Perfect Competition Overheads

Market Structure Market structure refers to all characteristics of a market that influence the behavior of buyers and sellers, when they come together to trade Market structure refers to all features of a market that affect the behavior and performance of firms in that market

Key Factors Determining Market Structure Short run & long run objectives of buyers and sellers in the market Beliefs of buyers and sellers about the ability of themselves and others to set prices Degree of product differentiation Technologies employed by agents in the market Amount of information available to agents about the good and about each other Degree of coordination or noncooperation of agents Extent of entry and exit barriers

Definition of a competitive agent competitive A buyer or seller (agent) is said to be competitive if the agent assumes or believes that the market price is given and that the agent's actions do not influence the market price We sometimes say that a competitive agent is a price taker

Common Market Structures Perfect (pure) competition Agents take prices as given Entry and exit barriers are minimal or nonexistent

Common Market Structures Monopoly (seller) or Monopsony (buyer) Firm sets price (faces market demand or supply curve) Entry and exit barriers result in the existence of one seller or one buyer

Common Market Structures Oligopoly Firm sets prices (faces residual demand) Entry and exit barriers result in the existence of few sellers or buyers

Common Market Structures Monopolistic competition Firm sets prices (faces residual demand) Entry and exit barriers are minimal

Perfect Competition 1.Buyers and sellers are competitive or price takers 2.All firms produce homogeneous (standardized) goods and consumers view them as identical 3.All buyers and sellers have perfect information regarding the price and quality of the product 4.Firms can enter and exit the industry freely 5.There are no transaction costs to participate in the market 6.Each firm bears the full cost of its production process 7.There is perfect divisibility of output

Competitive agents Large number of agents What really matters are beliefs

Homogeneous Goods Price and nothing else matters The demand for your product goes to zero if you raise price

Perfect Information Buyers and sellers know everything quality opportunities to buy and sell factors affecting the market in the future

Ease of Entry and Exit New firms enter when there are profits Existing firms leave when there are losses

No Transactions Costs Firms are not dissuaded by participation fees Buyers can take advantage of opportunities

No Externalities What is good for this market is good for society The market fully accounts for all costs

Divisible output Small price changes don’t lead to large quantity jumps Examples such as buildings and machinery

Demand facing the perfectly competitive firm The demand curve facing a perfectly competitive firm is horizontal at the market price If the firm were to raise its price, even a tiny bit, above this price, its sales would go to zero And no matter how much the firm produces, this price will not change

Industry Supply-Demand Equilibrium $ Output S(p ) p0p0 Q0Q0 D(p) Demand for Individual Firm $ Output p0p0 D(p) The demand curve for a perfectly competitive firm is horizontal If the firm were to raise its price above this price, sales would go to zero And no matter how much the firm produces, the price will not change

Behavior of a Single Competitive Firm The firm’s goal is to maximize profit

What is profit? Profit is revenue minus costs or

The firm’s goal is then to maximize returns from the technologies it controls, taking into account: The demand for final consumption goods Opportunities for buying and selling factors / products The actions of other firms in the market

The Firm Solves the Problem

Example Problem P = $184

yFCVCCAFCAVCATCMC Price TRMRProfit

Note that TR is linear with slope = 184 Total Revenue and Cost Curves Output $ TR C

Price Price = MR = Demand Price, Marginal Cost, and Average Cost Output $ ATC MC

Price MC AVC ATC AFC Add average variable and average fixed costs Output $

Maximizing profit Choose the level of output where the difference between TR and TC is the greatest

yCMCPriceTRMRProfit

Profit Max Using MR and MC An increase in output will always increase profit if MR > MC An increase in output will always decrease profit if MR < MC

The rule is then Increase output whenever MR > MC Decrease output if MR < MC

Should we increase output from 5 to 6? Should we increase output from 6 to 7? Should we increase output from 7 to 8? Yes No ! yCMCPriceTRMRProfit

Measuring Total Profit Profit is always given by Graphically it is the distance between total revenue and total cost

Total Revenue and Cost Curves Output $ TR C

Profit, price, and average total cost Profit per unit is given by

MC The distance between price and ATC at the optimum output level is profit per unit Cost Curves and Profit Output $ ATC Price ATC Opt Q Opt

Total profit is given by the area of the box bounded by price, the optimum quantity, average total cost at the optimum quantity, and the price axis

MC Cost Curves and Profit Output $ ATC Price ATC Opt Q Opt

The firm earns a profit whenever p > ATC yCAVCATCMCPriceTRProfit ( ) = ( ) (7) = $388

A firm suffers a loss whenever p < ATC at the optimum level of output Let p = $97 We can show that the optimum quantity is 4 units

yCAVCATCMC Price TR Profit

Cost Curves and Profit Output $ ATC MC Price ATC Opt Q Opt Loss

yFCVCCAFCAVCATCMCPriceTRMRProfit

Another example problem P = $120

yPriceTRMRFCVCCAFCAVCATCMCProfit

For a given price we can find optimal output HOW ? Choose output level where MC = MR = P

AVC MC ATC P = 120 Short Run Equilibrium Output $ P = MC  y* = 10 Q Opt  = $400 Profit

yPriceTRMRCostMCProfit  = $400 The firm is happy!! And R - VC (ROVC) = $600

AVC MC ATC P = 120 Short Run Equilibrium Output $ P = MC  y* = 10 Q Opt ROVC = $600 ROVC

yPriceTRMRVCCMCProfit Now let p = $91 y* = 9,  = $124 The firm is still happy!! And R - VC (ROVC) = $324

AVC MC ATC P = 120 Short Run Equilibrium Output $ P = 91

AVC MC ATC Short Run Equilibrium Output $ P = 91 P = MC  y* = 9  = $ 124 ROVC = $324 Q Opt Profit ROVC

yPriceTRMRVCCMCProfit Now let p = $68 y* = 8,  = $-72 The firm is not so happy!! But R - VC (ROVC) = $128

AVC MC ATC P = 120 P = 68 Short Run Equilibrium Output $ P = 91

AVC MC ATC P = 68 Short Run Equilibrium Output $ P = MC  y* = 8  = $-72 ROVC = $128 ROVC Q Opt Loss

yPriceTRMRVCCMCProfit Now let p = $51 y* = 7,  = $ -200 The firm may as well shut down  

AVC P = 51 MC ATC P = 120 P = 68 Short Run Equilibrium Output $ P = 91

AVC P = 51 MC ATC Short Run Equilibrium Output $ P = MC  y* = 7  = $-200 ROVC = $0 ROVC Q Opt Loss

yPriceTRMRCMCProfit Now let p = $40 y* = 6,  = $ -272 The firm should get out in a hurry!

AVC P = 51 MC ATC P = 120 P = 68 Short Run Equilibrium Output $ P = 40 P = 91

AVC P = 51 MC ATC P = 120 P = 68 Short Run Equilibrium Output $ P = 40 P = 91 P = MC  y* = 6  = $- 272 ROVC = $-72 Loss ROVC

AVC P = 51 MC ATC P = 196 P = 120 P = 68 Short Run Equilibrium Output $ P = 40 P = 91

Short run supply At different prices we know how much the firm will choose to supply By plotting these points we can obtain the short run supply curve

Short-run supply curve AVC P = 51 MC P = 196 P = 120 P = Output $ P = 40 P = 91

MC AVC ATC Short Run Supply Curve Output $ Supply Output Short Run Equilibrium $

We can connect the dots? Not really Short Run Supply Curve Output $ Supply

We connect, but with a discontinuity Short Run Supply Curve Output $ Supply

The competitive firm's supply curve has two parts To summarize For all prices above the minimum point on the firm’s average variable cost (AVC) curve, the supply curve coincides with the marginal cost curve (MC) For prices below the minimum point on the average variable cost curve (AVC), the firm will shut down, so its supply curve is a vertical line at zero units of output

MC AVC Short Run Supply Output $

AVC MC Short Run Supply Output $

AVC ATC Short Run Supply Output $ MC

We write the individual supply curve as p - price of output w 1, w 2, w 3, … - prices of inputs z - fixed inputs

Assumptions about the industry in the short-run The number of firms is fixed The firm is operating on a short-run cost curve Some inputs are fixed

Short run industry or market supply It is constructed by summing the quantities supplied by the individual firms Shows the quantity supplied by the industry at each price when the plant size of each firm and the number of firms remain constant

The market or industry supply curve, Q S, is the horizontal summation of the individual firm supply curves We account for the fact that will be zero at some price levels

The market supply curve is then a curve indicating the quantity of output that all sellers in a market will produce at different prices. If there are L identical firms, each with supply, then

Example L = 50 P = $120 y i = 10 Q S = (50)(10) = 500

Example L = 50 P = $196 y i = 12 Q S = (50)(12) = 600

Individual Short Run Supply Curve Output $ Supply P = 51, y = 7 P = 68, y = 8 P = 120, y = 10

Short Run Market Supply Curve Output $ Supply P = 51, y = 350 P = 68, y = 400 P = 120, y = 500

Short Run Market (Industry) Equilibrium Market Demand Curve Output $ D

Short Run Market Supply & Demand Curves Finding the market equilibrium P = $120, Q = Output $ Supply Demand P Q*

D1 Increase the demand to P = $196, Q = 600 Short Run Market Supply & Demand Curves Output $ Supply Demand P Q* P1 Q1*

D1 Decrease the demand to P = $68, Q = 400 Short Run Market Supply & Demand Curves Output $ Supply Demand P Q* Q1* D2 P2 Q2* P1

AVC MC Going back to the individual firm y i = 10 Life is good ATC P = Output $  i = 400

What about the equilibrium price of $68.00? Not what the managers had in mind! AVC MC ATC P = Output $

With short run losses, the firm will only stay in the industry in the short run In the long run, a firm with losses will exit the industry At the same time, short run profits will encourage firms to enter the industry

And so we must consider the long run!

The End

AVC P = 91 MC P = 51 ATC P = 196 P = 120 P = 68 Short Run Equilibrium Output $ P = 40 P = MC  y* = 10  = $400

P1 Increase the demand to P = $196, Q = 600 Short Run Market Supply & Demand Curves Output $ Supply Demand P Q* D1 Q1* D2 P2 Q2*