Perfect Competition Dr Monika Jain

MARKETS AND COMPETITION A market is a group of buyers and sellers of a particular good or service. The terms supply and demand refer to the behavior of people . . . as they interact with one another in markets. 4

MARKETS AND COMPETITION Buyers determine demand. Sellers determine supply 4

ALTERNATIVE MARKET STRUCTURES Classifying markets by degree of competition number of firms freedom of entry to industry nature of product nature of demand curve The four market structures perfect competition monopoly monopolistic competition oligopoly 2

Market Structure More competitive (fewer imperfections) Perfect Competition Pure Monopoly More competitive (fewer imperfections)

Less competitive (greater degree of imperfection) Market Structure Perfect Competition Pure Monopoly Less competitive (greater degree of imperfection)

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

Market Structure Importance: Degree of competition affects the consumer – will it benefit the consumer or not? Impacts on the performance and behaviour of the company/companies involved

Competitive Markets A competitive market is a market in which there are many buyers and sellers so that each has a negligible impact on the market price. 5

Competition: Perfect and Otherwise Perfect Competition Products are the same Numerous buyers and sellers so that each has no influence over price Buyers and Sellers are price takers Monopoly One seller, and seller controls price 6

Competition: Perfect and Otherwise Oligopoly Few sellers Not always aggressive competition Monopolistic Competition Many sellers Slightly differentiated products Each seller may set price for its own product 6

Features of the four market structures

Perfect Competition

A Perfectly Competitive Market A perfectly competitive market must meet 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.

The Meaning of Competition As a result of its characteristics, the perfectly competitive market has the following outcomes: The actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given. Thus, each buyer and seller is a price taker.

Two Necessary Conditions for Perfect Competition For an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share. A producer’s market share is the fraction of the total industry output accounted for by that producer’s output. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent. A good is a standardized product, also known as a commodity, when consumers regard the products of different producers as the same good.

Total, Average, and Marginal Revenue for a Competitive Firm

Market Demand Versus Individual Firm Demand Curve Market supply 1,000 3,000 Price $10 8 6 4 2 Quantity 10 20 30 Price $10 8 6 4 2 Quantity Market demand Individual firm demand

Demand curve facing a single firm no individual firm can affect the market price demand curve facing each firm is perfectly elastic

Profit-Maximizing Level of Output The goal of the firm is to maximize profits. Profit is the difference between total revenue and total cost.

Profit-Maximizing Level of Output Marginal revenue (MR) – the change in total revenue associated with a change in quantity. Marginal cost (MC) – the change in total cost associated with a change in quantity.

Marginal Revenue A perfect competitor accepts the market price as given. As a result, marginal revenue equals price (MR = P). Thus, the profit-maximizing condition of a competitive firm is MC = MR = P.

Marginal Cost Initially, marginal cost falls and then begins to rise. Marginal concepts are best defined between the numbers.

The Marginal Cost Curve Is the Supply Curve The marginal cost curve is the firm's supply curve above the point where price exceeds average variable cost.

The Marginal Cost Curve Is the Supply Curve The MC curve tells the competitive firm how 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 in turn equals marginal revenue.

Profit Maximization: MC = MR To maximize profits, a firm should produce where marginal cost equals marginal revenue.

How to Maximize Profit If marginal revenue does not equal marginal 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.

How to Maximize Profit The supplier will cut back on production if marginal cost is greater than marginal revenue. Thus, the profit-maximizing condition of a competitive firm is MC = MR = P.

Short-run equilibrium of industry and firm under perfect competition AC MC P £ S D AR D = AR = MR Pe AC O O Qe Q (millions) Q (thousands) (a) Industry (b) Firm

Loss minimising under perfect competition AC MC P £ S AC D1 = AR1 = MR1 AR1 Qe P1 D O O Q (millions) Q (thousands) (a) Industry (b) Firm

The Shutdown Point The shutdown point is the point at which the firm will be better off it it shuts down than it will if it stays in business.

Short-run shut-down point AVC P £ AC MC S D2 AR2 D2 = AR2 = MR2 P2 O O Q (millions) Q (thousands) (a) Industry (b) Firm

The Shutdown Point The firm will shut down if it cannot cover average variable costs. A firm should continue to produce as long as price is greater than average variable cost. If price falls below that point it makes sense to shut down temporarily and save the variable costs.

The Firm’s Short-Run Decision to Shut Down A shutdown refers to a short-run decision not to produce anything during a specific period of time because of current market conditions. Exit refers to a long-run decision to leave the market.

The Shutdown Decision MC 2 4 6 8 Quantity Price 60 50 40 30 20 10 ATC ATC Loss P = MR AVC A $17.80

Long-Run Competitive Equilibrium Profits and losses are inconsistent with long-run equilibrium. Profits create incentives for new firms to enter, output will increase, and the price will fall until zero profits are made. The existence of losses will cause firms to leave the industry.

Long-Run Competitive Equilibrium Only at zero profit will entry and exit stop. The zero profit condition defines the long-run equilibrium of a competitive industry.

The long run Perfect Competition long-run equilibrium of the firm all supernormal profits competed away LRAC = AC = MC = MR = AR 5

Long-run equilibrium of the firm under perfect competition LRAC Long-run equilibrium of the firm under perfect competition (SR)MC £ (SR)AC AR = MR DL LRAC = (SR)AC = (SR)MC = MR = AR O Q

Long-Run Competitive Equilibrium Zero profit does not mean that the entrepreneur does not get anything for his efforts. Normal profit – the amount the owners of business would have received in the next-best alternative.

Short-run equilibrium adjustment from an increase in demand

An Increase in Demand An increase in demand leads to higher prices and higher profits. Existing firms increase output. New firms enter the market, increasing output still more. Price falls until all profit is competed away If input prices remain constant, the new equilibrium will be at the original price but with a higher output.

Long-Run Equilibrium: Constant-Cost Case Assume that the entry of new firms in an industry has no effect on the cost of inputs no matter how many firms enter or leave an industry, a firm’s cost curves will remain unchanged This is referred to as a constant-cost industry

Market Response to an Increase in Demand Quantity Price Firm Price Quantity MC AC D1 S0SR D0 S1SR B B $9 840 $9 C Profit 12 7 700 SLR 7 A 1,200 10 A McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Long-Run Market Supply In the long run firms earn zero profits. If the long-run industry supply curve is perfectly elastic, the market is a constant-cost industry.

Long-Run Market Supply Two other possibilities exist: Increasing-cost industry – factor prices rise as new firms enter the market and existing firms expand capacity. Decreasing-cost industry – factor prices fall as industry output expands.

Classification of Long-Run Supply Curves Constant Cost entry does not affect input costs the long-run supply curve is horizontal at the long-run equilibrium price Increasing Cost entry increases inputs costs the long-run supply curve is positively sloped

Classification of Long-Run Supply Curves Decreasing Cost Entry reduces input costs the long-run supply curve is negatively sloped

An Increasing-Cost Industry If inputs are specialized, factor prices are likely to rise when the increase in the industry-wide demand for inputs to production increases.

An Increasing-Cost Industry This rise in factor costs would force costs up for each firm in the industry and increases the price at which firms earn zero profit.

An Increasing-Cost Industry Therefore, in increasing-cost industries, the long- run supply curve is upward sloping.

Increasing-cost industry

A Decreasing-Cost Industry Input prices may decline to the zero-profit condition when output rises. New entrants make it more cost-effective for other firms to provide services to all firms in the market.

A Decreasing-Cost Industry If input prices decline when industry output expands, individual firms' marginal cost curves shift down and the long-run supply curve is downward sloping.

Figure 9.21 Decreasing-cost industry

An Example in the Real World K-mart decided to close over 300 stores after experiencing two years of losses (a shutdown decision). K-mart thought its losses would be temporary.

An Example in the Real World Price exceeded average variable cost, so it continued to keep some stores open even though those stores were losing money.

An Example in the Real World Price Quantity MC ATC Loss AVC P = MR

An Example in the Real World After two years of losses, its prospective changed. The company moved from the short run to the long run.

An Example in the Real World They began to think that demand was not temporarily low, but permanently low. At that point they shut down those stores for which P < AVC.

Financial markets – stock exchange, currency markets, bond markets Market Structure Examples of perfect competition: Financial markets – stock exchange, currency markets, bond markets Agriculture

Market Structure Advantages of Perfect Competition: High degree of competition helps allocate resources to most efficient use Price = marginal costs Normal profit made in the long run Firms operate at maximum efficiency Consumers benefit

Market Structure What happens in a competitive environment? New idea? – firm makes short term abnormal profit Other firms enter the industry to take advantage of abnormal profit Supply increases – price falls Long run – normal profit made Choice for consumer Price sufficient for normal profit to be made but no more!

PERFECT COMPETITION Advantages of perfect competition P = MC production at minimum AC only normal profits in long run responsive to consumer wishes: consumer sovereignty competition  efficiency no point in advertising 6

PERFECT COMPETITION Disadvantages of perfect competition insufficient profits for investment lack of product variety lack of competition over product design and specification 7

Consumer and producer surplus Consumer surplus = net gain from trade received by consumers (MB > P for consumers up to the last unit consumed) Producer surplus = net gain received by producers (P > MC up to the last unit sold)

Consumer and producer surplus Consumer surplus Gains from trade = consumer surplus + producer surplus Producer surplus