Microeconomics I Perfect Competition By Kwame Agyire-Tettey (PhD)

Learning outcomes The impact of the product market on firms’ prices and output choices is determined by the nature of the product and the market structure in which they operate. In perfect competition firms produce a homogeneous product and are price-takers in their output markets. All profit-maximising firms choose their output to equate marginal cost and marginal revenue. Under perfect competition marginal cost will equal the market price, and so the supply curve of firms is determined by the marginal cost curve. The long-run supply curve of a competitive industry may be positively sloped, horizontal, or negatively sloped depending on how input prices are affected by the industry’s expansion. Perfect competition maximizes benefits that consumers receive from the output of the product in question.

Market Structure and Firm Behaviour Market structure is defined by the characteristics that influence the behaviour and outcomes of the firms activities in that market. The structure of the market is determined by the following factors: the number of economic agents in the market, both sellers and buyers; their relative negotiation strength, in terms of ability to set prices; the degree of concentration among them; the degree of differentiation and homogeneity of products; and the degree of barriers to entry and exit. Differences and interactions between these factors leads to the existence of several market structures, including: Perfect competition; imperfect competition; monopoly; oligopoly; monopolistic competition Competitive behaviour among economic agents refers to the extent to which individual firms compete with each other to sell their products. Competitive market structure refers to the power that individual firms have over the market - perfect competition occurring where firms have no market power and hence no need to react to each other.

Perfectly Competitive Markets: Assumptions The theory of perfect competition is based on the following assumptions: Firms sell homogenous product; Large number of sellers and buyers; Freedom to enter and leave the industry; No government interference in the market; Firms aim at profit maximisation; There is the absence of collusion among firms; There is prefect mobility of factors of production; Customers and firms are well informed i.e. there is perfect knowledge in the market. These two assumptions make each firm a price-taker. Makes the firm’s demand curve horizontal.

Short-run equilibrium For the firm to maximised profit it produces and output level that equates marginal cost curve to the marginal revenue curve but the marginal cost should be rising - or by producing nothing if average cost exceeds price at all outputs. Note that price is equal to the marginal revenue, thus, in this market price is also equal to the marginal cost at equilibrium. A perfectly competitive firm is a quantity-adjuster, facing a perfectly elastic demand curve at the given market price and maximizing profits by choosing the output that equates its marginal cost to price. Teach the student the mathematical derivation of profit maximisation in the short-run.

Short-run equilibrium At equilibrium in the short-run: MR = MC Since price is the same as the marginal revenue, it implies that in equilibrium P=MR=MC The slope of the MC must be greater than that of the MR. However, under perfect competitive market the slope of the MR is zero, hence in equilibrium the slope of the MC curve must be positive.

Alternative Short-run Equilibrium Positions for the Firm [ii] £ per unit £ per unit SRATC MC MC SRATC SARVC E E p1 p2 q1 Output q2 Output MC [iii] SRATC £ per unit E p3 q3 Output

Shut down point of the firm GHC per unit MC SRATC SRAVC E p1 q1 Output

Industry or market demand curve The horizontal summation of all individual demand curves. At higher price consumers will purchase a lesser quantity of the good At lower prices all things being equal consumers will purchase more of the product. The industry or market demand curve is downward sloping, depicting a negative relationship between price and quantity.

Industry or market demand curve Price Price Dfirm D quantity quantity

The short run Supply Curve for a perfectly competitive Firm MC 5 5 £ per nut 4 4 AVC Price [£] 3 3 E0 p0 2 2 1 1 Output q0 Quantity [ii] The supply curve [i] Marginal cost and average variable cost curves

The Supply Curve for a Price-taking Firm MC 5 5 £ per nut 4 4 AVC Price [£] E1 p1 3 3 E0 p0 2 2 1 1 q0 q1 Output Quantity [ii] The supply curve [i] Marginal cost and average variable cost curves

The short run Supply Curve for a perfectly competitive Firm MC 5 5 E2 p2 4 4 AVC £ per nut Price [£] E1 p1 3 3 E0 p0 2 2 1 1 Output q0 q1 q2 Quantity [ii] The supply curve [i] Marginal cost and average variable cost curves

The short run Supply Curve for a perfectly competitive Firm MC S E3 p3 5 5 GHC per nut E2 p2 4 4 AVC Price [GHC] E1 p1 3 3 E0 p0 2 2 1 1 q0 q1 q2 q3 Output Quantity [i] Marginal cost and average variable cost curves [ii] The supply curve

The short run Supply Curve for a perfectly competitive Firm For a price-taking firm the supply curve has the same shape as its MC curve above the level of AVC. The point E0, where price, p0, equals AVC is the shutdown point. As price rises from £2 to £3 to £4 to £5, the firm increases its production from q0 to q1 to q2 to q3 . For example at a price of £3, the firm produces output q1 and earns the contribution to fixed costs shown by the dark blue shaded rectangle. The firm’s supply curve is shown in part (ii). It relates market price to the quantity the firm will produce and offer for sale. The supply curve of a firm in perfect competition is its marginal cost curve above the minimum AVC, and the supply curve of a perfectly competitive industry is the sum of the marginal cost curves of all its firms.

The short run Supply Curve for a perfectly competitive Firm The market supply curve is derived on the assumption that factor prices and technology are given and that there is a large number of firms in the market. Thus the total market output at each price is the sum of the outputs supplied by all firms at the prevailing price. The shape of the market supply curve is dependent on: Technology; Factor prices and Size distribution of firms in the market. Note that the firms are not of the same sizes as there are different entrepreneurial efficiencies. These factors will determine the shape of the market supply because they determine the cost structure of the firms in the market and thus by extension determine the shape of the industry supply curve. Mathematical derivation of the supply curve

Short-run market/industry equilibrium The intersection of this curve with the market demand curve for the industry’s product determines market price in the short-run. Price S E Market price p0 D Quantity q0

SR and LR Equilibrium of a Firm in Perfect Competition SRATC0 MC0 GHC per unit p0 MC* c0 SRATC* LRAC p* q0 q*

SR and LR Equilibrium of a Firm in Perfect Competition The firm’s existing plant has short-run cost curves SRATC0 and MC0 while market price is p0. The firm produces q0, where MC0 equals price and total costs are just being covered. Although the firm is in short-run equilibrium, it can earn profits by building a larger plant and so moving downwards along its LRAC curve. Thus the firm cannot be in long-run equilibrium at any output below q*, because average total costs can be reduced by building a larger plant. If all firms do this, industry output will increase and price will fall until long-run equilibrium is reached at price p*. Each firm is then in short-run equilibrium with a plant whose average cost curve is SRATC* and whose short-run marginal cost curve, MC*, intersects the price line p at an output of q*. Because the LRAC curve lies above p* everywhere except at q*, the firm has no incentive to move to another point on its LRAC curve by altering the size of its plant. Thus a perfectly competitive firm that is not at the minimum point on its LRAC curve cannot be in long-run equilibrium.

SR and LR Equilibrium of a Firm in Perfect Competition At the long-run equilibrium SMC=Minimum SRATC=Minimum LRATC=LMC=MR=P All firms will produce at the minimum LRATC However, all firms operating at the minimum LRATC does not imply that the firms are of the same size and have the same efficiency level. Firms the hire more efficient factors of production will be relative more productive or efficient

Optimal allocation of resources Output is produced at the minimum feasible cost in the long run. In the long-run consumers pay the lowest price, which is equal to the cost of producing the commodity. The firm’s plant capacity is fully utilised, that is all firms operate at the full capacity level in the long run. The firms earn normal profits in the long run.

Allocative efficiency A state of the economy in which production represents consumer preferences; in particular, every good or service is produced up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it. Firms will supply all those goods that provide consumers with a marginal benefit at least as great as the marginal cost of producing them because: The price of a good represents the marginal benefit consumers receive from consuming the last unit of the good sold. Perfectly competitive firms produce up to the point where the price of the good equals the marginal cost of producing the last unit. In this regard, firms produce up to the point where the last unit provides a marginal benefit to consumers equal to the marginal cost of producing it.

Productive efficiency It is the situation in which a good or service is produced at the lowest possible cost. The presence of competitive forces drive the market price down to the minimum average cost of the typical firm. From the definition of productive efficiency, perfect competition results in productive efficiency. Firm owner strive to earn an economic profit by reducing costs, but in a perfectly competitive market, firms learn from others and reduce costs. Therefore, in the long run, only the consumer benefits from cost reductions.

Long-Run Market Supply 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. 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. Therefore, in increasing-cost industries, the long-run supply curve is upward sloping. Decreasing-Cost Industry Input prices may decline to the zero-profit condition when output rises and when new entrants make it more cost-effective for other firms to provide services to all firms in the market. Constant-Cost Industry When market output rises and prices of input remain unchanged thus the entry of new firm does not affect input prices. The cost curve remain the same. The long-run market supply is a horizontal curve.

Increasing cost industry

Decreasing-cost industry

Constant-cost industry

Changes in cost and perfect competition Changes in fixed cost Changes in the variable cost Effect of the imposition of a tax