Industrial Organization & Perfect Competition

Perfectly Competitive Markets Structure Assumptions Many buyers and sellers Homogeneous product or output Note: these first two assumptions imply that the perfectly competitive firm is a price taker. P(x) = P* =  where  is the demand for the individual firm’s output. Also note that if P(x) is just P*, then mr=P*, too. “Free” entry and exit Full and symmetric information

Perfectly Competitive Markets Every demander is a price-taker (no buyer can influence the price). Every supplier is a price-taker (no seller can influence the price). The market price is known to all potential buyers and sellers and anyone who wishes to trade at that price can do so.

An Example Jonathan’s farm is perfectly competitive and uses the inputs shown to produce the quantities of apples indicated on the table.

Production Detail Here is some finer detail regarding the apple farm.

Factor Prices Jonathan is a factor price taker. Use these factor prices to build the cost tables.

Costs

Finer Cost Details

Graph of Jonathan’s Cost Curves The marginal cost of each ton of apples is shown as the red line. The average cost is shown as the blue line. Notice that the marginal cost = average cost at average cost’s minimum.

Profit Maximization Profit () = total revenue(tr) - total cost(tc). Profit depends on the firm’s output level (x). So…  (x) = tr(x) - tc(x) Define marginal revenue (mr) = tr/x marginal cost (mc) = tc/x NOTE: Since we have a perfectly competitive firm P=mr for all levels of production.

Profit Maximization General rules for profit maximization: If x* maximizes  , then mr = mc at x* x* is a profit max and not a profit min at x* it’s worth operating Reminder: since the firm is perfectly competitive, P=mr for all values of x.

Jonathan’s Profit and Loss Suppose the market price is $600/ton. The vertical difference between Jonathan’s total revenue and total cost curve is his profit. The profit maximum occurs at 240 tons/year.

Finding Profit Maximizing Points Using The Marginal Cost Curve Jonathan will supply apples to the market in increasing quantities as the price rises. The points on the marginal cost curve correspond to profit maximizing quantities at two different market prices. The quantity supplied at a market price of $600/ton is (about) 240 (black dot). Consider another market price, P=1,200 and note that x* increases. Marginal Cost of Apples 1,600 mc 1,400 mr when P=1,200 1,200 1,000 Price ($/ton) 800 mr when P=600 600 400 200 100 200 300 400 Apples (tons/year)

Finding the Value of Profit - Case A mc atc If market price is P*, then the firm supplies x* where mr=mc. Total Revenue=OACQ* Total Cost=OBDQ* Note: use the atc curve to get the value of total costs by multiplying atc by x* Profit = tr-tc=BACD P* = mr A C B D O x* Quantity

Finding the Value of Profit - Case B mc atc If market price is P*, then the firm supplies x* where mr=mc. Total Revenue=OBDQ* Total Cost=OBDQ* Profit = tr-tc=0 Note: economic profit = 0 P* = mr B D O x* Quantity

Finding the Value of Profit - Case C If market price is P*, then the firm supplies x* where mr=mc. Total Revenue=OACQ* Total Cost=OBDQ* Profit = tr-tc = -ABDC Note: Profits are negative. They are loses. Should firm continue to operate? Good question. Now need to look at where the average variable cost curve is. Recall: produce at a loss provided tr  vc or p  avc Since P>avc at x*, firm should produce x*. P mc atc avc D B P* = mr A C O x* Quantity

The Firm’s Supply Curve An individual perfectly competitive firm’s supply curve (the srsfirm) is its marginal cost curve above its average variable cost curve. For a perfectly competitive firm, choosing the output at which market price equals marginal cost maximizes profits. Remember, it’s really mr=mc at x*, but since the firm is a price taker, P=mr all the time, so P=mc at x*.

Jonathan’s Supply Curve At the market price indicated on the vertical axis, profit maximizing apple production is given by the marginal cost curve, which is Jonathan’s supply of apples curve. The supply curve is the the marginal cost curve above average variable cost because profit maximizing behavior means increasing production until marginal cost = market price.

Total Costs and Economic Profits Total costs include fixed costs, variable costs (at market prices) and the opportunity cost of owned factors (such as the owner’s time, land, and equipment owned by the business). Economic profits are the difference between total revenue from sales and total costs, as defined above.

Back to Jonathan’s Farm... The apple market is competitive. Jonathan cannot control the price of apples. Consider, for the moment, a price of say $528/ton now To profit maximize Jonathan produces until P (=mr) = mc

Jonathan’s Economic Profit and Loss At the market price of $528, the profit maximizing apple production is the highlighted line.

Graph of Jonathan’s Revenue and Cost The vertical difference between Jonathan’s total revenue and total cost curves is his economic profits. The slope of the total cost line (marginal cost) is equal to the slope of the total revenue line (marginal revenue = market price)

Graph of Jonathan’s Economic Profits The chart at the right shows that Jonathan’s economic profits are maximized at apple production where the market price is equal to the marginal cost (230 tons/year). Profits are maximized when marginal cost is as close as possible to market price, without exceeding it. The slope of economic profits = zero at the profit maximum.

Accounting Profits Accounting profits are defined as total sales revenue (the same as total revenue in the economic profits definition) minus operating costs (costs of goods sold + administrative and sales costs for those who know some accounting). Accounting Profits = Sales Revenue - Accounting Costs

Did Jonathan Make Accounting Profits? The blue line in the table illustrates that Jonathan makes an accounting profit of $40,800 when the apple price is $528/ton.

Economic Profits Economic profits are the difference between total revenue and total costs. Economic total costs include the opportunity costs of all inputs to the production process–in particular, the opportunity costs of the owner’s time and physical capital (equipment and space).

Reconciling Economic and Accounting Profits The table to the right shows that Jonathan’s economic profits equal his accounting profits minus the opportunity cost of his time. Thus, when the price of apples is $528/ton and 230 tons/year are sold, economic profits = $27,600

Question 1 At a market price of $440/ton for apples, what is the optimal annual production of apples? Use the data on your handout to answer this question.

Answer 1 Marginal cost = market price = $440/ton at a production level of 210 tons/year. This is the profit maximizing level of output when the market price is $440/ton.

Question 2 At a market price of $440/ton for apples, what are Jonathan’s accounting and economic profits?

Answer 2 Total revenue = $440 x 210 = $92,400. Total costs = $124 x 100 (land) + $8.00 x 7,320 (labor) + $12.00 x 1,100 (proprietor’s time) = $84,160 . Economic profits = total revenue - total costs = $92,400 - $84,160 = $8,240.

Answer 2 (continued) Total revenue = $440 x 210 = $92,400. Accounting costs = $124 x 100 (land) + $8.00 x 7,320 (labor) = $70,960. Accounting profits = total revenue - accounting costs = $92,400 - $70,960 = $21,440. Economic profits = accounting profits - opportunity cost of owner’s time = $21,440 - $13,200 = $8,240.

Question 3 At a market price of $400/ton for apples, what are Jonathan’s accounting and economic profits?

Answer 3 Optimal production = 200 tons/year. Total revenue = $400 x 200 = $80,000. Economic profits = total revenue - total costs = $80,000 - $80,000 = 0. Accounting profits = total revenue - accounting costs = $80,000 - 66,800 = 13,200.

Question 4 Should Jonathan continue to operate the apple farm if the market price of apples is $400/ton?

Answer 4 Jonathan’s economic profits are zero when the market price of apples is $400/ton ($0.20/pound, about the current price wholesale price for first quality fresh apples). Jonathan just recovers the opportunity cost of his time ($13,200), so he is indifferent between producing apples and taking a job at $12/hour.

Producers Surplus Revisited Producers surplus measures the gain to the firm from selling all units at the market price. Producers surplus is the supply-side equivalent of consumers surplus. Total producers surplus = the area above the marginal cost curve and below the market price = economic profits + fixed costs. Incremental producers surplus = the difference between the market price and the marginal cost of the given unit of production.

Jonathan’s Producers Surplus Jonathan’s total producers surplus, when the market price is $528, is the sum of his economic profits ($27,600) and his fixed costs ($25,600) = $53,200.

Producers Surplus and Economic Profits Producers surplus is not equal to economic profits. Producers surplus includes fixed costs. Economic profits = producers surplus - fixed costs. Producers surplus = economic profits + fixed costs.

The Market Supply Curve The market supply curve is the sum of the quantities supplied by each seller at each market price. Market supply, thus reflects the marginal costs of each of the producers in the market. This is Short Run Market Supply (SRS)

Supply Curve for a New York Apple Farm The data used to construct Jonathan’s supply curve were representative of the typical New York State apple farm. The supply curve for a single apple farm is shown to the right. It is the same as the supply curve we have been using, based on the marginal cost curve of a single farm.

Market Supply Curve: Horizontal Summation Farm A’s Supply of Apples Farm B’s Supply of Apples 1,600 1,600 1,400 1,400 1,200 1,200 1,000 1,000 Price ($/ton) Price ($/ton) 800 800 600 600 400 400 200 200 100 200 300 400 100 200 300 400 Apples (tons/year) Apples (tons/year) At a price of $1000/ton, add Farm A’s supply to Farm B’s supply to get market supply (about 560 tons/year). Add over all farms. The market supply curve is the horizontal summation of the firms’ supply curves.

Short Run Equilibrium - Summary The firm is profit maximizing - no desire at current market price to change the quantity supplied. Firm is on its short run supply curve Market Demand = Short run Market Supply No tendency for market price to change Note: number of firms fixed, technology given and firm’s capital fixed. Get: (P*, X*, x*) Firms can have +/0/- profit.

Profit Signal When profit in the short run is positive there are firms at the margin that want to enter the market and it is assumed that they can. When profit in the short run is negative there are firms at the margin that want to exit the market and it is assumed that they will.

Long Run Equilibrium All the short run equilibrium properties. But also…no firms wish to exit the market nor do firms want to enter. Get: (P*, X*, x*, N*) Note: For there to be neither entry or exit, need economic profit to be zero. This is a long run equilibrium requirement. Otherwise the number of firms in the market will still be in flux.

Long Run Equilibrium Position Profit max implies that mr=lrmc at x*. Zero profit implies P=lratc at x*. Since the firm is perfectly competitive, P=mr at all values of x. By substitution, P=lratc at x* and P=lratc at x*. Therefore lrmc=lratc at x*. This implies that x* is at the minimum of the typical firm’s lratc. x* is at MES. P* must be the price consistent with the minimum value on the lratc curve. N* and X* determined by position of market demand.

Long Run Equilibrium Picture SRS w/N* lratc A a P* P* mr D X* X x* x market typical firm

Steps to Draw The Picture? Doesn’t matter how you draw it, as long as you draw it correctly in the end. Draw-a-person test.

What’s not ok...

Increases in Demand When demand increases and is expected to remain at the increased level, the short run response is to move along the short run supply curve--higher price and greater quantity supplied. The long run response is to have entry in the market, movement along the long run supply curve--price returns to the minimum average total cost and quantity supplied increases.

Long Run Adjustment Picture srmc D new SRS w/N* sratc lratc B b mr’ P’ P’ A a P* P* mr D X* X’ X x* x’ x market typical firm

Long Run Equilibrium Picture srmc D new SRS w/N* sratc lratc SRS w/N** B b mr’ P’ P’ A C a P* P* mr LRS D X* X’ X** Q x* x’ x market typical firm

Long Run Supply in the Market Both points A and C in the previous picture are long run equilibrium points. Point B is a temporary short run equilibrium point. If you connect all points like A and C you get the market long run supply curve in a perfectly competitive market. D new SRS w/N* SRS w/N** B P’ A C P* LRS D X* X’ X** X

Long Run Supply in the Market The long run supply curve in the market is horizontal at the long run equilibrium price P*. P* is sometimes called the “normal price.” P* is the price consistent with the typical firm’s minimum long run average total cost. Note: important assumption is that the position of the firm’s cost curve is unaffected by entry (or exit) of firms in the market. D new SRS w/N* SRS w/N** B P’ A C P* LRS D X* X’ X** X

Example: Long Run Supply in the System-fixer Market The market demand for system installations is shown by the blue line in the graph. The market is very much larger than firm’s at the efficient scale, so we expect competitive conditions to prevail. The long run supply (in red) reflects the technological and competitive conditions in the market: surviving firms must operate at the scale of firm B at a minimum average total cost of $26/installation. Short run supply is shown in brown.

Question How many firms are there in the long run in the system-fixer market?

Answer Firms with the efficient scale do 8 installations per week at an average total cost of $26/installation. At $26/installation the market demand is 8,000 installations per week. Therefore, there are 1,000 firms in the market.

Increase in Demand in the System-fixer Market Demand increases in the market as indicated by the new (black) demand curve. The short run response is an increase in price with not much additional quantity supplied (point A), movement along the short run supply curve. The long run response is a return to the original price of $26/installation and an expansion of quantity supplied along the long run supply curve (point B).

Question What would be the long run result of a fall in demand for system installations when the quantity demanded at $26/installation is 4,000.

Answer Now, only 500 firms operating at the minimum efficient scale will survive. The industry will shrink by exit of some system fixer firms. Of the original 1,000 firms, only 500 survive.

External Economies and Diseconomies of Scale If the industry exhibits no external economies or diseconomies of scale, then the industry long run supply curve is perfectly elastic (horizontal). The industry grows by replicating firms at the efficient scale. Entry and exit leaves the position of cost curves intact. This is called a constant cost industry. If the industry exhibits external diseconomies of scale, then the industry long run supply curve is upward sloping. The minimum average total cost of all firms in the industry rises as the size of the market grows. This is called an increasing cost industry. If the industry exhibits external economies of scale, then the industry long run supply curve is downward sloping. The minimum average total cost falls as the size of the industry grows. This is called a decreasing cost industry.

Constant Cost Industry When we draw the long run supply curve as a horizontal line, we are asserting that there are no external economies or diseconomies of scale. Lack of economies or diseconomies of scale means that growth of the industry doesn’t foster technological improvements and doesn’t change the prices of inputs.

External Diseconomies of Scale When an industry long run supply curve slopes upward, the industry exhibits external diseconomies of scale. This can occur because the prices of the inputs rise as the industry expands. This can also occur because the industry becomes “congested” and the minimum average total cost at the efficient scale rises. Quantity Price Long run supply with external diseconomies of scale in the industry

Examples of Long Run Supply Curves that Slope Up As a competitive industry grows its demand for certain specialized factors increases (information systems specialists in the accounting service industry, fabrication equipment in the microprocessor industry). Increased demand for specialized factors means that the equilibrium price of these factors will increase (movement along a factor supply curve--increased quantity and increased price of the factor). So as the industry (not the firm) grows, the price of these specialized factors increases and the minimum average total cost rises. Thus, the long run supply curve slopes upward.

Long Run Competitive Equilibrium - Reviewed The firms in a perfectly competitive market are in long run equilibrium when Quantity supplied = Quantity demanded at the current market price. Firm’s are profit maximizing so that marginal revenue (= Price) = marginal cost for all firms in the market. Price = minimum average total cost for all firms in the market, implying zero economic profit. No firm wants to enter the market. No firm currently in the market wants to exit.

Why are there zero economic profits in the long run? Zero economic profits means that all factors used in production make exactly their opportunity cost. Purchased factors receive their market price, which is equal to their opportunity cost. Owned factors receive the same compensation that they would receive in their next best use, which is also equal to their opportunity cost. Thus, no firm wants to enter the market because it cannot make any more money than it is currently making. Similarly, no firm wants to leave the market because it cannot make any more money in any other business.

Performance Efficiency: Equity: Allocative efficiency: (look at market) The level of output traded is allocatively efficient if it maximizes net social surplus. Productive efficiency: (look at the firm) The firm’s output level is productively efficient if it is at the minimum of the firm’s long run average total cost curve, that is, if it is at least as large as minimum efficient scale of production. Equity: Is the outcome of the allocatoin process fair? Equitable? Just?

Long Run Competitive Equilibrium - Performance Efficiency: The market equilibrium is allocatively efficient. That is, at X*, net social surplus is maximized. Each firm is productively efficient. That is each firm operates at, at least, minimum efficient scale. Each firm operates at the minimum of its long run average total cost curve. Equity: Is the outcome of the competitive process fair? Equitable? Just? Good questions that we do not answer here and now.

Allocative Efficiency - Proof If X* is allocatively efficient, then net social surplus should be as high as it can feasibly be. Net Social Surplus = $TBsociety - $TCsociety When net social surplus is as high as it can be, $MBsociety = $MCsociety Question: Is the outcome of the competitive process allocatively efficient?

Answer Demand=Supply at X*. Demand represents $marginal benefit. Supply represents $marginal cost. So…marginal benefit equals marginal cost at X*. So…net social surplus is maximized at X*. There is no transaction among the buyers and sellers that improves the welfare of at least one person without reducing the welfare of at least one person.

Productive Efficiency - Proof Profit max implies that mr=lrmc at x*. Zero profit implies P=lratc at x*. Since the firm is perfectly competitive, P=mr at all values of x. By substitution, P=lratc at x* and P=lratc at x*. Therefore lrmc=lratc at x*. This implies that x* is at the minimum of the typical firm’s lratc. x* is at MES. P* must be the price consistent with the minimum value on the lratc curve.