Some of the assumptions of perfect competition include:

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Myles Parsons
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1 This session focuses on how managers determine the optimal price, quantity and advertising decisions under perfect competition. In earlier sessions we have looked at the nature of competitive markets. We are now going to analyze the competitive market again along with the cost curves. The prescribed reading for this session is chapter 10 of the text. The text talks about varying degree of competition and focuses on highly competitive markets. These notes label highly competitive markets as perfect competition. This is consistent with the labels used by economists. Perfectly or highly competitive market are used to mean the same thing. 1

2 Some of the assumptions of perfect competition include: Many buyers and sellers- They are many individual buyers and sellers who buy/sell a small proportion of the good. This implies that both suppliers and consumers take the market price as given and are unable to influence the price by their buying or selling decisions. For example, whether I or this whole class buys milk or not makes absolutely no difference to the price of milk at Woolies. Homogenous (identical) products- This condition means that the goods are exactly the same and consumers view goods by different suppliers as perfect substitutes. For example, the home brand milk in Woolies and Coles or other agricultural products. This assumption is difficult to satisfy in most other markets and most real situations only approximately meet this assumption. This assumption, however, is very important to buyers switching between retailers to take advantage of price differences. Perfect information on both sides of the market- Again this assumption is only roughly met in reality. If buyers and sellers are badly informed then they are unable to exploit profitable opportunities in the prevailing markets. Free entry and exit- The most important implication of this assumption is that if 2

3 a seller wants to enter a profitable market, then they are able to obtain the necessary resources such as labor and capital. The implications of these conditions are a single market price is determined by the interaction of demand and supply and each buyer and seller is a price taker. firms earn zero economic profits in the long run. 2

4 Firms in a competitive market try to maximise profit, where Profit=Total Revenue Total Cost; where total revenue is simply price times quantity. Think of a commodity like milk which is homogenous and produced by many different producers. Essentially the market Demand and Supply diagram determines the market price and quantity of milk. The market supply is made up of many individual suppliers and the market demand is made up of many individual consumers. Lets say the equilibrium price is Pe. Under perfect competition an individual firm can sell as much as they want at price Pe. Since the individual is a small supplier in the market, the amount sold by an individual does not have any influence on the market price and the individual can sell as much as they want at price Pe. But if an individual firm charges a price higher that Pe, the individual firm will sell nothing. Therefore, we say that under perfect competition the individual supplier is a price taker. 3

5 Once we have the price and quantity we can calculate marginal revenue and average revenue. Average revenue is the total revenue divided by the amount sold. Marginal revenue is the change in total revenue from the sale of each additional unit of output. Since price is constant AR = P MR = P We are assuming that under perfect competition the firm is so small that it cannot influence the price and is hence a price taker. 4

6 Recall that in the short run some inputs are fixed. Profit maximizing in the short run requires that the firm must take the fixed inputs as given and determine how much variable inputs to employ. To maximize profit producers must produce at quantity where total revenue minus total cost is greatest. In previous session we also identified that profit maximization point can be found by comparing marginal revenue with marginal cost If MR > MC: increase production If MR < MC: decrease production Maximize profit where MR = MC 5

7 This figure shows the marginal-cost curve (MC), the average-total-cost curve (ATC), and the average-variable-cost curve (AVC). It also shows the market price (P), which for a competitive firm equals both marginal revenue (MR) and average revenue (AR). At the quantity Q 1, marginal revenue MR 1 exceeds marginal cost MC 1, so raising production increases profit. At the quantity Q 2, marginal cost MC 2 is above marginal revenue MR 2, so reducing production increases profit. The profit-maximizing quantity Q MAX is found where the horizontal line representing the price intersects the marginal-cost curve. Think about outputs below Q MAX. At all such points P>MC. This means that the firm gets more for each additional unit than the cost of producing it. Thus, profits go up as firm increases output below Q MAX. Similarly, at output levels above Q MAX, MC>P. In this instance, each additional unit is costing more than the gain in revenue from production. A profit maximising firm would reduce output. Thus, Q MAX is the profit-maximizing level of output. To summarise under perfect competitive or highly competitive market price is determined by demand and supply conditions. Each individual firm takes this price as given. The market price is essentially equal to marginal revenue. To maximise profit, firm needs to find the point where MR=MC. 6

8 Rules for profit maximization: If MR > MC, firm should increase output If MC > MR, firm should decrease output If MR = MC, profit-maximizing level of output Marginal-cost curve essentially determines the quantity of the good the firm is willing to supply at any price. A perfectly competitive firm produces the output at which price equals marginal cost. Marginal cost curve is essentially the supply curve of the firm. 7

9 Lets assume there is an increase in the price from P 1 to P 2. This leads to an increase in the firm s profit-maximizing quantity from Q 1 to Q 2. Because the marginal-cost curve shows the quantity supplied by the firm at any given price, it is the firm s supply curve. However, we need to clarify one caveat before making this statement. 8

10 To fully appreciate the role of MC curve in firm s supply, we need to understand the shutdown decision which is: Short-run decision not to produce anything Is made during a specific period of time because of current market conditions The shut down decision does not free the firm from paying fixed costs Shutdown decision is free from the exit decision. Exit is a long run decision that firms make to leave the market. If the firms leave in the long term then they don t have to carry the burden of short run or long run costs. 9

11 To maximize short-run profits, a perfectly competitive firm should produce in the range of increasing marginal cost where P = MC, provided that P AVC. If P < AVC, the firm should shut down its plant to minimize it losses. Thus, competitive firm s short-run supply curve is the portion of its marginal-cost curve that lies above average variable cost. The reason is simple. If the firm cannot even get a price in the market that can recoup its average variable costs, then it is better to shut down. But why should firm continue operation if price is any lower than ATC. This is because in the short run firm is stuck with fixed costs. Completely shutting down at P>AVC will mean firm will make bigger losses than if it continued operation 10

12 So what exactly is the firms short run supply curve. Each firms short run supply in perfectly competitive market will be the firms MC curve starting from minimum point of AVC curve or the red line on the above diagram. Firms should produce at P=MC=MR as long as P AVC, which is essentially the red line in the graph. 11

13 However, in the long run the situation is slightly changed: Firm exit the market if in the long run if: Total revenue < total costs; TR < TC Same as: P < ATC Firm enter the market if in the long run if: Total revenue > total costs; TR > TC Same as: P > ATC In the long run firms will not stay in the industry if they cannot recoup all their costs. 12

14 In the long run, the competitive firm s supply curve is its marginal-cost curve (MC) above average total cost (ATC). If the price falls below average total cost, the firm is better off exiting the market. 13

15 Profit is traditionally expressed as: Profit=TR-TC. We can unpack this further: Profit=((TR/q) (TC/q)) x q Profit= (P ATC) ˣ Q If there is a loss. Loss=TC-TR Which is the same thing as expressing it as: Loss = TC - TR = (ATC P) ˣ Q 14

16 The diagram above shows perfectly competitive firms. Both firms maximize profits by setting MC=MR. Whether the firms make profit or loss depends on the position of ATC. The area of the shaded box between price and average total cost represents the firm s profit. The height of this box is price minus average total cost (P ATC), and the width of the box is the quantity of output (Q). In panel (a), price is above average total cost, so the firm has positive profit. In panel (b), price is less than average total cost, so the firm incurs a loss, shown by the pink box. The height of the pink box is (ATC P) and the width of the box is the quantity of output (Q). 15

17 The market (or industry) supply curve is derived from individual firms supply curve. In the competitive market, each firm s supply curve is the firm s marginal cost curve above the minimum AVC. Each firm will supply at P=MC if it is getting price greater than AVC. The market supply curve for a perfectly competitive industry is the horizontal sum of each firms individual supply curve. Remember each firm in a perfectly competitive market is producing exactly the same stuff and face exactly the same market conditions. Thus, the MC curves of perfectly competitive are probably identical. 16

18 In the short run, the number of firms in the market is fixed. As a result, the market supply curve, shown in panel (b), reflects the individual firms marginalcost curves, shown in panel (a). Here, in a market of 1,000 firms, the quantity of output supplied to the market is 1,000 times the quantity supplied by each firm. So at price $1.00, one individual firm supplies 100 units. Because there are a total of 1000 firms in the market then the total market output is 100,

19 So far we have discussed the short run behaviour of firms in a competitive industry. Since we know that firms can freely enter or exit the competitive market, if firms sustain long term losses then some will leave the market. This will shift the supply curve to the left and the market price will increase. For individual firms the demand curve will move up increasing their profits. On the other hand, if firms are making positive economic profit in the industry then other firms will enter the market, shifting the supply curve to the right and causing a drop in price. This will result in a reduction in profits. The process will continue until all firms earn zero economic profit in the long run. 18

20 Firms can enter and exit the market If P > ATC, firms make positive profit New firms enter the market because of the profit potential If P < ATC, firms make negative profit Firms exit the market because of long term losses 19

21 In the Long run Process of entry and exit ends when Firms still in market make zero economic profit (P = ATC) Because MC = minimum ATC, it is known as the efficient scale Long run supply curve is perfectly elastic Horizontal at minimum ATC 20

22 The market starts in a long-run equilibrium, shown as point A in panel (a). In this equilibrium, each firm makes zero profit, and the price equals the minimum average total cost. To clarify the market supply curve in the long run is horizontal at P1. In the short run we face the familiar looking demand and supply curve. The long run point for a individual firm is P=min ATC=MC. Since we know that firms can freely enter or exit the competitive market, if firms sustain long term losses then some will leave the market. This will shift the supply curve to the left and the market price will increase. For individual firms the profit maximising point will move up along the MC curve, increasing their profits. On the other hand, if firms are making positive economic profit in the industry then other firms will enter the market, shifting the supply curve to the right and causing a drop in price. This will result in a reduction in profits. The process will continue until all firms earn zero economic profit in the long run. 21

23 We have just stated that in perfect competition firms make zero economic profit. But why do the firms operate if they make zero economic profit? The key lies in the way we defined costs. The total cost defined earlier includes the opportunity cost of time of the firm s owner. This is different from accounting profit. So in the long run economic profit is zero. At the equilibrium point the firm s revenue must compensate the owners for the time and money that they devote to the business. The zero economic profit is also known as normal profit. 22

24 Now that we have covered the long run and short run, we will bring the two time horizon together in one graph to see what happens when there is a change in market condition. In this case we will look at the change in market demand. 23

25 Lets say the market starts in a long-run equilibrium, shown as point A in panel (a). In this equilibrium, each firm makes zero profit, and the price equals the minimum average total cost. 24

Now lets say that there is an increase in demand and price increases. The increase in price means that the firms profit maximising point will change leading to short run profits.

26 Now lets say that there is an increase in demand and price increases. The increase in price means that the firms profit maximising point will change leading to short run profits. Panel (b) shows what happens in the short run when demand rises from D 1 to D 2. The equilibrium goes from point A to point B, price rises from P 1 to P 2, and the quantity sold in the market rises from Q 1 to Q 2. Because price now exceeds average total cost, each firm now makes a profit, which over time encourages new firms to enter the market. 25

27 Because there is potential for profit, other firms enter the market causing the supply curve to shift to the right- leading to a lower price. As the price falls, each individual firm reaches the point P1, restoring long run equilibrium point. 26

Lecture 11. Firms in competitive markets

Lecture 11. Firms in competitive markets Lecture 11 Firms in competitive markets By the end of this lecture, you should understand: what characteristics make a market competitive how competitive firms decide how much output to produce how competitive