Chapter 24 Perfect Competition. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 24-2...

Chapter 24

Perfect Competition

Copyright © 2008 Pearson Addison Wesley. All rights reserved. 24-2

Introduction

Why has the range of choices among providers of digital photo printing services expanded so much during the 2000s?

How has this expansion contributed to the decline in the price of printed digital photos?

Does this expansion relate to the concept of perfect competition?

In this chapter, you will find some answers.


Learning Objectives

• Identify the characteristics of a perfectly competitive market structure

• Discuss the process by which a perfectly competitive firm decides how much output to produce

• Understand how the short-run supply curve for a perfectly competitive firm is determined


Learning Objectives (cont'd)

• Explain how the equilibrium price is determined in a perfectly competitive market

• Describe what factors induce firms to enter or exit a perfectly competitive industry

• Distinguish among constant-, increasing-, and decreasing-cost industries based on the shape of the long-run industry supply curve


Chapter Outline

• Characteristics of a Perfectly Competitive Market Structure

• The Demand Curve of the Perfect Competitor

• How Much Should the Perfect Competitor Produce?

• Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production

• Short-Run Profits


Chapter Outline (cont'd)

• The Short-Run Breakeven Price and the Short-Run Shutdown Price

• The Supply Curve for a Perfectly Competitive Industry

• Price Determination Under Perfect Competition

• The Long-Run Industry Situation: Exit and Entry

• Long-Run Equilibrium

• Competitive Pricing: Marginal Cost Pricing


Did You Know That...

• In common speech, competition simply means “rivalry?”

• Under extreme perfectly competitive situations, individual buyers and sellers cannot affect the market price?

• Economic profits that perfectly competitive firms may earn for a time ultimately disappear as other firms enter the industry?


Characteristics of a Perfectly Competitive Market Structure

• Perfect Competition

A market structure in which the decisions of individual buyers and sellers have no effect on market price


Characteristics of a Perfectly Competitive Market Structure (cont'd)

• Perfectly Competitive Firm

A firm that is such a small part of the total industry that it cannot affect the price of the product or service that it sells



• Price Taker

A competitive firm that must take the price of its product as given because the firm cannot influence its price



• Why a perfect competitor is a price taker

1. Large number of buyers and sellers

2. Homogenous products are perfect substitutes

3. Buyers and sellers have equal access to information

4. No barriers to entry or exit


E-Commerce Example: A Monastery Takes Advantage of Unhindered Entry

• When they discovered that they could purchase generic printing supplies, remanufacture printer ink cartridges, and offer them for sale on the Internet, a new business called Lasermonk.com was born.


E-Commerce Example: A Monastery Takes Advantage of Unhindered Entry (cont'd)

• By the mid-2000s, the business was earning more than $3 million per year, which the monastery uses to fund activities ranging from computer classes for orphans to food programs for homeless children.


The Demand Curve of the Perfect Competitor

• Question

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


Neither an individualbuyer nor seller caninfluence the price

The interaction of marketsupply and demand yieldsan equilibrium price of $5

Figure 24-1 The Demand Curve for a Producer of Flash Memory Pen Drives, Panel (a)


The Demand Curve of the Perfect Competitor (cont'd)

• 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


Figure 24-1 The Demand Curve for a Producer of Flash Memory Pen Drives


How Much Should the Perfect Competitor Produce?

• Perfect competitor accepts price as given Firm raises price, it sells nothing Firm lowers its price, it earns less

revenues than it otherwise would

• Perfect competitor has to decide how much to produce Firm uses profit-maximization model


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

• The model assumes that firms attempt to maximize their total profits. The positive difference between total

revenues and total costs

• The model also assumes firms seek to minimize losses. When total revenues may be less than

total costs



• Total Revenues

The price per unit times the total quantity sold

The same as total receipts from the sale of output



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


Figure 24-2 Profit Maximization, Panel (a)


TotalOutput/Sales/ Total Market Total Total

day Costs Price Revenue Profit

0 $10 $5 $0 $10

1 15 5 5 10

2 18 5 10 8

3 20 5 15 5

4 21 5 20 1

5 23 5 25 2

6 26 5 30 4

7 30 5 35 5

8 35 5 40 5

9 41 5 45 4

10 48 5 50 2

11 56 5 55 1

Figure 24-2 Profit Maximization, Panel (b)



• Profit-Maximizing Rate of Production

The rate of production that maximizes total profits, or the difference between total revenues and total costs

Also, the rate of production at which marginal revenue equals marginal cost


Figure 24-2 Profit Maximization, Panel (c)Total

Output/Sales/ Market Marginal Marginal

day Price Cost Revenue

0 $5

1 5

2 5

3 5

4 5

5 5

6 5

7 5

8 5

9 5

10 5

11 5

$5 $5

3 5

2 5

1 5

2 5

3 5

4 5

5 5

6 5

7 5

8 5


Using Marginal Analysis to Determinethe Profit-Maximizing Rate of Production

• Marginal Revenue The change in total revenues divided by

the change in output

• Marginal Cost The change in total cost divided by the

change in output


Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production (cont'd)

• Profit maximization occurs at the rate of output at which marginal revenue equals marginal cost.


Short-Run Profits

• To find out what our competitive individual flash memory producer is making in terms of profits in the short run, we have to determine the excess of price above average total cost.


Short-Run Profits (cont'd)

• From Figure 24-2 previously, if we have production and sales of seven flash drives, TR = $35, TC = $30, and profit = $5.

• Now we take info from column 6 in panel (a) and add it to panel (c) to get Figure 24-3.


•Profits are maximized where MR = MC

•This occurs at Q = 7.5 units

Figure 24-3 Measuring Total Profits



• Graphical depiction of maximum profits

The height of the rectangular box represents profits per unit.

The length represents the amount of units produced.

When we multiply these two quantities, we get total economic profits.


•Losses are minimized where MR = MC

•This occurs at Q = 5.5 units

Figure 24-4 Minimization of Short-Run Losses



• Short-run average profits are determined by comparing ATC with P = MR = AR at the profit-maximizing Q.

• In the short run, the perfectly competitive firm can make either economic profits or economic losses.


The Short-Run Shutdown Price

• What do you think?

Would you continue to produce if you were incurring a loss? In the short run?

In the long run?


The Short-Run Shutdown Price (cont'd)

• As long as the loss from staying in business is less than the loss from shutting down, the firm will continue to produce.

• A firm goes out of business when the owners sell its assets; a firm temporarily shuts down when it stops producing, but is still in business.



• As long as the price per unit sold exceeds the average variable cost per unit produced, the earnings of the firm’s owners will be higher if it continues to produce in the short run than if it shuts down.



• Short-Run Break-Even Price The price at which a firm’s total revenues equal its

total costs At the break-even price, the firm is just making a

normal rate of return on its capital investment (it’s covering its explicit and implicit costs).

• Short-Run Shutdown Price The price that just covers average variable costs It occurs just below the intersection of the

marginal cost curve and the average variable cost curve.


Figure 24-5 Short-Run Shutdown and Break-Even Prices


The Meaning of Zero Economic Profits

• Question Why produce if you are not making

a profit?

• Answer Distinguish between economic profits and

accounting profits. Remember when economic profits are

zero a firm can still have positive accounting profits.


The Supply Curve for a Perfectly Competitive Industry

• Question What does the short-run supply curve for

the individual firm look like?

• Answer The firm’s short-run supply curve is its

marginal cost curve at and above the point of intersection with the average variable cost curve.


Figure 24-6 The Individual Firm’s Short-Run Supply Curve•Given the price, the

quantity is determined where MC = MR

•Short-run supply = MC above minimum AVC


The Supply Curve for a Perfectly Competitive Industry (cont'd)

• The Industry Supply Curve

The locus of points showing the minimum prices at which given quantities will be forthcoming

Also called the market supply curve


Figure 24-7 Deriving the Industry Supply Curve


The Supply Curve for a Perfectly Competitive Industry (cont'd)

• Factors that influence the industry supply curve (determinants of supply)

Firm’s productivity

Factor costsWages, prices of raw materials

Taxes and subsidies

Number of sellers


Price Determination Under Perfect Competition

• Question How is the market, or “going,” price

established in a competitive market?

• Answer This price is established by the

interaction of all the suppliers (firms) and all the demanders.


Price Determination Under Perfect Competition (cont'd)

• The competitive price is determined by the intersection of the market demand curve and the market supply curve.

The market supply curve is equal to the horizontal summation of the supply curves of the individual firms.


Pe and Qe determined by

the interaction of the industry S and market D

Pe is the price

the firm must take

Figure 24-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve, Panel (a)


Figure 24-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve, Panel (b)

•Given Pe, firm produces qe where MC = MR

If AC = AC1, break-even

•If AC = AC2, losses

•If AC = AC3, economic profit


The Long-Run Industry Situation: Exit and Entry

• Profits and losses act as signals for resources to enter an industry or to leave an industry.


The Long-Run Industry Situation: Exit and Entry (cont'd)

• Signals

Compact ways of conveying to economic decision makers information needed to make decisions

An effective signal not only conveys information but also provides the incentive to react appropriately.



• Exit and entry of firms

Economic profits Signal resources to enter the market

Economic losses Signal resources to exit the market



• Allocation of capital and market signals

Price system allocates capital according to the relative expected rates of return on alternative investments.

Investors and other suppliers of resources respond to market signals about their highest-valued opportunities.



• Tendency toward equilibrium (note that firms are adjusting all of the time)

At break-even, resources will not enter or exit the market.

In competitive long-run equilibrium, firms will make zero economic profits.



• Long-Run Industry Supply Curve

A market supply curve showing the relationship between prices and quantities after firms have been allowed time to enter or exit from an industry, depending on whether there have been positive or negative economic profits



• Constant-Cost Industry

An industry whose total output can be increased without an increase in long-run per-unit costs

Its long-run supply curve is horizontal.


Figure 24-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (a)



• Increasing-Cost Industry

An industry in which an increase in industry output is accompanied by an increase in long-run per unit costs

Its long-run industry supply curve slopes upward.


Figure 24-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (b)



• Decreasing-Cost Industry

An industry in which an increase in industry output leads to a reduction in long-run per-unit costs

Its long-run industry supply curve slopes downward.


Figure 24-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries, Panel (c)


Example: Decreasing Costs and the Market for Transistors

• Since the late 1960s, the annual production of transistors has expanded from 1 billion to 1 quintillion.

• At the same time, the cost per unit has dropped from about $1 to a miniscule fraction of a penny.

• Transistor production serves as a good illustration of a decreasing-cost industry.


Figure 24-10 World Transistor Production and Prices Since 1968


Long-Run Equilibrium

• In the long run, the firm can change the scale of its plant, adjusting its plant size in such a way that it has no further incentive to change; it will do so until profits are maximized.

• In the long run, a competitive firm produces where price, marginal revenue, marginal cost, short-run minimum average cost, and long-run minimum average cost are equal.


Figure 24-11 Long-Run Firm Competitive Equilibrium


Competitive Pricing: Marginal Cost Pricing

• Marginal Cost Pricing

A system of pricing in which the price charged is equal to the opportunity cost to society of producing one more unit of the good or service in question

The opportunity cost is the marginal cost to society.


Competitive Pricing: Marginal Cost Pricing (cont'd)

• Market Failure

A situation in which an unrestrained market operation leads to either too few or too many resources going to a specific economic activity


Issues and Applications: The Big Rush to Provide Digital Snaps in a Snap

• The photography industry brings in about $85 billion in revenues each year.

• Since 2000, the majority of those revenues have been earned from the sale of digital cameras and related digital photography products and services.

• During the mid-2000s, a rapidly growing part of the digital photography business has been the market for digital photo printing services.


Issues and Applications: The Big Rush to Provide Digital Snaps in a Snap (cont'd)

• The demand for digital photo printing services increased, and the market clearing price rose from 15 to about 19 cents.

• Numerous firms entered the industry causing market supply to increase and the market clearing price declined from 19 cents to about 12 cents.

• Hence, the long-run supply curve in this industry sloped downward, indicating that this is a decreasing-cost industry.


Figure 24-12 Short-Run and Long-Run Adjustments in the Digital Photo Printing Industry


Summary Discussion of Learning Objectives

• The characteristics of a perfectly competitive market structure

1. Large number of buyers and sellers

2. Homogeneous product

3. Buyers and sellers have equal access to information

4. No barriers to entry and exit


Summary Discussion of Learning Objectives (cont'd)

• How a perfectly competitive firm decides how much to produce

Economic profits are maximized when marginal cost equals marginal revenue as long as the market price is not below the short-run shutdown price, where the marginal cost curve crosses the average variable cost curve.



• The short-run supply curve of a perfectly competitive firm The rising part of the marginal cost curve

above minimum average variable cost

• The equilibrium price in a perfectly competitive market A price at which the total amount of output

supplied by all firms is equal to the total amount of output demanded by all buyers



• Incentives to enter or exit a perfectly competitive industry

Economic profits induce entry of new firms.

Economic losses will induce firms to exit the industry.



• The long-run industry supply curve and constant-, increasing-, and decreasing-cost industries

The relationship between price and quantity after firms have been able to enter or exit the industry

Constant-cost industry Horizontal long-run supply curve

Increasing-cost industry Upward-sloping long-run supply curve

Decreasing-cost industry Downward-sloping long-run supply curve

End of Chapter 24

Perfect Competition

Chapter 24 Perfect Competition. Copyright © 2008 Pearson Addison Wesley. All rights reserved. 24-2...

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