1. PERFECTLY COMPETITIVE MARKET - FIRM’S SUPPLY

2. Slides’ Outline
Perfect Competitive Market (Perfect Competition) Assumptions
Competitive Firm’s Demand and “MR=P”
Competitive Firm’s Short-run Supply Decision
Competitive Firm’s Long-run Supply Decision
Producer’s Surplus vs Profit

3. Perfect Competition
Market structure provides information about how firms operating in the market will behave. Well-known market structures are:
Perfect Competition
Monopoly
Oligopoly
Monopolistic Competition
Perfect Competition is one type of market structure in which buyers and sellers choose to be price takers.
A firm is unable to sell its output at a price greater than market price. A consumer is unable to purchase at a price less than the market price.
This is what most people mean when they talk about “competitive firms.”

4. Perfect Competition
Perfect competition is a market structure in which:
there are a large number of firms
firms sell identical products
buyers and sellers have full information about prices charged by all firms
transaction costs, the expenses of finding a trading partner and completing the trade above and beyond the price, are low
firms can freely enter and exit the market
Examples:
Agricultural/commodities markets like wheat and soybeans

5. Perfect Competition: Assumptions
Large number of small firms
No single firm’s actions can raise or lower the price.
Individual firm’s demand curve is a horizontal line at market price.
Identical (homogeneous) products
If all firms are selling identical products, it is difficult for any firm to raise the price above the going market price charged by all firms.
Full information
Consumer knowledge of all firms’ prices makes it easy for consumers to buy elsewhere if any one firm raised its price above market price.
Negligible transaction costs
Buyers and sellers waste little time or money finding each other.
Free entry and exit
Leads to large number of firms and promotes price taking.

6. Competitive Firm’s Demand
If the firm sets its own price above the market price then the quantity demanded from the firm is zero.
If the firm sets its own price below the market price then the quantity demanded from the firm is the entire market quantity-demanded.

7. Competitive Firm’s Demand
So what is the demand curve faced by the individual firm?

8. Competitive Firm’s Demand
$/output unit
Market Supply pe
Market Demand Q

9. Competitive Firm’s Demand
$/output unit
Market Supply p’
At a price of p’, zero is demanded from the firm. pe
Market Demand Q

10. Competitive Firm’s Demand
$/output unit
Market Supply p’
At a price of p’, zero is demanded from the firm. pe p”
Market Demand Q
At a price of p” the firm faces the entire market demand.

11. Competitive Firm’s Demand
So the demand curve faced by the individual firm is ...

12. Competitive Firm’s Demand
$/output unit
Market Supply p’
At a price of p’, zero is demanded from the firm. pe p”
Market Demand q
At a price of p” the firm faces the entire market demand.

13. Competitive Firm’s Demand
$/output unit p’ pe p”
Market Demand q

14. Smallness
What does it mean to say that an individual firm is “small relative to the industry”?

15. Smallness $/output unit Firm’s MC Firm’s demand curve pe q
The individual firm’s technology causes it always to supply only a small part of the
total quantity demanded at the market price.
Due to smallness, we can assume that the firm’s demand
Is perfectly elastic (i.e. never produces in downward sloping
part). The outcome of this observation is Marginal Revenue is
Constant and equal to market price (i.e. MR=P)

16. The Firm’s Short-Run Supply Decision
Each firm is a profit-maximizer and in a short-run.
Q: How does each firm choose its output level?

17. The Firm’s Short-Run Supply Decision
Each firm is a profit-maximizer and in a short-run.
Q: How does each firm choose its output level?
A: By solving

18. The Firm’s Short-Run Supply Decision
What can the solution qs* look like?

19. The Firm’s Short-Run Supply Decision
What can the solution qs* look like? ( Assume firm’s find it profitable to produce, i.e. qs* > 0):
P(q)
qs* q

20. The Firm’s Short-Run Supply Decision
For the interior case of qs* > 0, the first- order maximum profit condition is
That is,
So at a profit maximum with qs* > 0, the market price p equals the marginal cost of production at q = qs*.

21. The Firm’s Short-Run Supply Decision
$/output unit
In addition, at a profit maximum with qs* > 0, the firm’s MC curve must be upward-sloping. pe
MCs(q) q’
qs* q

22. The Firm’s Short-Run Supply Decision
$/output unit
At q = qs*, p = MC and MC slopes upwards. q = qs* is profit-maximizing. pe
MCs(q) q’
qs* q
At q = q’, p = MC and MC slopes downwards. q = q’ is profit-minimizing.

23. The Firm’s Short-Run Supply Decision
At q = qs*, p = MC and MC slopes upwards. q = qs* is profit-maximizing So a profit-max supply level can lie only on
the upwards sloping part of the firm’s MC curve.
$/output unit pe
MCs(q) q’
qs* q

24. The Firm’s Short-Run Supply Decision
But not every point on the upward-sloping part of the firm’s MC curve represents a profit-maximum.
The firm’s profit function is
If the firm chooses q = 0 then its profit is

25. The Firm’s Short-Run Supply Decision
So the firm will choose an output level q > 0 only if
I.e., only if
Equivalently, only if

26. The Firm’s Short-Run Supply Decision
AVCs(q)
ACs(q)
MCs(q)
$/output unit q

27. The Firm’s Short-Run Supply Decision
AVCs(q)
ACs(q)
MCs(q)
p < AVCs(q) qs* = 0.
The firm’s short-run supply curve
$/output unit q
p > AVCs(q) qs* > 0.

28. The Firm’s Short-Run Supply Decision
AVCs(q)
ACs(q)
MCs(q)
The firm’s short-run supply curve
Shutdown point
$/output unit q

29. The Firm’s Short-Run Supply Decision
Shut-down is not the same as exit.
Shutting-down means producing no output (but the firm is still in the industry and suffers its fixed cost).
Exiting means leaving the industry, which the firm can do only in the long-run.

30. The Firm’s Long-Run Supply Decision
How does the firm’s long-run supply decision compare to its short-run supply decisions?

31. The Firm’s Long-Run Supply Decision
A competitive firm’s long-run profit function is
The long-run cost c(q) of producing q units of output consists only of variable costs since all inputs are variable in the long-run.

32. The Firm’s Long-Run Supply Decision
The firm’s long-run supply level decision is to
The 1st-order maximization conditions are, for
q* > 0,

33. The Firm’s Long-Run Supply Decision
Additionally, the firm’s economic profit level must not be negative since then the firm would exit the industry. So,

34. The Firm’s Long-Run Supply Decision
MC(q)
AC(q) q
$/output unit

35. The Firm’s Long-Run Supply Decision
MC(q)
AC(q) q
$/output unit
The firm’s long-run supply curve

36. Producer’s Surplus
Producer surplus (PS) is the difference between the amount for which a good sells (market price) and the minimum amount necessary for sellers to be willing to produce it (marginal cost)
The firm’s producer’s surplus is the accumulation, unit by extra unit of output, of extra revenue less extra production cost.
How is producer’s surplus related profit?

37. Producer’s Surplus q
$/output unit
AVCs(q)
ACs(q)
MCs(q)

38. Producer’s Surplus q
$/output unit
AVCs(q)
ACs(q)
MCs(q) p
q*(p)

39. Producer’s Surplus q
$/output unit
AVCs(q)
ACs(q)
MCs(q) p PS
q*(p)

40. Producer’s Surplus So the firm’s producer’s surplus is
That is, PS = Revenue - Variable Cost.

41. Producer’s Surplus q
$/output unit
AVCs(q)
ACs(q)
MCs(q) p PS
q*(p)

42. Producer’s Surplus q
$/output unit
AVCs(q)
ACs(q)
MCs(q) p
q*(p)

43. Producer’s Surplus $/output unit q AVCs(q) ACs(q) MCs(q) p q*(p)
Revenue
= py*(p)

44. Producer’s Surplus $/output unit q AVCs(q) ACs(q) MCs(q) p q*(p)
Revenue
= py*(p)
vc(q*(p))

45. Producer’s Surplus q
$/output unit
AVCs(q)
ACs(q)
MCs(q) p PS
q*(p)

46. Producer’s Surplus PS = Revenue - Variable Cost.
Profit = Revenue - Total Cost = Revenue - Fixed Cost Variable Cost.
So, PS = Profit + Fixed Cost.
Only if fixed cost is zero (the long-run) are PS and profit the same.