12 competitive market

8/7/2019 12 competitive market

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1

Competitive MarketCompetitive MarketHall and Lieberman, 3Hall and Lieberman, 3rdrd edition,edition,

Thomson South Thomson South--Western, Chapter 8 Western, Chapter 8



2

O verview O verview

What you will learn in this lecture What you will learn in this lecture

1.1. Short run equilibriumShort run equilibrium

Profit or lossProfit or loss

2.2. Long run equilibriumLong run equilibrium

Zero profitsZero profits

3.3. Perfect competition and plant size in the long runPerfect competition and plant size in the long run

4.4. What happens when things change? What happens when things change?



3

Figure 1: Perfect CompetitionFigure 1: Perfect Competition

Quantity

Demanded at

Different Prices

Quantity

Supplied at

Different Prices

Quantity Supplied

by Each Firm

Quantity

Demanded by

Each Consumer

IndividualDemand

Curve

IndividualSupplyCurve

Quantity Demanded

by All Consumers at

Different Prices

Quantity Supplied by

All Firms at Different

Prices

MarketDemand

Curve

MarketSupplyCurve

P S

D

Q

Market Equilibrium

Added together Added together



4

Part I. ShortPart I. Short--Run EquilibriumRun Equilibrium

InIn perfect competition, market sums buying perfect competition, market sums buying and selling preferences of individualand selling preferences of individualconsumers and producers, and determinesconsumers and producers, and determines

market pricemarket price Each buyer and seller then takes marketEach buyer and seller then takes market

price as givenprice as given

Each is able to buy or sell desired quantity Each is able to buy or sell desired quantity

Competitive firmsCompetitive firms can earncan earn an economic profit oran economic profit orsuffer an economic losssuffer an economic loss

Example: Figure 2Example: Figure 2



Figure 2Figure 2 ShortShort--run Profit Maximizationrun Profit Maximization

10 firms each producing 100 units10 firms each producing 100 units

ShortShort--run equilibrium conditions met (K fixed)run equilibrium conditions met (K fixed)FirmFirm Industry Industry

P P

q Q

D

S

MC ATC

P0P0

1000100



But firm is making positive economic profit :But firm is making positive economic profit :

Long Run equilibrium?Long Run equilibrium?

Incentive for entry or exit?Incentive for entry or exit?FirmFirm Industry Industry

P P

q Q

D

S

MC ATC

P0P0

1000100

Profit>0



Part II. LongPart II. Long--run equilibrium conditionsrun equilibrium conditions

ShortShort--runrun

Firm: Price = Marginal Cost: Firms maximize profitsFirm: Price = Marginal Cost: Firms maximize profits

Industry: supply = demandIndustry: supply = demand Long Long--runrun

Firm: Price = ATC: Zero economic profitFirm: Price = ATC: Zero economic profit

No incentive to enter or exitNo incentive to enter or exit



8

Profit and Loss in the Long RunProfit and Loss in the Long Run

Economic profit and loss are the forces driving long Economic profit and loss are the forces driving long--run changerun change

Entry of outsiders if expecting continued economic profitEntry of outsiders if expecting continued economic profit

Exit of insiders if expecting lossesExit of insiders if expecting losses

In real world entry and exit occur literally every day In real world entry and exit occur literally every day

In some cases, we see entry occur through formation of In some cases, we see entry occur through formation of an entirely new firm or occur when an existing firman entirely new firm or occur when an existing firmadds a new product to its lineadds a new product to its line

Exit can occur in different waysExit can occur in different ways Selling off its assets and freeing itself once and for all from allSelling off its assets and freeing itself once and for all from all

costscosts

Switches out of a particular product line, even as it continuesSwitches out of a particular product line, even as it continuesto produce other thingsto produce other things



Figure 3 Positive Economic Profit Invites Entry in theFigure 3 Positive Economic Profit Invites Entry in the

LongLong--run and Causes Industry Supply to Riserun and Causes Industry Supply to RiseFirmFirm Industry Industry

P P

q Q

D

S

MC ATC

P0P0

1000100

P1 P1

S¶

90 1080



LongLong--run equilibriumrun equilibrium

Number of firms rises to12 firms = 1080/90Number of firms rises to12 firms = 1080/90

P = ATCP = ATCFirmFirm Industry Industry

P P

q Q

D

S

MC ATC

P0P0

1000100

P1 P1

S¶

90 1080



11

From ShortFrom Short--Run Profit to LongRun Profit to Long--Run EquilibriumRun Equilibrium

---- start with profit in the short runstart with profit in the short run Positive economic profit will attract new entrantsPositive economic profit will attract new entrants

Increasing number of firms in marketIncreasing number of firms in market

As number of firms increases, market supply curve will As number of firms increases, market supply curve will

shift rightward causing several things to happenshift rightward causing several things to happen

1.1. Market price fallsMarket price falls

2.2. Then demand curve facing each firm shifts Then demand curve facing each firm shifts

downwarddownward

3.3. Each then slide down its marginal cost curve,Each then slide down its marginal cost curve,

decreasing outputdecreasing output



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---- start with profit in the short runstart with profit in the short run This process of adjustment continues, requiring This process of adjustment continues, requiring

market supply curve to shift rightward enough,market supply curve to shift rightward enough,and the price to fall enoughand the price to fall enough

Until when the reason for entry Until when the reason for entry ²²positivepositiveprofitprofit²²no longer exitsno longer exits

So that each existing firm is earning So that each existing firm is earning zerozeroeconomic profiteconomic profit

In sum, in a competitive market, positiveIn sum, in a competitive market, positiveeconomic profit continues to attract new economic profit continues to attract new entrants until economic profit is reduced to zeroentrants until economic profit is reduced to zero



Figure 4 : ShortFigure 4 : Short--run Profit Maximizationrun Profit Maximization



P P

q Q

D

S

MC ATC

P0P0

120080

AVC



ShortShort--run Profit Maximizationrun Profit Maximization



P P

q Q

D

S

MC ATC

P0P0

120080

AVC

LOSS



FirmFirm Industry Industry

P P

q Q

D

S

MC ATC

P0P0

120080

AVC

Negative Economic Profit InducesNegative Economic Profit Induces

Exit in the LongExit in the Long--run, Industry Supply Fallsrun, Industry Supply Falls

Number of firms falls to 12 firms = 1080/90Number of firms falls to 12 firms = 1080/90

P1 P1

S¶

90 1080



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---- start with loss in the short runstart with loss in the short run

In a competitive market, economic lossesIn a competitive market, economic losses

continue to cause exit until losses arecontinue to cause exit until losses are

reduced to zeroreduced to zero

Raising market price until typical firmRaising market price until typical firm

breaks even againbreaks even again



17

Distinguishing ShortDistinguishing Short--Run fromRun from

LongLong--RunO

utcomesRunO

utcomes In shortIn short--run equilibrium, competitiverun equilibrium, competitive

firms can earn profitsfirms can earn profits or or suffer lossessuffer losses

In long In long--run equilibrium, after entry orrun equilibrium, after entry orexit has occurred, economic profit isexit has occurred, economic profit isalwaysalways ze roze ro

When economists look at a market, they When economists look at a market, they choose the period more appropriate forchoose the period more appropriate forquestion at handquestion at hand



18

Figure 5a/b: From ShortFigure 5a/b: From Short--Run Profit ToRun Profit To

LongLong--Run EquilibriumRun Equilibrium

S 1

d 1 ATC

MC

$4.50

With initial supplycurve S 1, marketprice is $4.50«$4.50

900,000 9,000

So each firmearns an

economic profit. A A

Price per Bushel

Market

Bushelsper Year

Dollars

Firm

Bushelsper Year

D



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Figure 5c/d: From ShortFigure 5c/d: From Short--Run Profit ToRun Profit To

LongLong--Run EquilibriumRun Equilibrium

S 1

d 1 ATC

MC

$4.50

Profit attracts entry, shiftingthe supply curve rightward«

$4.50

900,000 9,0005,000

until market price falls to$2.50 and each firm earnszero economic profit.

S 2

d 1

A A

2.502.50EE

Market Firm

Price per Bushel

Bushelsper Year

Dollars

Bushelsper Year

D

1,200,000



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Part III. The Notion of Zero Profit inPart III. The Notion of Zero Profit in

Perfect CompetitionPerfect Competition

The same forces The same forces²²entry and exitentry and exit²²thatthatcause all firms to earn zero economiccause all firms to earn zero economic

profit also ensureprofit also ensure in long in long--run equilibrium, every run equilibrium, every

competitive firm will select its plantcompetitive firm will select its plant

size and output level so that itsize and output level so that itoperates atoperates at minimum point of itsminimum point of itsLRATC curveLRATC curve



21

Perfect Competition and Plant SizePerfect Competition and Plant Size

Figure 6 illustrates a firm in a perfectly competitive marketFigure 6 illustrates a firm in a perfectly competitive market

Left panel does not show a true long Left panel does not show a true long--run equilibriumrun equilibrium

In long In long--run typical firm will want to expand by sliding run typical firm will want to expand by sliding down its LRATC curve and produce more output at adown its LRATC curve and produce more output at a

lower cost per unitlower cost per unit potentially earn an economic profitpotentially earn an economic profit

Same opportunity to earn positive economic profitSame opportunity to earn positive economic profit will attract new entrants that will establish larger will attract new entrants that will establish largerplants from the outsetplants from the outset

Entry and expansion must continue in this market untilEntry and expansion must continue in this market untilthe price falls to Pthe price falls to P* where each firm earn zero economic* where each firm earn zero economicprofitprofit



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Figure 6: Perfect Competition and Plant SizeFigure 6: Perfect Competition and Plant Size

P 1

q1

d 1 = MR 1

LRATC MC 1 ATC 1

E

d 2 = MR 2

LRATC

MC 2 ATC 2

P*

q* 4.and all firms earnzero economic profitand produce at

minimum LRATC.

.

Dollars Dollars

Output per Period

Output per Period

3. As all firms increase plant size andoutput, market price falls to its lowestpossible level . . .

1.With its current plant and ATC curve, this firm earns zeroeconomic profit.

2.The firm could earnpositive profit with alarger plant,producing here.



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A Summary of the Competitive Firm in A Summary of the Competitive Firm in

the Longthe Long--RunRun At each competitive firm in long At each competitive firm in long--runrun

equilibriumequilibrium

P = MC = minimum ATC = minimumP = MC = minimum ATC = minimum

LRATCLRATC This equality is satisfied when the typical firm This equality is satisfied when the typical firm

produces at point E in figure 6produces at point E in figure 6

Where its demand, marginal cost, ATC, and Where its demand, marginal cost, ATC, and

LRATC curves all intersectLRATC curves all intersect In perfect competition, consumers are getting In perfect competition, consumers are getting

the best deal they could possibly getthe best deal they could possibly get



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Part IV. What Happens When Things Change?Part IV. What Happens When Things Change?

---- 1. A Change in Demand1. A Change in Demand

ShortShort--run impact of an increase in demand isrun impact of an increase in demand is

Rise in market priceRise in market price

Rise in market quantity Rise in market quantity

Economic profitsEconomic profits This will cause: This will cause:

More entrants and higher market supply More entrants and higher market supply

Market equilibrium will move from point A to point CMarket equilibrium will move from point A to point C

Long Long--run supply curverun supply curve indicating quantity of output that all sellers in a market willindicating quantity of output that all sellers in a market will

produce at different prices after all long produce at different prices after all long--run adjustmentsrun adjustments

have taken placehave taken place



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Figure 7a/b: An IncreasingFigure 7a/b: An Increasing--Cost IndustryCost Industry

INITIAL EQUILIBRIUM

D1

S 1

AP 1

Q1

P 1

q1

MC

A

ATC 1

d 1 = MR 1

Output per Period

MarketDollars

Firm

Output per Period

Priceper Unit



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Figure 7c/d: An IncreasingFigure 7c/d: An Increasing--Cost IndustryCost Industry

NEW EQUILIBRIUM

MC

ATC 1

DollarsFirm

P 1

q1

Ad 1 = MR 1

Output per Period

Market

S 1

Output per Period

Priceper Unit

D1

AP 1

Q1

d SR = MR SR

d 2 = MR 2 P 2

P SR

P 2

P SR ATC 2 C

B

B

C

QSR Q2 q1 qSR

S 2

S LR

D2



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Increasing Cost IndustryIncreasing Cost Industry

This type of industry (which is the most common) This type of industry (which is the most common)

is calledis called an inc r e asing c ost indust ry an inc r e asing c ost indust ry

Entry Entry Increase in demand for inputsIncrease in demand for inputs prprice of ice of

those inputs increasesthose inputs increases

Shifts up typical firmShifts up typical firm¶¶s ATC curves ATC curve

Raises market price at which firms earn zeroRaises market price at which firms earn zero

economic profiteconomic profit

As a result, long As a result, long--run supply curve slopes upwardrun supply curve slopes upward



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Decreasing and Constant Cost IndustriesDecreasing and Constant Cost Industries

A c onstant c ost indust ry A c onstant c ost indust ry -- -- entry has no effect on input pricesentry has no effect on input prices Industry might use such a small percentage of total inputs thatIndustry might use such a small percentage of total inputs that

there is no noticeable effect on input pricesthere is no noticeable effect on input prices

Typical firm Typical firm¶¶s ATC curve stays puts ATC curve stays put

Market price at which firms earn zero economic profit does notMarket price at which firms earn zero economic profit does notchangechange

Long Long--run supply curve is horizontalrun supply curve is horizontal

De c r e asing c ost indust ry De c r e asing c ost indust ry ---- entry by new firmsentry by new firmsactually actually decreases input pricesdecreases input prices

Causes typical firmCauses typical firm¶¶s ATC curve to shift downwards ATC curve to shift downward Lowers market price at which firms earn zero economic profitLowers market price at which firms earn zero economic profit

Long Long--run supply curve slopes downwardrun supply curve slopes downward



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Small SummarySmall Summary

IncreasingIncreasing

Cost IndustryCost Industry

Constant CostConstant Cost

IndustryIndustry

DecreasingDecreasing

Cost IndustryCost Industry

Entry effect onEntry effect on

input pricesinput prices

UpUp No effectNo effect DownDown

ATC curve ATC curve Shifts upShifts up StaysStays Shifts downShifts down

Zero profitZero profit

market Pricemarket Price

UpUp Not changeNot change DownDown

Long Long--runrun

supply curvesupply curve

Slope upwardSlope upward HorizontalHorizontal SlopeSlope

downwarddownward



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Part V. Using the Theory: Changes inPart V. Using the Theory: Changes in

Technology Technology

Technological advance that results in increasing returns to scale Technological advance that results in increasing returns to scale will will

Induce some firms to change technologies and produce moreInduce some firms to change technologies and produce more

lead to a rightward shift of market supply curve, decreasing lead to a rightward shift of market supply curve, decreasing market pricemarket price

In shortIn short--run, early adopters may enjoy economic profitrun, early adopters may enjoy economic profit

in long in long--run, more will adopt, economic profit falls to zerorun, more will adopt, economic profit falls to zero

Firms that refuse to use the new technology will not surviveFirms that refuse to use the new technology will not survive

Some technologies are biased toward large firms, othersSome technologies are biased toward large firms, otherstoward smaller firms. If technologies lower minimumtoward smaller firms. If technologies lower minimumefficient scale, more firms will enter as industry price fallsefficient scale, more firms will enter as industry price falls



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Increasing Returns to ScaleIncreasing Returns to Scale



32

C. Boessen, J. Lawrence and G. Grimes, ³Production and Marketing Characteristics of

U.S. Pork Producers -2003´ ISU Agricultural Economics Working Paper 2004-4

Large Firms atypically likely to survive at lower pricesLarge Firms atypically likely to survive at lower prices



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http://www.ers.usda.gov/publications/aer 818/aer 818d.pdf

Number of hogNumber of hogfarms hasfarms hasdeclined 71%declined 71%

Number of Number of hogs per farmhogs per farm

has tripledhas tripled



34http://www.econ.iastate.edu/outreach/agriculture/periodicals/chartbook/Chartbook2/frames.html

Average Prices have Fallen $7Average Prices have Fallen $7



35

C. Boessen, J. Lawrence and G. Grimes, ³Production and Marketing Characteristics of U.S.

Pork Producers -2003´ ISU Agricultural Economics Working Paper 2004-4

MarketS

hare of MarketS

hare of Farms >10K rose from 20% to 80%Farms >10K rose from 20% to 80%

Farms < 3K fell from 62% to 10%Farms < 3K fell from 62% to 10%

12 competitive market

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