Introduction. 2 things every firm shares with all other firms: certain market structure. 2/2/ To answer certain questions:

Transcription

1 MARKET MODEL FROM PERFECT COMPETITION TO MONOPOLY Part 1: Perfect Competition Introduction 2 things every firm shares with all other firms: 1. To answer certain questions: 1. What price for the goods it produces and sell? 2. How many units should it produce its good? 3. How much resources it needs to produce its goods? 2. Every firm finds itself operating within a certain market structure. 1

2 What is Market Structure? The particular environment of a firm, the characteristics of which influence the firm s pricing and output decision. 4 Different Market Structure Classification of market depend on; Number of firms in a market Nature of the product homogenous (identical), differentiated? Freedom of entry and exit Control over supply/output Control over price Type of competition 2

3 4 Different Market Structure Perfect Competition Monopoly Monopolistic Competition Oligopoly 4 Different Market Structure Perfect Competition - Big number of buyer and seller - Homogenous product - Freedom of entry / exit Monopolistic Competition - Many sellers and buyers - Each firm in the industry produces and sells a slightly differentiated product - Easy entry and exit Monopoly - Single supplier - No close substitute for product - Extremely high barriers to entry Oligopoly - a few sellers and many buyers - Firms produce and sell either homogeneous or differentiated products - Significant barriers to entry 3

4 The Theory of Perfect Competition The characteristics 1. There are many sellers and many buyers, none of which is large in relation to total sales and purchases. - because there are many buyers and sellers, it is reasonably assumed that each buyer and each seller acts independently of other buyers and sellers, respectively, and each is so small a part of the market that he or she has NO influence on price. The Theory of Perfect Competition Built on 4 assumptions 2. Each firm produces and sells a homogenous product - each firm sells a product that is indistinguishable from all other firm s products in a given industry. As a consequence, buyers are indifferent to the sellers of the product. 4

5 The Theory of Perfect Competition 3. Buyers and Sellers have all relevant information about prices, products quality, sources of supply and so forth - buyers and sellers know who is selling what, at what prices, at what quality, and on what term. In short, they know EVERYTHING that relates to buying, producing, and selling the product. The Theory of Perfect Competition Built on 4 assumptions 4. Firms have easy entry and exit - New firms can enter the market easily, and existing firms can exit the market easily. There are no barriers to entry or exit. 5

6 Characteristics of the Perfectly Competitive Firm (resulted from the 4 assumptions) 1. A Price Taker does not have the ability to control the price of the product it sells: it takes the price determined in the market. Why? Because a firm is restrained by the environment of perfect competition the 4 assumptions. Characteristics of the Perfectly Competitive Firm (resulted from the 4 assumptions) 2. The Demand Curve for a Perfectly Competitive Firm is Horizontal Perfectly competitive setting: Many buyers and many sellers Together, all the buyers make up the market demand curve Together, all the sellers make up the supply curve 6

7 When the equilibrium price has been established, a single perfectly competitive firm faces a horizontal demand curve at the equilibrium price. This means, the firm takes the equilibrium price as given and sells ALL quantities of output at this price. What happens if a firm increase the price of its products? What happens if a firm decrease the price of its products? The equilibrium price is the only relevant price for the perfectly competitive firm. 7

8 Characteristics of the Perfectly Competitive Firm (resulted from the 4 assumptions) 3. The Marginal Revenue Curve for a Perfectly Competitive Firm is the Same as its Demand Curve Total revenue (TR) = price of goods x quantity sold Marginal revenue (MR) = ΔTR / ΔQ 8

9 Therefore, for a perfectly competitive firm, price is equal to marginal revenue (P = MR) And so, the marginal revenue curve for the perfectly competitive firm is the same as its demand curve. Demand curve plots price against quantity Marginal Revenue curve plots MR against quantity Since P=MR, the demand curve and MR curve are the same. 9

10 Perfect Competition in the Short Run Background For a perfectly competitive firm, price is equal to MR. So the demand curve = MR curve Lets focus on the amount of output the firm will produce in the short run. What level of Output Does the Profit Maximising Firm Produce? 2 approaches: 1. Marginal Approach 2. Total Approach 10

11 What level of Output Does the Profit Maximising Firm Produce? Before that: The concept of Decisions at the Margin 1. Marginal Benefits Vs Marginal Cost Marginal Benefits = Additional Benefits. The benefits connected to consuming an additional unit of a good or undertaking one more unit of activity Marginal Cost = Additional Cost. The cost connected to consuming an additional unit of a good or undertaking one more unit of an activity. Marginal Cost in formula: MC = Δ Total Cost / Δ Quantity What level of Output Does the Profit Maximising Firm Produce? Decisions at the Margin = Decision making characterised by weighing the additional (marginal) benefits of a change against the additional (marginal) costs of a change with respect to current condition. Efficiency = When the marginal benefits equal marginal costs. 11

12 What level of Output Does the Profit Maximising Firm Produce? With reference to the curves : 1. Demand curve/mr Curve 2. Marginal Cost Curve 12

13 What level of Output Does the Profit Maximising Firm Produce? A firm will continue to increase its quantity output as long as marginal revenue is greater than marginal cost. A firm will stop increasing its quantity output when MR and MC are equal. The profit-maximising rule for a firm says; Produce the quantity of output at which MR = MC. What level of Output Does the Profit Maximising Firm Produce? For the perfectly competitive firm, the profit-maximising rule can be written as P = MC because the perfectly competitive firm, P = MR. In perfect competition, profit is maximised when P = MR = MC 13

14 To Produce or Not to Produce Profit maximising rule: P = MC Perfectly competitive firm is resource allocative efficient as quantity produce is at MR=MC, and since P=MR, so P=MC. 3 applications of the profit-maximisation (lost-minimisation) rule by a perfectly competitive firm: 1. Price is above ATC 2. Price is below AVC 3. Price is below ATC but above AVC 2. Price is below AVC 1. Price is above ATC 3. Price is below ATC but above AVC 14

15 To Produce or Not to Produce A perfectly competitive firm produces in the short run as long as price is above AVC (Case 1 & 3). A perfectly competitive firm shuts down in the short run if price is less than AVC (Case 2) P > AVC: Firm produces P< AVC : Firm shuts down Or, in other words; A perfectly competitive firm produces in the short run as long as Total Revenue is greater than Total Variable Costs (Case 1 & 3). A perfectly competitive firm shuts down in the short run if TR is less than TVC (Case 2) To Produce or Not to Produce P > AVC: Firm produces P< AVC : Firm shuts down Or, in other words; A perfectly competitive firm produces in the short run as long as Total Revenue is greater than Total Variable Costs (Case 1 & 3). A perfectly competitive firm shuts down in the short run if TR is less than TVC (Case 2) 15

16 What level of Output Does the Profit Maximising Firm Produce? Or, through TR Vs TC (Total Approach) Break even points are at which TC crosses TR Max profit = the biggest gap between TR and TC, and TR>TC Max loss = the biggest gap between TR and TC, and TR<TC Exercise! Q P ($) TR($) TC($) Total Profits ($) Complete the table above and plot the TC and TR Curves 16

17 Axis Title 2/2/ TC TR And another one Q P TR MR TVC TC MC AVC ATC TP Complete the table above and plot the MC, ATC, AVC and MR Curves What will the firm with the above condition do? 17

18 Firm s short run supply curve Since the perfectly competitive firm always produces where MR=P=rising MC (as long as P exceeds AVC), the firm s short run supply curve is given by the rising portion of its MC curve over and above its AVC, or shutdown point Industry s short run supply curve May be obtained by adding up the supply of firms in the industry 18

19 Perfect Competition in the Long Run The number of firms in industry changes over time. Long run equilibrium of the competitive firm If the firms in a perfectly competitive industry are making short-run profits, more firms will enter the industry in the long run. This increases the market supply of the commodity and reduces the market price until all profits are competed away an all firms just break even. The exact opposite occurs if we start with firms with short-run losses. As a result, all firms in a perfectly competitive industry with long run equilibrium produce where P=lowest LRAC. Resources are utilised in the most efficient way to produce the goods and services most wanted by society, and consumers pay the lowest possible price. 19

20 The characteristics of Long-Run Competitive Equilibrium: 1. Economic Profit is Zero: Price (P) is equal to short-run ATC. Why? If P>ATC, more industry will come join the industry. P<ATC, losses will result and some firms will leave the industry. 2. Firms are producing the Quantity of output at which P=MC. 3. NO firm as an incentive to change its plant size to produce its current output The conditions of Long-Run Competitive Equilibrium: (how it can exist) 1. There is no incentive for firms to enter or exit the industry 2. There is no incentive for firms to produce more or less output 3. There is no incentive for firms to change plant size. 20

21 Constant-, Increasing-, and Decreasing-Cost Industries Happens when industry output expands as more firms enter the industry, and more factors of production are demanded in the long run, factor prices might remain constant, rise or fall. The long-run supply curve of a constant cost industry is horizontal. The curve rises in an increasing-cost industry And it falls in a decreasing-cost industry. Of the 3, increasing-cost industries are the most common 21

22 Tutorial (to be submitted next week) Elaborate on the following: 1. Constant-cost industry 2. Increasing-cost industy 3. Decreasing-Cost Industries Advantages of Perfect Competition Firms operate at maximum efficiency. Price = marginal costs High degree of competition helps allocate resources to most efficient use Normal profit made in the long run Consumers benefit Freedom to choose and act on type of economic activity to be involved 22

23 Disadvantages of Perfect Competition No motivation for research and innovation Limited consumer choice Social cost: due to increase of supplier, as no barrier to entry manipulation of resources tend to be high. Disadvantage in specialised industry which could help lead to cost reduction The Theory of Perfect Competition Predicts the followings: 1. Economics profit will be squeezed out of the industry in the long run by the entry of new firms that is zero economic profit exists in the long run 2. In equilibrium, firms produce the quantity of output at which the price equals marginal cost, 3. In the short run, firms will stay in business as long as price covers average variable costs 23

24 The Theory of Perfect Competition 4. In the long run, firms will stay in business as long as price covers average total costs. 5. In the short run, an increase in demand will lead to a rise in price; whether the price in the long run will be higher than, lower than, or equal to its original level depends on whether the firm is in an increasing, decreasing, or constantcost industry. The Theory of Perfect Competition Applicable to predict the market behaviour for 1. SOME of the real-world market closely met the assumptions in the theory of perfect competition. E.g: Agricultural markets and a small subset of the retail trade. 2. There are some of the real-world market that approximated to the four assumptions, where the number of sellers may not be large enough to for every firm to be a price taker but the firm s control over price may be negligible. So the firm acts as if it were a perfectly competitive firm 24

25 The Theory of Perfect Competition A market that does not exactly meet the assumptions of perfect competition MAY nonetheless approximate those assumptions to such a degree that it behaves AS IF it were a perfectly competitive market. 25