Chapter 5: Competitive markets

Transcription

1 Chapter 5: Competitive markets The Assumptions of Perfectly Competitive Market are: - 1) All firms under perfect competition are price takers: - All firms and consumers are small compared to the size of the market. No one of them has any market power, and they are price taker. If the firm raises its price above the market level, it would lose sales to competitor. Firms can only choose how much output to sell, rather than choosing a combination of quantity and price. All buyers and sellers of the exactly same (identical) product know perfectly (perfect information) where the product is available and what is the price of that identical product. Price taking: a price taker is a firm or consumer whose output or demand is so small relative to the market that it has no effect on the market price. 2) Buyers and sellers have perfect information: - In perfect competition all buyers and sellers of the same (identical) product know perfectly (perfect information) where the product is available and what is the price of that identical product. 3) Products are homogeneous or products are identical Buyers can see nothing to differentiate one firm s product from another s. So if firms are to be price takers, products must be homogeneous in the markets in which they sell. 4) There is freedom of market entry and exit In a perfect competition new firms are free to enter the market and there will be no restriction for entering. On the other hand, the firm which is making a loss is free to leave the market rather continue producing. This is most likely to be the case when minimum efficient scale is small; costs are relatively low, and economies of scale will not pose an entry barrier. All assumption must exist to consider as a perfect competition. Competitive Firm s Demand Curve: - What do you think competitive demand curve looks like? What do you think the demand curve facing a price-taking firm will look like? Why perfectly competitive firm s demand curve is horizontal? The perfectly competitive firm is so small compared to the industry and it s a price taker; so its demand curve is horizontal; indicating it has no power at all about what price to charge and it's a price taker. (Below is the demand curve of a single firm under perfect competition). 1

2 What is the price elasticity of demand of a horizontal demand curve? The market determines the price of products service and the firm determines only how much to sell. When a firm s demand curve is horizontal, the price elasticity of demand (PED) of such demand curve is perfectly elastic. % Q %ΔQ PED Now for a horizontal demand curve % P 0, this means PED = = infinitely large. % P 0 When PED is infinitely large, we call it a perfectly elastic. The competitive firm output decision: - When a demand curve is horizontal, the demand curve (D) is same as the marginal revenue (MR) curve. Remember from last chapter: TR TR TR P Q AR P MR Q Q (AR) is always is the price (P) or demand curve (D) is always the (AR) revenue curve. But for a horizontal demand curve; demand curve is also MR curve as shown below: The following table shows the calculations of (MR) and we can see from the table that P = AR = MR for a horizontal demand curve. Price Quantity Total Revenue Average Marginal ( ) (Q) (TR) Revenue (AR) Revenue (MR) (MR) is the change in (TR) due to a unit change in quantity. In the table P = AR = MR = 7. يعني اذا قال بسؤال انه وحده من هذيل MR( p(,ar, = 7 وقال انه الشركة بال perfect competitive market تحطون ال) MR,p( AR, نفس الرقم اذا كان طالبهم Competitive Firm s Profit Maximizing Output: - Like monopoly market a firm under perfect competition should produce the quantity of output at which marginal cost (MC) of production is equal to the marginal revenue (MR), that is, a firm s profit maximizing condition is: MR = MC For all firms if MR is greater than MC, the firm will increase profits by producing and selling more output. Conversely, if MR is less than MC, the firm can increase its profits by reducing output. Note: In a table if you do not have any quantity at which MR = MC, then keep on choosing higher quantity at which at least MR > MC that will give the maximum profit in the table. يعني بالجدول اذا ما كان في quantity يكون فيها ال MR = MC اختاروا ال quantity الي بيكون فيها ال.MC اكبر من ال MR 2

3 Exercise 5.1 Output TC (a) Derive MC (b) If the market price is 7, what output maximizes profit? بنطلع الحل من قوانين المدتيرم - Solution: Q P TR MR TC MC Profit Firm produces Q = 6 units at which MR = MC = 7 and maximum profit = 6. Note profits are same at Q = 6 and Q = 5, choose always higher quantity as Q = 6 here. Also note that for a competitive firm (P = MR). So, the profit maximizing condition of a competitive firm will be (P = MR = MC) Or (P = MC) This condition is illustrated in the figure below. Profit is maximized at quantity Q at which P = MC.AT quantity Q1, P = MR is greater than MC, so the firm should increase quantity till Q. On the other hand, at quantity Q2, P is less than MC, so the firm should decrease quantity till Q. So, the only profit maximizing quantity is Q at which P = MC. 3

4 Sometimes a firm in a competitive market produces with a loss in the short run because it may incur more loss if it shuts down or don't produce (Q = 0). A firm s profit is maximized or loss is minimized as long as MR is greater or equal to MC, and the shut down condition is: 1) The firm will not shut down in the short run even with a loss as long as (P > minimum AVC). 2) Firm will shut down if (P Minimum AVC). هون الزم الشركة تقرر اما تكمل انتاج بال short run او توقف وتسكر الشركة على حسب الحالتين السابقتين Exercise 5.2 Q P TR MR TC MC TVC AVC Profit Here we supposed P = 3.1 > minimum AVC = 3. Any quantity firm produces it makes a loss. If the firm doesn't produce any quantity (Q = 0) or shuts down, its loss is = On the other hand if it produces Q = 4, its loss is minimum which is equal to So, in this case the firm will not shut down in the short run but will produce Q = 4 units. Note at Q = 4, MR MC = 3 and P > minimum AVC of 3. هون الشركة باي كمية تنتجها الشركة عم تخسر مثل ما مبين بال profit كل االرقام بالسالب, الحين اذا الشركة قررت ما تنتج وتسكر الشركة رح يكون خسارتها اول رقم بعمود ال 12-.profit= واذا الشركة انتجت بكمية = 4 رح يكون عندها خساره ناخذها من عمود ال profit= بهالحالة الشركة ما رح تسكر ورح اضل تنتج بال short run بالكمية = 4 النه فيها ال p اكبر من ال,minimum AVC وخسارتها =11.6- اقل من خسارتها اذا سكرت= 12- Exercise 5.2 Q P TR MR TC MC TVC AVC Profit Now suppose P = 2.9 < min. AVC = 3 and in that case again at any quantity firm makes a loss. If the firm doesn't produce any quantity (Q = 0) or shuts down, its loss is On the other hand if it produces all losses are greater than So, in this case the firm will shut down and production is Q = 0 and this is because as we mentioned above P minimum AVC. هون الشركة رح توقف انتاج وتسكر وتكون خسارتها= 12 - النه بكل الحاالت خسارتها بتكون اكبر من خسارتها اذا سكرت. ودايما خسارة تسكير الشركة بتكون اول وحده بعمود ال.profit The Supply Curve of the Perfectly Competitive Firm: - The supply curve: supply curve of a firm shows how much the firm will supply at each market price. Similar to the demand curve: that shows how much consumers will buy at each price. 4

5 The figure below shows the profit-maximizing quantities; Q1 and Q2. It shows that a competitive firm supplies Q1 if the market price is P1. And Q1 gives the profit maximizing quantity because at Q1 (P1 or MR1 = MC). Similarly, the firm will supply Q2 if the market price is P2 were (P2 or MR2 = MC). This means rising part of the MC curve is a supply curve of competitive firm because it shows how much the firm will supply at each price. Short-Run Supply Curve of a Perfectly Competitive Firm: - Note: not all rising part of the MC curve is a supply curve, only a certain rising part of MC curve is a supply curve. To see this, remember we discussed that in the short-run: (TC = TFC + TVC) and if we divide by quantity we get (AC = AFC + AVC). Where AC = SRAC is the short-run average cost, and AFC = SRAFC is the shortrun average fixed cost and AVC = SRAVC is the short-run average variable cost. Types of cost in the short run are: - 1) Fixed costs: are those costs which are not varying with the level of output in the short run; such as the rent on factory buildings. 2) Variable costs: are the costs of those factors of production that vary with the level of output, such as the price of raw materials and the wages paid to labour. 3) Total costs: comprise both fixed cost and variable cost elements. In the figure below a firm s short-run MC, average cost (AC) and average variable cost (AVC) curves are drawn. MC = SRMC, AC = SRAC, and AVC = SRAVC, where SR means short-run. MC curve intersects at the minimum point of both AC (SRAC) and AVC (SRAVC) curves. At quantity Q1, price P1 is equal to minimum SRAVC, the firm is selling at a price equal to the per unit variable cost. Any price below P1 would be less than per unit variable cost, then the firm will not supply any output at any price below P1. Red line is the supply curve which is MC above minimum AVC. 5

6 -Point B is the break-even point at which (Profit = TR TC = 0) or (TR = TC). Any output between points F and B, firm will produce (not shut down) in the short-run but with a loss. Any price below P1 (or Q < Q1), the firm shuts down (closes). -If the price is P2, the firm will supply Q2; however, the firm will incur loss in the short-run but still will supply Q2 because the price is higher than SRAVC. That is, a firm in the short-run can't do anything about the fixed cost, but if it can cover the variable cost, it will produce even with a loss. -If the price is P3, the firm will supply Q3, the firm now earn normal or zero profit because P = AC means profit is zero. That is, at P3, the firm covers both fixed and variable cost so that total revenue is total cost. Or (price or average revenue equal to AC (P or AR =AC)). -Any price above P3, the firm will supply with a profit. But also note that the firm is all the time supplying P = MC, that is MC determines its supply. That means; the MC curve starting from the minimum SRAVC curve (point F) is the firm s supply curve. So the part of the MC curve market by red line is the firm s short-run supply curve. Short-run supply curve: the Short-run supply curve of the perfect competitive firm is that part of the short-run marginal cost curve above the short-run average variable cost curve. Long-Run Supply Curve of a Perfectly Competitive Firm: - In the long-run, there is no fixed cost. All costs are variable costs, so the long-run average cost (LRAC) is same as long-run average variable cost (LRAC = LRAVC). Because a firm s supply curve is the marginal cost above average variable cost. What distinguish the long run from the short run cost curves of firms? 1) In the long run, the firm is able to vary all its inputs. 2) There are no fixed costs. 3) The long-run average cost curve varies in shape depending on the technology the firm is using. 4) (LRMC) curve, and the (LRAC) curve, is flatter than the short-run curves. Deriving the long-run supply curve (LRMC) curve, and the (LRAC) curve, is flatter than the short-run curves, the reason is that costs can be reduced in the long run by adjusting capacity as output rises, this is the MES and marks the level of output at which long-run costs are minimized. The firm will produce where price equals LRMC provided that price is not below LRAC. This means the firm's long-run supply curve: is that part of the LRMC curve above minimum average costs (red line). As shown in the figure below. 6

7 Market Demand, Supply and Equilibrium: - We have seen that an individual firm s demand curve under perfect competition is horizontal which means a firm is so small compared to the whole industry, it becomes a price taker or it can't influence the market price. Remember Industry: is a collection of firms. One firm can't influence the price but all firms together or industry as a whole or market as a whole can influence the price. So, a firm s demand curve is horizontal but the market or industry demand curve is downward slopping demand curve, as shown in the Figure below. We have also seen that supply curve of a firm is marginal cost (MC) starting from the minimum average variable cost curve. The industry supply curve will be supply of all firms together. Remember; if price increases each firm will supply more (upward sloping) which means both the firm and the industry or market supply curve also the upward sloping supply curve as shown in the middle figure below. It shows the market or industry demand curve as downward sloping curve and also shows the market or industry supply curve as upward sloping curve. Also in the middle figure below, demand and supply curves intersects at point A and it is called equilibrium point: at which quantity demanded is equal to quantity supplied. So, price P0 is the equilibrium price and quantity Q0 is the equilibrium quantity. Equilibrium quantity means quantity demanded by the consumers will be equal to quantity supplied by the firms. Any price above equilibrium price, quantity supplied will be larger than quantity demanded and there is excess supply in the market and price will decrease to equilibrium price. Any price below equilibrium price, quantity demanded will be larger than quantity supplied and there is excess demand in the market and price will increase to equilibrium price. 0 A Q0 Consumer demand Market equilibrium Firm's supply 7

8 Changes in Market Conditions: - For demand curve if the price of a good changes, there will be movement along the supply curve. If factors such as weather, technology, and cost of production (other than price) change, the entire supply curve will shift to the right or left. Also note: supply curve shifts to the left means decrease in supply and supply curve shifts to the right means increase in supply. For example, bad weather or cost of production increase means supply decreases and supply curve shifts to the left from S1 to S2, as shown in the figure below: - We see that when bad weather or cost of production causes supply decreases and supply curve shifts to the left from S1 to S2, the equilibrium or market price increases to P2. This is because when supply decreases, it immediately at the initial price P1 creates excess demand equal to (Q1 Q3) and the excess demand makes the price increase to P2. In other words, supply decrease causes price to increase. And when supply increases due to good weather or due to better technology, the supply curve shifts to the right from S1 to S2 and the equilibrium price will decrease as shown in the figure below: - We see that when new and better technology reduces cost of production, supply increases and the supply curve shifts to the right from S1 to S2, the equilibrium or market price decreases to P2. This is because when supply increases, it immediately at the initial price P1 creates excess supply equal to (Q2 Q1) and the excess supply makes the price decrease to P2. In other words, supply increase causes price to decrease. ممكن يجي سؤال انو شو يصير لكيرف السبالي اذا صار في تطوير بالتكنولوجيا او اذا صار الجو سيئ تجاوبون على حسب المعطى اما يصير excess supply او excess demand مثل المثالين السابقين. 8