Perfect Competition

Sometimes referred to as Pure Competition or just The Competitive Firm

Market Structure The specific market structure

determines their pricing and output production.

Background on Markets

When economists analyze the production decisions of a firm, they take into account the structure of the market in which the firm is operating.

Four Different Market Structures: Perfect Competition Monopoly Monopolistic Competition Oligopoly

Market Model Price/Output

Market economy has 4 models and they all vary from one seller to many sellers…

None is “typical.”

Each unique and attempting to operate with his “self-interest” in mind.

Each will work towards MC=MR

(Profit Maximizing point and loss minimizing point.)

Market structure characteristics

All four market structures have four distinguishing characteristics:

The number and size of the firms in the market. The ease with which firms may enter and exit the

market. The degree to which firms’ products are

differentiated. The amount of information available to both

buyers and sellers regarding prices, product characteristics and production techniques.

Characteristics of Pure Competition

(1) There are many sellers and many buyers, none of which is large in relation to total sales or purchases.

(2) Each firm produces and sells a homogeneous product.

(3) Buyers and sellers have all relevant information with respect to prices, product quality, sources of supply, and so on.

(4) There is easy entry into and exit from the industry.

Perfect Competitive Market There are very few if any competitive

markets. Why teach about a non-existent form

of competition? Many firms actually function as

purely competitive.

Questions to answer:

When is a firm making a profit? What are the unique characteristics of

competitive firms? How much output will a competitive

firm produce? When will competitive firm maximize

profits? When will the competitive firm shut

down?

A Perfectly Competitive Firm is a Price Taker – Why?

A seller that does not have the ability to control the price of the product it sells; it takes the price determined in the market.

Competitive Markets

If an industry is profitable, it lures in new firms and existing firms expand. Supply shifts right.

This causes price to fall and profits to decline.Some firms, both old and new, fail and

close.

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The Demand Curve of the Perfect Competitor Question

If the perfectly competitive firm is a price taker, who or what sets the price?

Answer - The Market

The Demand Curve - continued The perfectly competitive firm is a

price taker, selling a homogenous commodity with perfect substitutes.

Will sell all units for $5

Will not be able to sell at a higher price

Will face a perfectly elastic demand curve at the going market price

The Demand Curve for a Producer of Secure Digital Cards

How Much Should the Perfect Competitor Produce? (cont'd)

P determined by the market in perfect competitionQ determined by the producer to maximize profit

TR = P x Q

Profit = Total revenue (TR) – Total cost (TC)

TC = TFC + TVC

Profit Maximization

Take a personal look? How many of you owned a computer 15 years

ago? How many own a compact disc player today? How many have discarded the VCR in favor of a

another digital tool? Do you own an Ipod? Do you own an IPhone? Do you own an Ipad? Do you own a Blackberry? Do you own a graphing calculator? Did your parents have a graphing calculator? How did your parents type project papers for

economics class?Competition has brought the above changes

about.

Price Taker Discussion

When there are many firms, all producing and selling the same product using the same inputs and technology, competition forces each firm to charge the same market price for its good.

Because each firm sells the same homogeneous product, no single firm can increase the price that it charges above the price charged by other firms in the market (without losing business.)

No single firm can affect the market price by changing the quantity of output it supplies- because many firms- each firm is small in size.

Demand CurveIndividual firm/industry

The perfect competitor faces a horizontal or perfectly elastic demand curve.

The demand curve is identical to the Marginal Revenue Curve (because the firm can sell as much as it wants to sell at market price.) It is not necessary to lower the price to sell more.

The demand curve for the entire industry slopes downward (this is a result of aggregate entries and exits into the market.)

Demand Curve

Market Demand Curves vs. Firm Demand Curves

While the actions of a single competitive firm are negligible, the unified actions of many such firms are not.

The individual firm’s equilibrium quantity of output will be completely determined by the amount of output the individual firm chooses to supply

Profit Maximization

Quantity (bushels per day)0 1 2 3 4 5 6 7

2

4

6

8

10

12

14

16

$18

Pric

e or

Cos

t (p

er b

ushe

l)

Marginal cost

Price (= MR)

Profit-maximizing rate of output

MCB

MRB

p = MC Profits decreasing

Profits increasing

Profit Maximization

SHORT RUN

In the short-run, individual firm may make profit or loss

In long run will break even You can always tell if the firm is making a profit

or loss by looking at the DEMAND CURVE AND THE ATC CURVE

If the demand curve is ABOVE the ATC curve at any point the firm will make a profit.

If the demand curve is always BELOW the ATC curve the firm will lose money.

• In the short run, the price taker will expand output until marginal revenue (price) is just equal to marginal cost.

• When P > MC then the firm can make more on the next unit sold than it costs to increase output for that unit. In order for the firm to maximize its profits it increases output until MC = P.

Profit Maximization when the Firm is a Price Taker

• This will maximize the firm’s profits (rectangle BACP). d (P = MR)

Price

Output/ Time0 q

ATC

MC

• When P < MC then the firm made less on the last unit sold than it cost for that unit. In order for the firm to maximize its profits it decreases output until MC = P.

Profit

p = MC

AC

PB

P > MC

Increase qP < MC

decrease q

• In the graph to the right, the firm operates at an output level where p = MC, but here ATC > MC resulting in a loss for the firm.

• A firm experiencing losses but covering its average variable costs will operate in the short-run.

Operating

• The magnitude of the firm’s short-run losses is equal to the size of the of the rectangle BACP1

d (P = MR)

Price

Output/ Time0 q

ATCMCLoss

ACP1 B

AVC

P2

p = MC• A firm will shutdown in the short-run whenever price falls below average variable cost (P2).• A firm will shutdown in the long-run whenever price falls below average total cost.

For the perfect competitor in the LR, the most profitable output is at the minimum point of its ATC curve.

The firm is forced to operate at peak efficiency and that is why it operates at the minimum of its ATC curve.. Not anything to do with virtue------- just competition.

Total Revenue

Total revenue

0 1 2 3 4 5 6 7 8 9 10 11 12

pe= $8816243240485664728088

$96

Quantity

Tot

al R

even

ue

Most profitable point for any firm

Profit maximization is where MC = MREfficiency:A firm operates at peak efficiency when

it produces its product at the lowest possible cost… That would be at the MINIMUM POINT OF ITS ATC CURVE – the break even point.

Profit-Maximization Rule Profit is maximized by producing the

quantity of output at which MR = MC. For Perfect Competition, profit is

maximized when P = MR = MC* * This condition is unique for perfect

competition and does not hold for other market structures.

Realization

Marginal Cost A firm’s goal is not to maximize revenues, but to maximize profits.

Marginal revenue is compared to marginal costs to determine the best level of output.

What an additional unit of output brings in is its marginal revenue (MR).

Remember… Firm Demand Curve is Different from Industry’s Demand Curve

Output / Time

Price

Output / Time

Price

MarketSupply

MarketDemand

PPDemand forSingle Firm

Individual firms musttake the market price.

Entry and Exit• It is easy to enter or exit an industry in perfect

competition.– If more firms enter (lured in by economic profits),

the market supply curve shifts right and price falls.

– As price falls, economic profits decrease and approach zero.

• Entry will cease.• Some firms could be making losses by this time.• Many will cut back output or exit.• If so, the supply curve shifts back to the left and the

price rises.

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Long Run

In the long run there is time for firms to enter or leave the industry. This factor ensures that the firm will make ZERO profits in the long run.

Short- vs. Long-Run Equilibrium

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Profit- what kind is it???

Pure Profit -an amount above that necessary to keep the owner in the industry… is not considered part of total cost

Pure profit is the residual after all costs (including normal profit) have been met

Pure profit will attract other firms into the market

Normal Profit will not induce firms into the market- nor are they low enough to force others to leave.. Breaking even..

Long Run

In the LR, no firm will accept losses.

It will simply close up shop and go out of business.

But also remember – one firm leaving the industry WILL NOT affect market price.

Market Entry

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Profit Squeeze

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Factor Costs

Factor costs mean wages, rent and interest- are far the most important determinants of whether costs are falling, constant or increasing.

Usually factor costs will eventually rise which makes every industry an increasing costs industry. Example: as more and more land is used by an expanding industry, rent will be bid up…

Time influences supply: Whether industry is in SR or LR …all can adjust in LR if desire to do so.

LR Continued

If one firm is losing money, presumably others are too.

When enough firms go out of business, industry supply declines which pushes price up…

This price rise is reflected in a new demand curve for the individual firm.

P D1 D2 S1

Q

S2

OP I

NPI

OPI = Original Price for individual ; NPI = new price for individual

Rules for Entry and Exit

If P > ATC, economic profits exist. Enter the industry or expand capacity.

If P < ATC, economic losses exist.Reduce capacity (or exit if P < AVC).

If P = ATC, economic profits are zero.Maintain existing capacity (no entry or

exit).

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Lower Costs: Improve Profits and Stimulate Output

• If a firm lowers its costs of production, it will encourage increases in output.

• The cost curves fall, and MC appears to shift right.

• Profit maximization occurs at point J before and point N after the reduced costs take effect.

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The Decision to Shut Down in the Short Run

Firms can’t always make a profit Ski resort in summer Surf shop in winter

Shutting down Firm will shut down if it

cannot cover variable costs Shutting down is not the

same as going out of business and exiting the industry

Shutdown point for a firm

A firm compares total revenue with total cost to see what its profit or loss is.

Remember there are fixed and variable costs. Fixed costs have to be paid whether

operating or not. Suppose: a firm’s total cost is $300,000 at a

certain level of output. $200,000 made up of variable costs,such as labor and raw materials and $100,000made up of fixed costs such as interest payments, taxes, and rent.

Shutdown Continued

If the firm’s total revenue is $240,000 it is clearly taking a loss. The difference between TR and TC in this case is $60,000.

Notice that the total revenue of $240,000 pays all of the firms variable costs ($200,000) and also pays $40,000 of its fixed cost. If the firm were to shut down on the other hand, its loss would total $100,000- the amount of the fixed cost.

Shutdown

If competition drives price below AVC for a firm, it will shut down and exit the industry.If the exiting firm has inventory, it will

dump that inventory on the market at a reduced price.

This will cause the industry price to drop further, possibly causing losses for other industry firms.

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The Competitive Process(this is the market- not the individual)• Competitive forces drive the product’s

price down, making it more affordable to more consumers. Thus the market expands.

• Also, competitive forces spur firms to improve quality, add features, and look for lower costs.

• This is the market mechanism at work.– Market mechanism: the use of market

prices and sales to signal desired outputs (or resource allocations).

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Shutdown Continued

As long as a firm can cover ALL of its variable cost by remaining in operation, it will do so.

****It’s shutdown point will be where TR no longer covers TVC.

Shutdown: when MR falls below the firm’s minimum AVC. When a firm shuts down, it does not necessarily leave the industry. Shutdown is a SR response…and is based on fixed costs of established plant and variable costs of operating it.

Profit Maximization and Loss Minimization for the Perfectly Competitive Firm: Three Cases I

In Case 1, TR TC and the firm earns profits.

It continues to produce in the short run.

In Case 2, TR < TC and the firm takes a loss.

It shuts down in the short run because it minimizes its losses by doing so; it is better to lose $400 in fixed costs than to take a loss of $450.

Profit Maximization and Loss Minimization for the Perfectly Competitive Firm: Three Cases II

In Case 3, TR < TC and the firm takes a loss.

It continues to produce in the short run because it minimizes its losses by doing so; it is better to lose $80 by producing than to lose $400 in fixed costs by not producing.

Profit Maximization and Loss Minimization for the Perfectly Competitive Firm: Three Cases III

What Should a Perfectly Competitive Firm Do in the Short Run?

The firm should produce in the short run as long as price (P) is above average variable cost (AVC).

It should shut down in the short run if price is below average variable cost.

Output

Price

Market

DOutput

Price

Firm

Long-run Equilibrium• The two conditions necessary for long-run equilibrium in a price-taker market are depicted here.

• Second, the firms in the industry must earn zero economic profit (that is, the “normal market rate of return”) at the established market price (P1 below).

MC

q1 Q1

• First, the quantity supplied and the quantity demanded must be equal in the market, as shown below at P1 with output Q1.

ATC

P1 d

Ssr

P1

In competitive markets, economic profits attract new entrants.

Low entry barriers permit new firms to enter competitive markets.

The entry of new firms shifts the market supply curve to the right.

As long as economic profits are available in short-run competitive equilibrium, new entrants will continue to be attracted.

p = MCShort-run competitive

equilibrium:

The Lure of Profits

Signaling

Profits and losses act as signals to firms

SignalsConvey information about

the profitability of various marketsPositive profits

• A signal of profitability. More firms will enter the industry.

Negative profits (losses)• A signal that resources could be doing better

elsewhere. Firms will exit the industry.

The Competitive Process

If economic profits are high, consumers are willing to pay more than the opportunity cost of resources to acquire a product. It signals they want more of that industry’s

goods. Profit-seeking producers respond by

producing more to satisfy consumer demand.

This is allocative efficiency: the industry will end up producing the right output mix.

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The Competitive Process If economic profits are negative (losses),

consumers are unwilling to pay the opportunity cost of resources to acquire a product. It signals they want fewer of that industry’s goods.Profit-seeking producers respond by producing

less to satisfy a waning consumer demand.This is also allocative efficiency: the industry will

end up producing the right output mix.

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A Shift of Market SupplyAny short-run equilibrium will not last.

As supply increases, price drops, to the minimum of ATC.

Once at minimum of ATC, there are no longer economic profits to attract firms to enter.

In long-run equilibrium, entry and exit cease, and zero economic profit (i.e., normal profit) prevails.

Long-run equilibrium:

p =MC =minimum ATC

Short- vs. Long-Run Equilibrium

MCATC

pS

qS

PR

ICE

OR

CO

ST

QUANTITY

Short-run equilibrium (p = MC)

pS

PR

ICE

OR

CO

ST

pL

qL

QUANTITY

MCATC

Long-run equilibrium (p = MC = ATC)

Long-Run Rules for Entry and Exit

Price Level Result for typical firm Market Response

P > ATC Profits New firms enterindustry, Existing firmsexpand

P < ATC Loss Firms exit industry,Existing firms contract

P = ATC Break even No exit or entry,Existing firms maintaincurrent capacity

Technology improvements noted below

Old MC New MC

Old ATCNew ATC

JN

R

430 6000

$700

PR

ICE

(p

er c

ompu

ter)

QUANTITY (computers per month)

Two terms to remember

PRODUCTIVE EFFICIENCY

ALLOCATIVE EFFICIENCY

Allocative Efficiency

The market mechanism works best in competitive markets.Market mechanism - The market

mechanism is the use of market prices and sales to signal desired output.

Allocative efficiency means that we are producing the right output mix.

The price signal the consumer gets in a competitive market is an accurate reflection of opportunity cost.

Production Efficiency Production efficiency means that we are

producing at minimum average total cost.Efficiency (production) – Maximum output of

a good from the resources used to produce it. When competitive pressure on prices is

carried to the limit, the products in question are also produced at the least possible cost.

Society is getting the most it can from its available (scarce) resources. This market model is the best “buy” for consumers.

Reality of Attaining a Profit

The sequence of events common to a competitive market situation includes the following.

High prices and profits signal consumers’ demand for more output.

Economic profit attracts new suppliers. The market supply shifts to the right Prices slide down the market demand curve. A new equilibrium is reached with increased

quantities being produced and sold and the economic profit approaching zero.

Producers experience great pressure to keep ahead of the profit squeeze by reducing costs.

Profits Are The Bottom Line

Kiley studies profits a lot