Equilibrium in Perfect Competition Lecture 6

The perfectly competitive markets All sellers in a market will be perfectly competitive if: 1. a large amount of buyers and sellers, each is small relative to the industry supply, takes the price of its output as given and unaffected by the amount it sells (a price taker) 2. perfect knowledge, buyers and sellers are well informed about price, no production secrets 3. the product is homogeneous (identical), 4. firms can leave and enter the industry freely

Perfectly competitive market as an extreme case Markets which satisfy all the conditions for perfect competition: markets for agricultural products, for most stocks and bonds traded on WSE Perfectly competitive markets – an ideal to which other types of markets can be compared Good tool to learn about the various forms of imperfect competition

demand curve in perfect competition Horizontal demand curve

The firm’s short run supply decision The level of output that maximizes profit: marginal condition SMC=MR=P; P=SMC, a firm should compare price and average variable cost; if P ≥ SAVC decision to produce, if P<SAVC decision to shut down Fixed costs do not affect SMC or SAVC in the short run General principle: sunk costs are sunk

Decision: how much to produce (short run) SMC=MR=P At „D” (P4 >SATC) abnormal profit At „C” (P3=SATC) normal profit only, break even point Between „A” and „C” (SATC>P> SAVC) loses Below point „A” P< P1 firm is closed

The firm’s short run supply curve The portion of the marginal cost curve above the point A : SMR cuts SAVC curve at its minimum Short run price below minimum SAVC shutdown price - If the market price below shutdown price supply=0 Break-even price = minimum SATC: long run equilibrium: no economic (abnormal) profit, firms realize normal profit only, no incentives to enter or to leave the industry But any change of the supply or the demand at the industry level will change the price and shift the firm equilibrium point

The market’s short-run supply curve The sum of output supplied to the market at each price The short run – all the output must come from firms that are already in operation The quantity supplied increases when the market price rises for two reasons: 1) the supply curve of each individual firm slopes upward 2) the number of firms in operation increases as the output price rises Changes in the price of variable factors shift market’s supply curve Changes in prices of fixed inputs have no effect on supply in short run

Long run firm’s supply curves First step, decision to operate, optimal output level: P=MR=LMC Second step, P≥LAC P<LAC decision to leave the industry The long run supply curve of a firm: the portion of its LMC curve above minimum LAC Long run break-even price -minimum LAC At any price> break-even price firm receives abnormal (economic) profit

How much to produce (long run) Q3 Q4 At „B” (P2<LAC) loses, firm leaves the industry At „D” (P4> LAC) abnormal profit – motivation to enter the industry At „C” (P3 = LAC min) economic costs covered – normal profit, no motivation to enter or leave the industry How to explain that: a) „enter” eliminates profit; b) „exit” eliminates loses

The perfectly competitive firm’s optimal supply decision period Marginal condition Profit check Short run Choose the output level where P = MC produce only if P≥SAVC Shut down if P<SAVC Long run Choose the output level where P = LMC Produce only if P≥LAC Leave the industry if P < LAC

Perfect competition Short run Long run Abnormal profit Yes no Productively efficient (output at min. AC) yes Allocatively efficient (P = MC) firms produce what people want to buy

The industry long run supply curve The long run industry supply curve LS is flatter (more elastic) than the short run supply curve 2 reasons: 1. long-run supply curve for each firm in industry is flatter; 2. number of firms in the industry rises when price increases Horizontal or completely flat long run industry supply curve: sellers supply any quantity buyers demand at constant price The case possible if all firms have identical cost conditions (input prices constant). At higher levels of total output more firms in the market but the long run output per firm does not change, it stays at the P=LAC (long run break-even price) In practice long run supply curve may slope upward because: 1. important differences in costs among actual and potential sellers – many break-even price levels; 2. the prices of the inputs may rise as total production increases. Some industries are important buyers of particular specialized inputs

Shifts of the industry long run supply curves Two sorts of changes shift LR supply curves: 1). changes in the price of any input (no fixed inputs), an example: the interest rate goes up- the opportunity costs go up, LAC and LMC rise at all output levels and shift industry’s long run supply curve LR supply curves shifts upward 2). changes in technology, new technology in use, given inputs produce the same output at lower costs - supply curve shifts downward