Econ L6

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Market Structures - Perfect

Competition

Week 6: Lecture
Lecture Outcomes
By the end of this topic students would be able to:
1. Explain what is meant by market structure
2. Explain why a firm in perfect competition is a price taker
3. Derive the supply curve of a firm in perfect competition
4. Explain how price and output are determined in a competitive
industry in the short run and long run
5. Predict the effects of a change in demand and of technological
advances
6. Explain how firms in perfect competition maximize profit
7. Explain the output decisions for firms in perfect competition
Market Structure
Market structure describes the
important features of a market.

Four Basic Market Structures

• Perfect Competition
• Monopoly
• Oligopoly
• Monopolistic Competition
Aspects of market
structure
• Number of suppliers
• Many or few
• Product’s degree of uniformity
• Do firms in the market supply identical
products or are there differences across firms?
• The ease of entry into the market
• Can new firms enter easily or are they blocked
by natural or artificial barriers?
• Forms of competition among firms
• Do firms compete only through prices or are
advertising and product differences common
as well?
Perfect Competition
Characteristics of perfect competition
• Many buyers and sellers 🡺 so many that each buys and sells only a
tiny fraction of the total amount exchanged in the market

• Firms sell a standardized or homogeneous product

• Buyers and sellers are fully informed about the price and availability of
all resources and products

• Firms and resources are freely mobile 🡺 over time they can easily
enter or leave the industry
Price is determined by market
supply and demand 🡺 the
perfectly competitive firm is a
price taker 🡺 it must “take” or
accept, the market price
Perfect
Competition
Once the market establishes the
price, each firm is free to produce
whatever quantity maximizes
profit
Perfect
Competition:
Price
Determination

Since all firms in a


competitive market are
price takers, they will be
selling any amount of
quantity at the market
equilibrium price.
Demand Curve
facing a Competitive
Firm
• Because buyers and sellers in
perfect competition are all price
takers, the price to the firm for each
unit remains the same no matter
how much the firm sells.
• Demand curve of a firm is Perfectly
Elastic since consumers are willing
to buy as much as the firm is willing
to sell at the going market price.
• Demand curve is Horizontal at
the market price
Basic Business Decision
The decision to continue competing in a market depends upon the
answers to the following questions:
• How much should we produce?
• If we produce such an amount, how much profit will we earn?
• If a loss rather than a profit is incurred, will it be worthwhile to
continue in this market in the long run or should we exit?

A firm’s goal is to maximize its profit; which is total revenue minus total
cost.
The Revenue of a • Total revenue (TR): The value of a
Competitive Firm firm’s sales.

• Average revenue (AR): Average


revenue is total revenue divided by total
quantity sold.

• Marginal revenue (MR): The change in


TR from selling one more unit.
AR = MR = P
for a
Competitiv
e Firm
Total
Revenue
for a
Competitive
Firm
Profit Maximization
Maximum profit: Greatest difference between total revenue and
total cost.
Rule: MR = P =
MC at the profit-
maximizing Q
• At Qa, MC < MR. So,
increase Q to raise
profit.
• At Qb, MC > MR. So,
reduce Q to raise profit.
• At Q1, MC = MR.
Economic profit is
maximized. Changing Q
would lower profit.
Profit
Outcomes in
the Short Run
Economic profit
• If the ATC < P at the
profit maximizing output
(MR=MC), then the firm
is making economic
profit.
Profit
Outcomes in
the Short Run
Economic loss
• If the ATC > P at the
profit maximizing output
(MR=MC), then the firm
is making economic
loss.
Profit
Outcomes in
the Short Run
Normal profit
•If the ATC = P at the
profit maximizing output
(MR=MC), then the firm is
at normal profit level.
• At normal profit level,
economic profit is zero.
Shutdown vs. Exit
• Shutdown: A short-run decision not to produce anything
because of market conditions.

• Exit: A long-run decision to leave the market.

• A key difference:
• If shut down in SR, must still pay FC.
• If exit in LR, zero costs.
A Firm’s Short-run Decision to Shut
Down

• Cost of shutting down:


revenue loss = TR
• Benefit of shutting down:
cost savings = VC
(firm must still pay FC)
• shut down if TR < VC
(Divide both sides by Q: TR/Q <
VC/Q)
• Hence, firm’s decision rule is:
Shut down if P < AVC
A Competitive Firm’s SR Supply
Curve
A Competitive Firm’s Short-Run Supply
Curve
• Short run is a time period in which each firm has a given plant size,
hence short run;
▪ Supply is upward sloping due to diminishing (marginal) returns to a variable
input.
▪ Higher price compensates the firm for the higher cost of additional output and
increases total profit because it applies to all units.
▪ Firm’s shutdown point is the level of output and price where the firm is just
covering its total variable cost

• Firm’s Response to an Input Price Change


▪ When the price of a firm’s input changes, the firm changes its output level, so
that the marginal cost of production remains equal to the price (marginal
revenue).
A Firm’s Long-Run Decision to Exit
• Cost of exiting the market:
revenue loss = TR
• Benefit of exiting the market:
cost savings = TC (note: zero FC in the long run)
• Firm exits if TR < TC
(Divide both sides by Q to write the firm’s decision rule as)
Exit if P < LRATC
A New Firm’s Decision to Enter Market
• In the long run, a new firm will enter the market if it is profitable
to do so: if TR > TC.
(Divide both sides by Q to express the firm’s entry decision as)
Enter if P > ATC
The Competitive Firm’s Long Run
Supply Curve
All existing firms and
potential entrants
have identical costs.

Some Each firm’s costs do


not change as other
assumption firms enter or exit the
market.
fixed in the short run
s (due to fixed costs)
The number of firms
in the market is
variable in the long
run (due to free entry
and exit)
The Short As long as P ≥ AVC, each firm will produce
its profit-maximizing quantity, where MR =
MC.
Run Market
Supply Curve Recall:
At each price, the market quantity supplied
is
the sum of quantities supplied by all firms.
The Short Run
Market Supply
Curve
Example:
1,000 identical firms At
each P, market Qs =
1,000 x (one firm’s Qs)
Entry and Exit
in the Long
Run
• In the long run, the number of firms
can change due to entry and exit.
• If existing firms are earning positive
economic profits
• new firms enter, SR market
supply shifts right.
• P falls, reducing profits and
slowing entry.
• If existing firms incur losses,
• some firms exit, SR market
supply shifts left.
• P rises, reducing remaining
firms’ losses.
The Zero-Profit Condition

• Long-run equilibrium:
The process of entry or exit is complete—remaining firms earn zero economic profit
(normal profit).
• Zero economic profit occurs when P = ATC.
• Since firms produce where P = MR = MC, the zero-profit condition is P = MC = ATC.
• Recall that MC intersects ATC at minimum ATC.
• Hence, in the long run, P = minimum ATC
The Long Run Market Supply Curve
Why the Long Run Supply Curve Might
Slope Upward
• The long run market supply curve is horizontal if
1) all firms have identical costs, and
2) costs do not change as other firms enter or exit the market.

• If either of these assumptions is not true, then LR supply curve


slopes upward.
The Efficiency …..

Profit-maximization: • MC = MR
Perfect competition: • P = MR
In the competitive equilibrium: • P = MC
The competitive equilibrium
is efficient and maximizes
total surplus.
Perfect Competition and
Efficiency
How does perfect competition stack up as an
efficient allocator of resources?

There are two concepts of efficiency used to


judge market performance
• Productive efficiency refers to producing output at the
least possible cost
• Allocative efficiency refers to producing the output that
consumers value the most
• Perfect competition guarantees both allocative and
productive efficiency in the long run
SUMMARY
• For a firm in a perfectly competitive market, price = marginal
revenue = average revenue.
• If P > AVC, a firm maximizes profit by producing the quantity
where MR = MC.
• If P < AVC, a firm will shut down in the short run.
• If P < ATC, a firm will exit in the long run.
• In the short run, entry is not possible, and an increase in
demand increases firms’ profits.
• With free entry and exit, profits = 0 in the long run, and P =
minimum ATC.

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