Perfect Competition

insignificant Price taker homogeneous complete information costless no costs equal access barriers to entry/exit competition externalities

Objectives By the end of this lesson you should be able to… Draw and explain the long run equilibrium diagram Draw and explain the diagrams illustrating the moves to l ong run equilibrium following Short run abnormal profits Short run losses

Market Structure Perfect Competition Pure Monopoly Monopolistic CompetitionOligopoly Duopoly Monopoly The further right on the scale, the greater the degree of monopoly power exercised by the firm.

Many small firms each of whom produces an insignificant percentage of total market output and thus exercise no control over the market price P Q O D SP Q O P = D = AR Price takers…so small and so many – individual firms cannot influence price The firm’s demand curve is perfectly e l a s t i c because any firm that raises its prices sees demand fall to zero as consumers, with perfect knowledge, switch to other producers offering an identical product for a better price IndustryFirm

Long run equilibrium P Q O D SP Q O P = D = AR = MR IndustryFirm P1 Q1 MC AC MR=MC Maximum profits Before we look at the market dynamics, lets first understand what the end state looks like…

Long run equilibrium P Q O D SP Q O P = D = AR = MR IndustryFirm P1 Q1 MC AC MR=MC Maximum profits Before we look at the market dynamics, lets first understand what the end state looks like…

Scenarios The firm is making abnormal profits The firm is making losses To get to this end state, there are two possible starting scenarios… Long run Equilibrium Normal profits – that level of profits which is just sufficient to keep resources employed in making a particular product from being used for some other purpose. Any profit in excess of that amount is termed Abnormal or Supernormal

What could cause ‘abnormal’ profits to occur? Economies of scale – lower SRAC…. Innovation – better technology Or…. Major change in fashions…. What does this look like on the 2 split diagram?

SR abnormal profits

What impact would this have on the market? Act as a signal for other competitors to enter the market and produce/sell this product Increase in Supply….

Scenarios The firm is making abnormal profits The firm is making losses To get to this end state, there are two possible starting scenarios… Long run Equilibrium Normal profits – that level of profits which is just sufficient to keep resources employed in making a particular product from being used for some other purpose. Any profit in excess of that amount is termed Abnormal or Supernormal

SR abnormal profits

What impact would this have on the market? Act as a signal for other competitors to enter the market and produce/sell this product Increase in Supply….

Long run equilibrium So in the Long run – the abnormal profits disappear and return to equilibrium. Who benefit s from this?

Abnormal losses…

Long Run Equilibrium So in the Long run – the abnormal losses disappear and return to equilibrium. Who benefit s from this?

Scenarios The firm is making abnormal profits The firm is making losses To get to this end state, there are two possible starting scenarios… Long run Equilibrium New entrants Firms exit the market

Exam skills You will always be expected to be able to explain the effect that abnormal profit or abnormal loss would have on a perfectly competitive industry You need to be able to use both the D&S and the micro diagrams to do this….

Your tasks In your notes….

Show a change from abnormal profit back to equilibrium Use a step by step logic to your answers…. i.e. a list! And label diagrams clearly… Then show the effect of an abnormal loss going back to the equilibrium!

Your extension task…. Read article on Coal Industry

Quick questions…. 1. Which characteristics of perfect competition does the coal market have? 2. Which characteristics does it not meet? If facing a loss, a PC firm might prefer to leave the market than take the losses!

Steel – homework…. To complete for next Wednesday’s lesson Anderton p329 Add these marks to the Q’s – to give you an idea of quantity required in answers…. Q1 = 4 Q2 = 10 Q3 = 6

The firm in short run SUPPLY equilibrium The firm faces constant average and marginal revenue and will choose output at Q1 where MR=MC. If the market price were to change, the firm would react by changing output, but always choosing to supply output at the level at which MR=MC. This suggests that the short-run marginal cost curve represents the firm’s short-run supply curve…the quantity of output that the firm would supply at any given price. P Q O D SP Q O P = D = AR = MR IndustryFirm P1 Q1 MC AC Do not use diagrams

Abnormal profits If the firm is making abnormal profits If abnormal profits are being made in the short run, firms will enter the industry, pushing the supply curve from S1 to Se. At Se firms will no longer be attracted into the industry because they will only be able to make normal profits on their operations. P Q O P = D = AR = MR Firm Q1 MC AC PP Q O D S1 P1 Pe Se Industry Illustration P1 The firm faces constant average and marginal revenue and will choose output at Q1 where MR=MC. If the market price were to change, the firm would react by changing output, but always choosing to supply output at the level at which MR=MC. This suggests that the short-run marginal cost curve represents the firm’s short-run supply curve…the quantity of output that the firm would supply at any given price.

Abnormal profits If the firm is making abnormal profits If abnormal profits are being made in the short run, firms will enter the industry, pushing the supply curve from S1 to S2. At S2 firms will no longer be attracted into the industry because they will only be able to make normal profits on their operations. P Q O P = D = AR = MR Firm Q1 MC AC P Q O D SeP S1 P1 Pe Industry How to draw

Short run– abnormal profits P Q O D SP Q O P = D = AR = MR IndustryFirm P1 Q1 MC AC MR=MC Maximum profits

Perfect Competition Diagrammatic representation Cost/Revenue Output/Sales The industry price is determined by the demand and supply of the industry as a whole. The firm is a very small supplier within the industry and has no control over price. They will sell each extra unit for the same price. Price therefore = MR and AR P = MR = AR MC The MC is the cost of producing additional (marginal) units of output. It falls at first (due to the law of diminishing returns) then rises as output rises. AC The average cost curve is the standard ‘U’ – shaped curve. MC cuts the AC curve at its lowest point because of the mathematical relationship between marginal and average values. Q1 Given the assumption of profit maximisation, the firm produces at an output where MC = MR (Q1). This output level is a fraction of the total industry supply. At this output the firm is making normal profit. This is a long run equilibrium position.

Perfect Competition – Abnormal profits Diagrammatic representation Cost/Revenue Output/Sales P = MR = AR MC AC Q1 Now assume a firm makes some form of modification to its product or gains some form of cost advantage (say a new production method). What would happen? AC1 MC1 AC1 Abnormal profit Q2 Because the model assumes perfect knowledge, the firm gains the advantage for only a short time before others copy the idea or are attracted to the industry by the existence of abnormal profit. If new firms enter the industry, supply will increase, price will fall and the firm will be left making normal profit once again. P1 = MR1 = AR1 The lower AC and MC would imply that the firm is now earning abnormal profit (AR>AC) represented by the grey area. Average and Marginal costs could be expected to be lower but price, in the short run, remains the same.

Plenary – quick on the draw! By the end of this lesson you should be able to… Draw and explain the long run equilibrium diagram Draw and explain the diagrams illustrating the moves to l ong run equilibrium following Short run abnormal profits Short run losses