2PERFECT COMPETITION AND MONOPOLIES (3.2) Perfect Competition

Transcription

1 PERFECT COMPETITION AND MONOPOLIES (3.) Perfect Competition 19

2 0 PERFECT COMPETITION AND MONOPOLIES (3.) BEFORE you start this unit (in pencil)... write the key idea of this unit in the centre of the page write what you know about this idea around it and draw lines to them. try and group the ideas together Mind-maps are very good revision tools. Our minds learn by making patterns. Mind-maps help you to make these patterns and so makes the content easier to learn and remember. mind-map

3 PERFECT PERFECT COMPETITION AND AND MONOPOLIES (3.) 1 unit overview simply perfect In economics we study markets. There are many different types of markets - in each of which firms and consumers behave differently. In markets where there are more firms and customers, competition is usually greater - which is usually seen as a good thing. This unit looks at a theoretical type of market - perfect competition. It looks at the characteristics of this market, and how these affect the behaviour of firms and consumers. by the end of this unit, you should be able to answer these questions... 1 how do perfectly competitive firms maximise their profit? perfect competition how do perfectly competitive markets change over time?

4 PERFECT COMPETITION AND MONOPOLIES (3.) case study... does the theory match reality? In this unit you will study a THEOERTICAL type of market - one that is PERFECTLY competitive. WHY? Are there any markets which are perfectly competitive? Consider the following: Auckland Night Market This market consists of about stalls selling a range of quick (mostly Asian) food. The sellers set up on saturday afternoon, in a carpark beneath Pakuranga Mall, ready to sell food from 6.00pm pm. They are all gone by the next day... until next week. By 6.15pm the market is packed with customers, so there are many buyers and sellers, who are all selling a (nearly) identical product, i.e. fast food. It is very easy to set up, and so there are virtually no barriers to entry. Because the stalls are so small and close together, it is easy for consumers (and the stall holders) to walk along and compare prices - i.e. nearly perfect knowledge. Trademe Trademe provides a number of auctions for various goods and services. A search for LEGO on one day found auctions. So there are many buyers and sellers, who are all selling a (nearly) identical product - LEGO. It is very easy to join Trademe and start to sell goods... i.e. there are no barriers to entry. Sellers and consumers can easily search Trademe to compare prices and the quality of products being sold, i.e. perfect knowledge. So in Trademen, the internet has created a nearly perfectly competitive market. Many argue that the internet has increased the ability of consumers to compare prices - e.g. for shoes, cars, etc. This has increased the knowledge of consumers in markets - albeit not perfectly.

5 PERFECT PERFECT COMPETITION AND AND MONOPOLIES (3.) 3 topic.1 perfectly competitive firms costs & revenue how much is this going to cost? There s a saying that there s no such thing as a free lunch. It makes the point that everything has a cost. This is very much the case for firms. To provide a good or service they incur costs which they expect the customer to pay for. A firm s costs, therefore, are very important to how much of a good or service that a firm will produce... and what price it sells at. This topic looks at a typical firm s costs of production and revenue. We will then use this understanding in the next topic to identify how a firm decides how much of a good or service to produce. by the end of this topic, you should be able to... o identify the different resources used by firms to make goods and services o describe the difference between accounting and economic costs o describe the difference between fixed and variable costs o describe and show a firm s costs of production o describe and show a firm s revenue

6 4 PERFECT COMPETITION AND MONOPOLIES (3.) Noah s Ark Boating Ltd. builds luxury yachts for the world s elite. 1. Classify each of the following expenses as to whether they are fixed, variable or semi-variable. The cost of timber and marine varnish. Staff wages. Depreciation on tools, when the number of boats produced is considered to be the factor responsible for the amount of this cost. Rent paid on the building yard. This is negotiated bi-annually. The annual fire insurance premium on plant and buildings. PAYE paid to government. Annual marketing bill paid to Worldwide Promotions Ltd.. PAYE paid for workers who are employed on month-long contracts depending on demand. The electricity bill. Overtime wages paid to staff when jobs fall behind schedule.. Rank the following factors of production (costs) in terms of their being fixed, semi-variable or variable: Exercise.1 Firm s Costs Management (on monthly salary) Factory Buildings Casual Staff Leased Vehicles Land on a farm Electricity Marketing expenses fixed costs semi-variable costs variable costs

7 PERFECT COMPETITION AND MONOPOLIES (3.) 5 Betty the Builder has invested $ in her business. Her annual running costs are $ per annum, including depreciation (i.e. cost of replacing capital goods). Betty is also a trained Brain Surgeon and could earn $340,000 per annum. The current interest rate on personal savings is 6.4%. 1. Calculate the following: a) ncecessary income to earn an accounting profit $ b) opportunity cost of operating the business: $ c) economic cost $ c) necessary income to earn an economic profit: $ Mere Patena owns 100% of Dead Dogs Ltd. Last year Dead Dogs net profit after interest and tax was $ Mere could sell Dead Dogs Ltd for $7 million. 3. If current commercial interest rates are 8%, is Mere making an economic profit or loss? How much? James Morrison runs an orchard outside of Mapua. It is currently worth $600,000. His accounting costs are $ , and he earns $ income each year. a) opportunity cost of operating the orchard: $ b) economic costs: $ c) economic profit: $ James has the option to buy a neighbouring orchard for $ He has the cash for this in the bank. He will have to hire more staff and machinery to crop it. This will cost $ pa. The likely revenue is $ pa. 5. Assuming current interest rates are 9%, should James buy the new orchard? 6. Describe some advantages and disadvantages of considering economic profit rather than accounting profit? Economic Costs 4. If interest rates are 5% and James could earn $35,000pa in an alternative job, calculate the following: Negative: Exercise. Positive:

8 6 PERFECT COMPETITION AND MONOPOLIES (3.) Perfectly Competitive Firms Costs & Revenue notes Ideally competitive markets result in allocative efficiency for society, i.e. producer and consumer surplus are maximised... and so all resources are used to produce the goods and services demanded by society (consumers). To fully understand how competitive markets achieve allocative efficiency, we need to understand how individual firms decide to allocate resources to produce different goods and services. How do firms decide: - what to produce? - how much to produce? - what price to sell at? To understand this we will study a theoretical firm - a perfectly competitive firm. In a perfectly competitive market, all firms are identical. They all produce an identical product and have perfect knowledge of each other. If one firm were to change its product, all other firms would know exactly what that firm has done and would be able to copy it. Of course in reality firms are all different and have various goals. But to understand a theoretical firm, we assume that firms only have one goal - to maximise their profit, i.e. make as much profit as possible. In this topic we will look at the costs of production and revenue for a single, theoretical firm in a perfecty competitive market - such as a small retail shop. Identify and Classify Resources Used by Firms Firms use resources to produce goods and services. In economics, we classify resources into three categories: Natural: Resources that are extracted, grown or produced from the natural environment (e.g. timber, animals, hay) Human: The provision of services by humans (e.g. farmers, accountants, teachers) Capital: Resources used by people to produce of other goods and services (e.g. tractors, computers, etc.) The greatest Resource is the human Mind John F Kennedy Some economists also refer to a fourth resource entrepreneurship. This is the special ability of some people to bring together the other three resources to produce goods and services. However, this is usually considered part of human resources.

9 PERFECT COMPETITION AND MONOPOLIES (3.) 7 Describe Accounting and Economic Costs The resources (human, natural and capital) represent a firm s direct or accounting costs. For example employing staff (human resource) or using raw materials (natural resources) such as steel and rubber to produce cars, are both costs of production for a firm. However in economics, we also consider the opportunity cost of running a business as a cost of production. Imagine your teacher decides to give up his or her job to run a private business. That means that he or she is giving up a fixed salary to run the business. Assuming his or her only goal is to maximise his orher income (profit), then the business must earn at least as much as she or he could earn as a teacher. Otherwise it makes no sense to leave teaching. If she or he earned $70,000 as a teacher, then the business must make an accounting profit of at least $70,001 to make it worth operating. The next best income that an business owner could earn from her time and resources is the opportunity cost of running the business. In the case of your teacher, the opportunity cost is his or her salary as a teacher. For an economist this opportunity cost is a cost of production for a firm. The firm must cover this opportunity cost, or the owner will stop running the firm. Note: In reality a business owner may be willing to earn less than she could elsewhere because she or he may have other goals - e.g. running her own business, trying to grow the business long-term. However in this analysis we assume that firms only have one goal - maximise their profits (income). In economics we prefer to talk about economic costs rather than accounting costs. Economic costs are the accounting costs, i.e. human, natural and capital resources, plus the opportunity cost of running the business - i.e. the next best income the owner could earn from his time and resources. From now on, the word costs will automatically refer to economic costs. Accounting Costs: Economic Costs: The direct costs of running a business, i.e. the cost of human, natural and capital resources. business. Accounting costs plus the opportunity cost of being in Describe Fixed and Variable Costs Costs are also classifed by whether they are variable, i.e. they change depending on how much of a good or service a firm produces; or are fixed - i.e. they do not change according to a firm s output. Examples of variable costs include staff wages, electricity, raw materials. Examples of fixed costs might include the purchase of machines, annual rent or insurance premiums. Some costs aren t easily classified as fixed or variable, because part of the cost is fixed and part is variable. These costs are called semi-variable. An example of this is a telephone bill. Part of this involves a fixed charge which must be paid regardless of how often the phone is used. Then there is an extra charge that depends on how much the phone is used. Variable Costs: Costs that change according to how much output a firm produces. Fixed Costs: Costs that do not change according to the level of output.

10 8 PERFECT COMPETITION AND MONOPOLIES (3.) Describe and Show a Firm s Costs of Production If you add together all of a firm s (economic) costs, i.e. human, natural, capital and opportunity costs, you can calculate and graph its costs of production. This is useful because we can then use the graph to illustrate the firm s decisions about how much to produce and what price to sell it for. There are three main types of costs that we are interested in: Marginal Cost of Production This is the cost of producing one more good or service. Average Cost of Production This is the total cost of production divided by the quantity produced. Average Variable Cost of Production This is the part of average cost that only relates to a firm s variable costs such as labour, raw materials, etc. Table 1 below summarises the different costs faced by a firm, and how they are calculated. TABLE.1: FIRMS COSTS Cost Definition How to Calculate Total Cost (TC) The total cost of making a given number of goods. x Average Cost () The average cost of making goods. TC AFC + AVC Marginal Cost () The cost of producing one more good. TC - TC 1 marginal = extra, one more Average Variable Cost (AVC) The average variable cost of making goods. - AFC Average Fixed Cost (AFC) The average fixed cost of producing goods. TC - AVC We will investigate how we analyse these costs in more detail in Achievement Standard 3.3. For now the key thing is to understand what they are and what they look like when drawn on a graph. Figure.1 shows the graph of a typical firm s cost curves. The most important cost curve is the firm s marginal cost curve as it is used to determine how much of the good or service the firm will supply. Figure.1... An Individual Firm s Cost Curves In this course, we assume the cost curves for all firms share the same characteristics. The exact numbers may differ but the shape and relationships of the cost curves to each other will always remain the same. Key points to note are: $/unit (marginal cost) (average cost) AVC (average variable cost) All cost curves initially fall as the cost of production initially falls, and then rises. This is due to the Law of Diminishing Marginal Returns (see AS 3.3). The marginal cost () curve is the steepest of the curves. It always crosses the average variable cost (AVC) curve and the average cost () curve at their lowest points. The average variable cost (AVC) is always below the curve. It s lowest point always intersects with the marginal cost curve. The average cost () is always above the AVC curve. It s lowest point always intersects with the marginal cost curve.

11 PERFECT COMPETITION AND MONOPOLIES (3.) 9 Describe and Show a Firm s Revenue Revenue is another word to describe the income that firms earn from selling goods or services. To calculate firms revenue we multiply their selling price by the quantity sold. To determine the price that firms earn, we use the demand curve. In a perfectly competitive there are two types of demand curves - the market demand curve and the demand curve faced by an individual firm. Market Demand The demand curve in a perfectly competitive market is the same as the one we studied in Achievement Standard 3.1. This is the total demand for goods and services by all consumers in the market. It slopes down and to the right as shown in Figure.. Price ($) Figure.... Market Demand Curve The market demand curve shows the demand for goods and services by all consumers in a market. It slopes down to the right, illustrating the law of demand ,000 D uantity (000) Demand facing an Individual Firm In a perfectly competitive market there are very large numbers of firms all selling an identical product. This means that each individual firm is very small. Because of this and the other competitive assumptions, individual firms are price takers. This means that no matter how many goods an individual firm sells, it can not influence the market price and so always sells its goods for the same price. Consequently the demand curve facing an individual firm in a perfectly competitive market is perfectly horizontal as shown in Figure.3. $/unit Figure.3... Demand Curve Facing an Individual Firm D = MR = AR = P An individual firm in a perfectly competitive market is very small compared to the overall market. Therefore the firm can not influence the market price at all... it is a price taker. Therefore it s demand curve is perfectly horizontal, i.e. its customers will only pay the one price regardless of how much it produces.. Figure.3 shows the demand curve (D) for an individual firm. Notice how the values on the quantity axis are significantly smaller than for the market demand curve in Figure.3. Because the individual firm s demand curve is horizontal, this means that the firm s average revenue (AR) will always be the same. And it will always equal the market price (P). It also means that the extra or marginal revenue (MR) the firm earns from selling one more good or service will always be the same. This is a significant feature for a perfectly competitive firm. Both MR and AR are the same, and both are horizontal... for the individual firm.

12 30 PERFECT COMPETITION AND MONOPOLIES (3.) So market demand and the demand facing an individual demand curve are very different in the shape and size. Figure.4 shows both demand curves side by side. Figure.4... Market vs. Individual Demand $/unit MARKET DEMAND $/unit INDIVIDUAL FIRM S DEMAND S D = MR = AR = P 600,000 D The market price is set by the interaction of market demand and supply. This price is then taken by individual firms who must sell at this price. Unlike the market demand curve, the individual firm s demand curve is perfectly horizontal because the individual firm is so small (compare the quantity in the two graphs) compared to the market. This firm s marginal and average revenue is $30 regardless of what quantity it sells. Definition TOTAL REVENUE AVERAGE REVENUE MARGINAL REVENUE The total income received from all sales. The average income received per good. The extra income earned from selling one more good or service. Calculation price x quantity (Px) total revenue quantity (average revenue = price) the change in total revenue (TR - TR 1 )

13 PERFECT PERFECT COMPETITION AND AND MONOPOLIES (3.) 31 topic. profit maximisation making the most of a good thing Business owners have many goals when they decide to set up and run their business. However it s difficult for economists to analyse these. So... to make life easy for ourselves... we assume that firms in a perfectly competitive market have one goal - to maximise their profits. This topic looks at the costs and revenues faced by a firm in a perfectly competitive market, and how firms decide what level of output to produce in order to achieve this goal. by the end of this topic, you should be able to... o describe what profit maximisation (loss minimisation) is o identify the output level at which a firm maximises its profits o describe the different types of economic profit and show on a graph o describe and compare short-run and long-run o identify and explain break-even point o identify and describe a perfectly competitive firm s short-run supply

14 3 PERFECT COMPETITION AND MONOPOLIES (3.) The definition of short-run changes from one industry to another. 1. For each of the industries below, suggest what time frame you think relates to their momentary supply, short-run supply and long-run supply. a. Road-Side Fruit Stalls: Momentary: Short-Run: Long-Run: b. Forestry: Momentary: Short-Run: Long-Run: c. Car Manufacturers: Momentary: Short-Run: Long-Run: Exercise.3 Short-Run vs. Long-Run. Occasionally firms choose to shutdown their operations temporarily, rather than leave an industry altogether. Explain why firms choose to do this and contrast this to why they might elect to leave an industry permanently.

15 PERFECT COMPETITION AND MONOPOLIES (3.) 33 On Trade Me, there are now hundreds of sellers of second-hand console games, making the market nearly perfectly competitive. The graph below shows cost curves facing a typical seller of console games. 1. Label the axis and curves on the graph below Complete the following graph: uantity Marginal Cost Av. Variable Cost Average Cost Total Cost 3. At what price and quantity would the firm earn a normal profit? P: $ :... break even? P: $ :... shut down (below this price)? P: $ : Exercise.4 Firm s Costs

16 34 PERFECT COMPETITION AND MONOPOLIES (3.) Identify,, AR and MR on the graph below. $ SINGLE FIRM IN A PERFECTLY COMPETITIVE MARKET Use the graph above to complete the table below: Output TC MR AR Exercise.5 Profit Maximisation TR Economic Profit 3. What is the firm s profit-maximising level of output? How would you describe this type of profit? Output: Type of profit: 4. Shade in the area on the graph that represents the firm s economic profit at the profit-maximising output. 5. Why does the firm not maximise its profits if it produces 8 units of output? 6. Why does the firm not maximise its profits if it produces 5 units of output?

17 PERFECT COMPETITION AND MONOPOLIES (3.) 35 Show the profit-maximising (loss-minimising) output and economic profit for the following markets. Label the price as P 1 and output as 1. Shade in the economic profit as appropriate. 1. $ D = MR = AR = P AVC Type of Economic Profit:. $ AVC D = MR = AR = P 3. Type of Economic Profit: $ AVC D = MR = AR = P Type of Economic Profit: Exercise.6 Firms Decisions

18 36 PERFECT COMPETITION AND MONOPOLIES (3.) Imagine you are a business consultant. 1. The situations below represent different firms in a perfectly competitive market. What advice would you give each firm? a. You re doing great. Keep your output where it is currently. b. Increase your output to maximise your profits (minimise your loss). c. Decrease your output to maximise your profits (minimise your loss). d. Shutdown your business until market conditions (i.e. price) improves. e. Go back and re-do your books. Your numbers make no sense. Price Output Total Revenue Total Cost Total Fixed Cost Total Variable Cost Average Cost Average Variable Cost Marginal Cost A B Answer at minimum level C at minimum level D E at minimum level F Exercise.7 Profit Maximisation G H. Three of your clients prefer pictures to help them understand. Draw the situation facing clients A,F and H on the axis below. Be sure to fully label all the cost curves and add the MR/AR curve. Show the profit maximising price (P 1 ) and output ( 1 ), and show any economic profit. A F H

19 PERFECT COMPETITION AND MONOPOLIES (3.) 37 The following graph shows a perfectly competitive firm. $ Perfectly Competitive Firm 1. Fully label the curves on the graph.. Why are the marginal and average revenue curves horizontal for a firm in a perfectly competitive market? 3. Identify the profit maximising (loss-minimising) level of output ( PM ) and price (P PM ). 4. Identify the firm s economic profit by shading it in on the graph and giving it an appropriate label. 5. What kind of economic profit is the firm earning at PM? 6. Explain why the firm will not leave the firm in the short-run. 7. Explain why this firm will not raise its price. 8. Show a new MR/AR curve that would result in the firm earning normal economic profits. Identify the new profit-maximising output ( ) and price (P ). Exercise.8 Check Your Knoweldge

20 38 PERFECT COMPETITION AND MONOPOLIES (3.) Profit Maximisation notes Profit Maximisation and Marginal Analysis To understand the behaviour of the firm we assume that is has one goal - to maximise its profit, i.e. make as much profit as it possibly can. Common sense would suggest that to do this, the firm should sell as much of its product at as high a price as possible... but that s not correct. As we saw in Topic 1, a firm s costs of production rise as it produces more goods or services. At the same time a perfectly competitive firm s revenue does not change. So if a firm keeps producing more and more, eventually it will cost more to produce the goods than it can sell them for. Therefore the firm must identify the optimal level of output which maximises its profit. We can identify this profi-maximising level of output by using marginal analysis and comparing a firm s marginal costs to its marginal revenue. A firm maximises its profit when it produces at a level where its marginal cost equals its marginal revenue. Profit Maximisation: When a firm makes as much profit (revenue - costs) as possible. profit maximisation... MR = Identify a Firm s Profit Maximising Output To work out how much of a good or service that a firm must produce in order to maximise its profits, we compare its marginal cost and marginal revenue. A firm will produce more goods if the extra (marginal) revenue it earns, is greater than or equal to the extra (marginal) cost of producing the goods. Figure.5 below shows the marginal cost and marginal revenue curves for a firm in a perfectly competitive market. It s marginal cost curve initially falls and then rises. At the same time it s marginal revenue curve is perfectly horizontal. $/unit Figure.5... Profit Maximisation for a Perfectly Competitive Firm MR TC TR PROFIT D = MR = AR = P This firm will produce 3 goods, i.e. the level of output where MR =. To produce more than this will reduce it s total economic profit as shown in the table below. note: The firm will produce the 3rd good, event though it doesn t increase total profit. Remember that this is an economic profit, so it includes a minimum accounting profit which is worth earning.

21 PERFECT COMPETITION AND MONOPOLIES (3.) 39 The firm will produce the first good because it earns $30 and it only costs $10 to make. The firm makes a profit of $0 on that good, so it will make it. The firm will also produce the second good for the same reason. The marginal revenue is the same ($30) while the marginal cost has risen to $17. The marginal revenue from producing the second good exceeds the marginal cost of producing it and the firm earns a profit of $13 on it. This logic will continue up to the point where the marginal cost of producing another good equals the marginal revenue. In this case, the firm will continue to produce more goods up to the level of output where marginal cost equals $30. Beyond the point of MR=, the firm will not produce any more goods. It will cost the firm $55 to produce the fourth good, when it can still only sell it for $30. Producing and selling this good will reduce the firm s total output. So the firm will only produce three goods. By using marignal analysis, we can show that a firm will always produce at the level of output where its marginal cost equals its marginal revenue. NOTE: Why will the firm produce a good if its marginal revenue only equals the marginal cost of producing it? To answer this, you need to remember that the term costs refers to economic costs, i.e. it includes the minimum necessary accounting profit to keep the firm in the industry. For the firm in Figure.6, this means that the firm earns a minimum accounting profit from the 3rd good, and so will produce it. Identify and Describe Economic Profit Economists are very interested in how profitable a firm is, because this will affect the behaviour of firms - in and outside the industry. Remember - when we talk about profit we are referring to economic profit, i.e. how much revenue is a firm earning over and above its economic costs. Since economic costs include the minimum accounting profit for a firm to stay in business, an economic profit is any profit over and above the minimum necessary accounting profit. In economics we talk about three types of economic profit - normal, supernormal and subnormal. normal profit (AR = ) when earns its minimum accounting profit supernormal profit (AR>) when a firm earns more than its minimum accounting profit subnormal profit (AR<) when a firm earns less than its minimum accounting profit To identify a firm s economic profit, first identify the level of output that the firm is operating at. For a perfectly competitive firm, this should always be at it s profit-maximising (or loss-minimising as we ll discuss shortly) output level. Then, at this output level, compare average revenue (AR) and average cost (). The rectangle that this creates represents the firm s economic profit. If AR is greater than, then the firm is earning supernormal profits. If AR is less than, then it s earning subnormal profits. Figures.6 to.8 show the three types of economic profit. All of the firms are producing at a profitmaximising output level, i.e. where MR =.

22 40 PERFECT COMPETITION AND MONOPOLIES (3.) $/unit P 1 AVC D = AR = MR Figure.6... Normal Profit Normal Profit occurs when the firm is profit maximising and AR =. At this output level, total revenue equals total cost. Normal profit is the minimum profit necessary for an entrepreneur to keep his or her resources in the industry. 1 $/unit P 1 AVC D = AR = MR Figure.7... Supernormal Profit Supernormal profit occurs when the firm is profit maximising and AR >. At this output level, total revenue exceeds total cost. Supernormal profit is the profit over and above the minimum profit necessary for an entrepreneur to keep his or her resources in the industry. 1 $/unit Figure.8... Subnormal Profit Subnormal profit occurs when the firm is loss minimising (i.e. =MR) and AR <. At this output level, total revenue is less than total cost. P 1 AVC D = AR = MR A firm that is earning subnormal profits may still be earning an accounting profit but it is less than the next best alternative. Or it may be earning an accounting loss. 1 NOTE: Earning a subnormal profit does not mean that a firm is making an accounting loss. It may be earning an accounting profit. We don t know. But we do know that it s earning less than the minimum accounting profit necessary to make the firm (or firms owner) want to stay in the industry.

23 PERFECT COMPETITION AND MONOPOLIES (3.) 41 Describe Loss Minimisation Having identified a firm s profit-maximising level of output, you may discover that the firm is earning a subnormal profit. In this case, we say that the firm is loss-minimising rather than profitmaximising. In Figures.8 and.9 we say the the firm is loss-minimising at 1 or C. Compare Short-Run to Long-Run If a firm is loss-minimising and earning a subnormal profit, i.e. less than it could by investing its funds in another industry, the logical question is why doesn t it stop trading? The answer to this depends on what time-frame we are talking about. Firms act differently depending on the period of time that you consider. In economics, we talk about three different time periods - momentary, short-run or long-run. A momentary time period is any period time when all resources are fixed, and so firms can not change how much they supply. In the short-run firms have at least one resource is fixed. The firm can change how much it supplies because it can change its variable costs (e.g. labour, raw materials). However it can not completely close down and leave the industry because it has an asset it can t sell (e.g. a factory) or a financial obligation (e.g. rent) it must pay. In the long-run firms have no fixed resources. The long-run is any length of time in which a firm can sell all its assets and pay all of its financial obligations. In the longrun a firm can completely close down and transfer its resources (e.g. money, assets) to another industry. The table below summarises these different time periods. time period explanation example momentary short-run long-run This is a period of time (e.g. 1 hour, 1 day) during which a firm can t change how much of a good or service it supplies. This is any period of time during which a firm has at least one financial obligation (e.g. rent) that it must pay, or an asset that it can t yet sell. In the long-run, i.e. any length of time greater than the short-run, the firm is able to sell all of its assets and pay any financial obligations. SHOE SHOP... 1 / hour This is how long it might take a shoe shop to get more stock, or to stop sales. CAR FTORY... 1 week This is how long it might take a car factory to stop making cars... or to increase production. SHOE SHOP... 3 months This might be how long before a shop gets out of its rental agreement. CAR FTORY... 1 year It may take at least a year to sell the factory, so the owners can t completely leave the industry. SHOE SHOP... over 3 months After 3 months, a shop has no financial obligations and sold all of its assets. The owner may leave the industry. CAR FTORY... over 1 year After one year, the factory owners have paid all their expenses and sold the factory. The can now leave the industry NOTE: What is important here is that you can explain the difference between shortrun and long-run. You do not need to give specific examples. Short-Run: A period of time in which at least one resource (cost) is fixed. Long-Run: A period of time in which no resources (costs) are fixed.

24 4 PERFECT COMPETITION AND MONOPOLIES (3.) Identify a Firm s Shut-Down Point (Short-Run Decision) In the short-run, perfectly competitive firms have two choices: 1. how much to produce?. stay open or shut down? The first decision - how much to produce - relates to a firm choosing its profit-maximising (lossminimising) level of output. As we ve already seen, this occurs at the point where MR=. Assuming the firm is profit-maximising (loss-minimising), it only has a second choice to make - should it stay open (keep trading) or shut down, i.e. stay in the industry but temporarily stop trading until prices improve or it can leave the industry in the long-run. Shutting down differs to leaving the industry. In the long-run a firm can sell all of its assets and completely leave the industry. However, in the short-run at least one factor of production, e.g. a rental contract, is fixed and the firm must stay in the industry. If a firm shuts down, it stops trading. It stays in the industry and continues to pay its fixed costs, but it stops paying all variable costs such as labour or electricity - and it earns no revenue. Figure.9 shows a typical perfectly competitive firm with four different possible prices... P A - P D. Figure.9... Shutdown Point for Individual Firms $/unit The shut-down point is the lowest point on the AVC curve. If the price falls below this level, the firm will minimise its loss by shutting down in the short-run. 600 P A AVC 400 P B P C P D shutdown price shutdown point C D B A shutdown level of output Assuming that at each price, the firm tries to profit maximise (loss minimise) by producing at the quantity where MR =, then you get the following figures for the firm. TABLE.3: SHUT DOWN TIME FOR FAST FOOD OUTLET Option Average Revenue ($) Average Fixed Costs ($) Average Variable Costs ($) Average Economic Profit ($) Short-Run Decision A stay open B stay open C stay open D OPEN D SHUT shut down In the three options (A-C), the price equals or exceeds the average variable cost of production. So the firm will stay open. But if the price falls below $300, i.e. P D, then the firm is better to shut down. The table shows this by showing the consequences of staying open (D OPEN ) or shutting down (D SHUT ). The loss is less if the firm shuts down.

25 PERFECT COMPETITION AND MONOPOLIES (3.) 43 Identify a Perfectly Competitive Firm s Short-Run Supply In a competitive market, a firm will always profit maximise. This means that it will produce at the level of output where MR=. Therefore the curve is a competitive firm s supply curve. In the short-run a firm will only supply a good or service if the price equals or exceeds the lowest point on the AVC curve. If the price goes below this, the firm will shut down. So a competitive firm s short-run supply curve is the curve above AVC, as shown in Figure.10. Price ($) Figure A Perfectly Competitive Firm s Short-run Supply Curve S SHORT-RUN AVC A firm s short-run supply curve is the curve above the lowest point on the AVC curve or shutdown point. If the price falls below AVC, the firm will minimise its loss by stopping trading and just paying its fixed costs.

26 44 PERFECT COMPETITION AND MONOPOLIES (3.)

27 PERFECT PERFECT COMPETITION AND AND MONOPOLIES (3.) 45 topic.3 changes to pc markets change, change, change In the short-run, firms in a perfectly competitive market have limited choices. They can change their level of output, or choose to stay open or shut down. However they can t leave the market. This topic looks at how firms inside and outside of a perfectly competitive market respond to changes in the long-run. by the end of this topic, you should be able to... o describe the break-even point and show on a graph o identify a competitive firm s long-run supply o explain how competitive firms respond to long-run changes in the market, and show this on a graph o identify alternative business goals of firms

28 46 PERFECT COMPETITION AND MONOPOLIES (3.) Imagine the market for apricots is perfectly competitive. 1. Show the market equilibrium price and quantity in the market for apricots.. Show the short-run profit-maximising (loss-minimising) output for the individual orchard. 3. Identify and label the economic profit (if any) experienced by the individual orchard. MARKET FOR APRICOTS INDIVIDUAL ORCHARD $/unit $/unit S AVC 0 D (millions) Why will the situation shown above not change in the short-run? Exercise.9 Change in Perfect Competition 5. Show how the individual orchardist will respond to the current market situation in the long-run. Clearly show (and label) the impact of this on both graphs above. The graphs below show the market for apples. Assume that this market is perfectly competitive. 6. Show the short-run situation in the market and for the single orchard. 7. Show the long-run situation in the market and for the single orchard. $/unit MARKET FOR APPLES D S (millions) $/unit SINGLE ORCHARD AVC

29 PERFECT COMPETITION AND MONOPOLIES (3.) 47 The Pakuranga Night Market operates in the Pakuranga Mall every Saturday from 6.00pm until 1.00pm. There are many stall-holders selling fast food to the thousands of customers who come each week. It is a good example of a (nearly) perfectly competitive market. 1. In the graphs below, show: - the market equilibrium price (Pe) and quantity (e) - the average revenue (AR) and marginal revenue (MR) curves for the individual stall-holder - the profit-maximising level of output ( PM ) for the individual stall-holder $/unit MARKET FOR MEALS AT THE PAKURANGA NIGHT MARKET $/unit INDIVIDUAL STALL-HOLDER 7 S AVC 1 D 1 (000 of meals sold) (meals sold). The market has grown more popular as word of it spreads through Auckland, i.e. demand has grown. Show the short-run impact of this on the market for meals. 3. Compare the short-run and long-run response of individual stall-holders and the market as a whole to the increase in demand. Your answer should explain the difference between short-run and long-run, and how prices / economic profits affect producers decisions. Exercise.10 Perfect Competition

30 48 PERFECT COMPETITION AND MONOPOLIES (3.) The following graphs show perfectly competitive markets. For each market below: i) show the short-run market equilibrium for the market and profit maximising (loss-minimising) output ( SR ) and price (P SR ) for the individual firm. ii) describe the type of economic profit earned by the firm in the short-run. iii) show the long-run market equilibrium and profit-maximising output level for the individual firm 1. $/unit MARKET $/unit INDIVIDUAL FIRM S AVC D economic profit in the short-run: Exercise.11 Change in Perfect Competition. $/unit MARKET S D INDIVIDUAL FIRM economic profit in the short-run: Explain why a firm, faced with the market price being below the shutdown point, might shut down in the shortrun, but try to stay open in the long-run in the hope that other firms will leave the industry. $/unit AVC

31 PERFECT COMPETITION AND MONOPOLIES (3.) 49 Show Long-Run Changes to a Perfectly Competitive Market notes Identify Break-Even Point (Long-Run Decision) In the previous topic we saw that in the short-run, perfectly competitive firms have two choices: 1. how much to produce?. stay open or shut down? In the long-run, the firm has one more choice 3. stay in the industry or leave? If the firm is not earning a normal profit then in the longrun it makes no sense to stay in an industry. Remember - a normal economic profit means covering your costs and earning an accounting profit as good as your next best opportunity. If the firm can t do this, it would make more sense to close down, sell off all your assets and go into a different industry. If you refer back to Figures you will see how we determine what kind of economic profit a firm is making. A firm breaks even when its average revenue covers its average costs, i.e. when it earns a normal profit. Based on this, we can see that the break-even point occurs at the lowest point of the average cost curve (see Figure.11). If the price (i.e. AR/MR curve) falls below this point, the firm is making a subnormal profit and should leave the industry. Figure Break-Even Point for Individual Firms $ The shut-down point is the lowest point on the AVC curve. If the price falls below this level, the firm will minimise its loss by shutting down in the short-run. AVC P BE break-even price break-even point BE break-even level output 3 decisions of a perfectly competitive firm: 1. what level of output will maximise my profits?. short-run... should I stay open or shut-down? 3. long-run... should I stay in the industry or leave?

32 50 PERFECT COMPETITION AND MONOPOLIES (3.) Identify a Perfectly Competitive Firm s Long-Run Supply In the long-run a competitve firm will only supply a good or service if it is breaking even, i.e. its revenue equals or exceeds its average cost of production. So it s long-run supply curve is the curve above the break-even point on the curve as shown in Figure.1. Price ($) Figure.1... A Perfectly Competitive Firm s Long-Run Supply Curve S LONG-RUN AVC A firm s long-run supply curve is the curve above the lowest point on the curve or break-even point. If the price falls below and is earning subnormal profits, the firm will choose to leave the industry. Describe How Firms Respond to Long-Run Changes in a Market In the short-run firms respond to changes to the market (e.g. an increase in demand and therefore price) by changing their output level, or shutting down. In the long-run, firms respond to changes in the market by changing their output level or leaving the industry. How firms act depends on the type of economic profit firms in the industry are earning. Table.4 summarises the decisions of firms in and out of the industry in response to the type of economic profit being earned by firms in a perfectly competitive market. TABLE.4: LONG-TERM DECISIONS Type of Profit Firms Inside the Industry Firms Outside the Industry Market Consequence subnormal will leave the industry nothing market supply will fall market price will fall until firms inside the industry earn normal profits normal nothing nothing no change to the market or firms supernormal nothing will enter the industry market supply will rise market price will fall until firms inside the industry earn normal profits Figures.13 and.14 (over the page) show step-by-step how firms respond to an increase or decrease in market demand - in the long-run.

33 PERFECT COMPETITION AND MONOPOLIES (3.) 51 $ Figure Increase of Market Demand in a Perfectly Competitive Market 1. Initial Long-Run Equilibrium. Firms in the industry are making normal profits. S $ P 1 D = AR = MR 1 D. Short-Run Situation As demand rises, a shortage occurs at P 1. This shortage causes the price to rise and firms to earn supernormal profits. New firms cannot enter the market in the short-run, so existing firms respond by increasing output. 1 $ S $ P P 1 supernormal D =AR =M D=AR=MR D D Long-Run Equilibrium Attracted by the supernormal profits, firms outside the industry enter the market. As they do, they push the market price down until all firms earn a normal profit. Consequently individual firms supply less. $ S 1 $ S P P 1 D =AR =MR D=AR=MR D 1 3 1

34 5 PERFECT COMPETITION AND MONOPOLIES (3.) Figure Decrease of Market Demand in a Perfectly Competitive Market 1. Initial Long-Run Equilibrium Firms in the industry are making normal profits. $ S $ P 1 D=AR=MR D 1 1. Short-Run Situation As demand falls, a surplus occurs in the market. To sell the surplus stock, firms must drop the price. This will cause firms to earn subnormal profits. Firms cannot leave the market in the short-run. However, if the price falls below the average variable cost, the firm may shutdown. The graph below includes the AVC curve to show that the firm will not do so. $ S $ AVC P 1 P subnormal D=AR=MR D =AR =MR D 1 D Long-Run Equilibrium Firms will leave the industry, causing a shortage ( - 4 ) at P. The price will rise until the firms make normal profits and the shortage is removed. $ S S $ P 1 D=AR=MR P D =AR =MR D Identify Alternative Business Goals In reality, firms have a number of business goals, other than just maximising their profit. In the short-run, firms may focus on maximising sales to gain market share (before raising prices in the long-run). Or an entrepreneur may run a business to enjoy being self-employed, with the size of the profit being unimportant.

35 PERFECT PERFECT COMPETITION AND AND MONOPOLIES (3.) 53 revision

36 54 PERFECT COMPETITION AND MONOPOLIES (3.) This question checks that you can: identify the profit-maximising output level for a perfectly competitive firm compare short-run and long-run decisions of a perfectly competitive firm use marginal analysis to explain the output decisions of a perfectly competitive firm The Bhenghazi St market is a good example of perfect competition. Each day large number of individual vendors come and set up stalls to sell their various products. On one day, a researcher counted 40 vendors supplying printed material for sale to the hundreds of customers. The price of this was US$4.50 per square metre. 1. Explain why the individual vendors (sellers) of printed material are price takers in the Bhenghazi market. Graph 1: An Individual Vendor of Printed Material on Bhenghazi St US$ per square metre Revision.1 Perfect Competition On Graph 1... a) show the average revenue (AR) and marginal revenue (MR) curves for the typical individual vendor of printed material at the market price of US$4.50 per square metre b) show the profit-maximising equilibrium price (P PM ) and quantity ( PM ). c) identify and label the area that represents the economic profit at PM. 3. Explain why the price for printed material will not change in the short-run. uantity (square metres) AVC

37 PERFECT COMPETITION AND MONOPOLIES (3.) Explain how individual vendors of printed material, and therefore the market, will respond to the situation you showed in question () and on Graph 1. In your answer: compare the long-run response of individual vendors will respond to the situation in question () to their short-run decisions describe how the long-run decisions of individual vendors will affect the market make appropriate changes to Graph 1 to show the long-run changes to the marginal revenue / average revenue curve faced by the individual vendor identify on Graph 1 the new quantity ( NEW ) and price (P NEW ) of printed material in the long-run use marginal analysis to explain why individual firms change their quantity sold in response to the change in price Revision.1 Perfect Competition

38 56 PERFECT COMPETITION AND MONOPOLIES (3.) This question checks that you can: identify the profit-maximising output level for a perfectly competitive firm compare short-run and long-run decisions of a perfectly competitive firm use marginal analysis to explain the output decisions of a perfectly competitive firm The graphs below show a perfectly competitive market and the situation facing an individual firm in that market. Graph : The Perfectly Competitive Market Graph 3: Individual Firm Price ($) S Revenue/Cost ($) P D AVC uantity uantity 1. On Graph 3, identify and label the firm s: average revenue and marginal revenue profit-maximising price level (P PM ) and output level ( PM ) the economic profit experienced by the market. Using marginal analysis, explain why the firm will not produce more or less than PM. Revision. Perfect Competition 3. Describe the difference between short-run and long-run... AND... explain why new firms will enter the market in the long-run.

39 PERFECT COMPETITION AND MONOPOLIES (3.) Use marginal analysis to fully explain the changes that will occur in the long run to the price AND output in Graphs and 3. In your answer: show the relevant changes to Graph and Graph 3. clearly label your changes refer to the changes that you made to the graphs in your answer below Revision. Perfect Competition

40 58 PERFECT COMPETITION AND MONOPOLIES (3.) This question checks that you can: identify the profit-maximising output level for a perfectly competitive firm compare short-run and long-run decisions of a perfectly competitive firm use marginal analysis to explain the output decisions of a perfectly competitive firm An understanding of perfectly competitive market, even though it only exists in theory is useful to our understanding of how producers and consumers act in all markets. 1. Identify THREE characteristics of a perfectly competitive market.. Explain why one (or more) of the characteristics of a perfectly competitive market result in individual firms being price takers. Graph 4: A Perfectly Competitive Firm Revision.3 Perfect Competition Costs & Revenue (S) P 1 3. On Graph 4 above: a. Fully label the THREE cost curves. b. At the current price of P1, identify the profit maximising level of output ( e ). c. State the type of profit being made at the profit maximising output e and shade the appropriate area on the graph. Type of profit: AR = MR = D Output