©2012 the mcgraw-hill companies, all rights reserved 1 chapter 7: perfect competition
TRANSCRIPT
©2012 The McGraw-Hill Companies, All Rights Reserved
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Chapter 7: Perfect Competition
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Learning Objectives
1. Determine a perfectly competitive firm’s profit-maximizing output level and profit in the short run.
2. Show how economic profit and economic loss affect the allocation of resources across industries.
3. Explain the difference between economic profit and economic rent.
4. Use the theory of the invisible hand to analyze events in everyday life.
5. Understand and explain the relationship between a market equilibrium and a social optimum.
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Competition
In the previous chapter we learned that the average total cost facilitates the profit-maximizing firm’s assessment of profitability
This process, however, varies across different market structures Market structures are usually defined by
their level of competition How competitive is a market? Is a firm operating alongside others or
alone?
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Perfectly (Pure) Competitive Market
Perceived as unrealistic Provides a benchmark in evaluating other
market structuresCharacteristics of a perfectly
competitive market1.All firms sell the same standardized
product2.The market has many buyers and sellers,
each of which buys or sells only a small fraction of the total quantity exchanged
3.Productive resources are mobile4.Buyers and sellers are well informed
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Perfectly (Pure) Competitive Market
All firms sell the same standardized product Implies that buyers are willing to switch
from one seller to another
The market has many buyers and sellers, each of which buys or sells only a small fraction of the total quantity exchanged Implies that individual buyers and sellers
will be price takers
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Perfectly (Pure) Competitive Market
Productive resources are mobile Implies that sellers are able to obtain
labor, capital, and other productive resources necessary to enter or leave a market
Buyers and sellers are well informed Implies that buyers and sellers are
aware of the relevant opportunities available to them
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Profit-Maximizing Firms in Perfectly Competitive Markets
Supply Curves Most goods and services are
produced by private firms A profit-maximizing firm ‘s primary goal is
maximize profit• Profit = TR – TC
This primary goal + operating in a perfectly competitive market define the standard supply curves that we know and use
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Profit-Maximizing Firms in Perfectly Competitive Markets
Demand Curves How does a demand curve for a firm look like? Demand is perfectly elastic horizontal
Each firm can sell as much as it wants at the market price
Each firm is a price taker
A perfectly competitive firm has no control over the price
Its challenge becomes: what output level will allow it to maximize its profit taken into consideration a fixed price?
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Perfectly Competitive Firm's Demand
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Price = Marginal Cost: The Maximum Profit Condition
Assume that firm produces 200 bottles a day By producing the 201st bottle the firm will
increase its profit by 20 10 = 10 cents per day
Assume that firm produces 300 If the firm then
contracted its output by 1 it would cut its costs by 30 cents while losing only 20 cents in revenue
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Price = Marginal Cost: The Maximum Profit Condition
At a price of $0.20, the firm produces 260 bottles
Profit is TR – TC TR = 0.2 * 260 = $52 TC = 0.12 * 260 = $31.2
Profit is $52 - $31.2 = $20.8
Note that the minimum value of the firm’s AVC curve is $0.07 If the price falls below 7
cents the firm would shut down in the SR
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Price = Marginal Cost: The Maximum Profit Condition
Firms might be earning losses instead
When P < ATC, the firm loses (P – ATC) per unit of output
Total losses are the rectangle whose height is ATC – P and whose width is Q
Losses = (ATC – P) (Q)($0.10 – $0.08) (180) = $3.60
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Responses to Profits and Losses
If a firm is covering its variable cost, it can stay in the market in the SR
If a firm would like to stay in the market in the LR, it must cover all costs: explicit and implicit costs
A firm that earns no more than a normal profit has managed only to cover the opportunity cost of the resources
A firm that makes a positive economic profit earns more than the opportunity cost of the invested resources
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Responses to Profits and Losses
Markets in which firms are earning an economic profit tend to attract additional resources More firms want to enter the market Market supply is expected to increase
Markets in which firms are experiencing economic losses tend to lose resources Firms want to leave the market Market supply is expected to decrease
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Responses to Economic Profits
Markets with excess profits attract resources
P2
Quantity (000s of bushels/year)
Price $/bu MC
130
ATC
1.20
Typical Corn FarmPrice $/bu
2
Quantity (M of bushels/year)
S
D
65
Corn Industry
Economic Profit:
$104,000
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Shrinking Economic Profits
Supply increases
P
Quantity (000s of bushels/year)
Price $/bu MC
130
ATC
Typical Corn FarmPrice $/bu
2
Quantity (M of bushels/year)
S
D
65
Corn Industry
Economic Profit:
$50,400
S'
1.50
95 120
1.08
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Market Equilibrium
Zero economic profits
P
Quantity (000s of bushels/year)
Price $/bu MC
130
ATC
Typical Corn FarmPrice $/bu
2
Quantity (M of bushels/year)
S
D
65
Corn Industry
S'
1.50
115
1
S"
90
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Responses to Profits
The initial equilibrium price was above the minimum value of ATC, giving rise to positive economic profits Incentive for other firms to enter the market Supply increases Equilibrium price decreases until the
incentive to enter the market disappear P = minimum AVC
What if the price went below the minimum AVC?
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Economic Losses
Resources leave
1.05
Quantity (M of bushels/year) Quantity (000s of bushels/year)70
0.75 P
90
ATCMC
S
D
60
Price
$/bu
0.75
Price
$/bu
Typical Corn FarmCorn Industry
Economic Loss:
$21,000
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Market Equilibrium
No economic losses
Quantity (M of bushels/year) Quantity (000s of bushels/year)70
0.75P
90
ATCMC
S
D
60
Price
$/bu
Price
$/bu
1
S'
40
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Responses to Losses
Condition: P > minimum AVC TR = 0.75 * 70 = $52,500 TC = 1.05 * 70 = $73,500
Total losses = $21,000 Incentive for some firms to leave the
market Supply decrease Price increase until incentive to leave the
market disappear
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Responses to Profits and Losses
Assumptions Firms are free to enter and leave the
market Inputs can be purchased in any quantities
at fixed prices All firms employ similar standardized
production methods
Final outcome: zero economic profit Do firms want zero economic profit?
The zero economic profit is a consequence of price movements following entry and exit of firms
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Long Run Equilibrium
The fact that a new firm could enter or leave the market at any time means Production can always be augmented or
reduced in the long run at a cost of $1 per bushel
Long run supply curve us horizontal at $1 = min AVC
Both long run MC and long run ATC are constant at $1
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Long Run Equilibrium
In the long run, corn costs $1/bu regardless of the size of the industry
Quantity (M of bushels/year) Quantity (000s of bushels/year)
1.00
D
S P
MC ATCPrice $/bu
Price $/bu
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Long Run Equilibrium
Two attractive features of perfect competition long run equilibrium Market outcome is efficient in the long
run The value to buyers of the last unit is $1
per bushel, which is exactly the same as the long-run marginal cost of producing it
Market outcome can be described as fair
Buyers pay the cost incurred by suppliers
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Applied Example: Too many stylists and too few aerobics instructors
Initial equilibrium: All suppliers
are currently earning zero economic profit
What if preferences change?
Longer hair and increased physical fitness
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Short-Run AdjustmentsP
rice
($/
ha
ircu
t)
Haircuts/day Classes/day
Pri
ce (
$/cl
ass
)S
D
500
15
200
10
D
S
350
15
D'
12D'
300
Haircut Market Aerobics Market
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Short-Run Adjustments
MCH
QH
ATCH
Pric
e ($
/hai
rcut
)
Q'H
15.50
12
Economicloss
MCA
QA
ATCA
Pric
e ($
/cla
ss)
Q'A
15
11
Economicprofit
Typical Hair Salon Typical Aerobics Studio
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Short-Run Adjustments
Because of change in preferences Demand shifts in each market Haircut market lower equilibrium price
economic losses some hair salons exit the market price goes back to original equilibrium but now with lower equilibrium quantity
Aerobics market higher equilibrium price economic profits some Aerobics studios enter the market price goes down to original equilibrium but now with higher equilibrium quantity
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The Importance of Free Entry and Exit
From previous examples we have seen that entry and exit of firms play a crucial role in the final outcome of the market
Barrier to entry: any force that prevents firms from entering a new industry
Legal constraints / Practical factorsNo less important than the freedom to
enter a market is the freedom to leave Firms discover that if a market is difficult to
leave, they become reluctant to enter new markets
Barriers to exit thus become barriers to entry
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Economic Rent
Economic profits tend toward zero, yet people get rich How is that possible? Distinction between economic rent and
profitEconomic rent is the portion of a
payment to a factor of production that exceeds the owner's reservation price The case of the talented chef
Unique talent for cooking In equilibrium, pay the chef the increase in
revenue from his talent
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Economic Rent: Talented Chef
Assume: a city has 100 restaurants / 99 have “normal chefs” and 1 has a “talented chef” Each chef receives $30,000 yearly salary The 100th restaurant can charge 50% more
for each meal The 99 restaurants each earn $300,000 in TR
per year (ensuring a zero economic profit) The 100th restaurant’s TR is 50% more
$450,000 How much is the 100th restaurant willing to
pay the “talented chef”?
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Economic Rent: Talented Chef
Competition will ensure that the “talented chef's” pay is $180,000 per year $30,000 = what would he make from other
restaurants $150,000 = profit attributed to the “talented
chef” As such, $150,000 = economic rent to the “talented
chef” The owner of the 100th restaurant will earn zero
economic profit
What if the owner of the 100th restaurant paid $60,000 to the “talented chef” and kept the remaining $120,000 as profits?
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Invisible Hand
Adam Smith argued that although the entrepreneur “intends only his own gain,” he is “led by an invisible hand to promote an end which was no part of his intention.”
As Smith saw it, even though self-interest is the prime mover of economic activity, the end result is an allocation of goods and services that serves society’s collective interests remarkably well.
The invisible hand, in short, is about all the good things that can happen because of the Incentive Principle
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Invisible Hand in the Supermarket
Short check-out lines get longer – quickly Information is freely available
Start in the shortest line Observe the pace of all lines Decide whether to switch Most shoppers would do the same,
the short line seldom remains shorter for long
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Invisible Hand and Cost-Saving Innovations
Competitive firms are price takers Cost management required
Innovation lowers cost for one firm Profits increase by amount of cost savings Information is freely available
Industry costs decrease Equilibrium price decreases by amount of
costs savings No excess profits
Competition among firms ensures that the resulting cost savings will be passed along to consumers in the long run
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Shipping Innovation: Example
40 companies compete in trans-Atlantic shipping Cost per trip is $500,000
One firm innovates to save $20,000 in fuel per trip Short-run economic profit
Over time, competitors copy the innovation Industry costs decrease by $20,000 Equilibrium price decrease by $20,000
In the long run, no firm earns excess profits
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Invisible Hand in an Istanbul Cab: Regulated
Market Istanbul regulates the number of cabs
Issues a limited number of licenses Allows licenses to be bought and sold
privatelyUnregulated market has 15,000 cabs
and each costs $25,000City issues 13,000 licenses
Price of a cab $28,000With restricted supply, price
of a cab ride goes up Cabs make excess profits
13
SR
28
Pric
e (0
00s$
/cab
)
Cabs (000s cabs)15
D
S
25
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Value of a Taxi License
Total costs of operation are $40,000 per year plus cost of license
Total revenue is $60,000 per year $20,000 per year implicit cost of license
ownershipFind the amount you would pay today
to receive $20,000 per year forever Depends on the interest rate
At 6% interest, the value of a license is $333,333
If the license sells for $333,333, there are no excess profits from operating a cab
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Invisible Hand and Irrigation Program
Textile workers and tenant farmers each earn $8,000
Government program doubles revenue Short-term economic profits Land rents increase as farmers enter
industry Program benefits only land owners in the
long run and not farmers
LandOther
Explicit Costs
Normal Profit
Total Revenue
Economic Profit
Before $5,000 $3,000 $8,000 $16,000 $0
Short Run $5,000 $3,000 $8,000 $32,000 $16,000
Long Run $21,000 $3,000 $8,000 $32,000 $0
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Invisible Hand and Socially Optimal Outcome
There are only three ways to earn a big payoff: To work especially hard To have some unusual skill, talent, or training To be lucky
Markets work best when Buyers' marginal benefits = sellers' marginal
costsAND
Society's marginal benefits = society's marginal costs
Individual behavior may benefit the individual more than it does for the society