Chapter 22: Perfect Competition

Chapter Objectives The characteristics of perfect competition The perfect competitor’s demand curve The short run and and the long run Economic and accounting profits Decreasing, constant, and increasing cost industries

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Chapter 22Perfect CompetitionCopyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.22-122-2Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Chapter ObjectivesThe characteristics of perfect competitionThe perfect competitor’s demand curveThe short run and and the long runEconomic and accounting profitsDecreasing, constant, and increasing cost industries 22-3Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Perfect CompetitionIs the first of four competitive modesIt is a theoretical model that does not exist in the real worldThis will serve as the standard by which we will measure the next three competitive modelsMonopolyMonopolistic CompetitionOligopoly Definition of Perfect CompetitionThere are so many firms that no one firm is large enough to influence priceEither by withholding output from the market or by increasing its outputThe firms are selling an identical productA product is identical, in the minds of the buyers, if they have no reason to prefer one seller over another22-4Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Definition of Perfect CompetitionThe market has perfect mobilityNo barriers to entry such as licenses, long-term contracts, government franchises, patents, control over vital resources, etc.One possible exception is moneyPerfect knowledge about the market existEveryone knows about every possible economic opportunity22-5Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.22-6Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor’s Demand CurveThe intersection of the industry supply and demand curve set the price that is taken by the individual firm, in this case $622-7Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor’s Demand CurveThe perfect competitor faces a horizontal , or perfectly elastic, demand curveA firm with a perfectly elastic demand curve has an identical MR curve (MR=P)22-8Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor’s Demand CurveThe perfect competitor has to take the market price (it is a price taker!)22-9Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor’s Demand CurveWhy is the individual firm’s demand curve flat instead of sloping down to the right? The individual firm’s output is between 0 & 30 units. The industry’s output in the millions. It is impossible for the individual firm to increase output enough to change the price even one cent. Theoretically, the individual firm’s demand curve slopes down and to the right ever so slightly. But we can’t see the slope, so we draw it horizontally and consider it perfectly elastic30/4,000,000 = .00000757510,000,00022-10Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor in the Short RunIn the short run the perfect competitor may make a profit or lose money22-11Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor in the Short RunIs this firm making a profit or losing money?Answer: Losing money because the D,MR curve is below the ATC curve22-12Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor in the Short RunHow much money is this firm losing?Price = $6ATC = $8.50Output = $8TP = ( P – ATC) X OutputTP = ($6 - $8.50) X 8TP = -$2.50 X 8TP = - $2022-13Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor in the Short RunIs this firm making a profit or losing money?Answer: Making a profit because the D,MR curve is above the ATC curve22-14Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor in the Short RunOutput = $11ATC = $8.10Price = $10TP = ( P – ATC) X OutputTP = ($10 - $8.10) X 11TP = $1.90 X 11TP = $20.9022-15Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor in the Long RunIn the long run the perfect competitor breaks evenSince the ATC curve lives above the demand curve, the firm is losing money at a price of $6. How do we then get to the long run where the firm is breaking even?22-16Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Going from Taking a Loss in the Short Run to Breaking Even in the Long Run At a price of $6 the firm is losing money and so, too, are all the other firms in the industry22-17Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Going from Taking a Loss in the Short Run to Breaking Even in the Long Run Some firms leave the industry in the long run pushing the supply down from S1 to S222-18Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Going from Taking a Loss in the Short Run to Breaking Even in the Long Run This pushes the industry price up to $8. At this price the firm breaks even.22-19Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Going from Making a Profit in the Short Run to Breaking Even in the Long Run At a price of $10 all firms in the industry are making a profit22-20Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Going from Making a Profit in the Short Run to Breaking Even in the Long Run New firms are attracted into the industry. This increases supply moving the supply curve from S1 to S222-21Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Going from Making a Profit in the Short Run to Breaking Even in the Long Run This reduces the industry price to $8, at which the firms break even22-22Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor in the Long RunIn the long run the firm breaks evenThe ATC curve is tangent to the demand curve at the point where MC = MR.ATC will equal price at the break-even point (the minimum point on the ATC curve)Price = ATCThe most profitable level of output is 11.122-23Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.The Perfect Competitor in the Long RunPrice = ATCThe most profitable level of output is 11.1A firm operates at peak efficiency when it produces at the minimum point of its ATC. For the perfect competitor in the long run, the most profitable output is at the minimum point of its ATC because this is also where MC=MREfficiencyA firm operates at peak efficiency when it produces at the lowest possible costThat would be the minimum point of its ATC curve ( the break-even point)For the perfect competitor in the long run, the most profitable output is at the minimum point of is ATC curve because this will be where MC=MRBecause of the degree of competition, the perfect competitor is forced to operate at peak efficiencyOther forms of competition do not force firms to operate at peak efficiency22-24Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Economic and Accounting Profits22-25Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Accounting profits are what is left over from sales (revenue) after a firm has paid all of its explicit costExplicit cost is the cost of doing business rent, wages, cost of goods sold, fuel, taxes, etc. Sales $200,000- Explicit cost 115,000 Accounting Profit 85,000 Economic and Accounting Profits22-26Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Accounting profit $ 85,000- Explicit cost 85,000 Economic Profit 0 Economic profits are what is left over from accounting profits after a firm has subtracted its implicit costImplicit cost are a firm’s opportunity costthe opportunity cost of any choice is the forgone value of the next best alternative Suppose you have invested $100,000 of your own money in your business. You could have earned $15,000 interest on this money. Instead of you and your spouse working 12 hours a day , seven days a week, you both could have earned $70,000 working for some one else. ($15,000 + $70,000 = $85,000 implicit cost) Why stay in business if your economic profits are zero?You are still making accounting profitsYou wouldn’t do any better if you invested your money elsewhere and worked for someone elseYou are your own boss by having your own business22-27Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Economic and Accounting Profits22-28Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Economic and Accounting ProfitsWhen economic profits become negative, particularly if those losses are substantial and appear they may be permanent, more and more people will close their businessThey will go to work for some one elseThey will go into a different businessMarket supply decreases and forces prices upThis process continues until people stop getting out22-29Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Economic and Accounting ProfitsWhen economic profits become negative, particularly if those losses are substantial and appear they may be permanent, more and more people will close their businessThey will go to work for some one elseThey will go into a different businessMarket supply decreases and forces prices upThis process continues until people stop getting outS1S2P2P122-30Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Economic and Accounting ProfitsWhen there are economic profits (short run) more people are attracted into this type of businessMarket supply increases and forces prices downThis process continues until people stop getting inEconomic profits are zero at this point (long run)No one else wants to enter or leave22-31Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Economic and Accounting ProfitsWhen there are economic profits (short run) more people are attracted into this type of businessMarket supply increases and forces prices downThis process continues until people stop getting inEconomic profits are zero at this point (long run)No one else wants to enter or leaveS2S1P2P122-32Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Decreasing, Constant, and Increasing Cost IndustriesDecreasing cost industries are characterized by firms operating on the declining segments of their ATC curvesThey can take advantage of economies of scale (discounts for buying larger quantities, declining AFC as output expands, lower cost from specialization, etc.)22-33Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Decreasing, Constant, and Increasing Cost IndustriesConstant cost industries are where ATC does not change as output expandsEconomies of scale & diseconomies of scale are in balance (improvements in technology can help keep cost declining as output expands; improvements in production processes can increase quality and lower cost at the same time) 22-34Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Decreasing, Constant, and Increasing Cost IndustriesIncreasing cost industries are where diseconomies of scale overwhelm economies of scale.Examples of diseconomies of scale are managerial inefficiencies (the cost of maintaining a huge bureaucracy, increased difficulties of communication, duplication and waste, etc.)22-35Copyright 2002 by The McGraw-Hill Companies, Inc. All rights reserved.Decreasing, Constant, and Increasing Cost IndustriesFactor cost - wages, rent, and interest - are by far the most important determinants of whether cost are falling, constant, or increasingUsually, factor cost will eventually rise, which ultimately makes every industry an increasing cost industry (but the range of output within which they often operate is one of decreasing or constant cost)