Unit Perfect Competition Unit Overview

Transcription

1 Unit erfect competition Assumptions of the model Demand curve facing the industry and the firm in perfect competition rofit-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 Unit Overview Blog posts: "erfect competition" Blog posts: "rofit maximization" 222'2*34*+52#4#"/0#-5'-/0 6

2 Characteristics of erfectly Competitive markets 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! 222'2*34*+52#4#"/0#-5'-/0 &

3 Characteristics of erfectly Competitive markets 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. rice-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. ure 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. >>ure competition provides a norm or standard against which to compare and evaluate the efficiency of the real world. 222'2*34*+52#4#"/0#-5'-/0 (

4 Demand as seen by a C seller Why study pure competition if actual purely competitive markets do not exist? urely 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. urely 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= Total revenue (TR) is the price multiplied by the quantity sold. TR = 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. 222'2*34*+52#4#"/0#-5'-/0 7

5 Demand as seen by a C seller erfectly Competitive Industry S industry erfectly Competitive Firm e D firm MR=AR= D industry A C 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 e, the marginal revenue equals the price. Therefore: MR = D = AR = 222'2*34*+52#4#"/0#-5'-/0 8

6 rofit Maximization - Total Revenue and Total Cost Costs and Revenues rofit = Total Revenue - Total Cost Max profit! TR TC Total Revenue = rice x uantity Since the price a C firm receives is constant at all levels of the firm's output, TR increases at a constant rate with output. rofit maximization: Economic rofit = TR - TC. The firm wants to produce the level of output at which the vertical distance between TR and TC is greatest. Break even point rofit-max point Break even point 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. Break even points: TR and TC are equal, meaning the firm is earning a normal profit but zero economic profits. 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 222'2*34*+52#4#"/0#-5'-/0 9

7 rofit maximization: Marginal Revenue = Marginal Cost 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<, 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 =MC rule, since marginal revenue equals price in a purely competitive market. ractice rofit-maximization: Rainbow book Activity '2*34*+52#4#"/0#-5'-/0 :

8 A firm will produce where MR = MC: rofit maximization: MR = MC Shoe Market /C Shoe Firm MC S industry e MR=D=AR= 1 MR=D=AR= 1 D 1 D industry The profit-maximizing level of output by the firm depends on the price determined by the market 1) e is determined by the total market supply and demand. 2) The firm faces its own marginal cost curve 3) The firm will choose to produce at the level of output where the MC equals MR 4) If MR falls because of falling demand, profit maximizing level of output for the firm falls '2*34*+52#4#"/0#-5'-/0 ;

9 rofit-maximizing case: Shoe Market rofit maximization: MR = MC S industry /C Shoe Firm MC ATC e ATC MR=D=AR= 1 D industry e rofit = TR - TC No TR and TC curves in the firm diagram, but there is AR and ATC er unit profit = AR - ATC To determine the amount of a C firm's profit, subtract ATC from AR at the profit-maximizing level of output. f Is the firm above earning economic profits? Yes, because average revenue is greater than average cost! Total profits = (AR - ATC) x 222'2*34*+52#4#"/0#-5'-/0 <

10 uick uiz 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) 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. roviding 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] 222'2*34*+52#4#"/0#-5'-/0 6=

11 Loss-minimizing case: rofit maximization: MR = MC C Industry S industry /C C Firm MC ATC ATC e MR=D=AR= 1 D industry 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, 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 f AR - ATC is negative, meaning the firm is experiencing losses Total loss = (ATC-AR) x s 222'2*34*+52#4#"/0#-5'-/0 66

12 Shut-down scenario: rofit maximization: MR = MC C Industry /C C Firm ATC S industry MC ATC Loss e MR=D=AR= 1 D industry f 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. 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! 222'2*34*+52#4#"/0#-5'-/0 6&

13 Long-run Equilibrium Discussion uestion: How will the existence of economic profits in a purely competitive market affect the total supply in that market? Remember, FIRMS ARE ROFIT 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. uestion: 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! 222'2*34*+52#4#"/0#-5'-/0 6(

14 Entry eliminates profits: Long-run Equilibrium C Industry S industry /C C Firm MC 1 economic profit ATC MR=D=AR= D industry 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 f 222'2*34*+52#4#"/0#-5'-/0 67

15 Exit eliminates losses: Long-run Equilibrium C Industry S industry /C C Firm MC ATC ATC e MR=D=AR= 1 D industry f 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 222'2*34*+52#4#"/0#-5'-/0 68

16 Long-run equilibrium in C: Long-run Equilibrium C Industry S industry /C C Firm MC ATC 1 MR=D=AR= D industry The industry above is earning in long-run equlibirum: f 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? ractice SR and LR Equilibrium: Rainbow book Activity '2*34*+52#4#"/0#-5'-/0 69

17 Marginal Cost as the firm's Supply Curve C firms adjust their output in response to changes in price. A C firm will shut down when MR falls below. C Firm MC When MR is above, the firm will increase its output as price increases according to its upward sloping MC curve. 4 3 Firm's Supply curve MR 4 MR 3 The MC curve above shows a direct relationship between rice (AR) and quantity supplied. 2 1 MR 2 MR 1 The MC curve above IS THE INDIVIDUAL FIRM'S SULY CURVE! 222'2*34*+52#4#"/0#-5'-/0 6:

18 Marginal Cost as the firm's Supply Curve oints to understand about the MC curve as the firm's short-run supply curve The MC increases as ouput increases because of diminishing marginal returns C Firm MC 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. Firm's Supply curve In other words, the MC curve represents the relationship between price and quantity supplied. This is a direct relationship (demonstrating the law of supply!) What would cause the firm's supply (MC) curve to shift? 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 U. 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 M and A curves up, thus the MC and curves down). This corresponds with an outward shift of the firm's supply curve 222'2*34*+52#4#"/0#-5'-/0 6;

19 Marginal Cost and Market Supply C Firm MC C Market with 200 identical firms S=MC Firm's Supply curve $5 x200= MR=AR $5 D 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 222'2*34*+52#4#"/0#-5'-/0 6<

20 Allocative and roductive Efficiency Discuss: "urely 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?" 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? ractice graphing C: NCEE workbook Activity '2*34*+52#4#"/0#-5'-/0 &=

21 Allocative and roductive Efficiency 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 roductive Efficiency: = minimum ATC Interpretation: 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. Allocative Efficiency: = MC Interpretation: 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 = MC is the right amount of output being produced. 222'2*34*+52#4#"/0#-5'-/0 &6

22 Discussion uestions: Allocative and roductive Efficiency rice 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 = MC once more. Only then have the right amount of lattes been produced! ALLOCATIVE EFFICIENCY is achieved when = MC! Allocative Efficiency: Is = MC good for society? Why or why not? roductive Efficiency: Is = min. ATC good for society? Why or why not? Are ZERO economic profits bad for firms? Why or why not? 222'2*34*+52#4#"/0#-5'-/0 &&

23 ractice Free Response uestion 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) rice and output for the market (ii) rice 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) rice and output for the industry (ii) rice 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) rice in the industry (ii) Output of a typical firm (iii) The number of firms in the dairy industry 222'2*34*+52#4#"/0#-5'-/0 &(

24 ractice problems 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 C 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 Industry S industry Firm MC ATC e MR=D=AR= 1 D industry 222'2*34*+52#4#"/0#-5'-/0 &7

27 ractice problems 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 Industry S industry Firm MC ATC e MR=D=AR= 1 D industry 222'2*34*+52#4#"/0#-5'-/0 &:

28 ractice problems 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 Industry S Firm industry MC ATC e MR=D=AR= 1 D industry 222'2*34*+52#4#"/0#-5'-/0 &;

29 Unit uiz 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? 222'2*34*+52#4#"/0#-5'-/0 &<

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