EconS Competitive Markets Part 1

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1 EconS Competitive Markets Part 1 Eric Dunaway Washington State University October 11, 2015 Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

2 Introduction Today, we will bring the consumer and producer sides of the market together to see how Supply and Demand work together to manage production. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

3 Perfect Competition When producers choose their optimal level of output, they need to consider the market structure for which their output is to be sold. This can take several forms, including perfect competition, monopoly, oligopoly, monopolistic competition, etc. Today, we will be talking about perfect competiton. The other forms of imperfect competition will be discussed in a few weeks. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

4 Perfect Competition What is perfect competition? Essentially, it is when Supply and Demand operate in their purest form. We de ne perfect competition as having four main assumptions. Large number of buyers and sellers. Firms produce identical products. Everyone has perfect information. Firms can easily enter and exit the market. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

5 Large Number of Buyers and Sellers Under the assumption of large numbers of buyers and sellers, it is assumed that every individual rm s output and any individual consumers market share is negligible. This ensures that both producers and consumers are price takers. When no individual rm or consumer can a ect the market price, we get a condition where as much as wanted can be bought and sold at the market price. Monopoly (one seller) and monopsony (one buyer) violate this. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

6 Firm s Produce Identical Products When rms produce identical, or homogeneous products, consumers become unconcerned with who produced the product. This prevents brand loyalty (Coke vs Pepsi) that we will see in monopolistic competition. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

7 Everyone Has Perfect Information Everyone having perfect information prevents one rm from taking advantage of consumers by charging a higher price, hoping the consumer s will not notice. When consumers see the higher price, they will just shift to a competitor with a lower price. The real world violates this assumption. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

8 Free Entry and Exit When rms can freely enter and exit the market, they help to maintain the price taking assumption we talked about earlier. When the market price goes up, some rms enter the market. When the market price goes down, some rms exit the market. Regulations can prevent this assumption from holding. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

9 Perfect Competition These assumptions seem restrictive. They are, but the perfectly competitive model is theoretical. Many markets in the real world are very close to the perfectly competitive market, especially in agriculture and commodities. In general, the perfectly competitive market is fairly close to what many markets experience. That being said, think about how bad the assumptions are being violated before applying the perfectly competitive market to a real world situation. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

10 Pro t Maximization Let s talk about pro t maximization. This is an extension of what we saw last time when we solved the producer s cost minimization problem. Now, we are letting the level of output be endogenous, or inside of the model. Basically, depending on the pro t level of the rm, they will choose how much output to make. Last time, we took that as a given. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

11 Pro t Maximization Recall our pro t function π = TR TC where TR stands for total revenue and TC stands for total cost. Producers want to increase their pro ts until they reach the maximum level possible, and then produce no more (as it will lead to a loss). Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

12 Pro t Maximization π π * q * q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

13 Pro t Maximization To nd this level of output, we need to know the rate of change of the pro t function. This is called the marginal pro t. To get the marginal pro t, we apply the power rule to the pro t function. Without de ning the total revenue or total cost functions, I can tell you that applying the power rule to total revenue will yield the marginal revenue and applying the power rule to total cost will yield the marginal cost. Our marginal pro t function thus looks like Mπ = MR MC where Mπ stands for marginal pro t, MR stands for marginal revenue, and MC stands for marginal cost. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

14 Pro t Maximization The marginal pro t tells us how much pro t we will receive for one more unit of output. Looking back at the gure, the rm will increase its production until it can get no more pro t by increasing their production any further. Thus, we say that in equilibrium, the marginal pro t has to equal zero. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

15 Pro t Maximization Mπ = MR MC = 0 Since marginal pro t has to equal zero in equilibrium, we can see our rst, and most important result. Taking our current equation and adding MC to both sides MR MC = 0 MR = MC Firms will produce until marginal revenue equals marginal cost. If I could bold this any stronger, I would. This is the most important rule in producer theory, and it holds regardless of market structure. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

16 Pro t Maximization This relationship is also very intuitive. Marginal revenue measures the amount of extra revenue the rm brings in for one more unit of output. It starts out pretty high, and diminishes as output increases. Marginal cost, as we saw yesterday, measures the amount of extra cost the rm incurs for one more unit of output. It starts out pretty low, and then grows quickly. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

17 Pro t Maximization When marginal revenue is greater than marginal cost, the rm could increase pro ts by increasing output since the increased revenue will o set the increased costs. When marginal revenue is less than marginal cost, the rm could increase pro ts by decreasing output since the reduced costs will o set the reduced revenue. Only when marginal revenue is equal to marginal cost is the rm maximizing its pro ts. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

18 Pro t Maximization When do rms actually want to produce? Naturally, when revenues exceed costs, a rm will want to produce. Duh. A rm will also want to produce at a loss if the loss they receive is less than their loss by not producing. Not as simple. Let s look at an example. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

19 Example Dunder Mi in is looking to see whether they should continue to sell high quality paper products in the short term, or shut down for a while to let Dwight cool o. By producing, their weekly revenue is $30,000, they incur a variable cost $15,000 and a xed cost of $20,000. Should Dunder Mi in produce? Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

20 Example Yes. Let s look at their pro ts when they produce π = TR TC = {z } Revenue {z } VC {z } = 5000 F so Dunder Mi in runs at a loss. However, if they don t produce, their pro ts are π = TR TC = {z} 0 Revenue 0 {z} VC {z } = F which happens because in the short run, their xed costs are sunk. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

21 Example How can we explain this? By producing, Dunder Mi in is covering all of their variable costs, the costs they incur solely from producing. Furthermore, they cover part of their sunk xed costs. This makes producing the best option for Dunder Mi in. If the total revenue were less than the variable costs, it would be better for Dunder Mi in to shut down, since producing would actually be at a loss. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

22 Short Run Perfect Competition When we de ned perfect competition, we de ned it as everyone is a price taker. No individual rm or consumer can in uence the equilibrium price. This implies that the short run demand curve is perfectly elastic, or horizontal. Firms can sell and consumers can buy as much of the product that they want to at the market price. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

23 Short Run Perfect Competition Thus, the total revenue for the rm is the market price, p, times the equilibrium output level, q. TR = pq Applying the power rule with respect to q, we have the marginal revenue MR = p Thus, under short run perfect competition Let s look at this graphically. MR = MC p = MC Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

24 Short Run Perfect Competition C/q MC AC AVC q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

25 Short Run Perfect Competition C/q MC AC AVC p q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

26 Short Run Perfect Competition C/q MC AC AVC p q * q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

27 Short Run Perfect Competition C/q Profit MC AC AVC p q * q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

28 Short Run Perfect Competition Intuitively, the output level corresponds to where the at price line intersects with the marginal cost curve. We can then take the di erence between the price and the average cost curves, multiply it by the equilibrium quantity, and that is our level of pro t for the rm. What would happen if price were below average cost? Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

29 Short Run Perfect Competition C/q MC AC AVC p q * q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

30 Short Run Perfect Competition C/q Loss MC AC AVC p q * q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

31 Short Run Perfect Competition Now, since price is below average cost, the rm operates at a loss per unit sold. The per unit loss of price minus average cost times the equilibrium quantity is the total loss. Note that due to the reduced price, the rm also scales back its production. Will the rm still want to produce? Let s see. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

32 Short Run Perfect Competition Recall that I said that a rm will want to produce as long as its total revenue is above it s variable costs TR > VC We can substitute TR = pq to obtain dividing both sides by q, and remember that VC q as long as the rm will want to produce. pq > VC p > VC q is the de nition of average variable cost, thus, p > AVC Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

33 Short Run Perfect Competition C/q Loss MC AC AVC p q * q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

34 Short Run Perfect Competition In the previous gure, the price was between the average cost and average variable cost curves. Thus, the rm will produce, accepting the small loss. This is better than not producing, since the entirety of the variable costs are being covered along with some of the xed costs. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

35 Short Run Perfect Competition In summary, a rm should shut down in the short run if and only if p < AVC Hopefully, the rm will be able to reallocate xed resources in the long run to correct for its negative pro ts in the short run. We would call the shutdown price for the rm. p = AVC Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

36 Oil Production This actually has a lot of applicability to the real world, and one modern market, in particular. In North America, lots of oil is obtained through shale rock extraction and oil sands. Forgive me for not knowing the proper names for these, I m an economist, not an oil guy. These processes are very costly compared to traditional drilling. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

37 Oil Production In late 2014, Saudi Arabia started ooding the global oil markets with crude oil, drastically driving down its price. To the Saudis, the cost of producing its oil is much lower than in North America. The lower price has caused shut downs in the majority of North American oil rigs, due to them not breaking even with their cost. Did the Saudis do this on purpose? Maybe. Word in the global oil markets is that it is going to take a long time for the price of oil to get high enough again for it to be pro table to drill in the shale and sands. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

38 Supply Curve By the way, we also just derived the short run supply curve. It was easy to miss. The short run supply curve is actually just the marginal cost curve when price is above average variable cost. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

39 Supply Curve C/q MC AC AVC q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

40 Supply Curve C/q S AC AVC q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

41 Example Consider a rm with total cost function TC = q + q 2 for a given value of price, p, what is the optimal output level? Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

42 Example TC = q + q 2 First, let s derive the average, average variable, and marginal cost functions. For average, we divide the total cost function by q AC = TC q = 30 q q For average variable costs, we ignore the xed cost of 30 and divide the rest of the total cost function by q AVC = 20 + q Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

43 Example TC = q + q 2 Lastly, the marginal cost, we apply the power rule to the total cost function with respect to q, MC = q In perfect competition, remember that p = MC = q Solving this expression for q gives our optimal output level q = p 2 10 Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

44 Example Here s a bit of a tougher question. What is the shutdown price? We know that the rm will shut down if p < AVC = 20 + q We solved for q already q = p 2 10 Substituting this into the rst expression gives p < 20 + p 2 10 Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

45 Example p < 20 + p 2 10 Rearranging terms, we have p 2 < 10 and solving for p gives our shutdown condition p < 20 Thus, any price less than 20 would cause the rm to shutdown. We would say that p = 20 is the rm s shutdown price since it is right on the border. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

46 Summary While theoretical, perfectly competitive markets give fair approximations to real world behaviors. It is important to determine how far from reality the perfectly competitive market is on a case by case basis. Firms and Consumers act as price takers in a perfectly competitive market, and rms make their output decisions based on the assumption that they can t in uence the market price. Marginal Revenue equals Marginal Cost. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

47 Preview for Wednesday Long Run Perfect Competition. Shifts in cost curves. Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

48 Assignment 4-4 (1 of 1) 1. Consider a rm with total cost function TC = q + 2q 2 a. Derive the average, average variable, and marginal cost functions. b. As a function of price, what is the optimal output level, q? c. Let p = 50. What is the equilibrium output level, q? How much does the rm make in pro ts (or loss)? Eric Dunaway (WSU) EconS Lecture 19 October 11, / 48

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