©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 7: Perfect Competition.

©2012 The McGraw-Hill Companies, All Rights Reserved

1

Chapter 7: Perfect Competition


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Learning Objectives

1. Determine a perfectly competitive firm’s profit-maximizing output level and profit in the short run.

2. Show how economic profit and economic loss affect the allocation of resources across industries.

3. Explain the difference between economic profit and economic rent.

4. Use the theory of the invisible hand to analyze events in everyday life.

5. Understand and explain the relationship between a market equilibrium and a social optimum.


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Competition

In the previous chapter we learned that the average total cost facilitates the profit-maximizing firm’s assessment of profitability

This process, however, varies across different market structures Market structures are usually defined by

their level of competition How competitive is a market? Is a firm operating alongside others or

alone?


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Perfectly (Pure) Competitive Market

Perceived as unrealistic Provides a benchmark in evaluating other

market structuresCharacteristics of a perfectly

competitive market1.All firms sell the same standardized

product2.The market has many buyers and sellers,

each of which buys or sells only a small fraction of the total quantity exchanged

3.Productive resources are mobile4.Buyers and sellers are well informed


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All firms sell the same standardized product Implies that buyers are willing to switch

from one seller to another

The market has many buyers and sellers, each of which buys or sells only a small fraction of the total quantity exchanged Implies that individual buyers and sellers

will be price takers


6


Productive resources are mobile Implies that sellers are able to obtain

labor, capital, and other productive resources necessary to enter or leave a market

Buyers and sellers are well informed Implies that buyers and sellers are

aware of the relevant opportunities available to them


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Profit-Maximizing Firms in Perfectly Competitive Markets

Supply Curves Most goods and services are

produced by private firms A profit-maximizing firm ‘s primary goal is

maximize profit• Profit = TR – TC

This primary goal + operating in a perfectly competitive market define the standard supply curves that we know and use


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Profit-Maximizing Firms in Perfectly Competitive Markets

Demand Curves How does a demand curve for a firm look like? Demand is perfectly elastic horizontal

Each firm can sell as much as it wants at the market price

Each firm is a price taker

A perfectly competitive firm has no control over the price

Its challenge becomes: what output level will allow it to maximize its profit taken into consideration a fixed price?


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Perfectly Competitive Firm's Demand


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Price = Marginal Cost: The Maximum Profit Condition

Assume that firm produces 200 bottles a day By producing the 201st bottle the firm will

increase its profit by 20 10 = 10 cents per day

Assume that firm produces 300 If the firm then

contracted its output by 1 it would cut its costs by 30 cents while losing only 20 cents in revenue


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At a price of $0.20, the firm produces 260 bottles

Profit is TR – TC TR = 0.2 * 260 = $52 TC = 0.12 * 260 = $31.2

Profit is $52 - $31.2 = $20.8

Note that the minimum value of the firm’s AVC curve is $0.07 If the price falls below 7

cents the firm would shut down in the SR


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Firms might be earning losses instead

When P < ATC, the firm loses (P – ATC) per unit of output

Total losses are the rectangle whose height is ATC – P and whose width is Q

Losses = (ATC – P) (Q)($0.10 – $0.08) (180) = $3.60


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Responses to Profits and Losses

If a firm is covering its variable cost, it can stay in the market in the SR

If a firm would like to stay in the market in the LR, it must cover all costs: explicit and implicit costs

A firm that earns no more than a normal profit has managed only to cover the opportunity cost of the resources

A firm that makes a positive economic profit earns more than the opportunity cost of the invested resources


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Markets in which firms are earning an economic profit tend to attract additional resources More firms want to enter the market Market supply is expected to increase

Markets in which firms are experiencing economic losses tend to lose resources Firms want to leave the market Market supply is expected to decrease


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Responses to Economic Profits

Markets with excess profits attract resources

P2

Quantity (000s of bushels/year)

Price $/bu MC

130

ATC

1.20

Typical Corn FarmPrice $/bu

2

Quantity (M of bushels/year)

S

D

65

Corn Industry

Economic Profit:

$104,000


16

Shrinking Economic Profits

Supply increases

P


Price $/bu MC

130

ATC


2


S

D

65

Corn Industry

Economic Profit:

$50,400

S'

1.50

95 120

1.08


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Market Equilibrium

Zero economic profits

P


Price $/bu MC

130

ATC


2


S

D

65

Corn Industry

S'

1.50

115

1

S"

90


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Responses to Profits

The initial equilibrium price was above the minimum value of ATC, giving rise to positive economic profits Incentive for other firms to enter the market Supply increases Equilibrium price decreases until the

incentive to enter the market disappear P = minimum AVC

What if the price went below the minimum AVC?


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Economic Losses

Resources leave

1.05

Quantity (M of bushels/year) Quantity (000s of bushels/year)70

0.75 P

90

ATCMC

S

D

60

Price

$/bu

0.75

Price

$/bu

Typical Corn FarmCorn Industry

Economic Loss:

$21,000


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Market Equilibrium

No economic losses

Quantity (M of bushels/year) Quantity (000s of bushels/year)70

0.75P

90

ATCMC

S

D

60

Price

$/bu

Price

$/bu

1

S'

40


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Responses to Losses

Condition: P > minimum AVC TR = 0.75 * 70 = $52,500 TC = 1.05 * 70 = $73,500

Total losses = $21,000 Incentive for some firms to leave the

market Supply decrease Price increase until incentive to leave the

market disappear


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Assumptions Firms are free to enter and leave the

market Inputs can be purchased in any quantities

at fixed prices All firms employ similar standardized

production methods

Final outcome: zero economic profit Do firms want zero economic profit?

The zero economic profit is a consequence of price movements following entry and exit of firms


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Long Run Equilibrium

The fact that a new firm could enter or leave the market at any time means Production can always be augmented or

reduced in the long run at a cost of $1 per bushel

Long run supply curve us horizontal at $1 = min AVC

Both long run MC and long run ATC are constant at $1


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In the long run, corn costs $1/bu regardless of the size of the industry

Quantity (M of bushels/year) Quantity (000s of bushels/year)

1.00

D

S P

MC ATCPrice $/bu

Price $/bu


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Two attractive features of perfect competition long run equilibrium Market outcome is efficient in the long

run The value to buyers of the last unit is $1

per bushel, which is exactly the same as the long-run marginal cost of producing it

Market outcome can be described as fair

Buyers pay the cost incurred by suppliers


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Applied Example: Too many stylists and too few aerobics instructors

Initial equilibrium: All suppliers

are currently earning zero economic profit

What if preferences change?

Longer hair and increased physical fitness


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Short-Run AdjustmentsP

rice

($/

ha

ircu

t)

Haircuts/day Classes/day

Pri

ce (

$/cl

ass

)S

D

500

15

200

10

D

S

350

15

D'

12D'

300

Haircut Market Aerobics Market


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Short-Run Adjustments

MCH

QH

ATCH

Pric

e ($

/hai

rcut

)

Q'H

15.50

12

Economicloss

MCA

QA

ATCA

Pric

e ($

/cla

ss)

Q'A

15

11

Economicprofit

Typical Hair Salon Typical Aerobics Studio


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Short-Run Adjustments

Because of change in preferences Demand shifts in each market Haircut market lower equilibrium price

economic losses some hair salons exit the market price goes back to original equilibrium but now with lower equilibrium quantity

Aerobics market higher equilibrium price economic profits some Aerobics studios enter the market price goes down to original equilibrium but now with higher equilibrium quantity


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The Importance of Free Entry and Exit

From previous examples we have seen that entry and exit of firms play a crucial role in the final outcome of the market

Barrier to entry: any force that prevents firms from entering a new industry

Legal constraints / Practical factorsNo less important than the freedom to

enter a market is the freedom to leave Firms discover that if a market is difficult to

leave, they become reluctant to enter new markets

Barriers to exit thus become barriers to entry


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Economic Rent

Economic profits tend toward zero, yet people get rich How is that possible? Distinction between economic rent and

profitEconomic rent is the portion of a

payment to a factor of production that exceeds the owner's reservation price The case of the talented chef

Unique talent for cooking In equilibrium, pay the chef the increase in

revenue from his talent


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Economic Rent: Talented Chef

Assume: a city has 100 restaurants / 99 have “normal chefs” and 1 has a “talented chef” Each chef receives $30,000 yearly salary The 100th restaurant can charge 50% more

for each meal The 99 restaurants each earn $300,000 in TR

per year (ensuring a zero economic profit) The 100th restaurant’s TR is 50% more

$450,000 How much is the 100th restaurant willing to

pay the “talented chef”?


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Economic Rent: Talented Chef

Competition will ensure that the “talented chef's” pay is $180,000 per year $30,000 = what would he make from other

restaurants $150,000 = profit attributed to the “talented

chef” As such, $150,000 = economic rent to the “talented

chef” The owner of the 100th restaurant will earn zero

economic profit

What if the owner of the 100th restaurant paid $60,000 to the “talented chef” and kept the remaining $120,000 as profits?


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Invisible Hand

Adam Smith argued that although the entrepreneur “intends only his own gain,” he is “led by an invisible hand to promote an end which was no part of his intention.”

As Smith saw it, even though self-interest is the prime mover of economic activity, the end result is an allocation of goods and services that serves society’s collective interests remarkably well.

The invisible hand, in short, is about all the good things that can happen because of the Incentive Principle


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Invisible Hand in the Supermarket

Short check-out lines get longer – quickly Information is freely available

Start in the shortest line Observe the pace of all lines Decide whether to switch Most shoppers would do the same,

the short line seldom remains shorter for long


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Invisible Hand and Cost-Saving Innovations

Competitive firms are price takers Cost management required

Innovation lowers cost for one firm Profits increase by amount of cost savings Information is freely available

Industry costs decrease Equilibrium price decreases by amount of

costs savings No excess profits

Competition among firms ensures that the resulting cost savings will be passed along to consumers in the long run


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Shipping Innovation: Example

40 companies compete in trans-Atlantic shipping Cost per trip is $500,000

One firm innovates to save $20,000 in fuel per trip Short-run economic profit

Over time, competitors copy the innovation Industry costs decrease by $20,000 Equilibrium price decrease by $20,000

In the long run, no firm earns excess profits


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Invisible Hand in an Istanbul Cab: Regulated

Market Istanbul regulates the number of cabs

Issues a limited number of licenses Allows licenses to be bought and sold

privatelyUnregulated market has 15,000 cabs

and each costs $25,000City issues 13,000 licenses

Price of a cab $28,000With restricted supply, price

of a cab ride goes up Cabs make excess profits

13

SR

28

Pric

e (0

00s$

/cab

)

Cabs (000s cabs)15

D

S

25


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Value of a Taxi License

Total costs of operation are $40,000 per year plus cost of license

Total revenue is $60,000 per year $20,000 per year implicit cost of license

ownershipFind the amount you would pay today

to receive $20,000 per year forever Depends on the interest rate

At 6% interest, the value of a license is $333,333

If the license sells for $333,333, there are no excess profits from operating a cab


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Invisible Hand and Irrigation Program

Textile workers and tenant farmers each earn $8,000

Government program doubles revenue Short-term economic profits Land rents increase as farmers enter

industry Program benefits only land owners in the

long run and not farmers

LandOther

Explicit Costs

Normal Profit

Total Revenue

Economic Profit

Before $5,000 $3,000 $8,000 $16,000 $0

Short Run $5,000 $3,000 $8,000 $32,000 $16,000

Long Run $21,000 $3,000 $8,000 $32,000 $0


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Invisible Hand and Socially Optimal Outcome

There are only three ways to earn a big payoff: To work especially hard To have some unusual skill, talent, or training To be lucky

Markets work best when Buyers' marginal benefits = sellers' marginal

costsAND

Society's marginal benefits = society's marginal costs

Individual behavior may benefit the individual more than it does for the society

©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 7: Perfect Competition.

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Transcript of ©2012 The McGraw-Hill Companies, All Rights Reserved 1 Chapter 7: Perfect Competition.