Chapter 13: Perfect Competition

1© 2014 by McGraw-Hill Education 1 Chapter 13 Perfect Competition © 2014 by McGraw-Hill Education 2 What will you learn in this chapter? • What the characteristics of a perfectly competitive market are. • How to calculate average, marginal, and total revenue. • How to find a firm’s optimal quantity of output. • How to differentiate between a firm’s shut down and market exit decisions. • How to analyze a firm’s short-run supply curve for a competitive market. • How to analyze a firm’s long-run supply curve for a competitive market, and what its implications are for profit-seeking firms. • Why a long-run supply curve might slope upward. • What the effect of a demand shift is on a market in long-run equilibrium. © 2014 by McGraw-Hill Education 3 A competitive market • This chapter analyzes how firms make production decisions in a competitive market. • The characteristics of a competitive market are: – Full information exists. – Buyers and sellers are price takers. – The good or service is standardized. – Firms freely enter and exit the market. 2© 2014 by McGraw-Hill Education 4 A competitive market • Competitive markets have so much competition that no one has the ability to affect market prices. Thus, all are price takers. • If a buyer or seller has the ability to noticeably affect market prices, that person/firm has market power. – The only seller of food on a plane can charge a very high price, knowing that some people would be hungry enough to pay it. – The only buyer of food at a market at the end of the day could offer a very low price, knowing that some seller would be willing to sell. • Most sellers and buyers are not able to set their own price, although they may have some ability to set prices. • Participation in a competitive market places very specific constraints on a firm’s ability to maximize profits. © 2014 by McGraw-Hill Education 5 Revenues in a perfectly competitive market In a perfectly competitive market, producers are able to sell as much as they want without affecting the market price. • Price does not change. • Total revenue is price times quantity produced. • Average revenue is total revenue divided by quantity. • Marginal revenue is the change in revenue. • Notice that P = MR = AR. )5()4()3()2()1( Quantity of plantains (bunches) Price (CFA Francs) Total revenue Average revenue (CFA Francs/bunch of plantains) Marginal revenue (CFA Francs) 000,1000,1000,1000,11 000,1000,1000,2000,12 000,1000,1000,3000,13 000,1000,1000,4000,14 000,1000,1000,5000,15 (CFA Francs) © 2014 by McGraw-Hill Education 6 Active Learning: Revenue of a firm in a competitive market Fill in the table for a price taking firm in a competitive market. Quantity Price ($) Total revenue ($) Average revenue ($) Marginal revenue ($) 951 2 3 4 5 3© 2014 by McGraw-Hill Education 7 Profits and production decisions • Firms seek to maximize profits. • In a competitive market, the only choice that a price-taking firm can make to affect profits is the quantity of output to produce. • The profit-maximizing quantity corresponds to the quantity at which marginal revenue is equal to the marginal cost. © 2014 by McGraw-Hill Education 8 Profits and production decisions Profit maximization occurs where MR = MC for a perfectly competitive firm. Quantity of plantains (bunches) Total revenue (CFA Francs) Total cost Profit Marginalrevenue (CFA Francs) Marginal cost (CFA Francs) Marginal profit (CFA Francs 1 2 3 4 5 • Profits are maximized at a quantity of 3 and 4. • At a quantity of 4, MR =MC. (CFA Francs) (CFA Francs) 1,000 2,000 3,000 4,000 5,000 1,200 1,800 2,600 3,600 4,800 -200 200 400 400 200 1,000 1,000 1,000 1,000 1,000 500 600 800 1,000 1,200 500 400 200 0 -200 © 2014 by McGraw-Hill Education 9 Profits and production decisions • Point A: Produce more, as the MR from the next unit is greater than the MC. • Point B: The profit-maximizing quantity is at MR = MC (B). • Point C: Producing at this quantity causes a loss as the MC is greater than the MR. • Rule of thumb: Increase production as long as MR > MC, as total profit increases as another unit is produced. The profit maximizing point can be identified graphically. 0 200 400 600 800 1,000 1,200 1,400 1,600 1,800 1 2 3 4 5 MC Plantains (bunches) Price (CFA Francs) Profit at point C is lower than at point B, because MC is higher than MR. B A C MR Profit at point A is lower than at point B because marginal profit (marginal revenue - positive. Marginal profit stays positive up to point B. marginal cost) is 4© 2014 by McGraw-Hill Education 10 Deciding when to operate Producing the quantity where MR = MC may not always be to the firm’s advantage. Quantity of plantains Total revenue Total cost Profit Marginal revenue Marginal cost Marginal profit 1 800 1,200 -400 800 500 300 2 1,600 1,800 -200 800 600 200 -200 800 800 0 4 3,200 3,600 -400 800 1,000 -200 5 4,000 4,800 -800 800 1,200 -400 3 2,400 2,600 • Even though profit is maximized, it is negative. – Optimal to produce zero output. • If P < ATC, then profits will be negative. (bunches) (CFA Francs) (CFA Francs) (CFA Francs) (CFA Francs(CFA Francs) (CFA Francs) © 2014 by McGraw-Hill Education 11 Deciding when to operate • When deciding the quantity to produce, a firm additionally must decide whether to: – Produce. – Shut-down in the short-run. – Exit the market in the long-run. © 2014 by McGraw-Hill Education 12 Deciding when to operate • When a firm shuts down production, it avoids incurring variable costs. – Fixed costs remain and are sunk in the short-run. – Because fixed costs are sunk, they are irrelevant in deciding whether to shut down in the short-run. • The short-run decision to produce depends on variable costs, not fixed costs. • The long-run decision to produce depends on total cost, since all costs are variable in the long-run. 5© 2014 by McGraw-Hill Education 13 The short-run supply curve and the shutdown rule The short-run shutdown rule is to produce if price is higher than AVC. 1,000 600 0 2 4 MC AVC Plantains (bunches) Price (CFA Francs) 1. Whenever P > AVC the firm will produce along the point where P =MC, its short-run supply curve, because revenue exceeds variable cost. Shutdown point PAbove Short-run supply curve PShutdown 2. However, once the price is below the minimum of the AVC, the firm will not produce because doing so would generate a negative profit © 2014 by McGraw-Hill Education 14 The long-run supply curve and the shutdown rule Since all costs are variable in the long-run, the long-run shutdown rule is to produce only if price is greater than ATC. 1,000 860 0 43.3 MC AVC Plantains (bunches) Price (CFA Francs) PAbove Long-run supplycurve Exit point In the long run, firms will supply only if price is above ATC. When prices are below ATC, the firm will exit the market. PExit ATC © 2014 by McGraw-Hill Education 15 Active Learning: Supply curves and operation decisions Identify the shutdown point, the exit point, and the SR and LR supply curves. 0 MC AVC Quantity Price ATC 6© 2014 by McGraw-Hill Education 16 Firm and market supply curves • The firm’s supply curve is its marginal cost. • The market supply curve is the sum of each firm’s supply curve. Firm supply: one firm 0 200 400 600 1,000 1,200 1,400 1 2 3 4 5 6 Plantains (bunches) Price (CFA Francs) Market supply: 100 firms 0 100 400 500 600 Market supply 300200 Firm supply Price (CFA Francs) Plantains (bunches) 800 200 400 600 1,000 1,200 1,400 800 Below a price of 620, each firm will shut down, resulting in no production. A firm only produces above its AVC. Given a fixed number of firms, the market supply curve is established. © 2014 by McGraw-Hill Education 17 Long-run supply • The key difference between short-run and long-run supply is that firms are able to enter and exit the market in the long run. • If positive economic profits exist: – P > ATC. – New firms enter to gain profits. – The market supply curve shifts outward until P = ATC. – Economic profits go to zero for all firms. • If negative economic profits exist: – P < ATC. – Some firms exit the market. – The market supply curve shifts inward until P = ATC. – Economic profits go to zero for all firms. © 2014 by McGraw-Hill Education 18 Long-run supply • The process of market entry and exit causes firms in a perfectly competitive market to earn zero economic profits in the long run. – In the long-run, price = min(ATC) = MR = MC. – Accounting profits are positive in the long run. – Firms earn an accounting profit to compensate them for their opportunity cost. 7© 2014 by McGraw-Hill Education 19 Long-run supply Because all firms operate at the point where price = min(ATC), firms in a competitive market operate at an efficient scale. 0 MC ATC Plantains (bunches) Price (CFA Francs) MR e Pe Q A firm’s efficient scale is at the quantity where ATC=P=MC. © 2014 by McGraw-Hill Education 20 Long-run supply Given that P = min(ATC), price is the same at any quantity in the long run. Pe 0 Plantains (bunches) Price (CFA Francs) Supply • If anything causes the market equilibrium to move away from this price, the resulting positive or negative profits will cause firms to enter or exit the market until zero economic profits are restored. • The long-run supply curve is horizontal, or perfectly elastic. © 2014 by McGraw-Hill Education 21 Why the long-run market supply curve shouldn’t slope upward, but does • The competitive market theory suggests that the market supply curve should always be perfectly elastic. • Most long-run market supply curves are upward sloping. – This is due to the assumption that all firms have the same cost structure. • If new entrants have a higher cost than existing firms, price must rise sufficiently to entice new firms to enter the market. – Causes the long-run supply curve to be upward sloping. 8© 2014 by McGraw-Hill Education 22 Long-run economic profits • The competitive market theory suggests that all firms should earn zero economic profit in the long-run. • In reality, price = min(ATC) for only the least- efficient firms in the market. – Typically, this is the last firm to enter the market. – More efficient firms with lower ATC earn positive economic profit in the long-run. © 2014 by McGraw-Hill Education 23 2. and average total cost of production 1. Changing variable costs decrease marginal cost of production. Market entry due to changing production costs Improved technology and production capabilities lowers MC and ATC. Pe 0 Qe MC1 ATC1 Plantains (bunches) Price (CFA Francs) MR 3. Minimum ATC drops below the market price, and there is room for firm entry, because whenever ATC < MR, profit is possible MC2 ATC2 • Innovative firms search for better production processes and new technologies that enable them to produce goods at lower cost. - Lowers MC and ATC. • Positive profits entice entrants. • Price falls with production costs. © 2014 by McGraw-Hill Education 24 Responding to shifts in demand Suppose the demand for a perfectly competitive good increases; what happens in the short and long run? Pe Pe 0 Plantains (bunches) 0 Plantains (bunches) D2 S1 SL 1. New firms enter, shifting the supply curve right. S2 2. Equilibrium quantity increases; price returns to long-run equilibrium. Pe 0 D1 S1 SL Plantains (bunches) D2 S1 SL 1. Increase in demand shifts the demand curve right. 2. Equilibrium price and quantity increase. Market is in long-run equilibrium. Higher price causes short-run profits. D1 Market has new long- run equilibrium. 9© 2014 by McGraw-Hill Education 25 Summary • Perfectly competitive markets are defined by: – There is a large number of buyers and sellers. – No one buyer or seller can affect the market price. – There is a standardized good or service. – No barriers to entry exist. • Firms maximize profit by producing at the point where MR = MC. © 2014 by McGraw-Hill Education 26 Summary • Firms are able to enter and exit the market. – If economic profits are positive, firms enter the market and the supply shifts outward until profits are zero. – If economic profits are negative, firms exit the market and the supply shifts outward until profits are zero. • In the long-run: – Firms earn zero economic profits. – Firms operate at their efficient scale. – Supply is perfectly elastic. © 2014 by McGraw-Hill Education 27 Summary • If firms have different costs of production, the long-run supply curve will be upward sloping. • If firms innovate, the cost of production decreases and price decreases as well. • If the demand for a perfectly competitive good increases, then short-run positive profits induce entry of new firms and the supply shifts out, causing a higher quantity of goods to be produced at the same price.