1. Lecture by: Jacinto Fabiosa Fall 2005 Perfect Competition

2. 2 Market Structure Sellers want to sell at the highest possible price –Buyers seek lowest possible price –All trade is voluntary When we observe buyers and sellers in action –See that different goods and services are sold in vastly different ways When economists turn their attention to differences in trading they think immediately about market structure –Characteristics of a market that influence behavior of buyers and sellers when they come together to trade

3. 3 Factors Considered To determine structure of any particular market, we begin by asking –How many buyers and sellers are there in the market? –Is each seller offering a standardized product, more or less indistinguishable from that offered by other sellers Or are there significant differences between the products of different firms? –Are there any barriers to entry or exit, or can outsiders easily enter and leave this market?

4. 4 Classification of Market Structure Perfect competition Monopoly Monopolistic competition Oligopoly

5. 5 The Three Requirements of Perfect Competition Large numbers of buyers and sellers, and –Each buys or sells only a tiny fraction of the total quantity in the market Sellers offer a standardized product Sellers can easily enter into or exit from market

6. 6 A Large Number of Buyers and Sellers In perfect competition, there must be many buyers and sellers –How many? Number must be so large that no individual decision maker can significantly affect price of the product by changing quantity it buys or sells

7. 7 A Standardized Product Offered by Sellers Buyers do not perceive significant differences between products of one seller and another –For instance, buyers of wheat do not prefer one farmer’s wheat over another

8. 8 Easy Entry into and Exit from the Market Entry into a market is rarely free—a new seller must always incur some costs to set up shop, begin production, and establish contacts with customers –But perfectly competitive market has no significant barriers to discourage new entrants Any firm wishing to enter can do business on the same terms as firms that are already there In many markets there are significant barriers to entry –Legal barriers –Existing sellers have an important advantage that new entrants can not duplicate Brand loyalty enjoyed by existing producers would require a new entrant to wrest customers away from existing firms –Significant economies of scale may give existing firms a cost advantage over new entrants

9. 9 Easy Entry into and Exit from the Market Perfect competition is also characterized by easy exit –A firm suffering a long-run loss must be able to sell off its plant and equipment and leave the industry for good, without obstacles Significant barriers to entry and exit can completely change the environment in which trading takes place

10. 10 Is Perfect Competition Realistic? Assumptions market must satisfy to be perfectly competitive are rather restrictive In vast majority of markets, one or more of assumptions of perfect competition will, in a strict sense, be violated –Yet when economists look at real-world markets, they use perfect competition more often than any other market structure Why is this? –Model of perfect competition is powerful –Many markets—while not strictly perfectly competitive—come reasonably close We can even—with some caution—use model to analyze markets that violate all three assumptions Perfect competition can approximate conditions and yield accurate-enough predictions in a wide variety of markets

11. 11 The Perfectly Competitive Firm When we examine a competitive market from a distance, we get one view of what is occurring –When we closely examine the individual competitive firm, we get an entirely different picture In learning about competitive firm, must also discuss competitive market in which it operates

12. 12 The Competitive Industry and Firm

13. 13 Goals and Constraints of the Competitive Firm Perfectly competitive firm faces a cost constraint like any other firm Cost of producing any given level of output depends on –Firm’s production technology –Prices it must pay for its inputs

14. 14 The Demand Curve Facing a Perfectly Competitive Firm Demand curve facing Small Time Gold Mines –It’s horizontal, or infinitely price elastic Why should this be? –In perfect competition output is standardized –No matter how much a firm decides to produce, it cannot make a noticeable difference in market quantity supplied So cannot affect market price

15. 15 The Demand Curve Facing a Perfectly Competitive Firm Means Small Time has no control over the price of its output –Simply accepts market price as given In perfect competition, firm is a price taker –Treats the price of its output as given and beyond its control Since a competitive firm takes the market price as given –Its only decision is how much output to produce and sell

16. 16 Cost and Revenue Data for a Competitive Firm For a competitive firm, marginal revenue at each quantity is the same as the market price For this reason, marginal revenue curve and demand curve facing firm are the same –A horizontal line at the market price

17. 17 Profit Maximization in Perfect Competition

18. 18 The Total Revenue and Total Cost Approach Most direct way of viewing firm’s search for the profit-maximizing output level At each output level, subtract total cost from total revenue to get total profit at that output level –Total Profit = TR - TC

19. 19 The Marginal Revenue and Marginal Cost Approach Firm should continue to increase output as long as marginal revenue > marginal cost Remember that profit-maximizing output is found where MC curve crosses MR curve from below Finding the profit-maximizing output level for a competitive firm requires no new concepts or techniques

20. 20 Measuring Total Profit Start with firm’s profit per unit –Revenue it gets on each unit minus cost per unit Revenue per unit is the price (P) of the firm’s output, and cost per unit is our familiar ATC, so we can write –Profit per unit = P – ATC Firm earns a profit whenever P > ATC –Its total profit at the best output level equals area of a rectangle with height equal to distance between P and ATC, and width equal to level of output A firm suffers a loss whenever P < ATC at the best level of output –Its total loss equals area of a rectangle Height equals distance between P and ATC Width equals level of output

21. 21 Measuring Profit or Loss

22. 22 The Firm’s Short-Run Supply Curve A competitive firm is a price taker –Takes market price as given and then decides how much output it will produce at that price Profit-maximizing output level is always found by traveling from the price, across to the firm’s MC curve, and then down to the horizontal axis, or –As price of output changes, firm will slide along its MC curve in deciding how much to produce Exception –If the firm is suffering a loss large enough to justify shutting down It will not produce along its MC curve It will produce zero units instead

23. 23 Short-Run Supply Under Perfect Competition

24. 24 The Shutdown Price Price at which a firm is indifferent between producing and shutting down Can summarize all of this information in a single curve— firm’s supply curve –Tells us how much output the firm will produce at any price Supply curve has two parts –For all prices above minimum point on its AVC curve, supply curve coincides with MC curve –For all prices below minimum point on AVC curve, firm will shut down So its supply curve is a vertical line segment at zero units of output For all prices below $1—the shutdown price—output is zero and the supply curve coincides with vertical axis

25. 25 Competitive Markets in the Short- Run Short-run is a time period too short for firm to vary all of its inputs –Quantity of at least one input remains fixed Let’s extend concept of short-run from firm to market as a whole Conclusion –In short-run, number of firms in industry is fixed

26. 26 The (Short-Run) Market Supply Curve Once we know how to find supply curve of each individual firm in a market –Can easily determine the short-run market supply curve Shows amount of output that all sellers in market will offer at each price –To obtain market supply curve sum quantities of output supplied by all firms in market at each price As we move along this curve, we are assuming that two things are constant –Fixed inputs of each firm –Number of firms in market

27. 27 Deriving The Market Supply Curve

28. 28 Short-Run Equilibrium How does a perfectly competitive market achieve equilibrium? –In perfect competition, market sums buying and selling preferences of individual consumers and producers, and determines market price Each buyer and seller then takes market price as given –Each is able to buy or sell desired quantity Competitive firms can earn an economic profit or suffer an economic loss

29. 29 Perfect Competition

30. 30 Short-Run Equilibrium in Perfect Competition d 2 Loss per Bushel at p = $2 2.00 4,000 D 2 2.00 400,000

31. 31 Profit and Loss and the Long Run In a competitive market, economic profit and loss are the forces driving long-run change –Expectation of continued economic profit (losses) causes outsiders (insiders) to enter (exit) the market In real world entry and exit occur literally every day –In some cases, we see entry occur through formation of an entirely new firm –Entry can also occur when an existing firm adds a new product to its line Exit can occur in different ways –Firm may go out of business entirely, selling off its assets and freeing itself once and for all from all costs –Firm switches out of a particular product line, even as it continues to produce other things

32. 32 From Short-Run Profit to Long-Run Equilibrium As we enter long-run, much will change –Economic profit will attract new entrants Increasing number of firms in market –As number of firms increases, market supply curve will shift rightward causing several things to happen »Market price begins to fall »As market price falls, demand curve facing each firm shifts downward »Each firm—striving as always to maximize profit—will slide down its marginal cost curve, decreasing output

33. 33 From Short-Run Profit to Long-Run Equilibrium This process of adjustment—in the market and the firm—continues until…well, until when? –When the reason for entry—positive profit—no longer exits –Requires market supply curve to shift rightward enough, and the price to fall enough So that each existing firm is earning zero economic profit In a competitive market, positive economic profit continues to attract new entrants until economic profit is reduced to zero

34. 34 From Short-Run Profit To Long-Run Equilibrium

35. 35 From Short-Run Loss to Long-Run Equilibrium What if we begin from a position of loss? –Same type of adjustments will occur, only in the opposite direction In a competitive market, economic losses continue to cause exit until losses are reduced to zero When there are no significant barriers to exit –Economic loss will eventually drive firms from the industry Raising market price until typical firm breaks even again

36. 36 Distinguishing Short-Run from Long- Run Outcomes In short-run equilibrium, competitive firms can earn profits or suffer losses –In long-run equilibrium, after entry or exit has occurred, economic profit is always zero When economists look at a market, they automatically think of short-run versus long- run –Choose the period more appropriate for question at hand

37. 37 The Notion of Zero Profit in Perfect Competition We have not yet discussed plant size of competitive firm The same forces—entry and exit—that cause all firms to earn zero economic profit also ensure –In long-run equilibrium, every competitive firm will select its plant size and output level so that it operates at minimum point of its LRATC curve

38. 38 Perfect Competition and Plant Size llustrates a firm in a perfectly competitive market –But panel (a) does not show a true long-run equilibrium –How do we know this? In long-run typical firm will want to expand Why? –Because by increasing its plant size, it could slide down its LRATC curve and produce more output at a lower cost per unit –By expanding firm could potentially earn an economic profit Same opportunity to earn positive economic profit will attract new entrants that will establish larger plants from the outset Entry and expansion must continue in this market until the price falls to P* –Because only then will each firm—doing the best that it can do—earn zero economic profit

39. 39 Perfect Competition and Plant Size

40. 40 A Summary of the Competitive Firm in the Long-Run Can put it all together with a very simple statement –At each competitive firm in long-run equilibrium P = MC = minimum ATC = minimum LRATC This equality is satisfied when the typical firm produces at point E –Where its demand, marginal cost, ATC, and LRATC curves all intersect In perfect competition, consumers are getting the best deal they could possibly get

41. 41 A Change in Demand Short-run impact of an increase in demand is –Rise in market price –Rise in market quantity –Economic profits What happens in long-run after demand curve shifts rightward? –Market equilibrium will move from point A to point C Long-run supply curve –Curve indicating quantity of output that all sellers in a market will produce at different prices After all long-run adjustments have taken place

42. 42 An Increasing-Cost Industry

43. 43 An Increasing-Cost Industry Output per Period Price per Unit D1D1 S1S1 S LR A P1P1 Q1Q1 Market Dollars Firm Output per Period P1P1 q1q1 MC A ATC 1 d 1 = MR 1 NEW EQUILIBRIUM 2 ATC P2P2 d 2 = MR 2 q2q2 C Q2Q2 S2S2 C P2P2 Q SR D2D2 B P SR q SR P SR B d SR = MR SR

44. 44 Increasing, Decreasing, and Constant Cost Industries Increase in demand for inputs causes price of those inputs to rise This type of industry (which is the most common) is called an increasing cost industry –Entry causes input prices to rise Shifts up typical firm’s ATC curve –Raises market price at which firms earn zero economic profit »As a result, long-run supply curve slopes upward

45. 45 Increasing, Decreasing, and Constant Cost Industries Other possibilities –Industry might use such a small percentage of total inputs that— even as new firms enter—there is no noticeable effect on input prices Called a constant cost industry –Entry has no effect on input prices, so typical firm’s ATC curve stays put »Market price at which firms earn zero economic profit does not change »Long-run supply curve is horizontal –Decreasing cost industry, in which entry by new firms actually decreases input prices Entry causes input prices to fall –Causes typical firm’s ATC curve to shift downward »Lowers market price at which firms earn zero economic profit »As a result, long-run supply curve slopes downward

46. 46 Market Signals and the Economy In real world, demand curves for different goods and services are constantly shifting As demand increases or decreases in a market, prices change Economy is driven to produce whatever collection of goods consumers prefer In a market economy, price changes act as market signals, ensuring that pattern of production matches pattern of consumer demands –When demand increases, a rise in price signals firms to enter market, increasing industry output –When demand decreases, a fall in price signals firms to exit market, decreasing industry output

47. 47 Market Signals and the Economy Market signal –Price changes that cause firms to change their production to more closely match consumer demand No single person or government agency directs this process –This is what Adam Smith meant when he suggested that individual decision makers act for the overall benefit of society Even though, as individuals, they are merely trying to satisfy their own desires As if guided by an invisible hand

48. 48 Using the Theory: Changes in Technology Competitive markets ensure that technological advances are turned into benefits for consumers One industry that has experienced especially rapid technological changes in the 1990s is farming Let’s see what happens when new, higher-yield corn seeds are made available –Suppose first that only one farm uses the new technology In long-run, economic profit at this farm will cause two things to happen –All other farms in market will have a powerful incentive to adopt new technology—to plant the new, genetically engineered seed themselves –Outsiders will have an incentive to enter this industry with plants utilizing the new technology Shifting market supply curve rightward and driving down the market price

49. 49 Using the Theory: Changes in Technology Can draw two conclusions about technological change under perfect competition –All farms in the market must use the new technology –Gainers are consumers of corn, since they benefit from the lower price Impact of technological change –Under perfect competition, a technological advance leads to a rightward shift of market supply curve, decreasing market price In short-run, early adopters may enjoy economic profit, but in long-run, all adopters will earn zero economic profit Firms that refuse to use the new technology will not survive

50. 50 Using the Theory: Changes in Technology Technological advances in many competitive industries have spread quickly –Shifting market supply curves rapidly and steadily rightward over the past 100 years While this has often been hard on individual competitive firms it has led to huge rewards for consumers

51. 51 Technological Change in Perfect Competition Bushels per Day Price per Bushel $3 Q1Q1 S1S1 A D (a) Market 1000 ATC 1 d 1 = MR 1 Bushels per Day Dollars per Bushel $3 (b) Firm ATC 2 d 2 = MR 2 2 S2S2 Q2Q2 B 2