Chapter 24 Perfect Competition

Learning Objectives Identify the characteristics of a perfectly competitive market structure Discuss the process by which a perfectly competitive firm decides how much output to produce Understand how the short-run supply curve for a perfectly competitive firm is determined

Learning Objectives Explain how the equilibrium price is determined in a perfectly competitive market Describe what factors induce firms to enter or exit a perfectly competitive industry Distinguish among constant-, increasing-, and decreasing-cost industries based on the shape of the long-run industry supply curve

Did You Know That... Under extreme perfectly competitive situations, individual buyers and sellers cannot affect the market price? Economic profits that perfectly competitive firms may earn for a time ultimately disappear as other firms enter the industry?

Characteristics of a Perfectly Competitive Market Structure Perfect Competition A market structure in which the decisions of individual buyers and sellers have no effect on market price

Characteristics of a Perfectly Competitive Market Structure Perfectly Competitive Firm A firm that is such a small part of the total industry that it cannot affect the price of the product or service that it sells

Characteristics of a Perfectly Competitive Market Structure Price Taker A competitive firm that must take the price of its product as given because the firm cannot influence its price (Perfect Competitors are price takers and Monopolists are price searchers)

Characteristics of a Perfectly Competitive Market Structure Why a perfect competitor is a price taker Large number of buyers and sellers Homogenous products are perfect substitutes Buyers and sellers have equal access to information No barriers to entry or exit

The Demand Curve of the Perfect Competitor Question If the perfectly competitive firm is a price taker, who or what sets the price?

The Demand Curve for a Producer of Flash Memory Pen Drives Neither an individual buyer nor seller can influence the price The interaction of market supply and demand yields an equilibrium price of $5

The Demand Curve of the Perfect Competitor The perfectly competitive firm is a price taker, selling a homogenous commodity with perfect substitutes. Will sell all units for $5 Will not be able to sell at a higher price Will face a perfectly elastic demand curve at the going market price

The Demand Curve for a Producer of Flash Memory Pen Drives

How Much Should the Perfect Competitor Produce? Perfect competitor accepts price as given Firm raises price, it sells nothing Firm lowers its price, it earns less revenues than it otherwise would Perfect competitor has to decide how much to produce Firm uses profit-maximization model

How Much Should the Perfect Competitor Produce? The model assumes that firms attempt to maximize their total profits. The positive difference between total revenues and total costs The model also assumes firms seek to minimize losses. When total revenues may be less than total costs

How Much Should the Perfect Competitor Produce? Total Revenues The price per unit times the total quantity sold The same as total receipts from the sale of output

How Much Should the Perfect Competitor Produce? Profit = Total revenue (TR) – Total cost (TC) TR = P x Q TC = TFC + TVC P determined by the market in perfect competition Q determined by the producer to maximize profit

Profit Maximization

Profit Maximization Total Output/ Sales/ Total Market Total Total day Costs Price Revenue Profit 0 $10 $5 $0 $10 1 15 5 5 10 2 18 5 10 8 3 20 5 15 5 4 21 5 20 1 5 23 5 25 2 6 26 5 30 4 7 30 5 35 5 8 35 5 40 5 9 41 5 45 4 10 48 5 50 2 11 56 5 55 1

How Much Should the Perfect Competitor Produce? Profit-Maximizing Rate of Production The rate of production that maximizes total profits, or the difference between total revenues and total costs The rate of production at which marginal revenue equals marginal cost

Profit Maximization Total Output/ Sales/ Market Marginal Marginal day Price Cost Revenue 0 $5 1 5 2 5 3 5 4 5 5 5 6 5 7 5 8 5 9 5 10 5 11 5 $5 $5 3 5 2 5 1 5 4 5 5 5 6 5 7 5 8 5

Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production Marginal Revenue The change in total revenues divided by the change in output Marginal Cost The change in total cost divided by the change in output

Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production Profit maximization occurs at the rate of output at which marginal revenue equals marginal cost.

Short-Run Profits To find out what our competitive individual flash memory producer is making in terms of profits in the short run, we have to determine the excess of price above average total cost.

Short-Run Profits From Figure 24-2 previously, if we have production and sales of seven flash drives, TR = $35, TC = $30, and profit = $5. Now we take info from column 6 in panel (a) and add it to panel (c) to get Figure 24-3.

Measuring Total Profits Profits are maximized where MR = MC This occurs at Q = 7.5 units

Short-Run Profits Graphical depiction of maximum profits The height of the rectangular box represents profits per unit. The length represents the amount of units produced. When we multiply these two quantities, we get total economic profits.

Minimization of Short-Run Losses Losses are minimized where MR = MC This occurs at Q = 5.5 units

Short-Run Profits Short-run average profits are determined by comparing ATC with P = MR = AR at the profit-maximizing Q. In the short run, the perfectly competitive firm can make either economic profits or economic losses.

The Short-Run Shutdown Price What do you think? Would you continue to produce if you were incurring a loss? In the short run? In the long run?

The Short-Run Shutdown Price As long as the loss from staying in business is less than the loss from shutting down, the firm will continue to produce. A firm goes out of business when the owners sell its assets; a firm temporarily shuts down when it stops producing, but is still in business.

The Short-Run Shutdown Price As long as the price per unit sold exceeds the average variable cost per unit produced, the earnings of the firm’s owners will be higher if it continues to produce in the short run than if it shuts down.

The Short-Run Shutdown Price Short-Run Break-Even Price The price at which a firm’s total revenues equal its total costs At the break-even price, the firm is just making a normal rate of return on its capital investment (it’s covering its explicit and implicit costs). Short-Run Shutdown Price The price that just covers average variable costs It occurs just below the intersection of the marginal cost curve and the average variable cost curve.

Short-Run Shutdown and Break-Even Prices

The Meaning of Zero Economic Profits Question Why produce if you are not making a profit? Answer Distinguish between economic profits and accounting profits. Remember when economic profits are zero a firm can still have positive accounting profits.

The Supply Curve for a Perfectly Competitive Industry Question What does the short-run supply curve for the individual firm look like? Answer The firm’s short-run supply curve is its marginal cost curve at and above the point of intersection with the average variable cost curve.

The Individual Firm’s Short-Run Supply Curve Given the price, the quantity is determined where MC = MR Short-run supply = MC above minimum AVC

The Supply Curve for a Perfectly Competitive Industry The Industry Supply Curve The locus of points showing the minimum prices at which given quantities will be forthcoming Also called the market supply curve

Deriving the Industry Supply Curve

The Supply Curve for a Perfectly Competitive Industry Factors that influence the industry supply curve (determinants of supply) Firm’s productivity Factor costs Wages, prices of raw materials Taxes and subsidies Number of sellers

Price Determination Under Perfect Competition Question How is the market, or “going,” price established in a competitive market? Answer This price is established by the interaction of all the suppliers (firms) and all the demanders.

Price Determination Under Perfect Competition The competitive price is determined by the intersection of the market demand curve and the market supply curve. The market supply curve is equal to the horizontal summation of the supply curves of the individual firms.

Industry Demand and Supply Curves and the Individual Firm Demand Curve Pe is the price the firm must take Pe and Qe determined by the interaction of the industry S and market D

Industry Demand and Supply Curves and the Individual Firm Demand Curve Given Pe, firm produces qe where MC = MR If AC = AC1, break-even If AC = AC2, losses If AC = AC3, economic profit

The Long-Run Industry Situation: Exit and Entry Profits and losses act as signals for resources to enter an industry or to leave an industry.

The Long-Run Industry Situation: Exit and Entry Signals Compact ways of conveying to economic decision makers information needed to make decisions An effective signal not only conveys information but also provides the incentive to react appropriately.

The Long-Run Industry Situation: Exit and Entry Exit and entry of firms Economic profits Signal resources to enter the market Economic losses Signal resources to exit the market

The Long-Run Industry Situation: Exit and Entry Allocation of capital and market signals Price system allocates capital according to the relative expected rates of return on alternative investments. Investors and other suppliers of resources respond to market signals about their highest- valued opportunities.

The Long-Run Industry Situation: Exit and Entry Tendency toward equilibrium (note that firms are adjusting all of the time) At break-even, resources will not enter or exit the market. In competitive long-run equilibrium, firms will make zero economic profits.

The Long-Run Industry Situation: Exit and Entry Long-Run Industry Supply Curve A market supply curve showing the relationship between prices and quantities after firms have been allowed time to enter or exit from an industry, depending on whether there have been positive or negative economic profits

Long-Run Equilibrium In the long run, the firm can change the scale of its plant, adjusting its plant size in such a way that it has no further incentive to change; it will do so until profits are maximized. In the long run, a competitive firm produces where price, marginal revenue, marginal cost, short-run minimum average cost, and long-run minimum average cost are equal.

Long-Run Firm Competitive Equilibrium

Competitive Pricing: Marginal Cost Pricing Market Failure A situation in which an unrestrained market operation leads to either too few or too many resources going to a specific economic activity

Issues and Applications: The Big Rush to Provide Digital Snaps in a Snap The photography industry brings in about $85 billion in revenues each year. Since 2000, the majority of those revenues have been earned from the sale of digital cameras and related digital photography products and services. During the mid-2000s, a rapidly growing part of the digital photography business has been the market for digital photo printing services.

Issues and Applications: The Big Rush to Provide Digital Snaps in a Snap The demand for digital photo printing services increased, and the market clearing price rose from 15 to about 19 cents. Numerous firms entered the industry causing market supply to increase and the market clearing price declined from 19 cents to about 12 cents.

Short-Run and Long-Run Adjustments in the Digital Photo Printing Industry

Summary Discussion of Learning Objectives The characteristics of a perfectly competitive market structure Large number of buyers and sellers Homogeneous product Buyers and sellers have equal access to information No barriers to entry and exit

Summary Discussion of Learning Objectives How a perfectly competitive firm decides how much to produce Economic profits are maximized when marginal cost equals marginal revenue as long as the market price is not below the short-run shutdown price, where the marginal cost curve crosses the average variable cost curve.

Summary Discussion of Learning Objectives The short-run supply curve of a perfectly competitive firm The rising part of the marginal cost curve above minimum average variable cost The equilibrium price in a perfectly competitive market A price at which the total amount of output supplied by all firms is equal to the total amount of output demanded by all buyers

Summary Discussion of Learning Objectives Incentives to enter or exit a perfectly competitive industry Economic profits induce entry of new firms. Economic losses will induce firms to exit the industry.