ECON 211 ELEMENTS OF ECONOMICS I Session 6– Perfect Competition (Part 1) Lecturer: Dr. (Mrs.) Nkechi S. Owoo, Department of Economics Contact Information: nowoo@ug.edu.gh

Session Overview This session is the first of three that analyze different market structures. Market structure is a way of describing those characteristics of a market that influence the behavior of buyers and sellers when they come together to trade. To determine market structure, we must ask how many buyers and sellers are in the market, whether the product is standardized, and whether there are barriers to entry. The answers to these questions help to classify a market into one of four basic types: perfect competition, monopoly, monopolistic competition, or oligopoly. This session discusses the model of perfect competition.

Session Outline The key topics to be covered in the session are as follows: What is Perfect Competition? The Perfectly Competitive Firm The Competitive Firms Demand Curve The Competitive Firms Supply Curve

Reading List Hall and Lieberman Chapter 8, pp:219- 227

What is perfect competition? Topic One What is perfect competition?

Firms in Competitive Markets: Introduction Market Structure This refers to the x’tics of a market that influence how trading takes place How do we determine structure of a particular market? How many buyers and sellers are in the market? Is each seller offering a standardized product? Are there any barriers to entry or exit? Is there perfect knowledge about products? There are four main classifications of markets Perfect Competition Monopoly Monopolistic competition Oligopoly For this semester, we shall discuss the first 2 market structures.

Perfect Competition Many buyers and sellers Standardized product This condition is important so that no individual decision maker can significantly affect the price of the product Consider the market for maize vs. athletic shoes (Nike, Adidas, New Balance) Maize is a good example of a perfectly competitive market Standardized product buyers do not perceive differences between the products e.g. beans. The conditions of many buyers and sellers, and the presence of a standardized product imply that no single buyer or seller has any control over price Would a seller charge more than the going market price? No, because buyers can buy the same product from another seller Would a buyer demand a lower price? No, because sellers can sell at the given price to other consumers Therefore, in a perfectly competitive market, buyers and sellers are price takers.

Perfect Competition Sellers can easily enter/exit the market Entry: There are no significant barriers to discourage new entrants Same terms of entry for all firms Can you think of some potential barriers to entry? Large capital requirements, taxation, consumer base, etc Exit: Any firm can enter and exit the market at any time. A firm should be able to sell of equipment and exit market if making losses in the long run Can you think of some potential barriers to exit? Severance pay to workers, inability to sell of specialized machinery, etc This condition is important for long-run outcomes in competitive markets, which we will discuss in part 3

Perfect Competition Presence of well-informed buyers and sellers E.g. the Market for maize is a good example Not all markets satisfy this condition, however Consumers who purchase ‘China’ fabrics or buy used items e.g. cars, do not have perfect knowledge of the goods being purchased.

The Perfectly Competitive Firm A market is collection of individual buyers and sellers In PC markets, individual buyers and sellers and overall body (market) affect each other through feedback mechanisms Therefore, must understand how firm works ..and the competitive market in which it operates

The Competitive Firm’s Demand Curve The demand curve facing the perfectly competitive firm is horizontal– perfectly elastic - at the market price i.e. No matter how much firm produces, will sell at the same price Why? Output is standardized If firm charges even a little above competitors, will lose all customers Firm is a tiny producer in overall market Firm can increase production without lowering price Price taker The price of its output is given Decision The firm’s main decision is therefore to determine how much output to produce and sell

Demand Curves for the Firm and the Industry The demand curves facing the firm is different from the industry demand curve. A perfectly competitive firm’s demand schedule is perfectly elastic even though the demand curve for the market is downward sloping.

The Competitive Firm’s Demand Curve vs The Competitive Firm’s Demand Curve vs. The Competitive Industry Demand Curve The Competitive Industry and Firm $400 1. The intersection of the market supply and the market demand curve… $400 3. The typical firm can sell all it wants at the market price… Output Price Market Firm Output Price S D Demand Curve Facing the Firm 4. so it faces a horizontal demand curve. 2. determines the equilibrium market price

The Revenue of a Competitive Firm In the perfect competitive market structure, we assume that firms try to maximize profits Illustration

Cost and Revenue Data for a Competitive Firm (Market for Maize) Output (bags of maize) Price per bag Total Revenue (P x Q) Average Revenue (TR/ Q) Marginal Revenue Total Cost Marginal Cost Profit 400 550 -550 1 1000 450 -600 2 800 1200 200 -400 3 1250 50 -50 4 1600 1350 100 250 5 2000 1500 150 500 6 2400 1750 650 7 2800 2100 350 700 8 3200 2550 9 3600 3100 10 4000 3750

Profit maximization Profits= TR- TC Firm produces at point that maximizes profits as much as possible What then, is the profit-maximizing output level?

Cost and Revenue Data for a Competitive Firm Output Price per ounce Total Revenue Marginal Revenue Total Cost Marginal Cost Profit 400 550 -550 1 1000 450 -600 2 800 1200 200 -400 3 1250 50 -50 4 1600 1350 100 250 5 2000 1500 150 500 6 2400 1750 650 7 2800 2100 350 700 8 3200 2550 9 3600 3100 10 4000 3750

Profit Maximization Profit Maximization in Perfect Competition (a) TR-TC Bags of Maize per Day Ghc 1 2 3 4 5 6 7 8 9 10 TR TC 2,800 Profit = TR-TC Maximum Profit per Day = 700 2,100 550 Slope = 400

Profit maximization Another way to look at profit-maximizing output level MR- MC approach When MR > MC, increases in output increase profits When MC > MR, increases in output reduces profits

Cost and Revenue Data for a Competitive Firm Output Price per ounce Total Revenue Marginal Revenue Total Cost Marginal Cost Profit 400 550 -550 1 1000 450 -600 2 800 1200 200 -400 3 1250 50 -50 4 1600 1350 100 250 5 2000 1500 150 500 6 2400 1750 650 7 2800 2100 350 700 8 3200 2500 9 3600 3100 10 4000 3750

Profit Maximization Profit Maximization in Perfect Competition (b) MR=MC Bags of Maize per Day Dollars 1 2 3 4 5 6 7 8 9 10 Profit maximization MR=MC MC B A $400 d = MR Rules for Profit Maximization: If MR> MC, firm should increase output If MC> MR, firm should decrease output When MC= MR, profits are maximized

Profit Maximization MC- MR approach Produce where MR= MC, and MC crosses MR from below!

The Firm’s Short-Run Supply Curve takes the market price as given decides how much output to produce at that price Profit-maximizing output level: P=MC (=MR) As price of output changes, firm will slide along its MC curve in deciding how much to produce Recall a firm’s cost curves? (AVC, ATV, AFC, MC) Graphical Illustration

Recap: Standard Cost Curves Units of Output Ghc 4 3 2 1 30 90 130 160 196 MC AFC ATC AVC

The Firm’s Short-Run Supply Curve Short-Run Supply Under Perfect Competition (a) (b) Bushels per Year Dollars Price per Bushel ATC MC Firm's Supply Curve $3.50 d1=MR1 $3.50 2.50 d2=MR2 2.50 2.00 d3=MR3 2.00 AVC 1.00 d4=MR4 1.00 0.50 d5=MR5 0.50 1,000 4,000 7,000 2,000 4,000 7,000 2,000 5,000 5,000

The Firm’s Short-Run Supply Curve As the price of output changes, firm will slide along MC curve in deciding how much to produce But what if firm is suffering a loss A loss large enough to justify shutting down?

The Firm’s Short-Run Supply Curve What if P= Ghc2? (a) (b) Output Ghc Price ATC MC Firm's Supply Curve 3.50 d1=MR1 3.50 2.50 d2=MR2 2.50 2.00 d3=MR3 2.00 AVC 1.00 d4=MR4 1.00 0.50 d5=MR5 0.50 1,000 4,000 7,000 2,000 4,000 7,000 2,000 5,000 5,000

The Firm’s Short-Run Supply Curve What if P= Ghc0.50? (a) (b) Output Ghc Price ATC MC Firm's Supply Curve 3.50 d1=MR1 3.50 2.50 d2=MR2 2.50 2.00 d3=MR3 2.00 AVC 1.00 d4=MR4 1.00 0.50 d5=MR5 0.50 1,000 4,000 7,000 2,000 4,000 7,000 2,000 5,000 5,000

The Firm’s Short-Run Supply Curve What if P= Ghc1? (a) (b) Output Ghc Price ATC MC Firm's Supply Curve 3.50 d1=MR1 3.50 2.50 d2=MR2 2.50 2.00 d3=MR3 2.00 AVC 1.00 d4=MR4 1.00 0.50 d5=MR5 0.50 1,000 4,000 7,000 2,000 4,000 7,000 2,000 5,000 5,000

The Shutdown Price Price at which a firm is indifferent between producing and shutting down If P>AVC – produce If P<AVC – shut down Firm’s supply curve Is its MC curve for all prices above AVC, and a vertical line at zero units for all prices below AVC.

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. i.e. P> AVC Once price falls below that point it makes sense to shut down temporarily and save the variable costs. Consider the case of Basement on campus

The Shutdown Point The shutdown point is the point at which the firm will gain more by shutting down than it will by staying in business. As long as total revenue is more than total variable cost, temporarily producing at a loss is the firm’s best strategy since it is taking less of a loss than it would by shutting down.

References Economics: Principles and Applications: Hall R.E. and Lieberman M. (2008), Thomson/ South Western (4th Edition)