Introduction. Learning Objectives. Chapter 24. Perfect Competition

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1 Chapter 24 Perfect Competition Introduction Estimates indicate that since 2003, the total amount of stored digital data on planet Earth has increased from 5 exabytes to more than 200 exabytes. Accompanying this massive expansion of digital data has been the development of the data-storage industry. In spite of the considerable growth in demand for the services of such firms, the average price per byte of data stored has decreased over time. To understand how this has occurred, you must learn about the theory of perfect competition Learning Objectives Identify the characteristics of a perfectly competitive market structure Discuss the process by which a perfectly competitive firm decides how much output to produce Understand how the short-run supply curve for a perfectly competitive firm is determined 24-3

2 Learning Objectives (cont'd) Explain how the equilibrium price is determined in a perfectly competitive market Describe what factors induce firms to enter or exit a perfectly competitive industry Distinguish among constant-, increasing-, and decreasing-cost industries based on the shape of the long-run industry supply curve 24-4 Chapter Outline Characteristics of a Perfectly Competitive Market Structure The Demand Curve of the Perfect Competitor How Much Should the Perfect Competitor Produce? Using Marginal Analysis to Determine the Profit- Maximizing Rate of Production Short-Run Profits 24-5 Chapter Outline (cont'd) The Short-Run Breakeven Price and the Short-Run Shutdown Price The Supply Curve for a Perfectly Competitive Industry Price Determination Under Perfect Competition The Long-Run Industry Situation: Exit and Entry Long-Run Equilibrium Competitive Pricing: Marginal Cost Pricing 24-6

3 Did You Know That... An average of 6,000 farms have ceased independent operations in the United States during each of the past 30 years. Ease of exit from the industry is a fundamental characteristic of the theory of perfect competition. In perfect competition, individual buyers and sellers cannot affect the market price it is determined by the market forces of demand and supply. In this chapter, we examine these and other implications of the theory of perfect competition Characteristics of a Perfectly Competitive Market Structure Perfect Competition A market structure in which the decisions of individual buyers and sellers have no effect on market price 24-8 Characteristics of a Perfectly Competitive Market Structure (cont'd) Perfectly Competitive Firm A firm that is such a small part of the total industry that it cannot affect the price of the product or service that it sells 24-9

4 Characteristics of a Perfectly Competitive Market Structure (cont'd) Price Taker A competitive firm that must take the price of its product as given because the firm cannot influence its price Characteristics of a Perfectly Competitive Market Structure (cont'd) Why a perfect competitor is a price taker 1. Large number of buyers and sellers 2. Homogenous products are perfect substitutes 3. Buyers and sellers have equal access to information 4. No barriers to entry or exit E-Commerce Example: Blogging Becomes a Business There are an estimated 60 million Web blogs in existence. A few blogs have emerged as essentially niche magazines run as businesses and published in an online format. With today s low-cost computers and software, the main impediment to entering the blogging market is the opportunity cost of the time they devote to their blogs

5 E-Commerce Example: Blogging Becomes a Business (cont'd) Once bloggers generate a sufficient readership, they sell online ad space and begin generating revenues. Why is entry into the blogging market not entirely free? The Demand Curve of the Perfect Competitor Question If the perfectly competitive firm is a price taker, who or what sets the price? The Demand Curve of the Perfect Competitor (cont'd) The perfectly competitive firm is a price taker, selling a homogenous commodity with perfect substitutes. Will sell all units for $5 Will not be able to sell at a higher price Will face a perfectly elastic demand curve at the going market price 24-15

6 Figure 24-1 The Demand Curve for a Producer of Secure Digital Cards How Much Should the Perfect Competitor Produce? Perfect competitor accepts price as given Firm raises price, it sells nothing Firm lowers its price, it earns less revenues than it otherwise would Perfect competitor has to decide how much to produce Firm uses profit-maximization model How Much Should the Perfect Competitor Produce? (cont'd) The model assumes that firms attempt to maximize their total profits. The positive difference between total revenues and total costs The model also assumes firms seek to minimize losses. When total revenues may be less than total costs 24-18

7 How Much Should the Perfect Competitor Produce? (cont'd) Total Revenues The price per unit times the total quantity sold The same as total receipts from the sale of output How Much Should the Perfect Competitor Produce? (cont'd) Profit π = Total revenue (TR) Total cost (TC) TR = P x Q TC = TFC + TVC P determined by the market in perfect competition Q determined by the producer to maximize profit Figure 24-2 Profit Maximization, Panel (a) 24-21

8 Figure 24-2 Profit Maximization, Panel (b) Total Output/ Sales/ Total Market Total Total day Costs Price Revenue Profit 0 $10 $5 $0 $ Figure 24-2 Profit Maximization, Panel (c) Total Output/ Sales/ Market Marginal Marginal day Price Cost Revenue 0 $5 $5 $ How Much Should the Perfect Competitor Produce? (cont'd) Profit-Maximizing Rate of Production The rate of production that maximizes total profits, or the difference between total revenues and total costs Also, the rate of production at which marginal revenue equals marginal cost 24-24

9 Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production Marginal Revenue The change in total revenues divided by the change in output Marginal Cost The change in total cost divided by the change in output Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production (cont'd) Profit maximization occurs at the rate of output at which marginal revenue equals marginal cost Short-Run Profits To find out what our competitive individual secure digital cards producer is making in terms of profits in the short run, we have to determine the excess of price above average total cost

10 Short-Run Profits (cont'd) From Figure 24-2 previously, if we have production and sales of seven SD cards, TR = $35, TC = $30, and profit = $5 per hour. Now we take info from column 6 in panel (a) and add it to panel (c) to get Figure Figure 24-3 Measuring Total Profits Profits are maximized where MR = MC This occurs at Q = 7.5 units Short-Run Profits (cont'd) Graphical depiction of maximum profits and graphical depiction of minimum losses The height of the rectangular box in the previous figure represents profits per unit. The length represents the amount of units produced. When we multiply these two quantities, we get total economic profits

11 Short-Run Profits (cont'd) Short-run average profits are determined by comparing ATC with P = MR = AR at the profit-maximizing Q. In the short run, the perfectly competitive firm can make either economic profits or economic losses Figure 24-4 Minimization of Short- Run Losses Losses are minimized where MR = MC This occurs at Q = 5.5 units Short-Run Profits (cont d) We see in the previous Figure 24-4 that the marginal revenue (d2) curve is intersected (from below) by the marginal cost curve at an output rate of about 5 SD cards per hour. The firm is clearly not making profits because average total costs at that output rate are greater than the price of $3 per SD card. The losses are shown in the shaded area

12 The Short-Run Break-Even Price and the Short-Run Shutdown Price What do you think? Would you continue to produce if you were incurring a loss? In the short run? In the long run? The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd) As long as the loss from staying in business is less than the loss from shutting down, the firm will continue to produce. A firm goes out of business when the owners sell its assets; a firm temporarily shuts down when it stops producing, but is still in business The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd) As long as the price per unit sold exceeds the average variable cost per unit produced, the earnings of the firm s owners will be higher if it continues to produce in the short run than if it shuts down

13 The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd) Short-Run Break-Even Price The price at which a firm s total revenues equal its total costs At the break-even price, the firm is just making a normal rate of return on its capital investment (it s covering its explicit and implicit costs). Short-Run Shutdown Price The price that just covers average variable costs It occurs just below the intersection of the marginal cost curve and the average variable cost curve Figure 24-5 Short-Run Break-Even and Shutdown Prices The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd) The meaning of zero economic profits Question Why produce if you are not making a profit? Answer Distinguish between economic profits and accounting profits. Remember when economic profits are zero a firm can still have positive accounting profits

14 The Supply Curve for a Perfectly Competitive Industry Question What does the short-run supply curve for the individual firm look like? Answer The firm s short-run supply curve in a competitive industry is its marginal cost curve at and above the point of intersection with the average variable cost curve Figure 24-6 The Individual Firm s Short-Run Supply Curve Given the price, the quantity is determined where MC = MR Short-run supply = MC above minimum AVC The Supply Curve for a Perfectly Competitive Industry (cont'd) The Industry Supply Curve The locus of points showing the minimum prices at which given quantities will be forthcoming Also called the market supply curve 24-42

15 Figure 24-7 Deriving the Industry Supply Curve The Supply Curve for a Perfectly Competitive Industry (cont'd) Factors that influence the industry supply curve (determinants of supply) Firm s productivity Factor costs Wages, prices of raw materials Taxes and subsidies Number of sellers Price Determination Under Perfect Competition Question How is the market, or going, price established in a competitive market? Answer This price is established by the interaction of all the suppliers (firms) and all the demanders

16 Price Determination Under Perfect Competition (cont'd) The competitive price is determined by the intersection of the market demand curve and the market supply curve. The market supply curve is equal to the horizontal summation of the supply curves of the individual firms Figure 24-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve, Panel (a) P e is the price the firm must take P e and Q e determined by the interaction of the industry S and market D Figure 24-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve, Panel (b) Given P e, firm produces q e where MC = MR If AC = AC 1, break-even If AC = AC 2, losses If AC = AC 3, economic profit 24-48

17 The Long-Run Industry Situation: Exit and Entry Profits and losses act as signals for resources to enter an industry or to leave an industry The Long-Run Industry Situation: Exit and Entry (cont'd) Signals Compact ways of conveying to economic decision makers information needed to make decisions An effective signal not only conveys information but also provides the incentive to react appropriately The Long-Run Industry Situation: Exit and Entry (cont'd) Exit and entry of firms Economic profits Signal resources to enter the market Economic losses Signal resources to exit the market 24-51

18 The Long-Run Industry Situation: Exit and Entry (cont'd) Allocation of capital and market signals Price system allocates capital according to the relative expected rates of return on alternative investments. Investors and other suppliers of resources respond to market signals about their highestvalued opportunities The Long-Run Industry Situation: Exit and Entry (cont'd) Tendency toward equilibrium (note that firms are adjusting all of the time) At break-even, resources will not enter or exit the market. In competitive long-run equilibrium, firms will make zero economic profits The Long-Run Industry Situation: Exit and Entry (cont'd) Long-Run Industry Supply Curve A market supply curve showing the relationship between prices and quantities after firms have been allowed time to enter or exit from an industry, depending on whether there have been positive or negative economic profits 24-54

19 The Long-Run Industry Situation: Exit and Entry (cont'd) Constant-Cost Industry An industry whose total output can be increased without an increase in long-run per-unit costs Its long-run supply curve is horizontal Figure 24-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (a) The Long-Run Industry Situation: Exit and Entry (cont'd) Increasing-Cost Industry An industry in which an increase in industry output is accompanied by an increase in longrun per unit costs Its long-run industry supply curve slopes upward

20 Figure 24-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (b) The Long-Run Industry Situation: Exit and Entry (cont'd) Decreasing-Cost Industry An industry in which an increase in industry output leads to a reduction in long-run per-unit costs Its long-run industry supply curve slopes downward Figure 24-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (c) 24-60

21 International Example: Increasing Costs and Future Prices in the Oil Industry During the 1950s, there were predictions that the world would run out of oil by the 1980s. In the late 1970s, the predicted oil depletion date was pushed back to the 2000s. As Figure indicates, however, the world s known reserves of oil actually continued increasing. We find that as the price of oil increases, oil producers find new ways to search for and extract oil located at increasing depths beneath the earth International Example: Increasing Costs and Future Prices in the Oil Industry (cont d) Since 1998, the inflation-adjusted price of oil has increased by more than 800%, and the quantity of oil supplied has also risen, which may be an indication that the oil industry may be an increasing cost industry. Why are industries that specialize in extracting minerals such as coal and oil increasing-cost industries? Figure Proven Global Oil Reserves, Source: U.S. Department of Energy

22 Long-Run Equilibrium In the long run, the firm can change the scale of its plant, adjusting its plant size in such a way that it has no further incentive to change; it will do so until profits are maximized. In the long run, a competitive firm produces where price, marginal revenue, marginal cost, short-run minimum average cost, and long-run minimum average cost are equal Figure Long-Run Firm Competitive Equilibrium Competitive Pricing: Marginal Cost Pricing Marginal Cost Pricing A system of pricing in which the price charged is equal to the opportunity cost to society of producing one more unit of the good or service in question The opportunity cost is the marginal cost to society

23 Competitive Pricing: Marginal Cost Pricing (cont'd) Market Failure A situation in which an unrestrained market operation leads to either too few or too many resources going to a specific economic activity Issues and Applications: The Data- Storage Industry Booms, and Prices Decline The data storage industry is growing by leaps and bounds. It is also a highly competitive industry that has characteristics consistent with the theory of perfect competition. Firms offering to store commercial data have been around since the 1960s. Each data storage company provides essentially the same type of service: backing up data in storage boxes. Thus, numerous firms in the data storage industry sell a homogeneous product to many customers, and entering the industry only requires obtaining the latest data storage and networking equipment Issues and Applications: The Data- Storage Industry Booms, and Prices Decline (cont'd) Over time, an increasing number of businesses have determined that they possess more digital data than they wish to store. Thus, since the mid-1990s the demand for data storage services has increased dramatically. Figure examines the adjustments that have taken place in the data storage industry as demand has risen over time. In the long-run, what appears to have happened to the ATC and MC curves of firms that provide data storage services? 24-69

24 Figure Short-Run and Long-Run Adjustments in the Data-Storage Industry Summary Discussion of Learning Objectives The characteristics of a perfectly competitive market structure 1. Large number of buyers and sellers 2. Homogeneous product 3. Buyers and sellers have equal access to information 4. No barriers to entry and exit Summary Discussion of Learning Objectives (cont'd) How a perfectly competitive firm decides how much to produce Economic profits are maximized when marginal cost equals marginal revenue as long as the market price is not below the short-run shutdown price, where the marginal cost curve crosses the average variable cost curve

25 Summary Discussion of Learning Objectives (cont'd) The short-run supply curve of a perfectly competitive firm The rising part of the marginal cost curve above minimum average variable cost The equilibrium price in a perfectly competitive market A price at which the total amount of output supplied by all firms is equal to the total amount of output demanded by all buyers Summary Discussion of Learning Objectives (cont'd) Incentives to enter or exit a perfectly competitive industry Economic profits induce entry of new firms. Economic losses will induce firms to exit the industry Summary Discussion of Learning Objectives (cont'd) The long-run industry supply curve and constant-, increasing-, and decreasing-cost industries The relationship between price and quantity after firms have been able to enter or exit the industry Constant-cost industry Horizontal long-run supply curve Increasing-cost industry Upward-sloping long-run supply curve Decreasing-cost industry Downward-sloping long-run supply curve 24-75

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