Perfect Competition, Profits, Supply

Chapter 9

Costs and Supply Decisions

• How much should a firm supply?– Firms and their managers should attempt to

maximize profits (Revenues – Costs)– Select a pricing strategy that induces a

demand for a product that generates highest revenue relative to the cost of production of that level of supply.

• Profits depends on response of revenues to changes in production quantities.

Perfect Competition/ Price Taking

• We think of some markets as characterized by perfect competition– In competitive markets, no firm has the market

power to set their own price.

• Firms in perfectly competitive markets take their price as given.

• Demand curve for an individual producer of a commodity is perfectly elastic.

China Price Download

Characteristics of Competitive Markets

• Non-differentiated goods

• Large number of firms

• All firms are small relative to the market

• Free entry and exit.

Name some competitive markets in HK

Name some uncompetitive markets

MES and Market Structure

• If MES is relatively small in comparison with market demand:

$

Q

Many “small” firms in the market.

Revenues and Perfect Competition

• Revenues = Price * Quantity

• Average Revenue = Price

• Marginal Revenue is the extra revenue generated by selling an extra good. – If production by a firm doesn’t shift the price,

marginal revenue is the price.

Profits

• Profits = Revenues – Total Costs

• Remember, total costs includes economic costs.

Profit Maximization: Short Run• In the short-run, firm may only have a limited

number of avenues along which they may vary production.

• Cost of producing each good is likely to increase. But as long as the extra revenue that the good brings in exceeds the extra cost, it will be profitable to produce it.

• Maximize profits by producing up to that point that price is equal to marginal cost. Beyond that, producing more goods only subtracts from profits.

Increase Production until marginal cost reaches the price level.

Q

P

ATC

MC

P

Q*

Revenues are price × quantity

Q

P

ATC

MC

P

Q*

Revenues

Profits are Revenues - Costs

Q

P

ATC

MC

P

Q*

Profits

Costs

Profit Maximization: Price is 80

Output Average Total Marginal Marginal

(Loaves) Costs Costs Revenues Revenues Profits

0.00 0.00 -1000.0015.00 80.00

10.00 115 800.00 -350.0035.00 80.00

20.00 75 1600.00 100.0055.00 80.00

30.00 68 2400.00 350.0075.00 80.00

40.00 70 3200.00 400.0095.00 80.00

50.00 75 4000.00 250.00115.00 80.00

60.00 82 4800.00 -100.00

What if prices drop?

Q

P

ATC

MC

P

Q**

-Profits

Costs

P'

Breakeven point

• The average total cost of production (when marginal cost equals price) is above the new lower price. – If the firm sets production at a level such that

price equals marginal cost, but that is the best they can do in the short run.

– Firms only decision is to vary production costs along those dimensions that are available.

• Should the firm shut down?– No. The firm has paid costs which cannot be

retrieved [SUNK COSTS]. Since the firm cannot change this, they should ignore these sunk costs in making their marginal decision.

– As long as prices exceeds variable costs, produce.

Profit Maximization: Price is 60

Output Average Total Marginal Marginal

(Loaves) Costs Costs Revenues Revenues Profits

0.00 0.00 -1000.0015.00 60.00

10.00 115 600.00 -550.0035.00 60.00

20.00 75 1200.00 -300.0055.00 60.00

30.00 68 1800.00 -250.0075.00 60.00

40.00 70 2400.00 -400.0095.00 60.00

50.00 75 3000.00 -750.00115.00 60.00

60.00 82 3600.00 -1300.00

When should the firm stop production in the short-run?

Q

P

ATC

MC

P

Q**

P'

Breakeven point

AVCDropout point

Adjustment in the Long Run

• In the longer run, firms are able to adjust the size of their plant. (adjust the number of machines in the factory, adjust the number of oil rigs).

• If profits are positive. Firms will seek to build new equipment as they compete for profits.

• If profits are negative, firms will shut down equipment and sell it, or possibly go out of business.– Firms will adjust their physical plant until they are

making profits again.

Profit maximization and the supply curve

• In the short-run, firms produce up to that point where price equal marginal cost.

• Supply curve is the sum of the supply curves of the different firms in the market.

• In the long-run, capacity will be adjusted to the point where profits are zero (i.e. where marginal cost equals average total cost).

• Long run ATC curve is collection of points where MC = ATC and is the long-run supply curve.

Firm Level Supply Curve: Short Run

Output

SR ATC

MC

P

P*

SFirm 1

In the short run, MC curve is the relationship between firm price and production

Firm Level Supply Curve: Short Run

Output

SR ATC

MC

P

P*

SFirm 2

Industry Level Supply Curve: Short Run

Output

P

SFirm 1

In the short run, the sum of the MC curves is the relationship between price and industry production

+SFirm 2 +SFirm 3 SIndustry

Short Run Response to Increase in DemandIncrease Variable Inputs

SIndustry

Output

PD

Q*

P* D'

Q**

P**

1

2

Firm Level Supply Curve: Short Run

Output

SR ATC

MC

P

P*

SFirm 1

In the short run, MC curve is the relationship between firm price and production

P**

q* q**

1

2

Short-run profits attract new entrants

Output

SR ATC

MC

P

SFirm 1

In the short run, MC curve is the relationship between firm price and production

P**

q* q**

Profits

Profits2

New Entrants in the Long RunSupply Increases and Price Drops

SIndustry

Output

PD

Q*

P* D'

Q**

P**

+SFirm N+ 1

P**

Q***

1

2

3

Firm Level Response to New Entrants: Reduce Output

Output

SR ATC

MC

P

P*

SFirm 1

In the short run, MC curve is the relationship between firm price and production

P**

q* q**

P***

q***

1

2

3

New Entrants as Long as Profits at MESSupply Increases and Price Drops

SIndustry

Output

PD

Q*

P* D'

Q**

P**

+SFirm N+ 1

P**

Q***

1

2

3

+SFirm N+ J

4

Q****

Firm Level Response to New Entrants: Reduce Output

Output

SR ATC

MC

P

P*

SFirm 1

In the short run, MC curve is the relationship between firm price and production

P**

q* q**

P***

q***

1,4

2

3

Long Run, Supply is Flat along MES of New Entrants

SIndustry

Output

PD

Q*

P* D'

Q**

P**

P**

Q***

1

2

+SIndustry

4

Q****

SLR

Long Run Supply Curve

• If all firms are exactly the same, then new firms have same MES as old firms and supply curve is flat.

• In some cases, like oil drilling, new firms may have higher MES than old firms and supply curve is upward sloping.

• Long run supply curve is flatter, more elastic than short-term supply curve.

Long Run Equilibrium

• Firms are making zero profits.

• Firms will be producing at their minimum efficient scale and at a minimum of ATC

Learning Outcomes

Students should be able to • Characterize a perfectly competitive market.• Calculate total revenue, marginal revenue and

profit for a firm in a competitive market.• Describe the supply curve in a competitive

market in both the short and long run.• Explain economies of scale and compare the

effects of demand on price in a competitive market with increasing, decreasing, and constant costs.