Perfect Competitive Markets

1
Perfect Competitive Markets

• Characteristics Behavior of Firms in a
  Perfectly Competitive Market Structure

2
Market Structure

• Market structure(MS) is most important
  determinant of firm behavior
• MS refers to industry setting in which firm
  produces sells its product
• Industry setting is determined by
• Number of firms selling in the market
• Relative share of the market held by firms
• Degree of interdependence recognized by firms
• Two primary determinants of MS
• Differences between firms products
• Ease with which firms can enter leave the
  industry

3
How Does MS Affect Firm Behavior?

• Determines effects of an individual firms
  actions on market quantity price
• Many sellers means no single firm can
  significantly affect market quantity price
• If there is only one seller, the firm controls
  the whole market through its actions
• Small number of firms means interdependence of
  actions--actions of a firm can cause
  unpredictable reactions by other firms
• Range of market structure runs from perfect
  competition (individual firm has no control) to
  monopoly (firm has complete control)

4
Characteristics of Perfect Competition

• Many buyers many sellers
• individuals actions are small relative to market
  magnitudes
• both buyers and sellers are price takers
• All firms products are identical in all respects
• Many perfect substitutes for any firms product
• Complete freedom of entry exit
• No artificial limits on number of firms
• Capital investment requirements are small
• Firms are free to respond to profit loss
  conditions
• Each firm has complete knowledge about market
  including
• least cost method of production
• input and output prices
• potential entrants know whether firms are earning
  profits

5
Firms Objective Function

• Firms objective is to maximize economic profit
• Firm can approach profit maximization from either
  an output perspective or an input utilization
  perspective
• i.e. find level of output that maximizes profits,
  or
• find level of input use that maximizes profits
• Economic profit Total Rev - Total Economic Cost
• Total Economic Cost includes all explicit and
  implicit cost
• Normal return to investment is an element of
  firms implicit cost
• When Economic Profit is zero, firm is still
  earning a Normal Profit
• Normal Profit is payment for the opportunity cost
  of the owners resources (time money) used by
  the firm

6
Firm Demand Curve in Perfect Competition
Intersection of Supply Demand determine
equilibrium price quantity

• Individual firm takes price as given
• Firms demand curve is horizontal line
  corresponding to P0

Price (dollars)
Price (dollars)

• Each additional unit of output sold adds P0 to
  firms TR
• Firms MR and AR are constant and equal to P0

0
0
Quantity
Quantity
Panel B Firms Demand
Panel A Market
7
Profit-Maximization in the Short Run

• In the short run, managers must make two
  decisions
• Produce or shut down?
• If shut down, produce no output and hires no
  variable inputs
• If shut down, firm loses amount equal to TFC
• If produce, what is the optimal output level?
• If firm does produce, then how much?
• Produce amount that maximizes economic profit

Profit TR - TC
8
Profit Margin (or Average Profit)

• QMax p gt Q that maximizes profit margin (
  average profit)
• Managers should ignore profit margin (average
  profit) when making optimal decisions

9
Short-Run Output Decision

• Firms manager will produce output where P MC
  as long as
• TR ? TVC
• or, equivalently, P ? AVC
• If price is less than average variable cost (P ?
  AVC), manager will shut down
• Produce zero output
• Lose only total fixed costs
• Shutdown price is minimum AVC

10
Profit Maximization P 36
Total cost 19 x 600 11,400
11
Profit Maximization P 36
Panel A Total revenue total cost
Panel B Profit curve when P 36
12
Short-Run Loss Minimization P 10.50
Profit 3,150 - 5,100 -1,950
Total revenue 10.50 x 300 3,150
13
Irrelevance of Fixed Costs

• Fixed costs are irrelevant in the production
  decision
• Level of fixed cost has no effect on marginal
  cost or minimum average variable cost
• Thus no effect on optimal level of output

14
Summary of Short-Run Output Decision

• AVC tells whether to produce
• Shut down if price falls below minimum AVC
• SMC tells how much to produce
• If P ? minimum AVC, produce output at which P
  SMC
• ATC tells how much profit/loss if produce

15
Short-Run Supply Curves

• For an individual price-taking firm
• Portion of firms marginal cost curve above
  minimum AVC
• For prices below minimum AVC, quantity supplied
  is zero
• For a competitive industry
• Horizontal sum of supply curves of all individual
  firms always upward sloping
• Supply prices give marginal costs of production
  for every firm

16
Short-Run Producer Surplus

• Short-run producer surplus is the amount by which
  TR exceeds TVC
• The area above the short-run supply curve that is
  below market price over the range of output
  supplied
• Exceeds economic profit by the amount of TFC

17
Short-Run Firm Industry Supply
18
Computing Short-Run Producer Surplus
19
Long-Run Profit-Maximizing Equilibrium
Profit (17 - 12) x 240 1,200
20
Long-Run Competitive Equilibrium

• All firms are in profit-maximizing equilibrium (P
  LMC)
• Occurs because of entry/exit of firms in/out of
  industry
• Market adjusts so P LMC LAC

21
Long-Run Competitive Equilibrium
22
Long-Run Industry Supply

• Long-run industry supply curve can be flat
  (perfectly elastic) or upward sloping
• Depends on whether constant cost industry or
  increasing cost industry
• Economic profit is zero for all points on the
  long-run industry supply curve for both types of
  industries

23
Constant, or Increasing, Cost Industries

• Key factor is behavior of input prices as number
  of firms in industry increase
• Under what conditions are input prices not likely
  to be changed by the change in the number of
  firms in an industry?
• Industry use of inputs represents a small part of
  total use of the input
• Industry standard inputs used by many other
  industries
• Note that LR industry supply is perfectly elastic
• Typical firms LR cost curves do not shift as
  number of firms change
• Increasing Cost Industry
• Typical firms LR cost curves shift up as
  industry expands
• Market equilibrium price goes up as industry
  expands
• Note that economic profits always return to zero
  in both cases

24
Long-Run Industry Supply for a Constant Cost
Industry
25
Long-Run Industry Supply for an Increasing Cost
Industry
As firms enter LAC increases for each firm
Prices must rise to cover cost
Firms output
26
Economic Rents (or I got skills!)

• Assume that a firm in a competitive industry
  finds itself in a position of having lower costs
  than its competitors because it has a resource
  that is especially productive
• For some short period of time this firm may earn
  excess economic profits
• What would happen in the LR?
• Other firms would bid up the price of this
  productive resource and the owner of the resource
  would realize high returns than other resource
  owners.
• Firms cost curves would eventually return to
  level of other firms
• Resource owner would realize economic rents
  because of the superior skills of the resource
• Economic rents are payments in excess of a
  resources opportunity costs

27
Economic Rent in Long-Run Competitive Equilibrium
28
Profit Maximizing Input Usage

• When profit maximizing output is determined, the
  profit maximizing level of input use is also
  determined
• In some cases it may be useful to approach profit
  maximizing from input perspective
• Need to introduce two new concepts
• Marginal Revenue Product (MRP)
• It is the marginal contribution to firms revenue
  from using one additional unit of an input
• Marginal Factor Cost (MFC)
• It is the addition to total cost of hiring one
  additional unit of an input

29
Marginal Revenue Product(MRP)

• MRP is the MR from selling the output produced by
  the additional unit of input times the MP of the
  input
• For a perfectly competitive firm, MR ? P
• Firm is a price taker so price doesnt change no
  matter how much firm sells
• For price taker, MRP is simply a monetized MP
  curve
• MRP will change if either price of output, or MP
  curve changes

30
MRP Hiring Decision

• Hiring decision is simply Hire units of input up
  to point where MRP ? unit cost of the input
• Equivalency of output input approaches to
  optimization
• Profit max. level of output is where

• Substituting for MC, we have

• Which is our input max. rule

• Note that additional condition is that

31
Why is Perfect Competition Good?

• In equilibrium, all firms are producing the
  product in the most cost efficient plants and at
  the lowest cost within these plants
• Price that is being charged is just sufficient to
  cover all costs of production including a normal
  return to the entrepreneur
• Perfect competition provides a standard against
  which other market outcomes are judged

32
Summary

• The key feature in perfectly competitive markets
  is independent behavior dictated by market
  outcomes
• Buyers sellers operate independently of each
  other and their individual actions do not
  significantly influence the market
• Firms take prices in both input output markets
  as given
• Perfectly competitive markets are characterized
  by forces that push each firm to the same
  efficient position
• In equilibrium, each firm is identical in all
  respects--size, production techniques, prices
  charged, resources used, etc.
• All firms are earning zero economic profits, but
  this includes a normal return to investment