Economics 10 1 2017 September Lecture 14 Chapter 12 Perfect Competition 2017 Economics 101 CCC

Content Define perfect competition Explain how a firm makes its output decision Explain how price and output are determined in perfect competition Explain why firms enter and leave a market Predict the effects of technological change in a competitive market Explain why perfect competition is efficient

What is perfect competition?

What Is Perfect Competition? Perfect competition is a market that consists of many small firms each producing a similar good for sale and profit Four Conditions of Perfectly Competition Market All firms sell the same standard product Switching is easy Lots of buyers and sellers all buy or sell only a fraction of the quantity exchanged. Firm find it easy to exit & enter market - Productive resources are mobile.. Buyers and sellers are well informed re: cost and quality (full information)

What Is Perfect Competition? perfectly competitive firms are price takers Why? Firm has no influence over the price at which it sells its product Firms sells only a fraction of the market output Firm can sell as much output as it wishes Each firm’s output is a perfect substitute for the output of the other firms, so the demand for each firm’s output is perfectly elastic.

Sushi to You Is the Sushi market perfect competition??? Does it meet these 4 conditions? What are some barriers to entry and exit? Sushi to You

What Is Perfect Competition? Perfect competition & Economic Profit and Revenue Goal - maximize economic profit equals total revenue minus total cost. cost includes opportunity cost of production Each Firm total revenue equals P  Q. marginal revenue is the change in total revenue that results from a one-unit increase in the quantity sold.

Demand for Firm Product Where do we get the Demand curve of the firm? Demand Curve for the Firm – also known as the MR

Demand for Firm Product Demand for Sweaters in the Market versus Firm The demand for a firm’s product is perfectly elastic because one firm’s sweater is a perfect substitute for the sweater of another firm. The market demand is not perfectly elastic because a sweater is a substitute for some other good.

Firms’ Decision The Firm’s Decisions A perfectly competitive firm’s goal is to make maximum economic profit, given the constraints it faces. So the firm must decide: 1. How to produce at minimum cost 2. What quantity to produce 3. Whether to enter or exit a market

Output Decision

The Firm’s Output Decision A perfectly competitive firm chooses the output that maximizes its economic profit. How? Use firm’s total revenue and total cost curves. Use MC = MR and supply decision

The Firm’s Output Decision 1. Use firm’s total revenue and total cost curves. At low output levels, the firm incurs an economic loss—it can’t cover its fixed costs. At intermediate output levels, the firm makes an economic profit. At high output levels, the firm again incurs an economic loss— now the firm faces steeply rising costs because of diminishing returns. Profit - 9 sweaters a day.

The Firm’s Output Decision 2. Marginal Analysis and Supply Decision If MR > MC, economic profit increases if output increases. If MR < MC, economic profit decreases if output increases. If MR = MC, economic profit decreases if output changes in either direction, so economic profit is maximized.

The Firm’s Output Decision Where do we get the MR value? Consider definition of MR Revenue or $$ gained from selling one extra unit Consider definition of Price And where does price come from when you are a price takers? Where do we get the MC value? MC = Change in TC/Change in Q

Output Decisions & Shutdown Rule

The Firm’s Output Decision The Shut-Down Rule – P = AVC Perfectly competitive firms should always produce where P = MC, with one exception: when revenue falls below variable costs shut down: When P falls below the minimum of the AVC curve- Why? Don’t even cover VC then no contribution to FC so not worth it. Operate as long as you can contribute something to FC

The Firm’s Output Decision The Shut-Down Rule when P = AVC & Loss Comparisons Economic loss = TFC + TVC  TR = TFC + (AVC  P) x Q If the firm shuts down, Q is 0 and the firm still has to pay its TFC. So the firm incurs an economic loss equal to TFC. This economic loss is the largest that the firm must bear.

The Firm’s Output Decision The Shutdown Point Shutdown point is the price and quantity at which it is indifferent between producing the profit-maximizing quantity and shutting down. The shutdown point is at minimum AVC. This point is the same point at which the MC curve crosses the AVC curve. At the shutdown point, the firm is indifferent between producing and shutting down temporarily. At the shutdown point, the firm incurs a loss equal to total fixed cost (TFC).

The Firm’s Output Decision The Shut-Down Rule Graphically Minimum AVC is $17 a sweater. At $17 a sweater, the profit- maximizing output is 7 sweaters a day. The firm incurs a loss equal to the red rectangle.

The Firm’s Output Decision The Shut-Down Rule Graphically If the price of a sweater is between $17 and $20.14, … the firm produces the quantity at which marginal cost equals price. The firm covers all its variable cost and some of its fixed cost. It incurs a loss that is less than TFC.

The Firm’s Output Decision The Shut-Down Rule Graphically As a result of this idea.. the MC curve is the supply curve above minimum AVC .. As we will not supply anything if P < AVC as noted above.. We need to get at least that price = AVC or we will choose not to produce anything

If Price per bottle = $0.32 from the market ; TC = 0.28c Where is the 28 cents from? Shutdown? Profits per bottle= $0.32 - $0.28 = $0.04 Average total cost Marginal cost Average variable cost Minimum average total cost Minimum average variable cost Total profit = $0.04 x 400 = $16.00 0.50 0.40 0.30 0.20 0.10 0.32 0.28 100 200 300 400 500 Output (bottles/day) $/bottle

Firm’s Individual Supply Curve

The Firm’s Supply Curve A perfectly competitive firm’s supply curve shows how the firm’s profit-maximizing output varies as the market price varies, other things remaining the same.

The Firm’s Supply Curve LAW: Producers offer more of a product when the prices rises. Why? The perfectly competitive firm’s supply curve run is really the .. Marginal cost curve (i.e. when price is above average variable cost) At every point along a market supply curve is really what it would cost producers to expand production by one unit So if deciding based upon P=MC then If P increases the firm compares P to MC and if then > increase output.

The Firm’s Supply Curve How is the firm’s supply curve is constructed? If price equals minimum AVC, $17 a sweater, the firm is indifferent between producing nothing and producing at the shutdown point, T.

The Firm’s Supply Curve If the price is $25 a sweater, the firm produces 9 sweaters a day, the quantity at which P = MC. If the price is $31 a sweater, the firm produces 10 sweaters a day, the quantity at which P = MC. The blue curve in part (b) traces the firm’s short-run supply curve.

Output, Price, and Profit in the Short Run Text p 278 -280

Output, Price, and Profit in the Short Run Market Supply in the Short Run The short-run market supply curve shows the quantity supplied by all firms in the market at each price points At the shutdown price ($17), some firms will produce the shutdown quantity (7 sweaters) and others will produce zero. At this price, the market supply curve is horizontal.

Output, Price, and Profit in the Short Run Short-Run Market Equilibrium Short-run market supply and market demand determine the market price and output. Given D1 then P* = ?? And then each firm in the industry takes this price as given and compares that to their individual cost curves and decides the Q.

Output, Price, and Profit in the Short Run If there is a Change in Demand An increase in demand brings a rightward shift of the market demand curve: The price rises and the quantity increases. A decrease in demand brings a leftward shift of the market demand curve: The price falls and the quantity decreases. That is the price for the price takers!

Output, Price, and Profit in the Short Run Decision Making & Profits/Losses Determination in the Short Run Firms make the decision MR = MC to get profit max Q Then they produce Do they always make economic profit? For this we need to use the TR = TC an solve for profit

Output, Price, and Profit in the Short Run Mkt price equals average total cost firm makes zero economic profit (breaks even).

Output, Price, and Profit in the Short Run Mkt Price exceeds average total cost firm makes a positive economic profit.

Output, Price, and Profit in the Short Run Mkt price is less than average total cost firm incurs an economic loss—economic profit is negative.

Long Run: Output, Price, Profit , Exit & Entry

Output, Price, and Profit in the Long Run In short-run equilibrium, a firm might make an economic profit, break even, or incur an economic loss. In long-run equilibrium, firms break even because firms can enter or exit the market.

Output, Price, and Profit in the Long Run Entry and Exit New firms enter an industry in which existing firms make an economic profit. Firms exit an industry in which they incur an economic loss.

Output, Price, and Profit in the Long Run A Closer Look at Entry When the market price is $25 a sweater, firms in the market are making economic profit.

Output, Price, and Profit in the Long Run New firms have an incentive to enter the market. When they do, the market supply increases and the market price falls.

Output, Price, and Profit in the Long Run Firms enter as long as firms are making economic profits. In the long run, the market price falls until firms are making zero economic profit.

Output, Price, and Profit in the Long Run A Closer Look at Exit When the market price is $17 a sweater, firms in the market are incurring economic loss.

Output, Price, and Profit in the Long Run Firms have an incentive to exit the market. When they do, the market supply decreases and the market price rises.

Output, Price, and Profit in the Long Run Firms exit as long as firms are incurring economic losses. In the long run, the price continues to rise until firms make zero economic profit.

Changes in Demand & Supply due to technology changes in Long Run

Changes in Demand as Technology Advances An Increase in Demand An increase in demand shifts the market demand curve rightward. The price rises and the quantity increases. Starting from long-run equilibrium, firms make economic profits.

Changes in Demand as Technology Advances The market demand curve shifts rightward, the market price rises, and each firm increases the quantity it produces.

Changes in Demand as Technology Advances The market price is now above the firm’s minimum average total cost, so firms make economic profit.

Changes in Demand as Technology Advances Economic profit induces some firms to enter the market, which increases the market supply and the price starts to fall.

Changes in Demand as Technology Advances As the price falls, the quantity produced by all firms starts to decrease and each firm’s economic profit starts to fall.

Changes in Demand as Technology Advances Eventually, enough firms have entered for the supply and increased demand to be in balance and firms make zero economic profit. Firms no longer enter the market.

Changes in Demand as Technology Advances main difference between the initial and new long-run equilibrium is the number of firms in the market. More firms produce the equilibrium quantity.

Changes in Demand as Technology Advances A decrease in demand - opposite effects

Changes in Supply as Technology Advances Starting from a long-run equilibrium, when a new technology becomes available that lowers production costs, the first firms to use it make economic profit. But as more firms begin to use the new technology, market supply increases and the price falls.

Changes in Supply as Technology Advances Part (a) shows the market. Part (b) shows a firm using the original old technology. Firms are making zero economic profit.

Changes in Demand and Supply as Technology Advances When a new technology becomes available, the ATC and MC curves shift downward. Firms that use the new technology make economic profit.

Changes in Demand and Supply as Technology Advances Economic profit induces some new-technology firms to enter the market. The market supply increases and the price starts to fall.

Changes in Demand and Supply as Technology Advances With the lower price, old-technology firms incur economic losses. Some exit the market; others switch to the new technology.

Changes in Demand and Supply as Technology Advances Eventually all firms are using new technology. The market supply has increased and firms are making zero economic profit.

Competition & Efficiency

Competition and Efficiency Efficient Use of Resources Resources are used efficiently when no one can be made better off without making someone else worse off. This situation arises when marginal social benefit equals marginal social cost.

Competition and Efficiency Choices, Equilibrium, and Efficiency We can describe an efficient use of resources in terms of the choices of consumers and firms coordinated in market equilibrium.

Competition and Efficiency Equilibrium and Efficiency In competitive equilibrium, resources are used efficiently—the quantity demanded equals the quantity supplied, so marginal social benefit equals marginal social cost. The gain from trade for consumers is measured by consumer surplus. The gain from trade for producers is measured by producer surplus. Total gains from trade equal total surplus. In long-run equilibrium total surplus is maximized.

Competition and Efficiency Efficiency in the Sweater Market Figure 12.12(a) shows the market. Along the market demand curve D = MSB, consumers are efficient. Along the market supply curve S = MSC, producers are efficient.

Competition and Efficiency At the market equilibrium, marginal social benefit equals marginal social cost. Resources are allocated efficiently. Total surplus is maximized.

Competition and Efficiency Campus Sweaters makes zero economic profit. Each firm in the market has the plant that enables it to produce at the lowest possible average total cost. Consumers are as well off as possible because the good cannot be produced at a lower cost and the price equals that least possible cost.

Questions Define profit, profit-maximizing firms and factors of production. Define perfectly competitive firm and perfectly competitive markets. Understand implication of price-taking for firm’s demand curve. Identify difference between short run and long run time frame. Define production function, variable factor of production, and fixed factor of production. Define marginal product and average product.

Questions Explain how economic profits/losses motivate firm behaviour. Exit and entry in LR Demand and Supply Changes in LR SR profit decision/shutdown Perfect comp What are some barriers to entry and exit? Are all markets competitive? When is a market highly competitive? Are there any perfect competition markets?

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