Theory of Perfectly Competitive Markets

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1 Economics 147 John F. Stewart Theory of Perfectly Competitive Markets University of North Carolina Chapel Hill Theory: The Structure of an Economic Model Economic theory is based on deductive logic, if => then reasoning Inside the box & outside the box The Structure of an Economic Model Formal Economic Practical Assumption Structure Who, What, Why Constraint Deduction Optimization Algebra, Calculus Equilibrium other "pure logic" tools Conclusion Outcome Answer Structural Assumptions of Perfect Competition: The Firm Who: the FIRM What: chooses the quantity of output to produce and sell Why: to maximize profits (P xq) - total cost Constraints technology and input markets it must sell what it produces (demand) Econ 147 UNC-CH Econ 147 (3_p) Perfect Comp.prz, /14/04

reasoning Inside the box & outside the box The Structure of an Economic Model Formal Economic Practical Assumption Structure Who, What, Why Constraint Deduction Optimization Algebra, Calculus

2 Structural Assumptions of Perfect Competition: The Market Large number of small sellers (and buyers) homogeneous good full and free information entry and exit are easy and inexpensive Step 1: Costs Decision 1: How much "stuff" to buy to make this good => "cost" Result 1: Profit maximizing firm will choose inputs (given prices and tech.) in such a way as to minimize cost of producing the desired level of output. Usable Construct: Cost Curves (long & short run, Total, Average, & Marginal) Step 2: Firm's Output decision Decision 2: How much should the firm produce? (Marginal Analysis) If an increase in Q makes profits go up, DO IT. If an increase in Q makes profits go down, UNDO IT. Result 2: Profits are maximized (given cost and demand) when firm has chosen a Q such that MC = dtc/dq MR = dtr/dq dprofits = MR - MC MR = MC Econ 147 UNC-CH Econ 147 (3_p) Perfect Comp.prz, /14/04

) in such a way as to minimize cost of producing the desired level of output.

3 Step 3: Marginal Revenue for a competitive firm Given the structural assumptions we made about perfect competition, The firm's demand and marginal revenue curves are a horizontal straight line at the current price P Result 3: Firm will choose Q such that MC(Q) = P Usable Construct: Supply Curve of the firm Step 4: Where did the price come from? Usable Construct: Market Supply curve (if one firm maximizes profits at MC(Q) = P, so would all the others) Putting the Pieces Together At a given price, there is an amount each firm is willing to produce because that amount will maximize profits. Add those amount all up and you have the total amount that would be produced at any given price. At a given price consumers would be willing to purchase a certain amount (demand curve) IF AT THE GIVEN PRICE, THE AMOUNT THE CONSUMERS ARE WILLING TO PURCHASE IS NOT THE SAME AS THE AMOUNT FIRMS ARE WILLING TO SELL, SOMETHING HAS GOT TO GIVE. That something is the market price For each Firm P =MC(Q) (they want to max profits) In the Market P must be such that Quant.. Demanded = Quant. Supplied. Econ 147 UNC-CH Econ 147 (3_p) Perfect Comp.prz, /14/04

Usable Construct: Market Supply curve (if one firm maximizes profits at MC(Q) = P, so would all the others) Putting the Pieces Together At a given price, there is an amount each firm is willing to

4 Short Run Competitive Market Equilibrium Long Run Perfectly Competitive Market Equilibrium If it is possible to earn ECONOMIC PROFITS (revenues are larger than total costs), other owners of resources will want to produce the good and, with nothing to stop them, firms will enter, supply will shift out, price will fall. Typical Firm Total Market Show on the graph where the long run equilibrium price and market quantity will be. What causes the market supply curve to shift? $ MC $ Market Demand Supply (100 firms) $100 AC $100 $ Qfirm Each firm producing at point where P = MC = AC Quantity demanded = Quantity supplied QMarket Firm has to Firm wants to Some Technical Footnotes Short Run Profit Maximizing breakeven and shutdown points Relationship between marginal revenue and price elasticity Relationship between scale economies and cost Econ 147 UNC-CH Econ 147 (3_p) Perfect Comp.prz, /14/04

Typical Firm Total Market Show on the graph where the long run equilibrium price and market quantity will be. What causes the market supply curve to shift?

5 Where is the shut down point? What is the logic behind it? Where is the competitive firm's short run supply curve? Shutdown & Break Even points $ SRMC SRATC AVC Quantiy MR and Price Elasticity TR = P Q = P( Q) Q δtr δp( Q) Q δ MR Q P ( Q ) δ = = = + P( Q) Q δq δq δq δq δ P Q P ( Q ) Q P = + = P δ 1 + = P 1 1 δq P δq η P δq where η = ; the price elaticity of demand Q δp For a linear demand function P = a bq TR = aq bq MR = a 2bQ 2 MR and Price Elasticity Tne Lerner Index MR = P 1 1 = MC for profit max η thus P MC 1 : = P η Econ 147 UNC-CH Econ 147 (3_p) Perfect Comp.prz, /14/04

δq δq δq δ P Q P ( Q ) Q P = + = P δ 1 + = P 1 1 δq P δq η P δq where η = ; the price elaticity of demand Q δp For a linear demand function P = a

6 (, ) (, ), If Q = f K L for a positivenumber α Scale economies f αk αl = αq implies constant returns to scale ( ) f αk, αl > αq implies increasing returns to scale ( ) f αk, αl < αq implies decreasing returns to scale $ increasing, constant, decreasing, returns to scale LRAC Q Real Competition Agriculture Actual structure: lots of firms, but not equal in size largest "firms" dominate in output (& profits) "corporate" farms Real Competition Agriculture Actual structure: Technological progress 450 Feed Required for Broiler Chickens Feed per 100 lbs Source: Adams and Brock. The Structure of American Industry, Prentice Hall 2001 Econ 147 UNC-CH Econ 147 (3_p) Perfect Comp.prz, /14/04

largest "firms" dominate in output (& profits) "corporate" farms Real Competition Agriculture Actual structure: Technological progress 450 Feed Required for Broiler Chickens 400 350 300 250 200

7 Real Competition Agriculture Supply & Demand relatively inelastic demand for many products higher short run fixed cost, steep SRMC, rapidly shifting supply curves Farm Product Elasticities Price Fluctuation and Public Policy P D1 S1 S2 Q Econ 147 UNC-CH Econ 147 (3_p) Perfect Comp.prz, /14/04

supply curves Farm Product Elasticities Price Fluctuation and Public Policy

8 Price Fluctuation and Public Policy P D1 S1 Target Price Q Next Time Theory of Monopoly Markets University of North Carolina Chapel Hill Econ 147 UNC-CH Econ 147 (3_p) Perfect Comp.prz, /14/04

Pricing and Output Decisions: i Perfect. Managerial Economics: Economic Tools for Today s Decision Makers, 4/e By Paul Keat and Philip Young

Chapter 9 Pricing and Output Decisions: i Perfect Competition and Monopoly M i l E i E i Managerial Economics: Economic Tools for Today s Decision Makers, 4/e By Paul Keat and Philip Young Pricing and