  (examples would be managerial inefficiencies,
  cost of maintaining a huge bureaucracy,
  difficulties of communication among various
  branches, also diminishing returns.)

33
Factor Costs

• Factor costs mean wages, rent and interest- are
  far the most important determinants of whether
  costs are falling, constant or increasing.
• Usually factor costs will eventually rise which
  makes every industry an increasing costs
  industry. Example as more and more land is used
  by an expanding industry, rent will be bid up
• Time influences supply Whether industry is in SR
  or LR all can adjust in LR if desire to do so.

34
Profit- what kind is it???

• Pure Profit -an amount above that necessary to
  keep the owner in the industry is not considered
  part of total cost
• Pure profit is the residual after all costs
  (including normal profit) have been met
• Pure profit will attract other firms into the
  market
• Normal Profit will not induce firms into the
  market- nor are they low enough to force others
  to leave.. Breaking even..

35
Basic Info

• As long as MR is greater than MC the firm will
  find an advantage in increasing its production.
• Rule is The most profitable point for any firm
  is the point at which MC MR. The firm can
  improve its profit position by increasing its
  output up to the point where MC crosses MR.

36
Shutdown point for a firm

• A firm compares total revenue with total cost to
  see what its profit or loss is.
• Remember there are fixed and variable costs.
• Fixed costs have to be paid whether operating or
  not.
• Suppose a firms total cost is 300,000 at a
  certain level of output. 200,000 made up of
  variable costs,such as labor and raw materials
  and 100,000made up of fixed costs such as
  interest payments, taxes, and rent.

37
Shutdown Continued

• If the firms total revenue is 240,000 it is
  clearly taking a loss. The difference between TR
  and TC in this case is 60,000.
• Notice that the total revenue of 240,000 pays
  all of the firms variable costs (200,000) and
  also pays 40,000 of its fixed cost. If the firm
  were to shut down on the other hand, its loss
  would total 100,000- the amount of the fixed
  cost.

38

• There may be instances where the firm can pay all
  fixed and part of variable. In those cases, it
  is possible the firm will opt for that.
• BUT. For the most part, and for you to
  remember if firm can pay variable and part of
  fixed, they will continue to operate.

39
Shutdown Continued

• As long as a firm can cover ALL of its variable
  cost by remaining in operation, it will do so.
• Its shutdown point will be where TR no
  longer covers TVC.
• Shutdown when MR falls below the firms minimum
  AVC. When a firm shuts down, it does not
  necessarily leave the industry. Shutdown is a SR
  responseand is based on fixed costs of
  established plant and variable costs of operating
  it.

40
Profit Maximization and Loss Minimization for the
Perfectly Competitive Firm Three Cases I

• In Case 1, TR TC and the firm earns profits.
• It continues to produce in the short run.

41
Profit Maximization and Loss Minimization for the
Perfectly Competitive Firm Three Cases II

• In Case 2, TR lt TC and the firm takes a loss.
• It shuts down in the short run because it
  minimizes its losses by doing so it is better to
  lose 400 in fixed costs than to take a loss of
  450.

42
Profit Maximization and Loss Minimization for the
Perfectly Competitive Firm Three Cases III

• In Case 3, TR lt TC and the firm takes a loss.
• It continues to produce in the short run because
  it minimizes its losses by doing so it is better
  to lose 80 by producing than to lose 400 in
  fixed costs by not producing.

43
What Should a Perfectly Competitive Firm Do in
the Short Run?

• The firm should produce in the short run as long
  as price (P) is above average variable cost
  (AVC).
• It should shut down in the short run if price is
  below average variable cost.

44
The Perfectly Competitive FirmsShort-Run Supply
Curve

• To see a tutorial on this topic click the
  graph to the right.

45
The Perfectly Competitive FirmsShort-Run Supply
Curve

• The short-run supply curve is that portion of
  the firms marginal cost curve that lies above
  the average variable cost curve.

46
Long-run Equilibrium

• The two conditions necessary for long-run
  equilibrium in a price-taker market are
  depicted here.

• First, the quantity supplied and the quantity
  demanded must be equal in the market, as
  shown below at P1 with output Q1.

• Second, the firms in the industry must earn zero
  economic profit (that is, the normal market
  rate of return) at the established market
  price (P1 below).

P1
q1
Q1
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The Lure of Profits

• In competitive markets, economic profits attract
  new entrants.
• Low entry barriers permit new firms to enter
  competitive markets.
• The entry of new firms shifts the market supply
  curve to the right.
• As long as economic profits are available in
  short-run competitive equilibrium, new entrants
  will continue to be attracted.
• p MC
• Short-run competitive equilibrium

48
A Shift of Market SupplyAny short-run
equilibrium will not last.

• As supply increases, price drops, to the minimum
  of ATC.
• Once at minimum of ATC, there are no longer
  economic profits to attract firms to enter.
• In long-run equilibrium, entry and exit cease,
  and zero economic profit (i.e., normal profit)
  prevails.
• Long-run equilibrium
• p MC minimum ATC

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Short- vs. Long-Run Equilibrium
50
Long-Run Rules for Entry and Exit
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Further Supply Shifts

• With strong competition, often the only way for a
  firm to improve profitability is to reduce costs.
• Cost reductions can be accomplished through
  technological improvements. This might increase
  productivity.
• Technological improvements are illustrated by a
  downward shift of the ATC and MC curves.

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Technology improvements noted below
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Allocative Efficiency

• The market mechanism works best in competitive
  markets.
• Market mechanism - The market mechanism is the
  use of market prices and sales to signal desired
  output.
• Allocative efficiency means that we are producing
  the right output mix.
• The price signal the consumer gets in a
  competitive market is an accurate reflection of
  opportunity cost.

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Production Efficiency

• Production efficiency means that we are producing
  at minimum average total cost.
• Efficiency (production) Maximum output of a
  good from the resources used to produce it.
• When competitive pressure on prices is carried to
  the limit, the products in question are also
  produced at the least possible cost.
• Society is getting the most it can from its
  available (scarce) resources. This market model
  is the best buy for consumers.

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Reality of Attaining a Profit

• The sequence of events common to a competitive
  market situation includes the following.
• High prices and profits signal consumers demand
  for more output.
• Economic profit attracts new suppliers.
• The market supply shifts to the right
• Prices slide down the market demand curve.
• A new equilibrium is reached with increased
  quantities being produced and sold and the
  economic profit approaching zero.
• Producers experience great pressure to keep ahead
  of the profit squeeze by reducing costs.

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Profits Are The Bottom Line