C H A P T E R E L E V E N. P e r f e c t c o m p e t i t i o n

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1 C H A P T E R E L E V E N P e r f e c t c o m p e t i t i o n Assume for the moment that you have completed your business training and that you are working for some consulting firm. The first assignment you receive is to advise the Tvelia Construction Corporation about the likelihood of success in that industry. Assumptions: 1. You are the young executive on the rise. 2. You are concerned about future advancement. 3. You want to present an accurate and reliable forecast. Assume that we know the Tvelia Construction Corp. is interested in building small frame houses and their expected costs are: Housing Units Total cost Per Month Per Month 0 $ 40, , , , , , , , , , , uestions: 1. What advice could you give them about their chance of success? 2. How many houses would they have to produce to make a profit? Before you can answer these questions you probably would like to investigate the market in which Tvelia Construction Corp. will be participating. Suppose you discover that at some time there is a lot of similar construction firms while at other times there are

2 relatively few. Can you successfully formulate an analysis when the variables are changing indiscriminately? If you guess there is going to be few rival firms in the market when Tvelia Construction Corp. enters, and there is not, then your report is incorrect. Your client could suffer and your career definitely will! How can you protect both yourself and your client? Well one way to protect yourself is to formulate assumptions about the market and base our study on those assumptions. Let s assume the worse case (for us) exists. This means that we discover a lot of competitors in the market. What does this imply? Well as we have learned, everything is relative so we would like to know how much competition exists. Let s assume that in this market the rivalry is so intense that the market drives the price of a house to its lowest possible price. This means that there are so many producers (sellers) in this market that one person alone cannot affect price. Now just to make this competition even more intense lets also assume that each producer is manufacturing exactly identical units. That is, there is no choice here. Given this we find the following: P S $29,500 D As the consultant you now have all the facts to properly advise your client. How many homes should be produced for this firm to maximize profits? To make this calculation all the costs of production must be generated and analyzed. From the data provided the following costs were computed: O TC FC VC ATC AFC AVC MC

3 Assuming that your client wishes to maximize profits: 1. How many homes should be produced? 2. What will the profit be? 3. What does the demand curve for this firm look like? 4. Construct a graph that demonstrates the point at which profit is maximized. Perfect Competition What we have done here is to create a model that depicts the conditions that would exist under perfect competition. Perfect competition is a market structure characterized by a large number of buyers and sellers all engaged in the purchase and sale of a homogeneous product, with perfect knowledge of market prices and quantities, no discrimination, and perfect mobility of resources. The assumption of this model are: 1. a large number of buyers and sellers; 2. homogeneous product; 3. freedom of entry and exit; and 4. perfect knowledge and mobility of resources. Graphically the model appears as follows: MC ATC D=MR=P P AVC

4 As producers we were interested in knowing how many homes we should produce to maximize our profits. From that complicated schedule of costs we see that profit is maximized when 6 homes are produced. Can we find a way to show the point of profit maximization graphically? Well we know that profit is simply total revenue minus total costs. How much must we produce to maximize our profits? Logically, we will only continue to produce if the benefits of producing a unit of output exceed the costs. The benefits of production have, thus far, been measured by looking at total revenue. However, it is more useful to know the amount of revenue each unit of output contributes to total revenue. This can be calculated rather simply by measuring the change in total revenue generated as output levels change. This is what economists call marginal revenue. Thus by calculating marginal revenues and comparing them to the marginal costs of production we can measure the benefits versus costs of production. Clearly the firm will produce units of output if the marginal revenue derived from the sale of that unit is equal to or exceeds the costs of producing it. This is a rule known as the profit maximizing rule. Profits will be maximized at the point where MR=MC. Proof of the profit maximization rule: 1. P=f(q) demand function 2. TR=q x f(q) total revenue function 3. C=b+ø(q) total cost function 4. =q x f(q) - ø(q) profit=tr-tc 5. d /dq=f (q)-ø (q) first derivative of equation 4 f (q)=ø (q) MR=MC Now in the example we have constructed are we making a profit? What kind? Normal or Economic? What will happen as a result of these economic profits? Other business people will be encouraged to enter this industry, in search of the high rates of return we are earning. Thus more competition is going to occur. This will drive prices downward to the point where normal profits are being realized.

5 Change in supply resulting in a loss S1 S2 MC ATC P5 P3 AVC D=MR=P P3 D If prices fall below this level the firm will suffer a loss and then must make a decision of whether or not to go out of business. Generally firms that face this decision have three choices: 1. Continue to operate in the short-run as long as AVC are being met. Some firms realizing a loss will decide to stay in business as long as they can pay their work force and their suppliers of raw materials. They do this with the hope that market conditions will soon turn favorable and provide at least economic profits. 2. shut down temporarily until the market conditions change. Firms facing this scenario have high variable costs and in an attempt to minimize those costs close their doors temporarily with hope that other similar firms facing losses will leave the industry leading to higher product prices. Once prices rise firms who have closed down will reopen and charge the higher price for their product. 3. Go out of business. Firms that cannot meet any variable or fixed costs will go out of business immediately. In this case neither supplier, workers or banks holding business loans can be paid for services provided to the firm thus forcing the firm to go out of business. Losses force firms out of the industry and price rises S1 P5 P4 P3 S3 S2 P4 MC ATC AVC D=MR=P D

6 Normal Profit P4 MC ATC D=MR=P AVC We have constructed a model of perfect competition that depicts the costs of production as well as the revenues (TR & MR) generated. We have observed that the MR curve in this case also represents the demand curve for this product. As you recall this demand curve demonstrates a series of prices and quantities at which demand exists. But no-where have we indicated or implied the willingness and ability of the producer to supply those goods. Where is the short-run supply curve in this model? For a purely competitive industry the short run market supply curve is the horizontal summation of the MC curves (above the level of AVC) for all the firms in the industry. This can be said to be true because a supply curve is nothing more than a series of prices and quantities at which supply exists, and, the MC curve shows the costs of producing an additional unit. If an additional unit has been produced then supply has increased by one unit. Furthermore, we make the observation that producers will be willing to supply additional units only if they can meet their variable costs in the process. Now, in the long run there may be adjustments in output and prices due to the type of industry we are looking at. We know that for competitive industries the quantity supplied will equal the quantity demanded at the market price. However, that long run equilibrium can change if demand changes, allowing us to identify three different types of industries that can exist. For example suppose there is an increase in demand that causes price to be bid upward. This would result in economic profits and so more firms will be attracted to the industry. If this leads to a return to the original price then factor prices cost the same while output has increased. This is known as a constant cost industry. In this case the long run supply curve is perfectly elastic. Constant Cost Industry: Is one that does not experience increases in resource prices or costs of production as new firms enter the industry. This happens when an industry s demand for resources is insignificant of the total demand for those resources (i.e. unskilled labor.)

7 Increasing Cost Industry S1 S2 LRS P D1 D2 For some industries, however, the costs of production increase as output expands. This we call an increasing cost industry. Increasing Cost Industry: Is one that does experience increases in resource prices and therefore increasing costs of production as new firms enter the industry. In this case the industry s demand for resources is a significant proportion of the total demand (i.e. skilled labor). Decreasing Cost Industry: Is one that experiences declining resource prices and therefore falling costs of production as new firms enter the industry. Decreasing Cost Industry S1 P S2 LRS D2 D1 MC=P=ATC=LRATC Equilibrium conditions under perfect competition. 1. MC=P Indicator of economic efficiency. This means that the value of the good to the consumer is equal to the value of the resources used to produce that good. Therefore, the

8 MC=P condition is a standard of allocative efficiency. It measures the extent to which the firm is making full utilization of its resources to fulfill the consumers preferences. 2. MC=MR Means that the firm is maximizing profit and there is no incentive for it to alter its output. 3. MR=P Tells you the firm is selling in a perfectly competitive market. 4. MC=ATC Means the firm is operating at the minimum point on its ATC curve. Therefore, the firm is incurring the least possible cost per unit given its current fixed inputs. 5. MC=ATC=LRATC Indicates that the firm is producing the optimum output with the optimum size plant. Therefore, the firm is allocating its resources in an efficient manner. Favorable Features of Perfect Competition: 1. Consumer behavior is maximized. Meaning that consumers can get the most for the least possible cost. 2. Our scarce resources are being allocated in the most efficient manner. 3. The high competition among employers for inputs and consumers for goods and jobs, would cause factor owners to be paid their opportunity costs. Unfavorable Features 1. May not address adequately all consumer desires. 2. Does not consider externalities and therefore my not contribute to social welfare. 3. Insufficient incentives for progress. Our Farm Problem: Applying the Perfectly Competitive Model The problems that farmers have traditionally faced stem from four conditions: 1. Price and income inelasticities; 2. Highly competitive structure; 3. Rapid technological change; and

9 4. Resource mobility. In regard to the price and income inelasticities we note that the demand for most agricultural goods is relatively inelastic. Meaning that the demand for food is unresponsive to price changes. In the same token the supply of most agricultural goods is also inelastic. Crops cannot be instantly changed to meet the ever changing whims of the consumer. Therefore, we know that crops cannot be increased during the growing season in response to price changes. Agricultural products are also income inelastic in demand. Income elasticity of demand measures the percentage change in quantity demanded resulting from a one percentage change in income. The income elasticity for farming products is somewhere between 0.1 and 0.2 which implies that if income increases by 10% the demand for agricultural products will increase by only 1 or 2%. Now as a result of both price and income inelasticities, increases in the rate of growth of farm production that exceed increases in the rate of growth of consumption will cause a downward trend in farm prices and therefore farmers' incomes fall. Farmers have thus been arguing that their incomes have been steadily decreasing over time and they have been seeking special considerations from government in the form of tax abatements or price supports. Now this observation is correct but also somewhat misleading. Economists argue that farmer s incomes are actually substantially higher than reported because of: 1. Unreported income estimates show that as much as 30% of the farmer s income is unreported. 2. Future Capital Gains - the soaring property values are not being included in the farmers calculations of wealth. 3. Tax Benefits - that farmers have traditionally benefited from special considerations under present tax laws. For example, over the years the farmer s lobby has received government support via: a. price supports b. surplus disposal c. acreage curtailment d. marketing quotas e. direct payments The issue according to the Reagan administration concerns the efficiency of the above and the subsequent costs to society.

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