Introduction to Markets & Perfect Competition

Introduction to Markets Market – any place or process that brings together buyers and sellers with a view to agreeing a price The basis of how an economy operates – through production and subsequent exchange

Introduction to Markets The range of markets: Organised markets – commodities e.g. rubber, oil, sugar, wheat, gold, copper, etc. Financial markets – stocks, shares, currencies, financial instruments Goods markets – the supply and demand of goods and services in general, food, clothing, leisure, houses, cars, etc. Factor markets – the supply and demand of factors of production – land, labour and capital

Introduction to Markets A market does NOT have to be a physical place like a shop The market place consists of all those who have items/services for sale and all those who are interested in buying those items/services Many businesses have global markets because of the developments in technology – see www.amazon.com

Introduction to Markets Demand – the amount consumers desire to purchase at various alternative prices Demand – reflects the degree of value consumers place on items – price and satisfaction gained from purchase (utility) Supply – the amount producers are willing to offer for sale at various prices Supply – reflects the cost of the resources used in production and the returns/profits required

Introduction to Markets Factors affecting the efficiency of markets The amount of information about the markets held by consumers and producers The ease with which factors of production can be put to alternative uses The extent to which price is an accurate signal of the true utility and true cost in determining the level of demand and supply (externalities) The degree to which firms hold monopoly power The degree to which property rights are clearly defined Whether the market can provide goods and services (public goods)

Revenue

Revenue Total revenue – the total amount received from selling a given output TR = P x Q Average Revenue – the average amount received from selling each unit AR = TR / Q Marginal revenue – the amount received from selling one extra unit of output MR = TRn – TR n-1 units

Profit

Profit Profit = TR – TC The reward for enterprise Profits help in the process of directing resources to alternative uses in free markets Relating price to costs helps a firm to assess profitability in production

Profit Normal Profit – the minimum amount required to keep a firm in its current line of production Abnormal or Supernormal profit – profit made over and above normal profit Abnormal profit may exist in situations where firms have market power Abnormal profits may indicate the existence of welfare losses Could be taxed away without altering resource allocation

Profit Sub-normal Profit – profit below normal profit Firms may not exit the market even if sub-normal profits made if they are able to cover variable costs Cost of exit may be high Sub-normal profit may be temporary (or perceived as such!)

Profit Assumption that firms aim to maximise profit May not always hold true – there are other objectives Profit maximising output would be where MC = MR

Profit MC – The cost of producing ONE extra unit of production Why? If the firm were to produce the 104th unit, this last unit would cost more to produce than it earns in revenue (-105) this would reduce total profit and so would not be worth producing. The profit maximising output is where MR = MC Assume output is at 100 units. The MC of producing the 100th unit is 20. The MR received from selling that 100th unit is 150. The firm can add the difference of the cost and the revenue received from that 100th unit to profit (130) Cost/Revenue The process continues for each successive unit produced. Provided the MC is less than the MR it will be worth expanding output as the difference between the two is ADDED to total profit If the firm decides to produce one more unit – the 101st – the addition to total cost is now 18, the addition to total revenue is 140 – the firm will add 128 to profit. – it is worth expanding output. MC MC – The cost of producing ONE extra unit of production MR – the addition to total revenue as a result of producing one more unit of output – the price received from selling that extra unit. 150 Total added to profit 145 Reduces total profit by this amount 140 Added to total profit 120 Added to total profit 40 30 20 18 MR Output 100 101 102 103 104

Perfect Competition The concept of competition is used in two ways in economics. Competition as a process is a rivalry among firms. Competition as the perfectly competitive market structure.

A Perfectly Competitive Market A perfectly competitive market is one in which economic forces operate unimpeded.

A Perfectly Competitive Market A perfectly competitive market must meet the following requirements: Both buyers and sellers are price takers. The number of firms is large. There are no barriers to entry. The firms’ products are identical. There is complete information. Firms are profit maximizers.

The Necessary Conditions for Perfect Competition Both buyers and sellers are price takers. A price taker is a firm or individual who takes the market price as given. In most markets, households are price takers – they accept the price offered in stores.

The Necessary Conditions for Perfect Competition Both buyers and sellers are price takers. The retailer is not perfectly competitive. A retail store is not a price taker but a price maker.

The Necessary Conditions for Perfect Competition The number of firms is large. Large means that what one firm does has no bearing on what other firms do. Any one firm's output is minuscule when compared with the total market.

The Necessary Conditions for Perfect Competition There are no barriers to entry. Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market. Barriers sometimes take the form of patents granted to produce a certain good.

The Necessary Conditions for Perfect Competition There are no barriers to entry. Technology may prevent some firms from entering the market. Social forces such as bankers only lending to certain people may create barriers.

The Necessary Conditions for Perfect Competition The firms' products are identical. This requirement means that each firm's output is indistinguishable from any competitor's product.

The Necessary Conditions for Perfect Competition There is complete information. Firms and consumers know all there is to know about the market – prices, products, and available technology. Any technological breakthrough would be instantly known to all in the market.

The Necessary Conditions for Perfect Competition Firms are profit maximizers. The goal of all firms in a perfectly competitive market is profit and only profit. The only compensation firm owners receive is profit, not salaries.

The Definition of Supply and Perfect Competition If all the necessary conditions for perfect competition exist, we can talk formally about the supply of a produced good.

The Definition of Supply and Perfect Competition Supply is a schedule of quantities of goods that will be offered to the market at various prices.

The Definition of Supply and Perfect Competition When a firm operates in a perfectly competitive market, it’s supply curve is that portion of its short-run marginal cost curve above average variable cost.

Demand Curves for the Firm and the Industry The demand curves facing the firm is different from the industry demand curve. A perfectly competitive firm’s demand schedule is perfectly elastic even though the demand curve for the market is downward sloping.

Demand Curves for the Firm and the Industry Individual firms will increase their output in response to an increase in demand even though that will cause the price to fall thus making all firms collectively worse off.

Market Demand Versus Individual Firm Demand Curve Market supply 1,000 3,000 Price $10 8 6 4 2 Quantity 10 20 30 Price $10 8 6 4 2 Quantity Market demand Individual firm demand

Profit-Maximizing Level of Output The goal of the firm is to maximize profits. Profit is the difference between total revenue and total cost.

Profit-Maximizing Level of Output What happens to profit in response to a change in output is determined by marginal revenue (MR) and marginal cost (MC). A firm maximizes profit when MC =MR.

Profit-Maximizing Level of Output Marginal revenue (MR) – the change in total revenue associated with a change in quantity. Marginal cost (MC) – the change in total cost associated with a change in quantity.

Marginal Revenue A perfect competitor accepts the market price as given. As a result, marginal revenue equals price (MR = P).

Marginal Cost Initially, marginal cost falls and then begins to rise. Marginal concepts are best defined between the numbers.

Marginal Cost, Marginal Revenue, and Price MC 1 2 3 4 5 6 7 8 9 10 $28.00 20.00 16.00 14.00 12.00 17.00 22.00 30.00 40.00 54.00 68.00 Price = MR Quantity Produced Marginal Cost $35.00 35.00 Costs 1 2 3 4 5 6 7 8 9 10 Quantity 60 50 40 30 20 C A P = D = MR A B McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Marginal Cost Curve Is the Supply Curve The marginal cost curve is the firm's supply curve above the point where price exceeds average variable cost.

The Marginal Cost Curve Is the Supply Curve The MC curve tells the competitive firm how much it should produce at a given price. The firm can do no better than produce the quantity at which marginal cost equals marginal revenue which in turn equals price.

The Marginal Cost Curve Is the Firm’s Supply Curve Cost, Price $70 60 50 40 30 20 10 1 Quantity 2 3 4 5 6 7 8 9 C A B

Firms Maximize Total Profit Firms seek to maximize total profit, not profit per unit. Firms do not care about profit per unit. As long as increasing output increases total profits, a profit-maximizing firm should produce more.

Costs Relevant to a Firm McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Costs Relevant to a Firm McGraw-Hill/Irwin © 2004 The McGraw-Hill Companies, Inc., All Rights Reserved.

Determining Profit and Loss From a Graph Find output where MC = MR. The intersection of MC = MR (P) determines the quantity the firm will produce if it wishes to maximize profits.

Determining Profit and Loss From a Graph Find profit per unit where MC = MR. Drop a line down from where MC equals MR, and then to the ATC curve. This is the profit per unit. Extend a line back to the vertical axis to identify total profit.

Determining Profit and Loss From a Graph The firm makes a profit when the ATC curve is below the MR curve. The firm incurs a loss when the ATC curve is above the MR curve.

Determining Profit and Loss From a Graph Zero profit or loss where MC=MR. Firms can earn zero profit or even a loss where MC = MR. Even though economic profit is zero, all resources, including entrepreneurs, are being paid their opportunity costs.

Determining Profits Graphically Quantity Price 65 60 55 50 45 40 35 30 25 20 15 10 5 1 2 3 4 6 7 8 9 12 D MC A P = MR B ATC AVC E Profit C Loss (a) Profit case (b) Zero profit case (c) Loss case Irwin/McGraw-Hill © The McGraw-Hill Companies, Inc., 2000

Short-Run Market Supply and Demand While the firm's demand curve is perfectly elastic, the industry's is downward sloping. For the industry's supply curve we use a market supply curve.

Short-Run Market Supply and Demand The market supply curve is the horizontal sum of all the firms' marginal cost curves, taking account of any changes in input prices that might occur.

Long-Run Competitive Equilibrium Profits and losses are inconsistent with long-run equilibrium. Profits create incentives for new firms to enter, output will increase, and the price will fall until zero profits are made. The existence of losses will cause firms to leave the industry.

Long-Run Competitive Equilibrium Only at zero profit will entry and exit stop. The zero profit condition defines the long-run equilibrium of a competitive industry.

Long-Run Competitive Equilibrium MC 60 50 40 30 20 10 Price 2 4 6 8 Quantity SRATC LRATC P = MR

Long-Run Competitive Equilibrium Zero profit does not mean that the entrepreneur does not get anything for his efforts. Normal profit – the amount the owners of business would have received in the next-best alternative.

Long-Run Competitive Equilibrium Normal profits are included as a cost and are not included in economic profit. Economic profits are profits above normal profits.

Long-Run Competitive Equilibrium Firms with super-efficient workers or machines will find that the price of these specialized inputs will rise. Rent is the income received by those specialized factors of production.

Long-Run Competitive Equilibrium The zero profit condition makes the analysis of competitive markets applicable to the real world. To determine whether markets are competitive, many economist focus on whether barriers to entry exist.