Understand Marginal analysis and the behaviour of firms A.S 3.1 Understand Marginal analysis and the behaviour of firms

SLO: Describe characteristics of a perfectly competitive firm. Derive the demand curve for a perfectly competitive firm given market demand and supply. Calculate Total, Average and Marginal Revenue for firms.

A Perfectly Competitive Market Has the following characteristics Large number of buyers and sellers (firms) Firms have no market power and are price takers Each firm supplies a small amount of the overall market supply Firms cannot influence the market price by altering its output. Only able to sell their good at the price determined in the market Output is homogenous Product is identical to that produced by other firms Resources are perfectly mobile Buyers and firms have perfect knowledge of the market No Barriers to entry or exit from the market

Perfect Competition Market garden Uses simple resources Land, seeds, water, fertiliser, equipment and labour Price determined by the market What will happen to the price if demand increases? What may happen to the price if the growing conditions have been favourable? NZ examples? Dairy farming Wool growing Fishing

Perfect Competition Deriving the demand curve Demand curve for the perfectly competitive firm Market Price Price S 60 50 40 30 20 10 60 50 40 30 20 10 P D D 1 2 3 4 5 6 Q 10 20 30 40 50 60 Quantity (million) Output (000) Because the perfectly competitive firm is a price-taker it faces a horizontal demand curve. The price is determined by demand and supply in the market.

Perfectly competitive Markets Perfectly competitive firms have no market power Market power is the ability to alter the market price of a good or service

Revenue curves of the business As a business we need to know the most profitable output we can produce. To find out how we can be the most profitable we need to understand more about the relationship between the revenue and cost curves of the business Revenue = Income producers receive from selling goods and services on the market

Profit Profit depends on The price the goods are sold for Normal Profit for a business is where: Total Cost =Total Revenue TC=TR Profit Profit depends on The price the goods are sold for How much is sold Cost of production Profit = Revenue- Costs Entrepreneurs include a return for risk in their costs of production this is why at TC=TR we call it normal profit even though there doesn’t appear to be any at all. Includes rent wages interest and other costs of production Income from sales

Profit Subnormal profit TR<TC Supernormal Profit TR>TC Supernormal profit will attract other businesses into the industry in the Long-run. Thus can only be achieved in the Short Run Subnormal profit TR<TC Subnormal profit may be sustainable in the short-run if you are covering variable costs

Revenue Curves Total Revenue (TR) = Price X Quantity of units sold Calculate the TR for a farmer that sells sheep at $40 each and sells 300 sheep. TR= 40 x 300 = $12,000 Average Revenue (AR) is the average contribution of each unit sold to TR. AR will be the same as price and is represented by the demand curve AR= TR/Q What's the AR for the above situation? 12,000/300 = 40 = Price per sheep Marginal Revenue (MR) is the additional revenue the firm receives from the sale of one more unit of output. Its calculated by the change in TR MR= TR2-TR1

Example revenue curves for perfectly competitive firm TR Price ($) Quantity Total Revenue Average Revenue Marginal Revenue 60 1 2 120 3 180 4 240 5 300 200 160 120 80 40 AR/MR/D 1 2 3 4 5 As a price taker, a perfectly competitive firm faces a price of $60 regardless of the amount they sell. This firm cannot affect this price in any way. The demand curve is horizontal. This means the firm can sell unlimited quantities at the same price (AR=MR).

Activity 10.2 page 154

Cost Structures for perfect competitors The two most important curves to remember are the Marginal cost curves “the big tick” Average cost curves “the fruit bowl” The marginal cost curve always cuts the AC curve at its lowest point.

Perfectly competitive firm MC Profit maximising equilibrium output is where MR=MC AC MR/AR/D Q

Behaviour of firms in other market structures SLO: Describe characteristics of different types of imperfectly competitive markets

Perfectly Competitive Market At Q1 MR > MC Therefore the firm should increase output to gain more profit on the additional units of output sold At Q3 MC>MR, therefore the firm should decrease output to avoid making a loss on the additional units of output sold Q1 Q2 Q3

Perfect Competition Diagrammatic representation MC AC P = MR = AR 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. 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. 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. 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 Cost/Revenue MC AC P = MR = AR Q1 Output/Sales

Perfect Competition Diagrammatic representation MC MC1 AC AC1 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. Average and Marginal costs could be expected to be lower but price, in the short run, remains the same. The lower AC and MC would imply that the firm is now earning abnormal profit (AR>AC) represented by the grey area. 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? Cost/Revenue MC MC1 AC AC1 P = MR = AR Abnormal profit AC1 P1 = MR1 = AR1 Q1 Q2 Output/Sales

Revenues for a Perfect Competitor Perfect Competition Perfect competitive firms are price takers and a decision to increase output will have no impact on the price they receive, their marginal revenue or average revenue. Study the table below. Revenues for a Perfect Competitor Output Price TR MR AR $3   1 2 3 4 5 6 3 3 3-0=3 3 6 6-3=3 3 9 9-6=3 3 3 12 12-9=3 15 15-12=3 3 18 18-15=3 3 1. Complete the graph above 2. Graph the revenue curves for the above firm.

Perfectly Competitive firm TR P MR/AR/D

Making Subnormal Profits If, in the short run firms are making subnormal profits in a perfectly competitive industry then in the long run some firms will exit the industry. As firms exit the industry the market supply will decrease and consequently the market price will increase. An increase in the market price will mean an increase in average revenue for the remaining firms. In the long run subnormal profits will be replaced by normal profits and only normal profits will be made in the long-run Making Supernormal Profits If firms are making short-run supernormal profits in a perfectly competitive industry then in the long- run new firms, attracted by the prospect of supernormal profits will enter the industry. As new firms enter the industry the market supply will increase resulting in a fall in the market price. A fall in the price will mean a fall in average revenue for the firms. Supernormal profits will be reduced and in the long-run only normal profits will be made. Making Normal Profits Perfectly competitive firms making normal profits in the short-run will continue to do so in the. There is no incentive for firms to either exit or enter the industry. Market supply does not change neither does the price nor average revenue. Normal profits will continue.

Imperfect competition There are a wide range of different markets, the structure of these markets differ by The good being produced The number of firms in the industry How much power each firm has in the market The firms behaviour The extent of the barriers to enter into that market

Monopolistic competition The main characteristics include Large number of firms May have some element of control over price due to the fact that they are able to differentiate their product in some way from their rivals – products are therefore close, but not perfect, substitutes Entry and exit from the industry is relatively easy – few barriers to entry and exit Consumer and producer knowledge imperfect

Monopolistic Competition Firms have a small level of control over price or output, so they will face a downward sloping demand curve Examples, diary’s, hairdressers, clothing shops

Monopolistic competition Easy to enter the market. So if a firm sees that they may have the opportunity to make (supernormal) profits they will enter the market This causes price to then fall in the market This reduces the level of profit until the firms can only earn normal profit

Monopolistic or Imperfect Competition Implications for the diagram: MC We assume that the firm produces where MR = MC (profit maximising output). At this output level, AR>AC and the firm makes abnormal profit (the grey shaded area). Marginal Cost and Average Cost will be the same shape. However, because the products are differentiated in some way, the firm will only be able to sell extra output by lowering price. Cost/Revenue This is a short run equilibrium position for a firm in a monopolistic market structure. If the firm produces Q1 and sells each unit for £1.00 on average with the cost (on average) for each unit being 60p, the firm will make 40p x Q1 in abnormal profit. Since the additional revenue received from each unit sold falls, the MR curve lies under the AR curve. The demand curve facing the firm will be downward sloping and represents the AR earned from sales. AC £1.00 Abnormal Profit £0.60 D (AR) MR Q1 Output / Sales

Monopolistic or Imperfect Competition Implications for the diagram: MC Because there is relative freedom of entry and exit into the market, new firms will enter encouraged by the existence of abnormal profits. New entrants will increase supply causing price to fall. As price falls, the AR and MR curves shift inwards as revenue from each sale is now less. Cost/Revenue AC AR1 D (AR) MR1 MR Q1 Output / Sales

Monopolistic or Imperfect Competition Implications for the diagram: MC Notice that the existence of more substitutes makes the new AR (D) curve more price elastic. The firm reduces output to a point where MC = MR (Q2). At this output AR = AC and the firm will make normal profit. Cost/Revenue AC AR = AC AR1 D (AR) MR1 MR Q2 Q1 Output / Sales

Monopolistic or Imperfect Competition Implications for the diagram: MC This is the long run equilibrium position of a firm in monopolistic competition. Cost/Revenue AC AR = AC AR1 MR1 Q2 Output / Sales

Monopolistic or Imperfect Competition Restaurants Plumbers/electricians/local builders Solicitors Private schools Plant hire firms Insurance brokers Health clubs Hairdressers Funeral directors Estate agents Damp proofing control firms

Monopolistic or Imperfect Competition In each case there are many firms in the industry Each can try to differentiate its product in some way Entry and exit to the industry is relatively free Consumers and producers do not have perfect knowledge of the market – the market may indeed be relatively localised. Can you imagine trying to search out the details, prices, reliability, quality of service, etc for every plumber in the UK in the event of an emergency??

Oligopoly If a business is successful it is able to grow bigger and develop greater market power Market Firm

Oligopoly Characteristics Few very large sellers that dominate the market Each firm has similar but differentiated product The price may be similar across the industry Firms have some control over price Firms prefer to use non-price competition Strong barriers to entry Collusion can occur between firms

Oligopoly Example: Music sales – The music industry has a 5-firm concentration ratio of 75%. Independents make up 25% of the market but there could be many thousands of firms that make up this ‘independents’ group. An oligopolistic market structure therefore may have many firms in the industry but it is dominated by a few large sellers. Market Share of the Music Industry 2002. Source IFPI: http://www.ifpi.org/site-content/press/20030909.html