Unit 8
Unit 8
Unit 8
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8.2 8.3
8.4
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8.5
8.6 8.7
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Normal Price Economies and Diseconomiesof Production Supply Curve of Perfectly Competitive Industry
8.8. I Changing Number of Firms
8.8
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I
8.9
Let Us Sum Up
8.10 Key Word 8.1 1 Some Usefill Books 8.12 Answers or Hints to Check Your Progress Exercises
8.0 OBJECTIVES
After going through tlis unit you should be able to: identify the different market forms; explain the characteristics of firm's equilibrium in short run as well as in long run; explain the conditions of equilibrium of industry under perfect competition; distinguish between short nln and long run equilibriumunder perfect competition; distinguish between external econon~ies diseconomies of scale; and and explain the supply ciu-ve under perfect competition.
8.1 INTRODUCTION
Until now we have learnt. how supply and demand determine an equilibrium price which rations limited out$ts and allocates scarce resources in a market system. the Previousblock (Unit 7) disci~ssed way in which a fmi's cost structure is influenced by diminishing returns in the short run and also explained how firms can produce at ~ninimiun in the long run when resources can be employed in the variable amounts. cost
In this unit, we aim to explore how a firm maximises its profit under perfect competition. As we know, profit is the difference between revenue receipts and costs. Revenue in the given demand- supply situation depends upon how much competition it faces in its industry (An industry is defined as the total of all firms selling a par-ticular product). Industries fall under one ofthe four categories of market forms: Perfect Competition, Monopoly, Monopolistic Competition and Oligopoly.
A nlonopoly exists when there is only on seller of a product that has no close substitutes. In this market form, the finn is t e industry and there can be barricrs to the ently of competitors. Because of the complete control over the si~ppl!ol'tllc product, the monopolist nomlally a charges a price for her product, which maximises her profits. We will examine this form of market in Unit 9.
Between the two extremes of perfect competition and monopoly, there is monopolistic competition. In a monopolistically competitive industry. there are large a number of s~nall sellers who are engaged in some slight amount of product differentiation. Firms have smaller degree of control over the price. entry into the industry is not as easy as in case of perfect competition. and lastly, there is ignorance about the market in this form of market structure. For a detailed discussion on this form of market we have to wait unti 11 we come to Unit 10. Closer to nlonopoly (and often tantamount to it) is an oligopoly. An oligopoly industry has a few giant sellers. each of which controls a significant share ofthe mayket. Ent1-y into an oligopoly industry is very difficult. The distinctive feature of this market form is the interdependence anlong its members. No firm can make independent decisions about the changes in price without reckoning to the reactions of its competitors.
prices of cars the sales will decline. On the other hand, it may reduce the price of the cars to attract more customers from its rivals in the market. Thus, the carmanufacturing firm is not a price-taker. It faces a downward slopingdemand curve and selects a price-output combination on that demand curve. The wheat farmer, on the other hand, differs from the car manufacturer in following respects that explain the price taking behaviour:
A homogenous product: Contrary to car manufacturers who sell differentiated products, a wheat farmer has no such choice. A particular variety of wheat is indistinguishable whether produced by one farmer or another. Therefore, we caa say that wheat farmers sell homogeneous product. The buyers will shift to the other farmers if one of them raises the price of wheat.
Various Forms o f M a r k e t
Note that Price taking behaviour requires that firms sell a homogeneous product Well-informed buyers: A necessary condition for price taking behaviour is that buyers are well informed and that they do not ~mknowingly more than is necessary pay for their purchases. Large number of sellers: An important distiilction between the car and the wheat industries is in terms of number of sellers. A wheat farmer's share in the total productioil ofwheat is very small. It has no effect on price. The farmer will therefore, face a horizontal demaild curve.
b) There are no transport costs and producers of all the goods (intermediary and final) work sufficiently close to each other. Check Your Progress 1
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2) Describe the situatiorls when a firm earns a normal profit.
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3 ) Explain the difference between monopoly and oligopoly in two sentences.
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M a r k e t Structure
(4 Market
Quantity
'Fig8.1:
Quantity
Market equilibrium occurs in segment (a) when D and S are eq<ated. The market price P i s determined. Individual competitive firm can sell whatever quantities it wishes to produce at this market price P Thus, demand w r v e for . a firm is horizontal line as shown in segment (b).
You know that the firm cannot control the price of its product. In other words, it is too small relative to the market to have any impact on the price and can sell any quantity of output at the equilibrium price prevailing in the market. So it faces a completely elastic demand curve for its product. However, the market demand for a product in a perfectly competitivemarket is not necessarily completelyprice elastic, as the market deinand D in Fig 8.1 (a) is the sum ofthe quantities demanded by all the households. Recall that we had discussed derivation of market demand curve from that of the individual's, in Unit.2. The market supply curve was also introduced in there. Since the inarket price is unaffected by variations in the output ofthe f r , means that the i m it marginal revenue resulting from an increase in sales by one unit is equal to the price of praduct, and the average revenue (Total revenue /No. of units sold) is also the same i.e., equal to price. All the three curves coincide in the same line and P = AR = MR5remains constant while the output varies. im Total Reveilue (TR) that the fr receives by selling any given output at a given price is simply the price per unit (P) multiplied by the quantity sold (Q), or,
im Since the fr is a price taker, every individual unit it produces adds the sameamount to total revenue. Or, we can say, TR increases at a constant rate as output increases since price is constant for all outputs.
Average Revenue (AR) is the revenue per unit of output, or, the ratio of total revenue over output. If a firm sells its product at a uniform price, average revenue is simply another term for price. Algebraically,
\'i~riuus Furlus
IJT N I H I ~ ~ C ~
Marginal Revenue (MR) is the change in total revenue that results from a unit change in output. It is the rate at which TR ch$nges as output changes. If the firm increases its outp~put one unit, MR tells how 4uch TR changes as a result of that one unit by change.
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MR = ATR/AQ
For a f r , i m which is price taker, price and marginal revenue will be identical, or,
MR=P
Every time price-taking fin11 raises its output by one unit, it increases its total revenue by Rs. 1 xP. Since MR is the change in TR due to the change in output, MR must equal 1xP = P
Wt: know that average cost curve is roughly U-shaped (recall from the Unit 7). We also know that in perfect competition, each firm's average revenue curve is a horizontal straight line. So in perfect competition, the only situation in which the firm can be in equilibrium and earning normal profits is when the average cost curve is just tangent to the average revenue curve. Only then the firm covers all its costs and just earns normal profits. This is illustrated in (Fig. 8.2).
Fig. 8.2
M2
M3
OUTPUT
Fig 8.2: Equilibrium ofthe firm occursat point N where its dqmand curve is just tangent to its average cost curve AC. Note that at p i n t N, average cost of production is minimum and marginalcost curve M C cuts A C at this very point. Hence at equilibrium we find that M R = M C = AR = AC.
1
The above figure makes it quite clear that the firm cannot be both in equilibrium and earning normal profits for any position of the AR = MR curve below PL. For example, with the average revenue curve PILlthe firm will earn less than normal profits whatever its output may be. At no level of output average cost is equal to price. On the other hand, ifthe average revenue curve is above PL, say, P,L,, it is possible for average cost to equal price (in this case at W). But at W the film would n8t be in equilibrium. The firm sees an opportunity to expand output in the short run to take the advantage of available price conditions. However, perfect information assumption can induce new firms to enter the market as well. So, on the one hand. this firm raises its own average cost ofproduction by moving up its AC curve, the new entrants on the other hand take away some of the possible customers. Hornever, as we know, the firm will be in equilibrium only when its marginal revenue equals marginal cost. With the average revenue curve P,L,, this will happen when the firm produces OM, and sells it at the price OP,. At this output, the firm will be in equilibrium but will be earning 'supernormal profits', equal to the area P,QST. This again is a signal to all the firms in the industry to try to expand as well as to new fir~nns to flock to this line of business. The only situation, in which the fm can be in equilibrium while canning only nonnal profits, is the position wliere it is producing OM output. This happella hen the price ofthe industry is OP. Then not only MR will be equal to MC, but average cost will also be equal to price or AR. Further, at such a point AC is tangent to AR.
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maximum profits are earned; but during which the fixed factors cannot be altered. Moreover, when we are discussing equilibrium in short run, we must be quite explicit about the cost conditions. If costs differ between firms, the equilibrium position of the industry will not be the same as is the case when they are identical. We shall, therefore, consider the short run equilibrium of the firm and of the industry in the following three different situations. First, we shall assume that all factors of production, including entrepreneurship,are homogeneous. Therefore, each entrepreneur will be able to combine the same factors of production in the same way. Now since we are assuming that every firm produces its output at the minimum possible cost, we may concludethat all firms will have identical cost curves when factors are homogeneous. Second, when we assume that all factors of production except entrepreneuership are homogeneous, costs will differ between firms because some entrepreneursare more efficient than others. Third, when all factors are assiuned to be heterogeneous,the cost differences between firms will be even greater because all factors are ofdifferent efficiency. Short run equilibrium of the firm can also be explained graphically. There are three possible positions for a firm in the short run equilibrium. The following Fig. 8.3 explains it using the l~on~ogeneous factors in a situation ofperfect competition in the factor market and where prices of all the factors are given. Let us assiune that to begin with the price ofthe product is OP2. Therefore, all the producers will set their output accordingly to maximise profit. A firm produces the output OM2and sells at the perfectly competitiye price of OP,. The average cost is M,R and the per ullit supernormal profit is LR. The firm earns the supernormal pr6tit shown by the area P,LRS. All firms in the industry are in equilibrium since they are earning the maximum profit.
Fig. 8.3
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Fig 8.3:
MI M
M,
OUTPUT
If short run price i s P, >P, the firm produces O M output and makes extra normal profits =P,LRS. Ifshort run price PI <P,the firm is not able to cover all the costs, yet i-t continues to produce i f at least the variables costs are covered. Output is O M , given by the equilibrium MR=MC.
Xlrrkct S t r u c t u r e
In the short run, same situation will continue since the firm(s) cannot introduce new fixed cost equipment and no new firm can enter the industry. In the long run, however, new f m s will enter the industry and they will compete away the supernormalprofits. Now ifprice were OP instead of OPz all the firms would be in equilibrium when producing the output OM. They would just be covering their normal costs and earning normal profits. Average cost curve is tangent to average revenue line at output OM. It thus reflects the situation of equilibrium even in the short run. The number of firms in the short run isjust large enough to help each ofthem earn normal profits. On the other hand, if price is OP,, the firms in the industry would be in equilibrium, producing output OM,. All would be losing money, losses being equal, to PIQNT. could earn would be a loss of P IQNT. This is the The maximuin profit each f i m ~ smallest loss each finn could make in the short run. In the long run, however, the firms would leave the industry until those remaining there just earn ilonnal profits. The next obvious question to ask is, therefore, does it pay a firm, which is loosing money, to stay in the industry? The answer to this question, liowever, lies on the length oftime. In the long run, if its efficiency does not impso\ e, it will leave the industry altogether. We have said above that, in the short run, the firm cannot alter its fixed assets. Such a constraint will influence the entrepreneur's actions to be able to stay in business. It, for sample, the variable costs ofthe firm is met in the short run; the firm would not close down. This is explained in Fig. 8.4. It shows the cost curves of a firm in our industry. The fin11 will remain in industry so long as it can cover its va~iable costs. If the firm closes down, it may be forced into bankruptcy, which may implytotal loss of fixed investment. On the other hand, continuing to produce, c\ cn when fixed costs are not entirely covered, will help it maintain its presence in the market. and its plant and machinery will not be reduced to junk. Fig. 8.4
I I
Y
R
PRICE (ANDCOST
OUTPUT
X.
Fig8.4: In short run, firms many find it better to keep producing at OM though the price OP does not cover all the costs. Its fixed cost TRSV is too large. By ,continuing production it makes a contribution towards fixed cost = TPQV. Therefore, at 0 price, its output OM is loss-minimising output.
Looking at the figure, we can see that the loss minimising output for the firm is OM at the price OP per unit of output. Price, therefore, exceeds average variable cost MV by QV. This amount is known as per unit contribution towards meeting the fixed costs. At this point, it will be worthwhile for the firm to continue running in the short run. Some fixed costs can be covered aftei-variable costs have been met. In such a situation, PQVT is described as total contribution. This is the total amount at which the firm reduces its loss by staying open. The firm is losing RSQP, which is less than it would have lost, had it been closed down altogether. In that case it would have lost an amoui~t equal to its total fixed cost. i.e. RSVT. Instead, it looses RSVT - PQVT. If short run price is only OP,, the cost per unit of output would have been MS and loses per unit SQ,. In this case, the firm is not able to cover even the average variable cost. For example. at output OM, the finn is losing more than its fixed cost RSVT by P Q,VT. Here, at this point it will therefore pay the fir@to stop producing anything even in the short run. I11 fact. the fin11 shall not produce anything if it is not able to get price at least as great as OT - the minimum average variable cost covering price.
V a r i o u r Forms of 4 l a r k c t
Now let us move to the second situation where entrepreneurs are not identical in efficiency. Costs then call be different between firms, despite the fact that all factor prices are the same to all finlls and all factors except entrepreneur are homogenous. Sonle entrepreneurs will be able to produce inore efficiently than the less efficient ones. and their fiml's costs will, therefore, be lower. Even though all finns produce the same product, sell it at the same price and seek maximum profits, firms with different costs will nlaximise profits at different levels of output. Maximum profits will of course. differs too. Let us assume that there are four firins in an indust$ Finn A has the most efficient entrepreneur ofthe four and is in short run equilibrium. When producing the output profits. Finn B with a somewhat less eficient at the given price it earns supemom~al eiltrepreneur produces an equilibrium output and earns only normal profits. Firm C with a still less efficient entrepreneur incurs losses. However, since firm C is covering variable costs it pays to go on producing the output in the short run. The losses are thereby minimised. Finally, tirin D has the least efficient entrepreneur of the four firms. This fir111is not able to recover its variable costs at ally level of output. Therefore, it minimises losses by closiilg down, even in the short run. Let us now look into a third situation where all the factors of production are is heterogeneous. So, the difference in costs between fim~s likely to be even bigger than where entrepreneiu-sonly were ofdiffering efficiency. The same kind of situation as described above will occur with the likelihood ofdifference between the costs 01' the fimls being greater.
h l r r k e t Structure
This will lead to the shift in the supply curve to the right. With unchanged demand conditions, the previous price will no longer prevail and the equilibrium price will fall. The falling prices will continue until all firms in the industry arejust covering their total costs or are at the zero-profit equilibrium. On the other hand, if the firms in the industry are suffering losses, some of the firms will exit. The supply curve will shift to theleft. Supply decreases with no change in demand will result in a rise ofthe market price. Firms continue to exit and price continues to rise until the remaining firms can cover their costs, that is, until they are earning normal profits. The equilibrium of the firm in the long run is shown graphically in the following Fig. 8.5 where it is earning normal profits.
Fig. 8.5
OUTPUT X
1) State 'true' for correct statement and 'false' for the wrong one.
a) Marginal revenue is the revenue per unit of output. b) Under perfect competition, the firm is not a price-maker. c) There are 110restrictions on the ently or exit offirms under perfect competitioil. d) Perfect co~npetitioll assumes the existence oftransport costs.
. (a).. . . . . . . . . . . . . ...(b).. . . . . . . . . . : . ...(c). . . . . . . . . . . . . . . ..(d) . . . . . . . . . . . . . . .
2) Explain the equilibrium attained by a firm in the short run when all factors of . production except entrepreneur are homogenous.
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3) Explain briefly the long n 7 equilibrium of the fiml. u
4 ) When a firm is incuning losses, at which point will it leave tine industry even in the short Run?
8.7
We will now leai-n to construct s11oi-t and long run supply ciwes ofthe industry. But external economies and diseconomies ofproduction. It before that we s1~all~discuss may be usef~il note that there are internal econo~nies diseconomies observed to and in the process of production. whicl~ be obtained by altering factor p~oportions can or by altering the internal organisation. External economies and disecono~nies contrast to that of internal, depend on the in increase in tlle output of the whole indust~y rather than 011 the output of individual fir111. External economies of the i~ldustry occur where an increase in the size of an i~ldustiy leads to lower costs for each individi~al in the industry. Ofcourse, it is fin11 quite possible that the gl-o\vthin the size of industry will lead to external diseconomies and to rise in the unit costs.
k l r r k c t Structurc
of production is fixed; (b) Short run: supply curve where not only the number of firms but the scale ofproduction of individual firm is given. We start with a situation where all firms in the industry have identical cost curves because factors are homogeneous. Each firm will, therefore, originally be in long run equilibrium, where it is produciilg an output of OM, (see Fig. 8.6) and selling it at a price of OPI. Short run output given by SMC = MR, is OM,. MR curve is All equal to both short and long run marginal cost for all firms in the indust~y. these firms are earning normal profits.
Fig. 8.6
1
R I C p2 p; PI
Fig 8.6
shows that the firm will be in the long run equilibrium. It will Produce output O M , and will sell at Price OP,.
In order to find out the shape of the supply curve, we assume that price of the product rises to OP, and thus marginal revenue curve to P2MR,. I11 the short run. it is obvious that in pedect competition. the supply curve ofthe i~dividual fir111is its short-run marginal cost curve (SMC). This is the only way in which a firm can produce inore by expanding output alongwith its short run marginal cost curve. If price rises to OP, as in Fig. 8.6, MR will be equal to MC at output level OM,. for n each firm in the industry. The firms7short n ~ SS curve is its SMC. The industiy SS will be lateral sumnlations ofSS's ofall its constituent firn~s. As each finn produces higher output, the industry SS shifts to the right. This will iillply that given the denland co~lditio~lsthe market, point of intersection of indushy in SS with market 'DD' takes place to the right. The industry can sell the increased output at a lower price only. Thus, as each firm tries to produce greater output, they tend to face a situation where they can realise a price OP, only. Tliiis, in long term. they all may produce say OM3 level of output and sell it at OP; price. Notice that OP; < OP, and also that OM3 <OM,. It is also clear that the long term marginal cost CW~-(LMC) less steep compared to short run marginal cost curve. is
1 lo'wever, even when the nunlber of finns remains constant, the long run equilibrium siti~ation Figure 8.6 will be, where output is OM3and price is OP;. l'he long run in marginal cost (LMC) cullre of the indust~y be less steep than the short run MC will and output wil I expand inore in the long run as compared to short run (by M IM: instead of M,M, for cacll of the firms. As we see this particular type cf supply curve also slopes upwards to the right though less steeply than the short run si~pply
curve. In the new long run situation, it may be noted that with price OP,, all the firms in the industry will be earning super normal profits. This can happen because the number of firms in the industry is assumed to be constant. But this situation cannot continue as information will spread soon and new firms will be attracted towards this industry.
Various Forms o f M a r k e t
However, in practice it is unlikely that all factors are homogeneous. A much more plausible case would be of heterogeneous factors, at least, due to the presence of entrepreneur. So far as the short-term supply curve is concerned, the fact that entrepreneurs are heterogeneous will make little difference. The short run supply curve will still represent a lateral sunmation of the short run marginal cost curve of the iildividual firms. Marginal cost curves will now be different for each firm and the process of summation more complicated. Whether or not factors of production are hon~ogeneous, short run supply curve is bound to slope upwards to the right. the However, with heterogeneous factors it will slope upwards rather more steeply. In the long rim, with the fiee elltly or exit in the industry, thesupply curve is likely to slope upwards rather less steeply than it does ill the short run. Change in input prices, technology, quality ofresources, taxes on the firm or its output, or any ofthe determinants ofproductiou and cost relationships will cause the perfectly competitive industry's long run and short run supply curves to shift. For example, higher fuel and energy prices will increase costs ofproduction of almost everything. Firms respond to higher costs by reducing the output and thereby shifting the short run supply curve to the left until a new long run equilibrium is reached.
Check Your Progress 3 1). Explain briefly what do you mean by external economies and diseconomies. (Answer in three sentences)
2) Find out the shape of the supply curve in an industry having firms with identical cost curves. (Answer in the space provided below.)
3) Explain the supply curve of perfectly competitive industry when not only the size but the number of firms also changes.
KEY WORDS
External Economies and Diseconomies
: External economies operate when an expanding industry has cost reducing effect on every firm due to better transport facilities,better supply of inputs etc. External diseconomies operate when and expanding industry gives rise to higher average cost for every firm due to scarcity of supply of inputs and the pressure on transport facilities, congestion etc.
: Internal economies operate within a firm with
increasing output, when cost reducing effects occur due to better utilisation offixed inputs, greater division of labour, better and cheaper marketing facilities, etc. Internal diseconomies operate due to excess of fixed
inputs and reduction in the propodon of fixed to variable inputs. Long Run Marginal Cost (MC) Marginal Revenue (MR) Short Run
: The time period when all inputs, including