Profit Maximization in Pure Competition

Perfect Competition Situation: Situation: Yves and Zoe are neighboring farmers and both grow organic tomatoes. Yves and Zoe are neighboring farmers and both grow organic tomatoes. Both sell to the same grocery store chains that carry organic foods. Both sell to the same grocery store chains that carry organic foods. Do Yves and Zoe compete with each other? Do Yves and Zoe compete with each other? YES! YES! Should Yves try to stop Zoe from growing tomatoes or should Yves and Zoe form an agreement to grow less? Should Yves try to stop Zoe from growing tomatoes or should Yves and Zoe form an agreement to grow less? NO! NO!

Perfect Competition In the real world (real in Economic Class world), there are tons upon tons of organic tomatoes farmers. In the real world (real in Economic Class world), there are tons upon tons of organic tomatoes farmers. Yves and Zoe compete with each other but with all those other farmers Yves and Zoe compete with each other but with all those other farmers If one of them produced more or less, there would be no measurable effect on market prices! If one of them produced more or less, there would be no measurable effect on market prices!

Perfect Competition Yves and Zoe are price-taking producers Yves and Zoe are price-taking producers – A producers whose actions have no effect on the market price of the good or service it sells Yves and Zoe are price-taking producers because their actions cannot affect the market price of the good or service they sell Yves and Zoe are price-taking producers because their actions cannot affect the market price of the good or service they sell When there is enough competition (when competition is “perfect”) every producer is a price-taker When there is enough competition (when competition is “perfect”) every producer is a price-taker

Perfect Competition Now, what about consumers? Now, what about consumers? A consumer whose actions have no effect on the market price of the good or service he buys is a price-taking consumer. A consumer whose actions have no effect on the market price of the good or service he buys is a price-taking consumer. The market price is unaffected by how much or how little of the good the consumer buys The market price is unaffected by how much or how little of the good the consumer buys

Defining Perfect Competition In a perfectly competitive market, all market participants, both consumers and producers, are price-takers. In a perfectly competitive market, all market participants, both consumers and producers, are price-takers. – Neither consumption decisions by individual consumers nor production decisions by individual producers affect the market price of the good The supply and demand model is a model of a perfectly competitive market. The supply and demand model is a model of a perfectly competitive market. – Depends on the assumption that no individual buyer or seller of a good believes it is possible to individually affect the price at which he or she can buy or sell the good

Defining Perfect Competition General rule: consumers are price-takers General rule: consumers are price-takers Industry in which producers are price-takers is called a perfectly competitive industry Industry in which producers are price-takers is called a perfectly competitive industry – This is an industry in which producers are price- takers When are all producers price-takers? When are all producers price-takers? There are two necessary conditions! There are two necessary conditions!

Two Necessary Conditions for Perfect Competition 1. Must contain many producers but none of which whom have a large market share 1. Must contain many producers but none of which whom have a large market share 2. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent 2. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent

Two Necessary Conditions for Perfect Competition Example for explanation is the market for major grains, like wheat and corn Example for explanation is the market for major grains, like wheat and corn The market is perfectly competitive – individual wheat and corn farmers, as well as individual buyers of wheat and corn, take market prices as given The market is perfectly competitive – individual wheat and corn farmers, as well as individual buyers of wheat and corn, take market prices as given The markets for some of the good items make from these grains – breakfast cereals – are by no mean perfectly competitive The markets for some of the good items make from these grains – breakfast cereals – are by no mean perfectly competitive There is intense competition among cereal brands, but NOT PERFECT COMPETITION There is intense competition among cereal brands, but NOT PERFECT COMPETITION

1. Must contain many producers but none of which whom have a large market share A producer’s market share is the fraction of the total industry output accounted for by that producer’s output A producer’s market share is the fraction of the total industry output accounted for by that producer’s output The distribution of the market share constitutes a major difference between the grain industry and the breakfast cereal industry The distribution of the market share constitutes a major difference between the grain industry and the breakfast cereal industry – Thousands of wheat producers but four producers dominate the breakfast cereal industry (Kellogg’s – hold 1/3 of the market --, General Mills, Post, and Quaker Foods) – The breakfast producers know their actions influence market prices

2. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent Not true in the case of the breakfast cereal market – consumers don’t consider Cap’n Crunch to be a good substitute for Wheaties Not true in the case of the breakfast cereal market – consumers don’t consider Cap’n Crunch to be a good substitute for Wheaties – Maker of Wheaties has some ability to increase its price without fear that it will lose all its customers to the maker of Cap’n Crunch Standardized Product is when a product that consumers regard as the same good even when it comes from a different producers, sometimes known as a commodity (something that is indistinguishable) Standardized Product is when a product that consumers regard as the same good even when it comes from a different producers, sometimes known as a commodity (something that is indistinguishable) – Example: Corn, Wheat, Pencils, Pen, lined paper, copy paper

2. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent With wheat being a standardized product, consumers regard the output of one wheat producer as a perfect substitute for that of another producer With wheat being a standardized product, consumers regard the output of one wheat producer as a perfect substitute for that of another producer BUT….one farmer cannot increase the price for his wheat without losing all sales to other wheat farmers BUT….one farmer cannot increase the price for his wheat without losing all sales to other wheat farmers → second necessary condition for a competitive industry is that the industry output is a standardized product

Free Entry and Exit Most perfectly competitive industries are also characterized by one more feature: it is easy for new firms to enter the industry and for firms already in the industry to leave Most perfectly competitive industries are also characterized by one more feature: it is easy for new firms to enter the industry and for firms already in the industry to leave No obstacles in the form of government regulations or limited access to key resources prevent new producers from entering the market No obstacles in the form of government regulations or limited access to key resources prevent new producers from entering the market No additional costs are associated with shutting down a company and leaving the industry No additional costs are associated with shutting down a company and leaving the industry

Free Entry and Exit Free Entry and Exit in an industry is when new producers can easily enter into an industry and existing producers can easily leave that industry Free Entry and Exit in an industry is when new producers can easily enter into an industry and existing producers can easily leave that industry This is a key factor in most competitive industries This is a key factor in most competitive industries It make sure that the numbers of producers in an industry can adjust to changing market conditions It make sure that the numbers of producers in an industry can adjust to changing market conditions Also ensures that producers in an industry cannot act to keep other firms out! Also ensures that producers in an industry cannot act to keep other firms out!