unit 2.3.2 perfect competition - the learning...

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Unit 2.3.2 - Perfect competition

• Assumptions of the model

• Demand curve facing the industry and the firm in perfect competition

• Profit-maximizing level of output and price in the short-run and long-run

• The possibility of abnormal profits/losses in the short-run and normal profits in the long-run

• Shut-down price, break-even price

• Definitions of allocative and productive efficiency

• Efficiency in perfect competition

Unit 2.3.2 Perfect CompetitionUnit Overview

Blog posts: "Perfect competition"

Blog posts: "Profit maximization"

http://welkerswikinomics.com/blog/category/profit-maximization/

http://welkerswikinomics.com/blog/category/perfect-competition/

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Discussion question:What will happen to the price of pizza when YOU demand more pizza? What about when you and your closest friends demand more pizza? Explain what will happen and why?

Discussion: Clearly, nothing will happen to the price of pizza when you or your closest friends demand more pizza. You pay the price that the market has determined.

Similarly, in a purely competitive market, nothing will happen to the price of a product when one firm (or a few firms) begin supplying more output.

• Firms in perfectly competitive markets are price takers. No individual firm exerts enough market power to influence the price. Firms must adjust to the market price, they cannot charge anything above the market price, or demand for their output will fall to ZERO.

• In other words, purely competitive firms face a perfectly elastic demand curve!

Perfect Competition Characteristics of Perfectly Competitive markets

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Many sellers: means that there are enough so that a single seller has no impact on price by its decisions alone.

Standardized products: The products in a purely competitive market are homogeneous or standardized; each seller’s product is identical to its competitor’s.

Price-takers: Individual firms must accept the market price; they are price takers and can exert no influence on price.

Freedom of entry and exit: means that there are no significant obstacles preventing firms from entering or leaving the industry.

Pure competition is rare in the real world, but the model is important.>>The model helps analyze industries with characteristics similar to pure competition.>>The model provides a context in which to apply revenue and cost concepts developed in previous chapters.>>Pure competition provides a norm or standard against which to compare and evaluate the efficiency of the real world.

Perfect Competition Characteristics of Perfectly Competitive markets

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Why study pure competition if actual purely competitive markets do not exist?• Purely competitive markets represent allocative efficiency. The operation of a purely competitive economy provides a “standard, or norm” for evaluating the efficiency of the real-world economy.

The individual firm will view its demand as perfectly elastic. • The demand curve is not perfectly elastic for the industry: It only appears that way to the individual firm, since it must charge the market price no matter what quantity it produces. Purely competitive firms are price takers!!!

What happens if the firm increases its output? >>Market price stays same Lowers its output? >>SAME equilibrium price!

Definitions of average, total, and marginal revenue:• Average revenue (AR) is the price per unit for each firm in pure competition. AR=P

• Total revenue (TR) is the price multiplied by the quantity sold. TR = PQ

• Marginal revenue (MR) is the change in total revenue that results from selling 1 more unit of output. MR will also equal the unit price in conditions of pure competition.

Perfect CompetitionDemand as seen by a PC seller

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A PC firm is a price taker: • The price faced by each firm is determined by market supply and demand• Since price equals average revenue, the firm's demand curve also represents the firm's average revenue at each level of output.• Since the firm can sell as much as it wants at P

e, the marginal revenue equals

the price. Therefore: MR = D = AR = P

P

Q

Sindustry

Dindustry

Pe

P

Q

Dfirm

MR=AR=P

Perfectly Competitive Industry Perfectly Competitive Firm

Perfect CompetitionDemand as seen by a PC seller

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Cost

s and R

eve

nues

Q

TRTC

Break even point Break even point

Profit-max point

Max profit!

Profit = Total Revenue - Total Cost Total Revenue = Price x Quantity

Since the price a PC firm receives is constant at all levels of the firm's output, TR increases at a constant rate with output.

Profit maximization: Economic Profit = TR - TC. The firm wants to produce the level of output at which the vertical distance between TR and TC is greatest.

Break even points: TR and TC are equal, meaning the firm is earning a normal profit but zero economic profits.

Perfect CompetitionProfit Maximization - Total Revenue and Total Cost

Normal profit: the minimum level of profit needed just to keep an entrepreneur operating in his current market. If he does not earn normal profit, an entrepreneur will direct his skills towards another market.

Economic profit: also called "super-normal profits". When revenues exceed all costs and normal profit. Firms are attracted to industries where economic profits are being earned

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A firm will maximize its profits when it produces at the point where its marginal cost of production is equal to its marginal revenue.

MR = MC• This maximizes profits because any time the last unit produced brings more additional revenue (MR) than it incurs in additional cost (MC), the firm can increase its profits by producing that unit

• On the other hand, if the last unit produced incurs a more additional cost (MC) than it brings in additional revenue, then the firm's profits will decline if it produces that unit.

Conclusion: When MR>MC at the margin, the firm will profit by producing more. When MC>MR at the margin, the firm will profit more by producting less. Only when MC=MR is the firm doing the best it possibly can!

• This rule applies only when producing is preferable to shutting down. If MR<AVC, the firm would be better off shutting down.• The rule applies to all market structures• In pure competition, the rule can also be stated as the P=MC rule, since marginal revenue equals price in a purely competitive market.

Perfect CompetitionProfit maximization: Marginal Revenue = Marginal Cost

Practice Profit-maximization: Rainbow book Activity 28

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P

Q

Sindustry

Dindustry

Shoe MarketP/C

Q

Shoe FirmMC

MR=D=AR=PP

e

Q1

D1

Q2

P1 MR=D=AR=P

1

The profit-maximizing level of output by the firm depends on the price determined by the market 1) P

e is determined by the total market supply and demand.

2) The firm faces its own marginal cost curve3) The firm will choose to produce at the level of output where the MC equals MR4) If MR falls because of falling demand, profit maximizing level of output for the firm falls

Perfect CompetitionProfit maximization: MR = MC

A firm will produce where MR = MC:

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ATC

AVC

P/C

Q

Shoe FirmMC

MR=D=AR=P1

Qf

P

Q

Sindustry

Dindustry

Shoe Market

Pe

Qe

ATC

Profit-maximizing case:

Profit = TR - TC• No TR and TC curves in the firm diagram, but there is AR and ATCPer unit profit = AR - ATC• To determine the amount of a PC firm's profit, subtract ATC from AR at the profit-maximizing level of output.

Is the firm above earning economic profits?

Total profits = (AR - ATC) x Q


Yes, because average revenue is greater than average cost!

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A firm in perfect competition is producing at the profit maximizing output, but making a loss. Using diagrammatic analysis, explain how this is possible.

(Total 10 points)

Perfect CompetitionQuick Quiz

The profit maximizing output is where MC = MR. If, at this output, AC is greater than AR, the firm will make a loss in the short run. Answers should illustrate this point using the standard perfect competition diagram.

Providing the above is clearly and accurately explained and illustrated, nothing further would be required for full marks. It would be extremely difficult to fully answer this question without the use of a diagram, and a maximum of [6 marks] should be awarded if there is no appropriate diagrammatic illustration.[10 marks]

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If the firm's costs increase or the price it can sell for decreases, it may be in a situation where it must minimize losses. • ATC > AR, the firm is losing money on each unit it produces. • The AR is still greater than AVC, meaning the firm can cover its variable costs in the short-run• The firm will remain open as long as it can cover its variable costs

P

Q

Sindustry

Dindustry

Pe

P/C

Q

PC Industry PC FirmMC ATC

AVC

MR=D=AR=P1

ATC

Qf

Loss-minimizing case:

AR - ATC is negative, meaning the firm is experiencing losses

Total loss = (ATC-AR) x Qs


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Why shut down? Because at every level of output, the firm's average variable cost is higher than its average revenue. This firm is not even earning enough revenue to pay its workers or pay for raw materials! The firm MUST SHUT DOWN!

P

Q

Sindustry

Dindustry

Pe

P/C

Q

PC Industry PC Firm ATC

AVC

MR=D=AR=P1

Loss

ATC

AVC

Qf

MCShut-down scenario:


If the supply in the industry increases or demand falls, or if the firm's costs increase, it may be in a situation where it would be better off shutting down.

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Perfect CompetitionLong-run Equilibrium

Discussion Question: How will the existence of economic profits in a purely competitive market affect the total supply in that market?

Remember, FIRMS ARE PROFIT SEEKERS!

Answer: Because there are NO BARRIERS TO ENTRY, new firms will enter a market where profits are being earned. As new firms enter, market supply will shift out, lowering the market price faced by firms, eliminating economic profits.

Question: How will the existence of economic losses among the firms in a purely competitive market affect the total supply in the market?

Answer: Because firms are loss averse, and there are NO BARRIERS TO EXIT, some firms will leave the industry, reducing market supply, increasing the price, eliminating losses for the remaining firms!

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PS

industry

Dindustry

PC Industry P/C

Q

PC Firm

MC

ATC

AVC

economic profitP

1

Q

MR=D=AR=P

Qf


Entry eliminates profits:

The firm above is earning economic profits because AR > ATC at its current level of output.

• What will happen to the firm's profits in the long-run? Why?• Illustrate the long-run changes that will occur on the graphs

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Exit eliminates losses:

The firm above is losing money becaues AR < ATC at its current level of output.

• What will happen to the firm's losses in the long-run? Why?• Illustrate the long-run changes that will occur on the graphs

P

Q

Sindustry

Dindustry

Pe

P/C

Q

PC Industry PC FirmMC ATC

AVC

MR=D=AR=P1

ATC

AVC

Qf

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Long-run equilibrium in PC:

P

Q

Sindustry

Dindustry

PC Industry P/C

Q

PC Firm MC

ATC

AVC

MR=D=AR=PP

1

Qf

The industry above is earning in long-run equlibirum:

• Why?• How would an increase in demand affect the industry? A decrease?• How would an increase in the firms' costs affect the industry? A decrease?

Practice SR and LR Equilibrium: Rainbow book Activity 29

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PC firms adjust their output in response to changes in price.

A PC firm will shut down when MR falls below AVC.

When MR is above AVC, the firm will increase its output as price increases according to its upward sloping MC curve.

The MC curve above AVC shows a direct relationship between Price (AR) and quantity supplied.

The MC curve above AVC IS THE INDIVIDUAL FIRM'S SUPPLY CURVE!

P

Q

PC Firm

MR1

MR2

MR3

MR4

P1

P4

P3

P2

MC

AVC

Firm's Supply curve

Perfect CompetitionMarginal Cost as the firm's Supply Curve

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The MC increases as ouput increases because of diminishing marginal returns

Since the MC increases at higher level of ouput, firms require a higher prices in order for them to increase output, so they can maintain the MR=MC level and maximize profits.

In other words, the MC curve represents the relationship between price and quantity supplied. This is a direct relationship (demonstrating the law of supply!)

Changes in the prices of variable inputs: For example, a higher minimum wage will shift the cost curve of a firm employing minimum wage workers UP. This corresponds to a leftward shift of the firm's supply curve.

Improvements in technology will shift MC down: since better technology makes all workers more productive (shift the MP and AP curves up, thus the MC and AVC curves down). This corresponds with an outward shift of the firm's supply curve

P

Q

PC Firm MC

AVC

Firm's Supply curve

Perfect CompetitionMarginal Cost as the firm's Supply Curve

Points to understand about the MC curve as the firm's short-run supply curve

What would cause the firm's supply (MC) curve to shift?

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P PC FirmMC

AVCFirm's Supply curve

Q10

MR=AR$5 x200=

P

Q

S=MC

$5

2000

D

PC Market with 200 identical firms

Perfect CompetitionMarginal Cost and Market Supply

From the firm to the market - Marginal Cost = Supply: • 200 identical firms making an identical product with identical costs• Each firm produces the profit maximizing level of output based on where the price equals its MC• Equilibrium output in the market is found at the intersection of market supply and market demand. • Total quantity supplied equals the product of the individual firms' output multiplied by the number of firms

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Discuss: "Purely competitive markets are clearly undesirable. Firms in such markets are doomed to earning NO profits, so how could such a market be good for society?"

Perfect CompetitionAllocative and Productive Efficiency

Firms in purely competitive industries:Why are they winners? Why are they losers?

Consumers in purely competitive industries:Why are they winners? Why are they losers?

Practice graphing PC: NCEE workbook Activity 31

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In long-run equilibrium, purely competitive firms will produce at the level of output where the price equals firms' marginal cost and its minimum average total cost. This represents


Allocative Efficiency: P = MCInterpretation: The right amount of output is being produced. There is neither under nor over-allocation of resources towards a good in a purely competitive industry. If the price were higher than the marginal cost, this is a signal that more output is desired, if price were lower than marginal cost, the signal from buyers to sellers is that less output is desired. Only when P = MC is the right amount of output being produced.

Productive Efficiency: P= minimum ATCInterpretation: The firms are using resources to their maximum efficiency by producing their output at the lowest possible average total cost. Competition forces firms to use resources as efficiently as possible.

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Are ZERO economic profits bad for firms? Why or why not?

Productive Efficiency: Is P = min. ATC good for society? Why or why not?

Allocative Efficiency: Is P = MC good for society? Why or why not?

Discussion Questions:


Price as a signal from consumers to producers: • If the price of a lattes goes up, it is a signal to producers that consumers wants more lattes, so more resources should be allocated towards the production of lattes. • As firms produce more lattes, their MC will increase until P = MC once more. Only then have the right amount of lattes been produced! ALLOCATIVE EFFICIENCY is achieved when P = MC!

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Perfect CompetitionPractice Free Response Question

Luigi's, a typical profit-maximizing pizzeria, is operating in a perfectly competitive industry that is in long-run equilibrium.

(a) Draw correctly labeled side-by-side graphs for the pizza market and for Luigi's and show each of the following.

(i) Price and output for the market(ii) Price and output for Luigi's

(b) Assume that pizza is a normal good and that consumer income falls. Assume that Luigi's continues to produce. On your graphs in part (a), show the effect of the derease in income on each of the following in the short run.

(i) Price and output for the industry(ii) Price and output for Luigi's (iii) Area of loss or profit for Luigi's

(c) Following the decrease in consumer income, what must be true for Luigi's to continue to produce in the short run?

(d) Assume that the market adjusts to a new long-run equilibrium. Compare the following between the initial and the new long-run equilibrium.

(i) Price in the industry(ii) Output of a typical firm(iii) The number of firms in the dairy industry

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Describe the situation in the market below and firm below. • Show the firm's i) MR, ii) Output, iii) Economic profit or loss• Assuming this is a PC market, describe and illustrate the long run adjustments that will restore this market to Equilibrium. Show on the graphs, for both the industry and the firm, the price and output after long-run adjustments

P

Q

Sindustry

Dindustry

Industry P

Q

FirmMC

ATC

AVC

MR=D=AR=P1

Pe

Perfect CompetitionPractice problems

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P

Q

Sindustry

Dindustry

Industry P

Q

Firm

MCATC

AVC

MR=D=AR=P1

Pe


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P

Q

Sindustry

Dindustry

Industry P

Q

Firm

MC ATC

AVC

MR=D=AR=P1

Pe


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Describe the situation in the market below and firm below. Assume price of a close substitute drops. Illustrate the changes that will occur in this market:• Show the new industry price and output• Show the new firm price and output

P

Q

Sindustry

Dindustry

Industry P

Q

Firm MCATC

AVC

MR=D=AR=P1

Pe


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Describe the situation in the market and firm below. Assume this product is featured in a new movie and consumers' tastes shift towards it overnight. Illustrate the changes that will occur in this market:• Show the new industry price and output• Show the new firm price and output

Q Q

PS

industry

Dindustry

Industry P FirmMC

ATC

AVC

MR=D=AR=P1

Pe


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1.Distinguish between normal profits and economic profits. Explain why firms in a perfectly competitive market are likely to earn only normal profits in the long-run.

2. What is meant by economic efficiency? How do purely competitive markets assure that economic efficiency is achieved?

Perfect CompetitionUnit 2.3.2 Quiz

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unit 2.3.2 perfect competition - the learning...

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