Perfect Competition, Profits, Supply Chapter 9

Costs and Supply Decisions How much should a firm supply? –Firms and their managers should attempt to maximize profits (Revenues – Costs) –Select a pricing strategy that induces a demand for a product that generates highest revenue relative to the cost of production of that level of supply. Profits depends on response of revenues to changes in production quantities.

Perfect Competition/ Price Taking We think of some markets as characterized by perfect competition –In competitive markets, no firm has the market power to set their own price. Firms in perfectly competitive markets take their price as given. Demand curve for an individual producer of a commodity is perfectly elastic. China Price DownloadDownload

Characteristics of Competitive Markets Non-differentiated goods Large number of firms All firms are small relative to the market Free entry and exit. Name some competitive markets in HK Name some uncompetitive markets

MES and Market Structure If MES is relatively small in comparison with market demand: $ Q Many “small” firms in the market.

Revenues and Perfect Competition Revenues = Price * Quantity Average Revenue = Price Marginal Revenue is the extra revenue generated by selling an extra good. –If production by a firm doesn’t shift the price, marginal revenue is the price.

Profits Profits = Revenues – Total Costs Remember, total costs includes economic costs.

Profit Maximization: Short Run In the short-run, firm may only have a limited number of avenues along which they may vary production. Cost of producing each good is likely to increase. But as long as the extra revenue that the good brings in exceeds the extra cost, it will be profitable to produce it. Maximize profits by producing up to that point that price is equal to marginal cost. Beyond that, producing more goods only subtracts from profits.

Increase Production until marginal cost reaches the price level. Q P ATC MC P Q*

Revenues are price × quantity Q P ATC MC P Q* Revenues

Profits are Revenues - Costs Q P ATC MC P Q* Profits Costs

Profit Maximization: Price is 80

What if prices drop? Q P ATC MC P Q** -Profits Costs P'P' Breakeven point

The average total cost of production (when marginal cost equals price) is above the new lower price. –If the firm sets production at a level such that price equals marginal cost, but that is the best they can do in the short run. –Firms only decision is to vary production costs along those dimensions that are available. Should the firm shut down? –No. The firm has paid costs which cannot be retrieved [SUNK COSTS]. Since the firm cannot change this, they should ignore these sunk costs in making their marginal decision. –As long as prices exceeds variable costs, produce.

Profit Maximization: Price is 60

When should the firm stop production in the short-run? Q P ATC MC P Q** P'P' Breakeven point AVC Dropout point

Adjustment in the Long Run In the longer run, firms are able to adjust the size of their plant. (adjust the number of machines in the factory, adjust the number of oil rigs). If profits are positive. Firms will seek to build new equipment as they compete for profits. If profits are negative, firms will shut down equipment and sell it, or possibly go out of business. –Firms will adjust their physical plant until they are making profits again.

Profit maximization and the supply curve In the short-run, firms produce up to that point where price equal marginal cost. Supply curve is the sum of the supply curves of the different firms in the market. In the long-run, capacity will be adjusted to the point where profits are zero (i.e. where marginal cost equals average total cost). Long run ATC curve is collection of points where MC = ATC and is the long-run supply curve.

Firm Level Supply Curve: Short Run Output SR ATC MC P P* S Firm 1 In the short run, MC curve is the relationship between firm price and production

Firm Level Supply Curve: Short Run Output SR ATC MC P P* S Firm 2

Industry Level Supply Curve: Short Run Output P S Firm 1 In the short run, the sum of the MC curves is the relationship between price and industry production +S Firm 2 +S Firm 3 S Industry

Short Run Response to Increase in Demand Increase Variable Inputs S Industry Output P D Q* P* D'D' Q** P** 1 2

Firm Level Supply Curve: Short Run Output SR ATC MC P P* S Firm 1 In the short run, MC curve is the relationship between firm price and production P** q*q* q ** 1 2

Short-run profits attract new entrants Output SR ATC MC P S Firm 1 In the short run, MC curve is the relationship between firm price and production P** q*q* q ** Profits 2

New Entrants in the Long Run Supply Increases and Price Drops S Industry Output P D Q* P* D'D' Q** P** +S Firm N+ 1 P** Q*** 1 2 3

Firm Level Response to New Entrants: Reduce Output Output SR ATC MC P P* S Firm 1 In the short run, MC curve is the relationship between firm price and production P** q*q* q ** P*** q *** 1 2 3

New Entrants as Long as Profits at MES Supply Increases and Price Drops S Industry Output P D Q* P* D'D' Q** P** +S Firm N+ 1 P** Q*** S Firm N+ J 4 Q****

Firm Level Response to New Entrants: Reduce Output Output SR ATC MC P P* S Firm 1 In the short run, MC curve is the relationship between firm price and production P** q*q* q ** P*** q *** 1,4 2 3

Long Run, Supply is Flat along MES of New Entrants S Industry Output P D Q* P* D'D' Q** P** Q*** 1 2 +S Industry 4 Q**** S LR

Long Run Supply Curve If all firms are exactly the same, then new firms have same MES as old firms and supply curve is flat. In some cases, like oil drilling, new firms may have higher MES than old firms and supply curve is upward sloping. Long run supply curve is flatter, more elastic than short-term supply curve.

Long Run Equilibrium Firms are making zero profits. Firms will be producing at their minimum efficient scale and at a minimum of ATC

Learning Outcomes Students should be able to Characterize a perfectly competitive market. Calculate total revenue, marginal revenue and profit for a firm in a competitive market. Describe the supply curve in a competitive market in both the short and long run. Explain economies of scale and compare the effects of demand on price in a competitive market with increasing, decreasing, and constant costs.