Market structures Perfect competition

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1 Market structures Perfect competition

2 Market Structures Market structure refers to the number and size of buyers and sellers in the market for a good or service. A market can be defined as a group of firms willing and able to sell a similar product or service to the same potential buyers.

3 Classification of market structures 4 broad categories 2. Perfect competition 3. Monopoly 4. Monopolistic competition 5. Oligopoly

4 Major features that determine market structure Number of sellers Product differentiation Entry and exit conditions

5 What we analyze in all Market Structures AR, MR AC, MC The point where MR = MC ( Profit maximum ) Q* ( Equilibrium Output ) P* ( Equilibrium Price )

6 Profit Normal Profit : That part of the cost that is paid to the entrepreneur as a part of his compensation. Super-normal Profit : The profit that the entrepreneur may get over and above the compensation he gets from the firm, for his contribution.

7 Perfect competition Features 2. Large number of buyers and sellers 3. Products are perfect substitutes of each other; homogeneous products 4. Free entry and exit from the market 5. Perfect knowledge of the market to both buyers and sellers 6. No govt. intervention 7. Transport cost are negligible hence don t affect pricing.

8 The Meaning of Competition As a result of its characteristics, the perfectly competitive market has the following outcomes: The actions of any single buyer or seller in the market have a negligible impact on the market price. Each buyer and seller takes the market price as given.

9 The Meaning of Competition Buyers and sellers in competitive markets are said to be price takers. Buyers and sellers must accept the price determined by the market.

10 Revenue of a Competitive Firm Total revenue for a firm is the selling price times the quantity sold. TR = (P X Q)

11 Revenue of a Competitive Firm Average revenue tells us how much revenue a firm receives for the typical unit sold.

12 Revenue of a Competitive Firm In perfect competition, average revenue equals the price of the good. Average revenue = = Total revenue Quantity (Price Quantity) Quantity = Price

13 Revenue of a Competitive Firm Marginal revenue is the change in total revenue from an additional unit sold. MR = TR/ Q

14 Revenue of a Competitive Firm For competitive firms, marginal revenue equals the price of the good.

15 Total, Average, and Marginal Revenue for a Competitive Firm Quantity Price Total Revenue Average Revenue Marginal Revenue (Q) (P) (TR=PxQ) (AR=TR/Q) (MR= T R / Q ) 1 $6.00 $6.00 $ $6.00 $12.00 $6.00 $ $6.00 $18.00 $6.00 $ $6.00 $24.00 $6.00 $ $6.00 $30.00 $6.00 $ $6.00 $36.00 $6.00 $ $6.00 $42.00 $6.00 $ $6.00 $48.00 $6.00 $6.00

16 Profit Maximization for the Competitive Firm The goal of a competitive firm is to maximize profit. This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost.

17 Short run price and output determination In SR a firm has to decide about the output it should produce at the market price so that profit is maximum. Some inputs are fixed=> fixed costs A firm may stay in business to cover these costs even if it incurs losses in SR Cost functions of firms are different as factors of production are not homogeneous Hence each firm has different profit levels.

18 Conditions for Profit Maximization MR = MC ( Necessary condition ) MCC should intersect MRC from below or MCC should be rising

19 Price and output determination for a perfectly competitive firm P S P MC AC P P * E * A AR = MR C B D Q Q * Q * Industry Firm Q

20 Firm has to take the price as given by the market At the ruling price firm can sell any amount of its product Demand is perfectly elastic AR is parallel to X axis Equilibrium is at pt. E where demand is equal to supply This determines the price P * This price is taken by the individual firm

21 Equilibrium for the firm is where MR =MC and MC curve cuts MR curve from below. I.e. at point A Profit in the short run is the P * ABC The firm may incur short run losses also. If the AC curve lies above the AR=MR curve the firm in the short run will incur losses.

22 Measuring Profit in the Graph for the Competitive Firm... Price A Firm with Profits P ATC Profit MC ATC P = AR = MR 0 Q Profit-maximizing quantity Quantity

23 Measuring Profit in the Graph for the Competitive Firm... Price A Firm with Losses MC ATC ATC P P = AR = MR Loss 0 Q Loss-minimizing quantity Quantity

24 Long run equilibrium of the firm and industry All factors are variable in the long run Hence all costs are variable Firm can change the plant and adjust the capacity according to the requirements of production If profits are supernormal, more firms enter the market and vice versa. Entry and exit of firms is possible

25 Long run equilibrium of the firm and industry If the number of firms increase, ( because they might be attracted towards the supernormal profits ), or the same firms increase their production, the supply curve moves to the right. At the same demand, this results in a decrease in price. If the number of firms decrease, ( because of losses ), or the same firms decrease production, the supply curve shifts to the left. At the same demand, this results in an increase in price.

26 Long run equilibrium of the firm and industry Hence, in the long run, supernormal profit is not possible and all firms have to survive at a Normal profit. This means that all the firms will stop production at the point where AC is lowest. This is also the price they will sell the goods at. Hence in the long run, firms have no incentive to expand or contract their production capacity or leave the industry and new firms have no incentive to enter the industry.

27 MR = MC in long run as well Under perfect competition, since MR =AR, in equilibrium also MC is equal to AR Price must also equal AC. P > AC => supernormal profits New firms enter the market If there are losses, firms will leave the market. Thus in the long run equality of P and AC becomes a necessary condition. Thus, P(AR) =MR =AC = MC in the long run

28 Long run

29 Economic Efficiency The fundamental economic problem is a scarcity of resources. Definition of Efficiency Efficiency is concerned with the optimal production and distribution or these scarce resources.

30 Types of Efficiencies There are different types of efficiency 1. Productive efficiency. This occurs when the maximum number of goods and services are produced with a given amount of inputs. This will occur on the production possibility frontier. ON the curve it is impossible to produce more goods without producing less services. Productive efficiency will also occur at the lowest point on the firms average costs curve

31 Types of Efficiencies 2. Allocative efficiency This occurs when goods and services are distributed according to consumer preferences. An economy could be productively efficient but produce goods people don t need this would be allocative inefficient. Allocative efficiency occurs when the price of the good = the MC of production

32 Types of Efficiencies 3. X inefficiency: This occurs when firms do not have incentives to cut costs, for example a monopoly which makes supernormal profits may have little incentive to get rid of surplus labor. Therefore a firms average cost may be higher than necessary

33 Types of Efficiencies 4. Efficiencies of scale This occurs when the firms produces on the lowest point of its Long run average cost and therefore benefits fully from economies of scale

34 Types of Efficiencies 5. Dynamic efficiency This refers to efficiency over time for example a Ford factory in 1920 would be very efficient for the time period but would now be inefficient by comparison therefore it is necessary for firms to constantly introduce new technology and reduce costs over time

35 Types of Efficiencies 6. Social efficiency This occurs when externalities are taken into consideration and the social cost of production (SMC) = the social benefit (SMB)

36 Types of Efficiencies 7. Technical Efficiency Optimum combination of factor inputs to produce a good: related to productive efficiency.

37 Efficiency of Perfect Competition 1. Allocative Efficient. This is because P = MC 2. Productive Efficient. This is because firms produce at the lowest point on the AC 3. X Efficient. Competition between firms will act as a spur to increase efficiency 4. Resources will not be wasted through advertising because products are homogenous 5. Normal profit means consumers are getting the lowest price. This also leads to greater equality in society

38 Disadvantages of Perfect Competition 1. No scope for economies of Scale, this is because there are many small firms producing relatively small amounts. Industries with high fixed costs would be particularly unsuitable to perfect competition. This is one reason why p.c. is unlikely in the real world 2. Undifferentiated products is boring giving little choice to consumers. Differentiated products are very important in industries such as clothing and cars 3. Lack of supernormal profit may make investment in R&D unlikely this would be important in an industry such as pharmaceuticals which require significant investment 4. With perfect knowledge there is no incentive to develop new technology because it would be shared with other companied 5. If there are externalities in production or consumption there is likely to be market failure without govt intervention Competitive Markets

39 In the real world perfect competition is very rare and the model is more theoretical than practical. However in general economists often talk about competitive markets which do not require the strict criteria of perfect competition. A competitive market is one where no one firm has a dominant position but the consumer has plenty of choice when buying goods or services. Therefore in competitive markets we would expect 1. Firms to have a small share of the market 2. Few barriers to entry 3. Low prices for consumers 4. Allocative efficiency 5. Incentives for firms to cut costs and develop new products 6. Profits will be lower than in markets with Monopoly power This is linked closely to the idea of Contestable markets which is concerned with low barriers to entry and freedom of entry.

40 Monopoly A monopoly has only one seller, who is able to influence the total supply and price of the goods and services. Further, there are no close substitutes for the goods produced by the monopolist and there are barriers to entry.

41 Main factors that lead to monopoly are: Ownership of strategic raw materials and exclusive technical know-how Possession of product/process patent rights Acquisition of government license to procure certain goods High entry costs The size of the market may not allow more than one firm to exist. Hence, the market creates a natural monopoly. Thus, the government usually supplies and produces the commodity to avoid consumer exploitation