Competitive firms and Markets

Perloff chapter 8

Competition

• Firms are price takers.– Firm’s demand curve is horizontal.

• Reasons for a horizontal demand curve:– Identical products from different firms;– Freedom of entry and exit;– Perfect knowledge of prices;– Low transaction costs.

• Where all conditions are satisfied: Perfect Competition.

Profit

• R – C• Definition of R straightforward.• Costs:

– Business profit includes only explicit costs, e.g. workers wages and materials.

– Owner doesn’t take a salary, what remains is profit.

– Economic profit uses opportunity cost.

– Suppose profit was £20000 but you could earn a salary of £25000, what should you do?

Profit maximisation, Profit

> 0 < 0

q* Quantity, q, Unitsper day

Profit

11

*

0

Source: Perloff

Output decision

• Produce where profit is maximised.

Profit maximisation, Profit

> 0 < 0

q* Quantity, q, Unitsper day

Profit

11

*

0

Source: Perloff

Output decision

• Produce where profit is maximised.

• Produce where marginal profit is zero.

• Marginal cost equals marginal revenue.– q)R(q) – C(q)– Marginal Profit(q) = MR(q) – MC(q) = 0– MR(q) = MC(q)

Shutdown rule

• Shutdown if it reduces its loss.– In the short-run, shutting down means revenue and

variable costs are zero.

– It must continue to cover fixed costs.

– R-VC-F=2000-1000-3000=-2000

– R-VC-F=500-1000-3000=-3500

• Shutdown if revenue is less than avoidable cost.– This rule is applicable in the long and short run.

Short-run output decision

• MC=MR

• R=pq

• MC=p

Cost, revenue,Thousand $

2841400

q me per year

2,272

4,800

426

1,846

100

–100

1

MR = 8

* = $426,000

*

(q)

Cost, C Revenue

p, $ per ton

e

2841400 q , Thousand metric tons of lime per year

8

6.50

6

10

p = MR

* = $426,000

AC

MC

, Thousand metric tons of li

Short run shutdown decision

• Shutdown if revenue less than avoidable cost.– In short run avoidable costs are variable costs.

AVCp

q

VC

q

pq

VCpq

Short run shutdown decisionp, $ per ton

10050 140 q, Thousand metric tons of lime per year

AVC

AC

MC

p

a

e

b

0

5.14

5.50

6.006.12

5.00

A = $62,000

B = $36,000

Short run supply curve of the firmp, $ per ton

q3 = 215 q4 = 285q1 = 50 q2 = 140

e1

e2

e3

e4

p2

p1

p3

p4

0q, Thousand metric tons of lime per year

6

7

8

5

AVC

MC

AC

S

Industry SR supply curve with 5 identical firms

p, $ per ton

14050 175

q, Thousand metric tonsof lime per year

6.47 6.47

6

7

p, $ per ton

7

5

0

AVC

(a) Firm

MC

200150

10050 250 700

Q, Thousand metric tonsof lime per year

6

5

0

(b) Market

S3

S 4

S5

S2S1 S1

Industry SR supply curve with 2 different firms

p, $ per ton

100 140 165 215 315 45025 50

S2 SS1

0q, Q, Thousand metric tons of lime per year

6

7

8

5

SR equilibrium in the market

p, $ per ton

q1 = 215q2 = 50 Q1 = 1,075Q2 = 2500

q, Thousand metric tonsof lime per year

Q, Thousand metric tonsof lime per year

6.97

6.206

5

0

5

6

7

8

7

8

e2

e1

E2

S

E1

p, $ per ton

(a) Firm (b) Market

AVC

AC

D2

S1D1

A

C

B

Supply curve of the firm in the long-run

p, $ per unit

50 110 q, Units per year

2524

28

35

20

0

p

SRAC

LRMC

LRAC

SRMC

SRAVC

BA

S SR SLR

Long run adjustment of the industry

• All factors are variable.• Entry and exit are possible.

– Entry occurs with positive long-run profits– Exit occurs with long-run losses

• Identical firms:– All firms make a loss when P<min(LAC), industry

supply is zero.– All firms make a profit if P>min(LAC), number of firms

is indeterminate. Note that elasticity of the industry supply curve increases with the number of firms.

Long run industry supply curve

p, $ per unit

150

LRAC

LRMC

(a) Firm

q, Hundred metric tons of oil per year

10

S1

0

p, $ per unit

(b) Market

Q, Hundred metric tons of oil per year

Long-run market supply10

0

Upward sloping long run industry supply curve

• Limited entry– New firms cannot enter because of legislative control.– New firms only enter when profits exceed the costs of entry.

• Firms differ– Minimum LAC is lower for some firms than others.– Number of low LAC firms is limited.

• Input prices vary with output– Increasing cost (firms in one industry account for much of

the supply of a particular input).– Decreasing cost (economies of scale in the input supplier)

Differing firms: the LR supply curve for cotton

0.71

Price, $ per kg

0 1 2 3

Iran

United States

Nicaragua, Turkey

BrazilAustralia

Argentina

Pakistan

4 5 6 6.8

Cotton, billion kg per year

1.081.15

1.27

1.43

1.56

1.71 S

Increasing cost industry

p, $ per unit

q1q2 Q1 = n1q1 Q2 = n2q2q, Units per year Q, Units per year

p1

p2

e2

e1

E2

S

E1

p, $ per unit

(a) Firm (b) Market

AC2

MC 2

MC 1

AC1

Decreasing cost industry

p, $ per unit

q1 q2 Q1 = n1 q1 Q2 = n2 q2q, Units per year Q, Units per year

p1

p2

e2

e1

E2

S

E1

p, $ per unit

(a) Firm (b) Market

AC2

MC2MC1

AC1

Long run competitive equilibrium

, $ per ton

e1

f2

1000 150 165

q, Hundred metric tonsof oil per year

1110

7

MC

AVC

(a) Firm

AC

p, $ per ton

F1E1

F2E2

1,5000 2,000 3,300 3,600

Q, Hundred metric tonsof oil per year

1110

7

(b) Market

D 1

SSR

S LR

D2

f

Profit in the long run

• Free entry– Entry occurs to the point where profits are zero

– No profit in long-run equilibrium

– Economic profit is revenue minus opportunity cost.

• Restricted entry– Entry is often limited because of a limited quantity of

an input eg. land.

– Profits become rent.

Economic Rentp, $ per bushel

q *

* = Rent

q, Bushels of tomatoes per year

AC (including rent)

AC (excluding rent)

MC

p*