in Perfect Competition

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1 ECON34 Ch.8: erfect Competition Dr. Mohammed Alwosabi CHATER EIGHT (art 1) ricing and Output Decisions in erfect Competition 1 Four Basic Market Types How firms establish their price and output levels in order to achieve their objective of profit maximization (or loss minimization)? The answer to this depends on the market structure in which the firm is operating. There are four main types of market structure: 1. erfect competition 2. Monopoly 3. Monopolistic Competition 4. Oligopoly Market structure refers to the size and number of firms in the market. 2 erfect Competition erfect competition refers to a market in which 1.there are large number of relatively small firms selling an identical (standardized) product, 2.large number of buyers who are indifferent from whom to buy. 3.None of the buyers or sellers has market ower, which refers to the ability to influence the market price of a good or service. Each firm is a price taker Very easy market entry and exit. 5. Information is available to all. 6. Non-price competition is not possible 7. Firm earns only zero economic profit in the long run. Examples: the markets for agricultural product (corn, wheat, coffee), financial instruments (stocks, bonds, foreign exchange), precious metals (gold, silver, platinum) and the global petroleum industry 4 Monopolistic Competition Monopolistic competition is a market in which: 1.large number of relatively small firms producing similar but differentiated products. 2.Each firm maintains i some control of its own price. 3.It is easy to enter or exit this market. 4.Non-price competition is possible 5.In the long run, economic profit of any firm in this type of markets is zero. 5 Examples: Small industries such as retail and service establishments (restaurants, boutiques, luggage stores, shoe stores, stationary stores, repair shops, laundries, beauty parlors) There are many of monopolistic competitive firms in any given city or area of the city. The start-up capital is relatively low, so it is fairly easy to start these types of business. Each one tries its best to stand out among its many competitors by differentiating its product. 6 1

2 ECON34 Ch.8: erfect Competition Dr. Mohammed Alwosabi Oligopoly Oligopoly is a market in which: 1. a small number of relatively large firms producing all or most of the market supply of a particular good or service. 2.The product may be identical (standardized) or differentiated. t d 3.It is difficult to enter this market. 4.Non-price competition is very important among the firms selling differentiated products 7 5. Firms in this market can make positive economic profit based on whether they compete with each other severely or they have some kind of mutual agreements regarding prices, market share and products. Examples: manufacturing sector, oil refining, certain types of computer hardware and software, chemical and plastics, steel, automobile, soft drinks, airline travel, banking industry, insurance companies, telecommunications, etc 8 Monopoly Monopoly refers to: 1.one firm that produces the entire market supply of a particular unique good or service that has no close substitutes. 2.The firm is the industry 3.It has market power. It is a price maker. 4.It is very difficult or impossible for any other firm to enter this market. 5.This firm makes high economic profit subject to regulations Firm earn positive economic profit in the long run. 7. Non-price competition is not necessary Examples: Examples of pure monopoly are not easy to find. Electricity and water industry in some countries, ti patent tlaws sometimes provide companies with temporary monopolies, a company that is so dominant might be said to exhibit monopolistic status (such as Microsoft) 1 ricing and Output Decisions in erfect Competition erfectly competitive market exists when: 1. Each firm (seller/producer) is small relative to market demand firm cannot affect market demand. 2. No unique characteristics ti of each firm s product consumers are indifferent about from which firm to buy. 11 This implies that in competitive market 1. Firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price of the product (MR=) 2. Average revenue of the firm is also equal to price (AR=) 3. No limit to the total revenue that the firm can gain in a perfectly competitive market. 4. The firm s objective is to maximize its profit in the short run. If it cannot earn a profit, then it seeks to minimize its loss. 12 2

3 ECON34 Ch.8: erfect Competition Dr. Mohammed Alwosabi The Basic Business Decision: Entering a market on the basis of the following questions: 1. How much should we produce to maximize profit? 2. If a loss rather than a profit is incurred, will it be worthwhile hil to continue in this market in the long run (in hopes that we will eventually earn a profit) or should we exit? 13 Market demand curve vs. firm demand curve It is important to distinguish between the market demand curve and the demand curve facing a particular firm. The equilibrium market price is determined by the interaction of market demand and market supply curves. The market demand curve for a product is downward sloping (less than infinite). The market supply curve is upward sloping However, the demand curve facing the perfectly competitive firm is different. 14 Since the output of each firm is such a very small share of this total output, no individual firm can affect the market price and therefore is a price taker. The perfectly competitive firm faces a horizontal, perfectly elastic demand curve (with price elasticity of demand equal to infinity). At a fixed price, the firm sells any quantity it wants. No matter of what is the quantity sold the firm charges the same price, i.e., = D Market S D Firm D = MR =AR 15 (in thousands) 16 Given the fixed price and the horizontal demand curve, the perfectly competitive firm faces two SR decisions and two LR decisions. 1. roduction decisions in SR: a. Whether to produce or shut down temporarily? b. If it is to produce, how much to produce? And how much profit will it earn? 2. Investment decisions in LR: a. Whether to enter, stay or leave the industry b. If the firm is already in the market, whether to expand or downsize the plant

4 ECON34 Ch.8: erfect Competition Dr. Mohammed Alwosabi Short Run Decision: The roduction Decision Since a competitive firm cannot affect market price (a price taker), it has to decide what is the amount of output that will maximize the firm's total economic profit (or minimize loss) To find the amount of output that maximizes profit we can use the total analysis or marginal analysis 19 Total Analysis approach: rofit is maximized at * where TR-TC is highest Compare the total revenue and total cost schedules and find the level of output that either maximizes the firm s profits or minimizes its loss. TR = *. Since a perfectly competitive firm can sell all of its output at one price, the total revenue curve of a perfectly competitive firm is an upward sloping straight line, with slope equal to market (equilibrium) price (*) 2 In order to calculate profit, we also have to see how costs vary with the rate of output in the short-run. TC is the opportunity cost of production, which includes normal profit. Total costs (TFC + TVC) increase as output expands. At first, they rise slowly due to the increasing marginal returns, and then they increase more quickly due to the diminishing marginal returns. Since profit depends on the difference between TR and TC, profit is maximized when TR exceeds TC by the largest amount; i.e., where the vertical distance between TR curve and TC curve is the largest TR R C rofit + Loss - Loss Loss a * rofit a * TC b b TR Break-even oint Max rofit Break-even oint Max rofit Loss π 23 Marginal Analysis approach: What an additional unit of output brings in revenue is its marginal revenue (MR) and what it costs to produce is its marginal cost (MC). A firm that wants to maximize its profit (or minimize its loss) should produce a level of output at which the additional revenue received from the last unit is equal to the additional cost of producing that unit; i.e., MR=MC. 24 4

5 ECON34 Ch.8: erfect Competition Dr. Mohammed Alwosabi, MR,MC MC (MR)= MC maintain (MR)> MC * (MR) < MC =MR =D Since perfect competition structure implies MR=, the MR=MC rule may be restated as =MC. Equating MR (or ) to MC shows us the efficient level of output. However, this level of output does not tell us whether the firm is maximizing profit or minimizing loss. To determine whether a firm is earning an economic profit or incurring an economic loss, we compare the firm s average total cost,, at the profit maximizing output with the market price rofit = TR TC = ( - AC) * 1. Total economic profit is maximized if =MC above ( > ) 2. Total economic profit is zero (normal profit) if = MC = Break-even minimum AC. 3. Total economic loss is minimized i i if =MC below ( < ) 1. rofit Maximization: Making ositive Economic rofit If curve is added to the diagram, a profit-maximizing firm will produce at the level of output (*) at which = MC > 27 28, MR,Costs MC C = 5 A = 3 B =MR=AR=D TR = = 5 * 2 = 1 TC = = 3 * 2 = 6 Total economic profit =TR TC = (-) * = 2 * 2 = 4 If a firm is receiving positive economic profits, the owners are receiving a return on their investment t that t exceeds what they could receive if their resources had been used in an alternative occupation. * =

6 ECON34 Ch.8: erfect Competition Dr. Mohammed Alwosabi 2. Zero Economic rofit (Normal rofit) If = MC = min, firm is earning zero economic profit, i.e., is earning normal profit (this is known also as break-even point), MR, Costs MC =5 =MR =D *= Total profit = ( ) *, But since = then (-) = total profit = 3. Loss Minimization and the Temporary Shutdown Decision If < at the level of output at which MR = MC, the firm will incur economic loss , MR, Costs MC A=8 =5 *=2 =MR =D 35 Total economic profit = (-)* = -3 * 2 = - 6 Economic loss Now, with this loss, should the firm continue its operations? If the firm suffers a loss, what is the best action? Remember that: rofit = ( ) *, and that = AFC + AVC Therefore, rofit = ( AFC - AVC) * Remember also that fixed costs must be paid even if output =. 36 6

7 ECON34 Ch.8: erfect Competition Dr. Mohammed Alwosabi Thus, if the firm shuts down its operation it has to pay the fixed costs To determine this, we have to compare the firm's loss if it stays in business with its loss if it shuts down. If the firm decides to shut down, its revenue will equal zero and its costs will equal its fixed costs. (Remember, fixed costs must be paid even if the firm shuts down.) Thus, the firm receives an economic loss equal to its fixed costs if it shuts down. The firm will stay in business in the short run even if it receives an economic loss as long as its loss is less than its fixed costs. This will occur if the revenue received by the firm is large enough to cover its variable costs and some of its fixed costs. In mathematical terms, this means that the firm will stay in business as long as TR = x > TVC Contribution Margin (CM): the amount by which total revenue exceeds total variable cost: CM = TR TVC If CM > firm will stay in business If CM = firm might stay in business or might shut down Dividing idi both sides of the above expression by, we can say that the firm will stay in business as long as > AVC The shutdown point is the output and price at which the firm just covers its TVC, where = MC = min AVC. 39, Costs c b a MC 1 AVC 4 The Firm Short-run Supply Curve Example: What is the profit maximizing output for a perfectly competitive firm selling its product at $1, with the following cost structure? TFC TVC MC , Costs MC c b a AVC

8 ECON34 Ch.8: erfect Competition Dr. Mohammed Alwosabi ricing and Output Decisions in erfect Competition in the LR In the long run, two adjustments are possible: 1. Existing firms may adjust plant size 2. Entry and exit of firms is possible Both actions will affect market supply and a new market price is established Existence of economic profit: 1. Invites existing firms to expand plant size 2. invites entry of new firms 3. This shifts the supply curve to the right, decreases price and reduces profits until economic profit is wiped out S 1 S 2 S n n n, MR, Costs MC Economic loss causes exit of firms or shrink plant size which shifts the supply curve to the left, increases price and reduces loss until it is eliminated. Thus, the price in the competitive market in the long-run will settle at the point where firms earn only normal profit (zero economic profit). D n Observations in perfectly competitive markets: 1. The earlier the firm enters a market, the better its chances of earning above-normal profit (assuming a strong demand in the market). 2. As new firms enter the market, firms that want to survive and perhaps thrive must find ways to produce at the lowest possible cost, or at least at cost levels below those of their competitors. 3. Firms that find themselves unable to compete on the basis of cost might want to try competing on the basis of product differentiation instead

9 ECON34 Ch.8: erfect Competition Dr. Mohammed Alwosabi Using Calculus: Total analysis: find * that maximize profit by differentiating profit function. Marginal analysis: set MR equal to MC and solve for * that maximize profit. Exercise: Given = 17-5 and TC = Find optimal output level * that maximize profit (* = 6, π = 32) 49 Exercise: A firm operating in perfectly competitive market has the following total cost function TC = a.what is the lowest (minimum) price at which the firm will shut down in the SR? b.if the market price is $31, what would be the profit maximizing output? What is the total profit (loss)? Should the firm produce at this price? 5 a. = $3 (Minimum AVC, below the firm should shutdown) =$31, profit maximizing output * =1.5 units, where TR TC is highest, or where MR = MC. (Use quadratic * =1.5, this firm makes a loss of $ (substitute * =1.5 in both TR & TC * =1.5, AVC = $3.5 < = $31. The firm should continue production so long it covers its AVC (contribution margin is positive)