colander ch11 perfectcompetition (1)

7/29/2019 Colander Ch11 PerfectCompetition (1)

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Perfect Competition

Chapter 11


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Perfect Competition

The concept of competition is used intwo ways in economics.

Competition as a process is a rivalry amongfirms.

Competition as the perfectly competitive

market structure.


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Competition as a Process

Competition involves one firm trying totake away market share from another

firm. As a process, competition pervades the

economy.


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Competition as a MarketStructure

It is possible to imagine something thatdoes not exist a perfectly competitive

market in which the invisible hand worksunimpeded.


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Competition as a MarketStructure

Competition is the end result of thecompetitive process under highly

restrictive assumptions. A perfectly competitive market is one

in which economic forces operate

unimpeded.


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A Perfectly CompetitiveMarket

Aperfectly competitive marketis one inwhich economic forces operate

unimpeded.


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A Perfectly CompetitiveMarket

A perfectly competitive market mustmeet the following requirements:

Both buyers and sellers are price takers. The number of firms is large. There are no barriers to entry. The firms' products are identical. There is complete information. Firms are profit maximizers.


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The Necessary Conditions forPerfect Competition

Both buyers and sellers are price takers. A price taker is a firm or individual who

takes the market price as given. In most markets, households are price

takers they accept the price offered instores.


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Both buyers and sellers are price takers.

The retailer is not perfectlycompetitive.

A store is not a price taker but a price

maker.


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The number of firms is large.

Large means that what one firm does has

no bearing on what other firms do. Any one firm's output is minuscule when

compared with the total market.


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There are no barriers to entry.

Barriers to entryare social, political, or

economic impediments that preventother firms from entering the market.

Barriers sometimes take the form ofpatents granted to produce a certaingood.


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There are no barriers to entry.

Technology may prevent some firms

from entering the market. Social forces such as bankers only

lending to certain people may createbarriers.


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The firms' products are identical.

This requirement means that each firm's

output is indistinguishable from anycompetitor's product.


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There is complete information.

Firms and consumers know all there is to

know about the market prices,products, and available technology.

Any technological advancement would beinstantly known to all in the market.


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Firms are profit maximizers.

The goal of all firms in a perfectly

competitive market is profit and onlyprofit.

Firm owners receive only profit ascompensation, not salaries.


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The Definition of Supply andPerfect Competition

If all the necessary conditions forperfect competition exist, we can talk

formally about the supply of a producedgood.

This follows from the definition of

supply.


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Supplyis a schedule of quantities ofgoods that will be offered to the market

at various prices.


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This definition requires the supplier tobe a price taker (the first condition for

perfect competition). Since most suppliers are price

makers, any analysis must be modified

accordingly.


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Because of the definition of supply, ifany of the conditions are not met, the

formal definition of supply disappears.


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That the number of suppliers be large(the second condition), means that they

do not have the ability to collude.


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Conditions 3 through 5 make itimpossible for any firm to forget about

the hundreds of other firms just itchingto replace their supply.

Condition 6 specifies a firm's goal

profit.


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Even if we cannot technically specify asupply function, supply forces are still

strong and many of the insights of thecompetitive model can be applied to firmbehavior in other market structures.


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Demand Curves for the Firmand the Industry

The demand curves facing the firm isdifferent from the industry demand

curve. A perfectly competitive firms demand

schedule is perfectly elastic even though

the demand curve for the market isdownward sloping.


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Demand Curves for the Firmand the Industry

This means that firms will increase theiroutput in response to an increase in

demand even though that will cause theprice to fall thus making all firmscollectively worse off.


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Market supply

Marketdemand1,000 3,000

Price

$108

6

42

0Quantity

Market Firm

Individual firmdemand

Market Demand Versus IndividualFirm Demand Curve

10 20 30

Price

$108

6

42

0Quantity


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Profit-Maximizing Level ofOutput

The goal of the firm is to maximizeprofits.

When it decides what quantity toproduce it continually asks how changesin quantity affect profit.


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Since profit is the difference betweentotal revenue and total cost, what

happens to profit in response to a changein output is determined by marginalrevenue (MR) and marginal cost (MC).

A firm maximizes profit when MC= MR.


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Marginal revenue(MR) the change intotal revenue associated with a change in

quantity. Marginal cost(MC) -- the change in

total cost associated with a change in

quantity.


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Marginal Revenue

Since a perfect competitor accepts themarket price as given, for a competitive

firm, marginal revenue is price (MR = P).


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Marginal Cost

Initially, marginal cost falls and thenbegins to rise.

Marginal concepts are best definedbetween the numbers.


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How to Maximize Profit

To maximize profits, a firm shouldproduce where marginal cost equals

marginal revenue.


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If marginal revenue does not equalmarginal cost, a firm can increase profit

by changing output. The supplier will continue to produce

as long as marginal cost is less than

marginal revenue.


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The supplier will cut back on productionif marginal cost is greater than marginal

revenue. Thus, the profit-maximizing condition

of a competitive firm is MC = MR = P.


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C

A

P = D = MR

Costs

1 2 3 4 5 6 7 8 9 10 Quantity

60

5040

30

20

10

0

A

B

MC

Marginal Cost, MarginalRevenue, and Price

0123456

789

10

$28.00

20.0016.0014.0012.0017.0022.0030.0040.0054.0068.00

Price = MR QuantityProduced

MarginalCost

$35.0035.0035.0035.0035.0035.0035.00

35.0035.0035.0035.00


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The Marginal Cost Curve Is theSupply Curve

The marginal cost curve is the firm'ssupply curve above the point where price

exceeds average variable cost.


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The Marginal Cost Curve Is theSupply Curve

The MC curve tells the competitive firmhow much it should produce at a given

price. The firm can do no better than

producing the quantity at which

marginal cost equals price which inturn equals marginal revenue.


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The Marginal Cost Curve Is theFirms Supply Curve

A

B

CMarginal cost

Cost,Price

$70

60

50

40

30

2010

0 1 Quantity2 3 4 5 6 7 8 9 10


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Firms Maximize Total Profit

When we speak of maximizing profit, werefer to maximizing total profit, not

profit per unit. Firms do not care about profit per unit;

as long as an increase in output will

increase total profits, a profit-maximizing firm should increase output.

f


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Profit Maximization UsingTotal Revenue and Total Cost

Profit is maximized where the verticaldistance between total revenue and total

cost is greatest. At that output, MR(the slope of the

total revenue curve) and MC(the slope

of the total cost curve) are equal.

P f D


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TC TR

0

Tot

alcost,reve

nue

$385350

315280245210175140105

7035

Quantity1 2 3 4 5 6 7 8 9

Profit Determination UsingTotal Cost and Revenue Curves

Maximum profit =$81

$130

Loss

Loss

Profit

T l P f h P f


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Total Profit at the Profit-Maximizing Level of Output

While the P = MR = MCcondition tells ushow much output a competitive firm

should produce to maximize profit, itdoes not tell us the profit the firmmakes.

D i i P fi d L


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Determining Profit and LossFrom a Table of Costs

Profit can be calculated from a table ofcosts and revenues.

Profit is determined by total revenueminus total cost.

D i i P fi d L


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Determining Profit and LossFrom a Table of Costs

The profit-maximizing position is notnecessarily a position that minimizes

either average variable cost or averagetotal cost.

It is only the position that maximizes

total profit.


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P = MR Output Total Cost

MarginalCost

AverageTotal Cost

TotalRevenue

ProfitTR-TC

0 40.00 0 40.00

35.00 1 68.00 28.00 68.00 35.00 33.00

35.00 2 88.00 20.00 44.00 70.00 18.00

35.00 3 104.00 16.00 34.67 105.00 1.00

35.00 4 118.00 14.00 29.50 140.00 22.0035.00 5 130.00 12.00 26.00 175.00 45.00

35.00 6 147.00 17.00 24.50 210.00 63.00

Costs Relevant to a Firm


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P = MR Output Total Cost

Marginal

Cost

Average

Total Cost

Total

Revenue

Profit

TR-TC

35.00 4 118.00 14.00 29.50 140.00 22.00

35.00 5 130.00 12.00 26.00 175.00 45.00

35.00 6 147.00 17.00 24.50 210.00 63.00

35.00 7 169.00 22.00 24.14 245.00 76.00

35.00 8 199.00 30.00 24.88 280.00 81.0035.00 9 239.00 40.00 26.56 315.00 76.00

35.00 10 293.00 54.00 29.30 350.00 57.00

Costs Relevant to a Firm

D t i i P fit d L


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Determining Profit and LossFrom a Graph

Find output where MC = MR.

The intersection of MC = MR(P)

determines the quantity the firm willproduce if it wishes to maximize profits.

D t i i P fit d L


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Determining Profit and LossFrom a Graph

Find profit per unit where MC = MR.

To determine maximum profit, you

must first determine what output thefirm will choose to produce.

See where MC equals MR, and then

drop a line down to the ATC curve. This is the profit per unit.


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Z P fit L Wh


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Zero Profit or Loss WhereMC=MR

Firms can also earn zero profit or even aloss where MC = MR.

Even though economic profit is zero, allresources, including entrepreneurs, arebeing paid their opportunity costs.

Z P fit L Wh


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Zero Profit or Loss WhereMC=MR

In all three cases (profit, loss, zeroprofit), determining the profit-

maximizing output level does not dependon fixed cost or average total cost, byonly where marginal cost equals price.


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The Shutdown Point

The firm will shut down if it cannot coveraverage variable costs.

A firm should continue to produce as long asprice is greater than average variable cost.

Once price falls below that point it makessense to shut down temporarily and save thevariable costs.


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The Shutdown Point

The shutdown pointis the point at whichthe firm will gain more by shutting down

than it will by staying in business.


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The Shutdown Point

As long as total revenue is more thantotal variable cost, temporarily

producing at a loss is the firms beststrategy since it is taking less of a lossthan it would by shutting down.


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MC

P = MR

2 4 6 8 Quantity

Price

60

50

40

30

20

10

0

ATC

AVC

Loss

A$17.80

The Shutdown Decision

Sh t R n M k t S ppl nd


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Short-Run Market Supply andDemand

While the firm's demand curve isperfectly elastic, the industry's is

downward sloping. For the industry's supply curve we use a

market supply curve.

Short Run Market Supply and


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In the short run when the number offirms in the market is fixed, the market

supply curve is just the horizontal sum ofall the firms' marginal cost curves,taking account of any changes in inputprices that might occur.

Short Run Market Supply and


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Since all firms have identical marginalcost curves, a quick way of summing the

quantities is to multiply the quantitiesfrom the marginal cost curve of arepresentative firm by the number offirms in the market.

Long Run Competitive


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Long-Run CompetitiveEquilibrium

Profits and losses are inconsistent withlong-run equilibrium.

Profits create incentives for new firmsto enter, output will increase, and theprice will fall until zero profits are made.

Only zero profit will stop entry.



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The existence of losses will cause firmsto leave the industry.

Zero profit condition is therequirement that in the long run zeroprofits exist.

The zero profit condition defines thelong-run equilibrium of a competitiveindustry.



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Zero profit does not mean that theentrepreneur does not get anything for

his efforts.



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In order to stay in business theentrepreneur must receive his

opportunity cost or normal profits theowners of business would have receivedin the nest-best alternative.



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Normal profitsare included as a costand are not included in economic profit.

Economic profits are profits abovenormal profits.



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Even if some firm has super-efficientworkers or machines that produce rent,

it will not take long for competitors tomatch these efficiencies and drive downthe price.

Rentis an income received by aspecialized factor of production.



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The zero profit condition is enormouslypowerful.

It makes the analysis of competitivemarkets far more applicable to the realworld than can a strict application of theassumption of perfect competition.



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MC

P = MR

0

60

50

40

30

2010

Price

2 4 6 8 Quantity

SRATC LRATC

Adjustment from the Long Run


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Adjustment from the Long Runto the Short Run

Industry supply and demand curves cometogether to lead to long-run equilibrium.


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An Increase in Demand

An increase in demand leads to higherprices and higher profits.

Existing firms increase output and newfirms will enter the market, increasingoutput still more, price will fall until all

profit is competed away.


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If the the market is a constant-costindustry, the new equilibrium will be at

the original price but with a higheroutput.

A market is a constant-cost industry

if the long-run industry supply curveis perfectly elastic.


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The original firms return to theiroriginal output but since there are more

firms in the market, the total marketoutput increases.


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In the short run, the price does more ofthe adjusting.

In the long run, more of theadjustment is done by quantity.

Market Response to an


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Profit$9

10 120

FirmPrice

Quantity

B

A

Market Response to anIncrease in Demand

Market

Quantity

Price

0

B

A

C

MC

AC

SLR

S0SR

D0

7

700

$9

8401,200

D1

S1SR

7


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Long-Run Market Supply

Two other possibilities exist: Increasing-cost industry factor prices

rise as new firms enter the market andexisting firms expand capacity.

Decreasing-cost industry factor pricesfall as industry output expands.


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An Increasing-Cost Industry

If inputs are specialized, factor pricesare likely to rise when the increase in

the industry-wide demand for inputs toproduction increases.


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This rise in factor costs would forcecosts up for each firm in the industry

and increases the price at which firmsearn zero profit.


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Therefore, in increasing-cost industries,the long-run supply curve is upward

sloping.


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A Decreasing-Cost Industry

If input prices decline when industryoutput expands, individual firms'

marginal cost curves shift down and thelong-run supply curve is downwardsloping.


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A Real World Example

Owners of the Ames chain ofdepartment stores decide to close over

100 stores after experiencing two yearsof losses (a shutdown decision).


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Initially, Ames thought the losses weretemporary.

Since price exceeded averagevariable cost, it continued to produceeven though it was losing money.


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After two years of losses, itsprospective changed.

The company moved from the shortrun to the long run.


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They began to think that demand was nottemporarily low, but permanently low.

At that point they shut down thosestores for which P < AVC.

A Real World Example:


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Price

Quantity

MC

ATC

AVC

P = MR

Loss

A Real World Example:A Shutdown Decision


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Perfect CompetitionEnd of Chapter 11


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colander ch11 perfectcompetition (1)

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