Perfect competition

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Perfect competition

• ECG 507
• Professor Allen
• 9/15/05

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1. Profit Maximization

• Determining the profit maximizing level of output
• Profit Total Revenue - Total Cost
• Total Revenue Pq
• Total Cost C(q)
• Therefore

3
2. Profit Maximization

• As firm expands q, TR increases with units sold
• But TR increases at a decreasing rate because
  prices have to be cut to generate extra sales
• TC increases at an increasing rate because of law
  of diminishing marginal returns
• Expand as long as extra TR gt extra TC

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3. Profit Maximization

• Maximize ? when
• d?/dq 0 q(dp/dq) p(q) dC/dq
• q(dp/dq) p(q) MR(q)
• dC/dq MC(q)
• At q, MR(q) MC(q)

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4. Practical considerations

• Firms do not calculate MR, MC at such a fine
  level of detail. Focus on hours, staffing
  levels, overtime, orders accepted vs. declined
• Careful using AVC as estimate of MC
• Model is fairly general. Applies when MC
  constant, MC zero, and P constant

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5. Output decision of competitive firm
MC
Price ( per unit)
60
50
Lost profit for qq lt q
Lost profit for q2 gt q
D
ARMRP
40
30
q1 MR gt MC and q2 MC gt MR and q0 MC MR
but MC falling
20
10
0
1
2
3
4
5
6
7
8
9
10
11
q0
q
q1
q2
Output
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6. A Competitive FirmMaking a Positive Profit
MC
Price ( per unit)
60
50
A
D
ARMRP
40
ATC
C
B
30
AVC
20
10
0
1
2
3
4
5
6
7
8
9
10
11
q0
q
Output
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7. A Competitive FirmIncurring Losses
MC
ATC
Price ( per unit)
B
C
D
P MR
A
AVC
F
E
q
Output
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8. A Competitive Firmat Zero Profits
MC
Price ( per unit)
60
50
40
30
ATC
ARMRP
20
AVC
10
6
0
1
2
3
4
5
7
8
9
10
11
Output
q
10
9. A Competitive FirmThat Produces Nothing
MC
Price ( per unit)
60
Losses ABCD are greater than fixed
costsAEFD. Lose less money at zero output.
50
40
ATC
A
D
30
AVC
F
E
ARMRP
20
B
C
10
6
0
1
2
3
4
5
7
8
9
10
11
Output
q
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10. Choosing Output in the Short Run

• Summary of Production Decisions

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11. A Competitive FirmsShort-Run Supply Curve
Price ( per unit)
S MC above AVC
MC
ATC
P2
AVC
P1
P AVC
Output
q1
q2
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12. Industry Supply in the Short Run
The short-run industry supply curve is the
horizontal summation of the supply curves of the
firms.
S
MC1
MC2
MC3
per unit
P3
P2
P1
0
2
4
8
10
5
7
14
21
Quantity
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13. Choosing Output in the Long Run

• In the long run, a firm can alter all its inputs,
  including the size of the plant.
• We assume free entry and free exit.
• Expect firms to select K so that long-run average
  cost is minimized

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14. Output Choice in the Long Run
Price ( per unit of output)
LMC
LAC
SMC
SAC
D
A
E
40
P MR
C
B
G
30
Output
q1
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15. Choosing Output in the Long Run

• Economic profit R - wL - rK determines whether
  firms enter or leave
• If R gt wL rK, then firms enter
• If R lt wL rK, then firms exit
• If R wL rK, then no tendency either way

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16. Long-Run Competitive Equilibrium
per unit of output
per unit of output
Firm
Industry
S1
LMC
40
P1
LAC
D
Output
Q1
Output
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17. Long-Run Competitive Equilibrium
per unit of output
per unit of output
Firm
Industry
S1
LMC
40
P1
LAC
S2
30
P2
D
Output
Q2
Q1
q2
Output
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18. Choosing Output in the Long Run

• Long-Run Competitive Equilibrium
• 1) MC P
• 2) QD QS
• 3) Zero economic profits
• In practice firms use Economic Value Added (EVA)
  to make strategic decisions

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19. The IndustrysLong-Run Supply Curve

• To determine long-run supply, we assume all firms
  have access to the available production
  technology.
• Output is increased by using more inputs, not by
  invention.
• The shape of the long-run supply curve depends on
  the extent to which changes in industry output
  affect the prices the firms must pay for inputs.

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20. Long-Run Supply in aConstant-Cost Industry
Price P1 and the industry is in long-run
equilibrium, P MC AC.
per unit of output
per unit of output
S1
AC
MC
A
P1
P1
D1
q1
Output
Output
Q1
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21. Long-Run Supply in aConstant-Cost Industry
Demand increases and price increases to P2.
per unit of output
per unit of output
S1
AC
MC
C
P2
P2
A
P1
P1
D1
D2
q1
q2
Output
Output
Q1
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22. Long-Run Supply in aConstant-Cost Industry
Economic profits attract new firms. Supply
increases to S2 and the market returns to
long-run equilibrium.
per unit of output
per unit of output
S1
S2
AC
MC
C
P2
P2
A
B
P1
P1
D1
D2
q1
q2
Output
Output
Q1
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23. Long-Run Supply in aConstant-Cost Industry
Q1 increase to Q2. Long-run supply SL
LRAC. Change in output has no impact on input
cost.
per unit of output
per unit of output
S1
S2
AC
MC
C
A
B
SL
P1
P1
D1
D2
q1
Output
Output
Q1
Q2
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24. Increase in input prices
per unit of output
per unit of output
S1
SMC1
LAC1
A
P1
P1
D1
q1
Output
Output
Q1
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25. Increase in input prices
S3
per unit of output
per unit of output
S2
S1
LAC2
SMC2
SMC1
LAC1
P3
P3
P2
P2
A
P1
P1
D1
q1
q2
Output
Output
Q3
Q1
Q2