PERFECTLY COMPETITIVE MARKET - FIRM’S SUPPLY

Slides’ Outline Perfect Competitive Market (Perfect Competition) Assumptions Competitive Firm’s Demand and “MR=P” Competitive Firm’s Short-run Supply Decision Competitive Firm’s Long-run Supply Decision Producer’s Surplus vs Profit

Perfect Competition Market structure provides information about how firms operating in the market will behave. Well-known market structures are: Perfect Competition Monopoly Oligopoly Monopolistic Competition Perfect Competition is one type of market structure in which buyers and sellers choose to be price takers. A firm is unable to sell its output at a price greater than market price. A consumer is unable to purchase at a price less than the market price. This is what most people mean when they talk about “competitive firms.”

Perfect Competition Perfect competition is a market structure in which: there are a large number of firms firms sell identical products buyers and sellers have full information about prices charged by all firms transaction costs, the expenses of finding a trading partner and completing the trade above and beyond the price, are low firms can freely enter and exit the market Examples: Agricultural/commodities markets like wheat and soybeans

Perfect Competition: Assumptions Large number of small firms No single firm’s actions can raise or lower the price. Individual firm’s demand curve is a horizontal line at market price. Identical (homogeneous) products If all firms are selling identical products, it is difficult for any firm to raise the price above the going market price charged by all firms. Full information Consumer knowledge of all firms’ prices makes it easy for consumers to buy elsewhere if any one firm raised its price above market price. Negligible transaction costs Buyers and sellers waste little time or money finding each other. Free entry and exit Leads to large number of firms and promotes price taking.

Competitive Firm’s Demand If the firm sets its own price above the market price then the quantity demanded from the firm is zero. If the firm sets its own price below the market price then the quantity demanded from the firm is the entire market quantity-demanded.

Competitive Firm’s Demand So what is the demand curve faced by the individual firm?

Competitive Firm’s Demand $/output unit Market Supply pe Market Demand Q

Competitive Firm’s Demand $/output unit Market Supply p’ At a price of p’, zero is demanded from the firm. pe Market Demand Q

Competitive Firm’s Demand $/output unit Market Supply p’ At a price of p’, zero is demanded from the firm. pe p” Market Demand Q At a price of p” the firm faces the entire market demand.

Competitive Firm’s Demand So the demand curve faced by the individual firm is ...

Competitive Firm’s Demand $/output unit Market Supply p’ At a price of p’, zero is demanded from the firm. pe p” Market Demand q At a price of p” the firm faces the entire market demand.

Competitive Firm’s Demand $/output unit p’ pe p” Market Demand q

Smallness What does it mean to say that an individual firm is “small relative to the industry”?

Smallness $/output unit Firm’s MC Firm’s demand curve pe q The individual firm’s technology causes it always to supply only a small part of the total quantity demanded at the market price. Due to smallness, we can assume that the firm’s demand Is perfectly elastic (i.e. never produces in downward sloping part). The outcome of this observation is Marginal Revenue is Constant and equal to market price (i.e. MR=P)

The Firm’s Short-Run Supply Decision Each firm is a profit-maximizer and in a short-run. Q: How does each firm choose its output level?

The Firm’s Short-Run Supply Decision Each firm is a profit-maximizer and in a short-run. Q: How does each firm choose its output level? A: By solving

The Firm’s Short-Run Supply Decision What can the solution qs* look like?

The Firm’s Short-Run Supply Decision What can the solution qs* look like? ( Assume firm’s find it profitable to produce, i.e. qs* > 0): P(q) qs* q

The Firm’s Short-Run Supply Decision For the interior case of qs* > 0, the first- order maximum profit condition is That is, So at a profit maximum with qs* > 0, the market price p equals the marginal cost of production at q = qs*.

The Firm’s Short-Run Supply Decision $/output unit In addition, at a profit maximum with qs* > 0, the firm’s MC curve must be upward-sloping. pe MCs(q) q’ qs* q

The Firm’s Short-Run Supply Decision $/output unit At q = qs*, p = MC and MC slopes upwards. q = qs* is profit-maximizing. pe MCs(q) q’ qs* q At q = q’, p = MC and MC slopes downwards. q = q’ is profit-minimizing.

The Firm’s Short-Run Supply Decision At q = qs*, p = MC and MC slopes upwards. q = qs* is profit-maximizing. So a profit-max. supply level can lie only on the upwards sloping part of the firm’s MC curve. $/output unit pe MCs(q) q’ qs* q

The Firm’s Short-Run Supply Decision But not every point on the upward-sloping part of the firm’s MC curve represents a profit-maximum. The firm’s profit function is If the firm chooses q = 0 then its profit is

The Firm’s Short-Run Supply Decision So the firm will choose an output level q > 0 only if I.e., only if Equivalently, only if

The Firm’s Short-Run Supply Decision AVCs(q) ACs(q) MCs(q) $/output unit q

The Firm’s Short-Run Supply Decision AVCs(q) ACs(q) MCs(q) p < AVCs(q) qs* = 0. The firm’s short-run supply curve $/output unit q p > AVCs(q) qs* > 0.

The Firm’s Short-Run Supply Decision AVCs(q) ACs(q) MCs(q) The firm’s short-run supply curve Shutdown point $/output unit q

The Firm’s Short-Run Supply Decision Shut-down is not the same as exit. Shutting-down means producing no output (but the firm is still in the industry and suffers its fixed cost). Exiting means leaving the industry, which the firm can do only in the long-run.

The Firm’s Long-Run Supply Decision How does the firm’s long-run supply decision compare to its short-run supply decisions?

The Firm’s Long-Run Supply Decision A competitive firm’s long-run profit function is The long-run cost c(q) of producing q units of output consists only of variable costs since all inputs are variable in the long-run.

The Firm’s Long-Run Supply Decision The firm’s long-run supply level decision is to The 1st-order maximization conditions are, for q* > 0,

The Firm’s Long-Run Supply Decision Additionally, the firm’s economic profit level must not be negative since then the firm would exit the industry. So,

The Firm’s Long-Run Supply Decision MC(q) AC(q) q $/output unit

The Firm’s Long-Run Supply Decision MC(q) AC(q) q $/output unit The firm’s long-run supply curve

Producer’s Surplus Producer surplus (PS) is the difference between the amount for which a good sells (market price) and the minimum amount necessary for sellers to be willing to produce it (marginal cost) The firm’s producer’s surplus is the accumulation, unit by extra unit of output, of extra revenue less extra production cost. How is producer’s surplus related profit?

Producer’s Surplus q $/output unit AVCs(q) ACs(q) MCs(q)

Producer’s Surplus q $/output unit AVCs(q) ACs(q) MCs(q) p q*(p)

Producer’s Surplus q $/output unit AVCs(q) ACs(q) MCs(q) p PS q*(p)

Producer’s Surplus So the firm’s producer’s surplus is That is, PS = Revenue - Variable Cost.

Producer’s Surplus q $/output unit AVCs(q) ACs(q) MCs(q) p PS q*(p)

Producer’s Surplus q $/output unit AVCs(q) ACs(q) MCs(q) p q*(p)

Producer’s Surplus $/output unit q AVCs(q) ACs(q) MCs(q) p q*(p) Revenue = py*(p)

Producer’s Surplus $/output unit q AVCs(q) ACs(q) MCs(q) p q*(p) Revenue = py*(p) vc(q*(p))

Producer’s Surplus q $/output unit AVCs(q) ACs(q) MCs(q) p PS q*(p)

Producer’s Surplus PS = Revenue - Variable Cost. Profit = Revenue - Total Cost = Revenue - Fixed Cost - Variable Cost. So, PS = Profit + Fixed Cost. Only if fixed cost is zero (the long-run) are PS and profit the same.