Chapter 11 Perfect Competition

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1 These notes provided by Laura Lamb are intended to complement class lectures. The notes are based on chapter 11 of Microeconomics and Behaviour 2 nd Canadian Edition by Frank and Parker (2004). Chapter 11 Perfect Competition In this chapter and the following two chapters we look at four basic market structures: perfect competition, monopoly, monopolistic competition and oligopoly. Economists assume that each firm s objective, regardless of its market structure, is to maximize profit. 1. Economic Profit What is profit? Economic profit is total revenue less total costs which consist of implicit and explicit costs. Economic profit differs from accounting profit in that accounting profit does not consider. Normal profit refers to the opportunity cost of using resources owned by the firm. Accounting profit includes normal profit whereas economic profit does not. (Normal profit is a cost) If a firm has an economic profit of zero, we can say that it is earning a normal profit. Why do firms profit maximize? 1. There is a long-run tendency towards profit maximizing behaviour. - This argument is in line with Darwin s theory of evolution by natural selection. - Those firms exhibiting profit maximizing behaviour will have larger surplus revenues and will grow. - Those firms not exhibiting profit maximizing behaviour have less, if any, surplus revenues and are more likely to go bankrupt. - Over time, the firms with the highest profits are more likely to. 1

2 - The evolutionary argument concludes that, over long periods of time, behaviour will tend toward profit maximization purely as a result of selection pressures in the competitive environment (p311) 2. Profit maximizing behaviour results from people intentionally pursuing their own interests. - For instance, related firms are more likely to do business with a profit maximizing firm. It is in a firm s best interests to do business with - i.e. Financial institutions want to lend money to a firm with the ability to repay the loan. Thus, firms using profit-maximizing methods are more likely to prosper. 3. There is often a financial incentive for managers to maximize profit - The salaries of upper management (CEOs, CFOs) are often tied to the profit performance of the firm. - although we have seen that this method of financial incentive does not always lead to positive outcomes i.e. the Enron fiasco In general, the assumption of profit maximization is a although it is important to acknowledge that firms do not always exclusively pursue profits at the expense of all other goals. Short-run versus long-run profit maximization Sometimes short-run profit maximization is sacrificed for the sake of long-run profit maximization. - For instance,. 2. Four Conditions of Perfect Competition 1. Standardized product - The product of any one firm is a for all the product of all other firms. 2

3 - The condition becomes more reasonable as the product is defined more narrowly. 2. Price takers - The market price is treated as. - No individual firm can influence the market price by the quantity of output it produces. Why? 1. A large number of producers, or 2. It believes that other firms will immediately if the price rises. 3. Mobile factors of production in the long- run - Economists do not believe that factors of production are - For instance, labour is not perfectly mobile because people buy homes, establish themselves in communities, and are often resistant to relocate. - Although, labour is mobile within a geographic region especially in the case where workers have portable skills. i.e. a laid off worker can often find work in a related industry. 4. Perfect information - Consumers and firms have perfect information. - The assumption of perfect information means that people can acquire most of the information relevant to their choices without great cost/difficulty. Note: 2 assumptions about short-run production: The number of firms is and each firm has some. 3. Profit Maximization in the Short-run How does a firm choose its level of output in the short-run? 2 methods: 1. Compare total revenue and total cost Choose the level of output at which total revenue exceeds total cost by the largest amount. 3

4 2. Compare marginal revenue and marginal cost Marginal revenue is the change in total revenue resulting from one additional unit of output sold. MR Q = TR Q / Q Marginal revenue is equal to the slope of the total revenue curve at any given point. For perfectly competitive firms, MR = P The firm should produce the level of output for which MR = MC on the rising portion of the MC curve. For a perfectly competitive firm, P = MC for profit maximization. (MR = P = MC) 4

5 Calculating profit The level of profit can be calculated at Q* (profit-maximizing level of Q) Profit = TR TC TR= P x Q* TC = ATC x Q* What happens if the profit maximizing level of output results in an economic loss for the firm? In this case, the firm is minimizing its loss instead of maximizing profit. A firm will incur a loss if P<ATC at Q*. If a firm incurs a loss, should it shut down in the short run? If a firm is incurring a loss and P > AVC, some of the fixed costs are being covered and thus the firm should continue to produce Q* level of output since the loss is less than it would be if the firm shuts down and produces nothing. Q* remains the optimal level of output to produce if the firm should produce at all. When is the firm better to produce nothing rather than Q*? If P < AVC, the firm should shut down in the short-run. In this case, the loss is minimized if the firm produces nothing. In sum: 5

6 If P < ATC, the firm is incurring an. If P > AVC, the firm should. If P < AVC, the firm should. Where is the supply curve in the model? The short run supply curve for a perfectly competitive firm is the upward sloping section of the MC curve beginning where AVC = MC. 4. Short-run Competitive Industry Supply The industry supply curve is the horizontal aggregate of individual firm supply curves. Graph (p319) In the special case where all firms have the identical firm supply curve, the industry or market supply curve is given by: Q = n Q i, where n is the number of firms and Qi is the quantity supplied for each individual firm. 6

7 Remember that the individual supply equation must be written with Q i on the left hand side (slope-intercept form). Example: Suppose an industry has 300 firms, each with supply curve P = Q i. What is the industry/market supply curve? Step 1: re-arrange to slope-intercept form Step 2: Q = n Q i Step3: re-arrange to have price alone on one side, if you want to graph the curve 5. Short-run Competitive Equilibrium How is price determined in the short-run? The equilibrium price is determined through market demand and supply in the industry. Note that the market demand curve is downward sloping and the demand curve facing the individual firm is perfectly elastic. The perfectly elastic demand curve indicates that any firm can sell as much output as it wants at the market price (equilibrium price). 7

8 If the firm raises its price, it will sell nothing because all buyers will purchase from a competing firm selling the identical product. The firm does not have any incentive to lower its price because it can sell as much as it wants at the market price. The market price could be such that individual firms incur an economic loss. Example: If the short-run marginal and average variable cost curves for a competitive firm are given by MC = 3Q and AVC = Q, how many units of output will the firm produce at a market price of P = $12 per unit? At what level of fixed cost will this firm earn an of economic profit of zero? Note that minimum AVC = 0, which tells us that with any P>0, the firm will not shut down. Profit = TR TC TR = P x Q TC = AVC x Q + FC Profit = Fixed costs must equal in order for the firm to earn an economic profit of zero. 8

9 6. The Efficiency of Short-run Competitive Equilibrium Allocative efficiency exists when resources are allocated towards producing the goods most want wanted by society. Mutual gains (to buyers and sellers) are maximized at an allocatively efficient level of output. A competitive equilibrium is allocatively efficient when there is no room for further mutually beneficial exchange. Buyers will always want to pay less, but sellers will not sell for less because the equilibrium price is equal to the value of the resources required to produce another unit. Firms will want to charge more, but buyers will not pay more because there are many other firms willing to sell at the equilibrium price. 7. Producer Surplus Producer surplus is an analogous measure to consumer surplus. It measures how much better off a firm is as a result of having supplied its profit maximizing level of output. It is equal to the economic profit plus fixed cost. There are two ways of measuring producer surplus for an individual firm. 9

10 To measure or analyse the change in an existing producer surplus use method a). To measure total producer surplus use method b). To measure aggregate producer surplus, we simply sum the producer surplus for each firm in the market. When the marginal cost curve is upward sloping through most of its range, it is measured by the area between the supply curve and the equilibrium price. The total benefit from exchange is illustrated with the sum of producer surplus and consumer surplus. Example: If market supply is given by P = Q and market demand is given by P = Q, calculate the sum of producer and consumer surplus. 8. Perfect Competition in the Long-run 10

11 In the short-run we assumed that the number of firms was fixed and that each firm has fixed inputs. In the long-run the number of firms can change. New firms may enter the industry and existing firms may leave the industry. In the long-run firms may change their scale of production by changing inputs that were fixed in the short run. In the long-run there are no fixed inputs. In the long run, a firm earning an economic loss will go out of business. The adjustment process from short-run to long-run The adjustment process in any industry depends on a number of factors, a few of which include: - To what degree are the firms identical in technology, cost structure, and efficiency? - The differences in speed of adjustment. - How long does it take to adjust capital stock? - How long does it take for a new firm to enter the industry? i.e. build a plant, become operational? Many models of adjustment are possible depending on assumptions of the factors listed above. Let s suppose an initial situation where market equilibrium price P = SMC = LMC. Our initial situation is inherently unstable. Why? Positive economic profits will attract new firms to the industry. 11

12 As new firms enter the industry: - The industry supply curve which is the sum of all individual firm SMC curves will shift to the right. - The market price falls - Each firm, being a price taker, now deals with a lower price and thus a lower marginal revenue curve. - If the firms expect price to fall further, they will reduce their capital stocks. - Economic profit falls. - SMC curves shift left (net effect on market supply is a rightward shift) due to lower price. (SMC is the firm supply curve) - Firms continue to enter as long as they can make a positive economic profit, thus the adjustment process continues until the 2 following conditions are met: 1. P = minimum LAC 2. All firms have a capital stock size such than the SAC curve is tangent to the LAC where LAC is at a minimum. (economic profit = 0) - Once the conditions are met, firms do not have any incentive to enter or exit the industry the equilibrium is stable. Evaluating the long-run outcome in a perfectly competitive industry Socially desirable properties: - Price equals to marginal cost in the short-run and long-run means that the equilibrium is allocatively efficient. i.e. mutual gains to both buyers and sellers are collectively maximized. (the marginal benefit to buyers equals the marginal cost to sellers of producing the last unit of output) 12

13 - Since all firms earn an economic profit of zero (a normal profit), buyers do not pay more that what it costs the firms to produce. There is no such thing as a free market The market is not costless. For instance, consider the case of the Soviet Union and its transition from a command economy into a market economy. Severe economic disruption resulted with the abandonment of central planning. Why? - The Soviet economies did not have fully developed market institutions necessary for a fully functioning market economy to operate. - These market institutions develop over time, they do not spontaneously appear. A competitive market system requires: - Low-cost systems for disseminating accurate information on prices and characteristics of products in order to minimize search and other transaction costs. - Basic numerical skills are required for consumers to use price information to make decisions. - A peaceful, secure and stable environment is needed. - A widely understood and enforced system of property rights. - Legal institutions and law enforcement to establish rules for economic/business transactions (impose penalties for those who cheat, commit fraud, extort resources, etc) - Government is one of the most important institutions required for providing necessary prerequisites for an efficient market system. The Long-run Market Supply Curve a) In the case where all firms in an industry have identical U-shaped LAC curves: - Assumption: changes in demand for the product do not cause the prices of capital, labour and other inputs to change. - The long-run supply curve for a competitive industry is a horizontal line coinciding with the minimum long-run average cost (LAC). - Short-run changes in demand and supply will result in firms entering and exiting the industry until a new long-run equilibrium is reached, which will always involve an equilibrium price equal to the minimum LAC. - A fall in demand will not lead to a fall in price when LAC curves are U- shaped, it results in an decrease in the number of firms in the industry. Vice versa for a rise in demand. 13

14 b) In the case where all firms in an industry have horizontal LAC curves: - Again, the long-run supply curve for a competitive industry is a horizontal line. - Since the LAC does not have a unique minimum (LAC is the same at any level of output), the size of the firms cannot be predicted. - The industry may consist of small, medium-sized and large firms. - The only thing we can state with certainty is that the price will tend towards the value of LAC in the long-run. c) The effect of changing input prices on supply - In most real world cases, an industry uses only a relatively small share of the total volume of inputs traded in the market place, and modest changes in industry output have no significant effect on input prices. For this reason, LAC curves are typically horizontal. - In some real world cases, input prices will change as an industry produces more goods and services. - For instance, the commercial airline industry consumes a significant share of total titanium whereby an increase in the quantity of airplanes produced often results in a rise in the price of titanium. - The concept pecuniary diseconomy describes the rise in production costs that occur when an expansion of industry output causes a rise in the prices of inputs, and vice versa for a contraction in industry output. - The LAC curve will rise (shift up) with industry output. - Firms tend towards minimum points LAC, but because the minimum point depends on the level of industry output, the long-run supply curve will slope upward. - Competitive industries in which rising input prices lead to upward sloping supply curves are called increasing cost industries. - In the case where production costs fall when an industry expands, we have pecuniary economies. - For instance, a dramatic increase in wind turbine generated electricity may result in economies of scale in the turbine blades, resulting in a lower price for inputs. - With pecuniary economies, the long-run industry supply curve will be downward sloping even when the LAC curve is either horizontal or U- shaped. 14

15 - Competitive industries in which falling input prices lead to downward sloping supply curves are called decreasing cost industries. Price Elasticity of Supply Analogous to price elasticity of demand, price elasticity of supply is a measure of the responsiveness of quantity supplied to changes in price. ε s = percent change in quantity supplied = Q P percent change in price P Q If ε s >1, supply is If ε s < 1, supply is If ε s = 1, supply is If the long-run supply curve is horizontal, elasticity of supply is infinite. (Output can be expanded indefinitely without a price change) With pecuniary economies, long run supply curves are downward sloping and long run elasticity of supply is negative. With pecuniary diseconomies, long run supply curves are upward sloping and long run elasticity of supply is positive. Competitive firms may be price takers, but they are also responsive innovators 15

16 In the 1970s the long distance trucking industry responded as the competitive model predicted to an increase in input prices as the price of fuel rose dramatically. Responses: - Short-term losses - Exit from the industry - Gradual price increases - Gradual restoration of profits for surviving firms As well, cost-saving innovations created opportunities for some firms to profit. - The tripling of diesel prices in the early 1980s induced entrepreneurs to devise innovative ways to reduce costs. - The airfoil was designed to deflect wind to the top of the trailer. - It is estimated that by reducing wind resistance the airfoil thereby decreased fuel consumption by 10 15% at highway speeds. - The first truckers to install the airfoils did so when the industry price was determined by the higher costs of running trucks. - These first truckers earned economic profits from their efforts. - As time passed, more and more trucks adopted the use of airfoils. And the industry price level declined in response to the lower costs. - Today, it is rare to see an 18-sheeler without an airfoil. - It can reasonably be assumed that the resultant cost savings has been fully reflected in lower trucking rates. - Now the owner of a truck must install an airfoil to earn a normal profit (economic profit of zero). 16

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