Chapter 6 – Production Behavior: Perfect Competition zThis chapter examines perfect competition as a market structure. zIt also develops the profit maximizing producers choice of output under perfect competition, and the formation of profits. zFinally, it examines how markets adjust to firms making excess profits, or suffering losses in perfect competition.

Perfect Competition: Key Characteristics zThere are a large number of producers within a market for a certain good. zThe goods within a market are homogeneous – there exist no quality differences, real or perceived, between the same good made by different producers. zEasy entry and exit (no barriers to entry).

Market Demand and Supply for Good in General zConsider, for example, eggs. zMarket Demand – usual market demand curve for eggs, discussed in chapter 4. zMarket Supply – usual market supply curve for eggs, discussed in chapter 5. zMarket forms an equilibrium price (P*) and equilibrium quantity (Q*) of eggs.

Market Demand for the Individual Producers Good zHomogeneous goods individual producers eggs are perfect substitutes with other egg producers eggs. zTherefore, the Demand for the individual producers eggs is described as a horizontal line at the market equilibrium price P*.

Total Revenue for the Individual Producer zPerfect Competition: firms are price takers, they have no power over setting or changing the price of their product. zTotal Revenue = (P*)(Q), where Q is the amount they decide to produce.

Total Cost for the Individual Producer zTotal Cost – the total expenditure the firm spends due to its use of inputs (materials, labor, capital) to produce a certain amount of output. -- Fixed Cost: the cost to the firm which remains the same no matter how much it produces (including zero). -- Variable Cost: the cost to the firm which varies based upon how much it produces

Average and Marginal Cost zAverage Cost (AC) – firms total cost per unit of output. AC = (Total Cost)/Q zMarginal Cost (MC) – the change in total cost due to a change in output. MC = (Total Cost)/ Q

An Example: King Davids Production Function Output (Lunches) Labor Input (People)

Computing Total, Average, and Marginal Cost zOne needs information about fixed cost, and cost per unit of labor. zFor our numerical example, suppose that: -- Fixed Cost (materials, machine and building rental) = $ Each Person Costs $30.

King Davids Total Cost Labor Fixed Cost + Wage Cost = Total Cost

King Davids Average Cost (AC) and Marginal Cost (MC) Output (Q) Total Cost AC MC

Characteristics of Average Cost and Marginal Cost Curves zBoth are u-shaped, zWhen AC is decreasing, MC < AC. zWhen AC is increasing, MC > AC. zAt the minimum point of the AC curve, MC = AC. zUpward sloping part of MC depicts Law of Diminishing Returns, relevant region of production choice.

The Production Decision and Producer Profits zTo maximize profits, the individual producer chooses to produce (Q 0 ) where P* = MC (marginal benefit of producing the additional unit equals the marginal cost of producing the additional unit. zProfit = (Total Revenue) – (Total Cost), Profit = (P*)(Q 0 ) – (Total Cost), Profit = (P*)(Q 0 ) – (AC)(Q 0 ).

Producer Choice and Profits: King Davids zSuppose that the market price for Marshall Street lunches (P*) equals $ zKing Davids chooses output (Q 0 ) where P* = MC. zThey compute Profits as Profits = (P*)(Q 0 ) – (AC)(Q 0 ).

King Davids Production (P* = 10.0) Output (Q) Total Cost AC MC

King Davids Production Choice and Profits zThey choose an output level (Q 0 ) where P* = MC, which corresponds to 104 lunches. zTotal Revenue = (10.00)(104) = zTotal Cost = 340 [approximately (AC)(Q 0 ), or (3.3)(104)]. zProfit = = 700.

Economic Profit ( ) zEconomic Profit ( ) – Profits for a firm where Total Costs include the opportunity cost of the entrepreneur taking his/her talents to another industry. zZero Economic Profit ( = 0) implies just enough accounting profits to keep the entrepreneur in the industry. zPositive Economic Profit ( > 0) implies accounting profits in excess of the minimum requirement.

A Graphical Description zFirms choose output (Q 0 ) where P* = MC. zTotal Revenue = Area of rectangle of width Q 0 and height P*. zTotal Cost = Area of rectangle of width Q 0 and height AC (based upon the choice of Q 0 ). zProfit ( ) = Difference in areas. zProfit ( ) can be positive (wonderful), zero (OK), or negative (firm considers closing).

Market Response to Positive Profits zIf firms in the industry are making positive profits, invites other firms to enter (no barriers to entry, or no market power). zIncreases market supply (shifts market supply curve rightward), decreases P*. zChanges the output choice (Q 0 ) and decreases the profits of the individual firm.

Market Response to Negative Profits zIf firms in the industry are making negative profits, some firms exit the industry. zDecreases market supply (shifts market supply curve leftward), increases P*. zChanges the output choice (Q 0 ) and increases the profits of the (surviving) individual firms.

Perfect Competition in the Long-Run zPerfect Competition in the Long-Run: Zero Economic Profits ( = 0) zUltimate long-run position of markets under perfect competition with the nice assumptions. zNo incentive for new firms to enter the market. zNo incentive for existing firms to exit the market.

The Agility of Markets Under Perfect Competition zThe ability of firms to enter highly favorable markets or exit highly unfavorable markets creates market-resolving changes in the equilibrium price level. zAs a result -- (1) firms dont maintain permanent advantages and (2) unfavorable markets dont stay unfavorable for the survivors.