P ERFECT C OMPETITION (C H. 10) Claudia Garcia-Szekely ©2001ClaudiaGarcia-Szekely 1

“THE MARKET IS THE WORST SYSTEM OF ECONOMIC AND SOCIAL DEVELOPMENT – EXCEPT FOR ALL THE OTHERS THAT HAVE BEEN TRIED FROM TIME TO TIME.” Sir Winston Churchill 2

MES: SMALLEST PLANT WITH LOWEST ATC IN THE LONG RUN MES: The smallest plant that prevents the firm from being “priced out” of the industry by firms with lower costs. Only firms with plants with the lowest cost will survive in the long run. 3

500,000 SRATC1 SRATC2 SRATC3 SRATC4 SRATC5 SRATC6 SRATC7 LRATC MES Total Market Demand = 3,000, ,000 # of surviving Firms = 3,000,000/500,000 = 6 firms each selling 500,000 # of surviving Firms = 3,000,000/150,000 = 20 firms each one sells 150,000 10,000 # of surviving Firms = 3,000,000/10,000 = 300 firms each sells 10,000 The smaller the size of the MES, the larger the number of firms that can successfully compete and survive in the industry The smaller the size of the MES, the more competitive the industry is. The larger the size of the MES, the more concentrated the industry is.

P ERFECT C OMPETITION A RISES W HEN The minimum efficient scale is small relative to Market demand. ©2001ClaudiaGarcia-Szekely 5

I N A P ERFECTLY C OMPETITIVE I NDUSTRY There are many firms: no single firm can affect the price Firms are price takers. There are many buyers: no single buyer can affect the price Buyers are price takers. All firms sell identical products. Established firms have no advantages over new firms. 6

P RICE IS D ETERMINED BY THE M ARKET 7 S D Q P All firms Sell at this price All firms Sell at this price Each firm produces only a tiny fraction(q) of this total Q Sum of all firms’ output Total Market Demand

P ERFECTLY COMPETITIVE FIRMS ARE PRICE TAKERS Each firm produces only small portion of the total supply Buyers know all prices from all firms in the market 8 A firm wouldn’t increase price above market price Because Lose all its customers to the competition A firm would not decrease its price Because It can sell all it wants at market price d Demand as perceived by each firm is perfectly elastic at the market price

P ERFECTLY C OMPETITIVE F IRMS ARE P RICE T AKERS 9 S D Q P d q1q1 P Given the price determined by the market PC firms decide how many units to produce at the market price. q2q2 q3q3 Which output level is best?

T OTAL R EVENUES Total Revenues = 10 Price x Quantity Sold TR quantity TR q Price TRPrice $ TR’ As the price increases, TR line becomes steeper $7

11 d P = $ Quantity purchased Price Quantity purchased TR MR MR = $ Q MR In PC markets: MR = Price

T OTAL R EVENUE /T OTAL C OST VIEW 12 Total Revenues Total Costs TR,TC Output Revenues (TR) - Total Costs (TC) Profit or Loss = Profit Total Revenues Total Costs Loss

Firms want to maximize Profits Total Revenues Total Costs Total Revenues Total Costs TR,TC -Total Costs (TC) =Profit (Loss) Total Revenues All these output levels generate losses. Losses All these output levels generate Profits. Profits All these output levels generate Losses.

14 Total Revenues Total Costs Total Revenues Total Costs TR,TC Firm must produce more than q 0 to offset these losses Firm chooses the output level that maximizes profits Profit The largest distance between TR and TC occurs when TR and TC have the same slope. TR TC q0q0 Losses

T OTAL P ROFITS ARE M AXIMIZED WHEN MR = MC 15 Total Revenues Total Costs TR,TC Slope of TC = Slope of TR MC = MR Profit Maximizing Output Level q*

C HOOSE OUTPUT WHERE MC= MR TO MAXIMIZE PROFIT TR TC Slope = MC Slope = MR MC = MR: Maximize Profit MAX Profit q*

P RICE DETERMINES P ROFIT /L OSS Total Revenues Total Costs Total Revenues Total Costs TR,TC Output Losses Profits If Price Decreases Slope of TR line decreases If the price continues to drop, there will be NO output level that generate a profit, only loss. For all these output levels the firm makes a profit: chooses the output with the largest profit. Profits Profit

C HOOSING Q WHERE MR = MC M AXIMIZE PROFIT OR M INIMIZE L OSS TR TC Slope = MC Slope = MR Loss q* MC = MR TR = TC Loss = zero Choose q where MC = MR to Minimize Loss

TR LESS THAN TC: E CONOMIC L OSSES At q*, the slope of TC (MC) = Slope of TR (MR) But the firm does not make a profit TR TC Slope = MC Slope = MR q* Smallest Loss Loss Choose q where MC = MR to Minimize Loss

M ARGINAL R EVENUE (MR): A DDITIONAL REVENUE FROM SELLING ONE MORE UNIT. 20 MR Q MR = Price = $5 In PC markets, the additional Revenue the firm gets from selling one more unit is the price per unit 5

PROFIT PER UNIT = MR-MC PROFIT PER UNIT = PRICE - MC 21 MR, MC Q MR= Price = $5 MC = Cost per unit Negative: Loss Positive: Profit

Number of Units (Q)Profit Per Unit = MR – MC Total Profit = Sum of Per unit profit Fill in the values in the table using the information in the next slide Price - MC

P = $5 MR=$5 MC Loss = $5 - $9 = -4 Loss = $5 - $8 = -3 Loss = $5 - $6 = -1 Loss = $5 - $5 = 0 Profit = $5 - $3 = +2 Profit = $5 - $2 = +3 Profit = $5 - $1 = +4 Profit = $5 - $2 = +3 Profit = $5 - $3 = Profit = $5 - $5 = 0 Profit = $5 - $4 = +1 Loss = $5 - $7 = -2 Loss = $5 - $8 = -3 Loss = $5 - $11 = -6

P = 5 MR MC If The firm produces more than 11 units, profits will shrink as losses start to accumulate… Profit maximizing output level

Number of Units (Q) Profit Per Unit = Price – MC Total Profit is sum of per unit profit = = = = – 3 = – 2 = – 1 = – 2 = – 3 = – 4 = – 5 = = = = -6-4 Max per unit profit at q = 7 Max TOTAL profit at q= 11 Always choose output at the maximum TOTAL profit Never choose output at the maximum PER UNIT profit

26 Per unit view Total view Profit maximizing output level Total Revenues Total Costs Total Revenues Total Costs TR,TC Output Losses Profits

27 Total Revenues Total Costs TR,TC Slope of TC = Slope of TR MR = MC The output level where the Total Profit is largest Is the same as the output level where per unit profit is zero TRTC

CHOOSING THE OUTPUT LEVEL THAT MAXIMIZES PROFIT Choose q* at the point where MC = MR Since MR = Price Choose q* where MC = Price 28

29 MC AVC ATC P=MR q* Profit Max Output level P M ARGINAL R EVENUE /M ARGINAL C OST VIEW

ATC LESS THAN P RICE : E CONOMIC P ROFIT 30 © 2001 Claudia Garcia-Szekely MC AVC ATC P=MR ATC AVC q* Profit Max Output level VC FC TC AVC x Q = VC AFC x Q = FC ATC x Q = TC P TR P x Q = TR TR – TC = Profit

ATC = P RICE : Z ERO E CONOMIC P ROFIT MC AVC ATC P = MR P q* Profit Max Output level AVC VC ATC = P TC = TR No loss or profit TC TR = TC

MC AVC ATC P = MR P q* Profit Max Output level AVC VC ATC TC larger than TR TC ATC LARGER THAN P RICE : L OSS LOSS TR

SHUT DOWN Firm continues to pay all the fixed costs in order to KEEP the plant. Produces zero units. Variable Cost= ZERO Total Cost = Fixed Cost Total Revenue = ZERO Loss = TR (0) – TC (FC) = FC. 33 If by producing q*, the firm generates a loss larger than the FC, the firm should shut down to minimize the loss

MC AVC ATC P = MR P q* Profit Max Output level AVC VC ATC FC LOSS < FC TR Loss if the firm produces q* is smaller than the FC ATC larger than P P larger than AVC Revenues cover all VC and some of FC

MC P=MR ATC AVC q* Profit Max Output P P Revenues are NOT enough to pay for ALL the VC Loss if the firm produces q* is larger than the FC VC VC TC FC TR Loss = + some of the Loss P less than ATC P less than AVC

MC P=MR ATC AVC q* Profit Max Output level =P Loss if the firm produces q* is equal to FC VC VC TC FC TR Loss = Revenues are enough to cover only the VC P less than ATC P =AVC Loss

TR TC q* VC F IRM SHOULD PRODUCE AT A LOSS Loss less than FC FC TC larger than TR TR larger than VC

TR TC q* VC F IRM IS INDIFFERENT Loss = FC FC TC larger than TR TR = VC

TR TC q* VC F IRM SHOULD SHUT DOWN Loss greater than FC FC TC larger than TR TR less than VC

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41 P0P0 P1P1 P2P2 P3P3 P4P4 q0q0 q1q1 q2q2 q3q3 q4q4 PQ s short run P0P0 q0q0 P1P1 q1 q1 P2P2 q2 q2 P3P3 q3 q3 P4P4 q4 q4 MR Choose output where: MC = MR = Price As long as Price > AVC Choose output where: MC = MR = Price As long as Price > AVC MC MR If Price < AVC The firm should shut down If Price < AVC The firm should shut down

42 Minimum AVC is the shutdown point. The firm minimizes its losses by producing zero units. Shut Down P Shutdown Price AVC If Price < AVC Producing at MC=MR will generate losses greater than fixed costs. The firm should shut down If Price < AVC Producing at MC=MR will generate losses greater than fixed costs. The firm should shut down

T HE S HORT R UN S UPPLY C URVE Shut Down MCMC Above AVC = Supply in the short run To determine the quantity supplied in the short run choose q where: Price = MC. = Shut down point = minimum AVC If price < shut down price then the quantity supplied = 0 Produce at MR=MC AVC

P Typical Firm’s q s short run 10,000 Firms Market Supply MR 80 1M 800, , or ,000 Or 0 0 P = Shutdown Price 100

I N THE L ONG R UN FIRMS EXIT THE INDUSTRY IF THEY ARE INCURRING LOSSES EXIT P EXIT Price = Min ATC MC= Supply in the long run If price > exit price choose q where Price = MC. If price > exit price choose q where Price = MC. If price < exit price quantity supplied = 0. P q If price = ATC Firm is indifferent ATC

46 L ONG -R UN A DJUSTMENT If firms in an industry are earning economic profits, firms will enter and the industry expands. If firms in an industry are earning economic losses, firms will exit and the industry contracts. If firms in an industry are earning normal profits, expect no further entry or exit.

F IRMS ENTER ATTRACTED BY PROFITS : S UPPLY SHIFTS RIGHT P0 MR 0 ATC MC Profit D S0S0 S1S1 P1 MR 1 q0q0 q1q1 Zero Profit Price drops Firms will enter until profits are zero Firms will enter until price = Min ATC q0q0 q0q0

F IRMS EXIT DUE TO L OSS : S UPPLY SHIFTS LEFT P0P0 MR 0 ATC MC Loss D S0S0 S1S1 P1P1 MR 1 q0q0 q1q1 Zero Loss / Profit Firms will exit until Losses/profits are zero Firms will exit until price = Min ATC

Perfectly Competitive Firms earn only Normal Profits ( Zero Economic Profits) in the long run

A N INDUSTRY IS NOT IN EQUILIBRIUM IF : Firms have an incentive to change their output level Firms have an incentive to enter or exit the industry. Firms have an incentive to expand or contract the plant size

51 F IRMS HAVE AN INCENTIVE TO CHANGE THEIR OUTPUT LEVEL IF : 1. They are not maximizing profits. Firm should produce moreFirm should produce less MR > MC MC MR q0q0 MR < MC MC q1q1

52 F IRMS HAVE AN INCENTIVE TO CHANGE THEIR PLANT IF : 2.They are not minimizing LRATC. Firm should Expand to Plant 5Firm should Contract to Plant 5 LRATC Min ATC sratc5 sratc1 q0 q1 LRATC sratc5 sratc1 q0 Min ATC q1

F IRMS HAVE AN INCENTIVE TO ENTER OR EXIT AN INDUSTRY IF New Firms will ENTER the industry Some Firms will EXIT the industry ATC Economic Profits MC MR Profit q0 Economic Losses MC ATC Loss q0 MR

C ONDITIONS FOR E QUILIBRIUM I N THE L ONG R UN 1.Firms must be maximizing Profits MR = MC 2.Firms must be Minimizing Long Run Costs SRATC = LRATC 3.Firms must be earning Zero Economic Profit (No entry, No exit) P = ATC MR = MC MC MR q0 LRATC SRATC ATC MC P

Long Run Equilibrium Condition MR = MC = Price = SRATC = LRATC Max Profit Zero Economic Profit/Loss Min Cost No change in Output No entry/exitNo change in plant size

C OMPETITION FORCES FIRMS TO BE EFFICIENT P0 MR 0 ATC MC D S0S0 S1S1 P1 MR 1 q1q1 Price drops Firms will produce at the lowest ATC Firms will enter until price = Min ATC No Excess Capacity

W HEN FIRMS EXPAND S UPPLY SHIFTS RIGHT MC SRATC 1 SRATC 2 SRATC 3 LRAC P0P0 D S0S0 S1S1 P1P1 Price drops Firms will expand until they minimize the LRATC Firms produce with the lowest cost plant

58 MC SRATC 1 SRATC 2 SRATC 3 LRAC Price = ATC Consumers in perfectly competitive markets pay the lowest possible price Price = ATC Consumers in perfectly competitive markets pay the lowest possible price Price