MICROECONOMICS CHAPTER 10A/23 · 2012-04-24 · • The Short-Run Breakeven Price and the Short-Run...

MICROECONOMICS

CHAPTER 10A/23PERFECT COMPETITION

Professor Charles Fusi

Learning Objectivesg j

• Identify the characteristics of a perfectly competitive Identify the characteristics of a perfectly competitive market structure

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

U d t d h th h t l f • Understand how the short-run supply curve for a perfectly competitive firm is determined

Lectures by Prof. Fusi 10A/23-2

Learning Objectives (cont'd)g j ( )

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

• D ib h t f t i d fi t t it • 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 l i d t l long-run industry supply curve


Chapter Outlinep

• Characteristics of a Perfectly Competitive Market Structurey p

• 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)p ( )

• 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 ...

• More than 1,600 U.S. auto dealerships closed during 2009?, p g• Ease of exit from an industry is a fundamental characteristic of

the theory of perfect competition —the topic of this chapter.


Characteristics of a Perfectly Competitive Market Structure Market Structure

• Perfect CompetitionPerfect Competition

A market structure in which the decisions of i di id l b d ll h ff t individual buyers and sellers have no effect on market price


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

• Perfectly Competitive FirmPerfectly Competitive Firm

A firm that is such a small part of the total industryth t it t ff t th i f th d t that it cannot affect the price of the product or service that it sells



• Price TakerPrice Taker

A competitive firm that must take the price of its d t i b th fi t i fl product as given because the firm cannot influence

its price



• Why a perfect competitor is a price takerWhy a perfect competitor is a price taker

1. Large number of buyers and sellers

2. Homogenous products are perfect substitutes

3. Both buyers and sellers have equal access to information

4. No barriers to entry or exit (any firm can enter or y ( yleave the industry without serious impediments)


The Demand Curve of the Perfect Competitor Competitor

• QuestionQuestion

If the perfectly competitive firm is a price taker, h h t t th i ?who or what sets the price?


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

• The perfectly competitive firm is a price taker, selling The perfectly competitive firm is a price taker, selling a homogenous commodity with perfect substitutes.

Will sell all units for $5 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 10A/23-1 The Demand Curve for a Producer of Titanium BatteriesTitanium Batteries


How Much Should the Perfect Competitor Produce? Produce?

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

otherwise would

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


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

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

The positive difference between total revenues and The positive difference between total revenues and total costs

• The model also assumes firms seek to minimize losses• The model also assumes firms seek to minimize losses

When total revenues may be less than total costs



• Total RevenuesTotal Revenues

The price per unit times the total quantity sold

The same as total receipts from the sale of output



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

TR = P x Q

TC = TFC + TVC

P i d t i d b th k t i f t titi

TC = TFC + TVC

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



• For the perfect competitor, price is also equal to For the perfect competitor, price is also equal to average revenue (AR) because

AR = = = PTRQ

PQQQ Q

• The demand curve is the average revenue curve


Figure 10A/23-2 Profit Maximization, Panel (a)


Figure 10A/23-2 Profit Maximization, Panel (b)

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 57 30 5 35 5

8 35 5 40 5

9 41 5 45 4

10 48 5 50 2


10 48 5 50 2

11 56 5 55 1

Figure 10A/23-2 Profit Maximization, Panel (c)

TotalOutput/Sales/ Market Marginal Marginal

day Price Cost Revenue

0 $50 $5

1 5

2 5

3 5

$5 $5

3 5

2 5

1 54 5

5 5

6 5

1 5

2 5

3 5

4 57 5

8 5

9 5

10 5

5 5

6 5

7 5


10 5

11 58 5


• Profit-Maximizing Rate of ProductionProfit Maximizing Rate of Production

The rate of production that maximizes total profits, th diff b t t t l d t t l or the difference between total revenues and total

costs

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


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

• Marginal Revenue Marginal Revenue

The change in total revenues divided by the change in outputin output

MR =change in TR

QMR = change in Q


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

• Marginal Cost Marginal Cost

The change in total cost divided by the change in outputoutput

MR =change in TC

QMR = change in Q


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

• Profit maximization occurs at the rate of output at Profit maximization occurs at the rate of output at which marginal revenue equals marginal costg q g

MR = MC


Short-Run Profits

• To find out what our competitive individual secure To find out what our competitive individual secure digital cards 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 10A/23-2 previously, if we have production and g / p y, psales of seven Titanium batteries, TR = $35, TC = $30, and profit = $5 per hour.

• Now we take info from column 6 in panel (a) and add it to panel (c) to get Figure 10A/23-3.


Figure 10A/23-3 Measuring Total Profits

• Profits are maximized where MR = MC

• This occurs at Q = 7.5 units



• Graphical depiction of maximum profits and Graphical depiction of maximum profits and graphical depiction of minimum losses

Th h i ht f th t l b i th i The height of the rectangular box in the previous figure represents profits per unit

The length represents the amount of units produced

When we multiply these two quantities, we get total p y q , geconomic profits



• Short-run average profits are determined by 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 lossesmake either economic profits or economic losses


Figure 10A/23-4 Minimization of Short-Run Losses

• Losses are minimized where

Losses

MR = MC• This occurs at Q = 5.5 units


Short-Run Profits (cont’d)( )

• We see in the previous Figure 10A/23-4 that the marginal p g / grevenue (d2) curve is intersected (from below) by the marginal cost curve at an output rate of 5 batteries per hourTh fi i l l ki fi b l • The firm is clearly not making profits because average total costs at that output rate are greater than the price of $3 per battery.

• The losses are shown in the shaded area.


The Short-Run Break-Even Price and the Short-Run Shutdown PriceRun Shutdown Price

• What do you think?What do you think?

Would you continue to produce if you were i i l ?incurring a loss?

In the short run?

In the long run?


The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd)Run Shutdown Price (cont d)

• As long as the loss from staying in business is less g y gthan 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

d i b i ill i b iproducing, but is still in business.



• As long as the price per unit sold exceeds the 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)covering its explicit and implicit costs).

• Short-Run Shutdown PriceTh i th t j t i bl t 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.


cost curve and the average variable cost curve.

Figure 10A/23-5 Short-Run Break-Even and Shutdown PricesShutdown Prices



• The meaning of zero economic profitsThe meaning of zero economic profits• Question

Why produce if you are not making a profit? Why produce if you are not making a profit?

• Answerf Distinguish between economic profits and

accounting profitsR b h i fit fi Remember when economic profits are zero a firm can still have positive accounting profits


Example: Why Firms Stubbornly Produced Aluminum in the Late 2000sAluminum in the Late 2000s

• Between the summer of 2008 and the end of the winter of 2009, the market clearing price of aluminum fell by more than 50 percent. M hil l ll l i fi i i d h i • Meanwhile, almost all aluminum firms maintained their production operations until early in the spring of 2009.

• They did so because, even though the equilibrium price fell They did so because, even though the equilibrium price fell below the short-run break-even price, for several months the price remained above the short-run shutdown price.


The Supply Curve for a Perfectly Competitive Industry Industry


What does the short-run supply curve for the individual firm look like?individual firm look like?

• Answer

The firm’s short-run supply curve in a competitive industry is its marginal cost curve at and above the point of intersection with the average variable cost curve


Figure 10A/23-6 The Individual Firm’s Short-Run Supply CurveSupply Curve

• Given the price, the pquantity is determined where MC = MR

• Short-run supply = MCabove minimum AVC


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

• The Industry Supply CurveThe Industry Supply Curve

The locus of points showing the minimum prices at hi h i titi ill b f th iwhich given quantities will be forthcoming

Also called the market supply curve


Figure 10A/23-7 Deriving the Industry Supply CurveCurve


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

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

Firm’s productivity Firm s productivity

Factor costs (wages, prices of raw materials)

Taxes and subsidies

Number of sellers


Price Determination Under Perfect Competition


How is the market, or “going,” price established in a competitive market?a competitive market?

• Answer

This price is established by the interaction of all the suppliers (firms) and all the demanders (consumers)


Price Determination Under Perfect Competition (cont'd)(cont d)

• The competitive price is determined by the 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 summation of the supply curves of the individual firms


Figure 10A/23-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve Panel (a)and the Individual Firm Demand Curve, Panel (a)

Pe is the pricethe firm must take

Pe and Qe determined by the interaction of the industry S and market D


Figure 10A/23-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve Panel (b)and the Individual Firm Demand Curve, Panel (b)

Gi P fi d h MC MR• 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 Entry

• Profits and losses act as signals for resources to enter 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)Entry (cont d)

• SignalsSignals

Compact ways of conveying to economic decision k i f ti d d t k d i imakers information needed to make decisions

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



• Exit and entry of firmsExit and entry of firms

Economic profits

Signal resources to enter the market

Economic losses Economic losses

Signal resources to exit the market



• Allocation of capital and market signalsAllocation of capital and market signals

Price system allocates capital according to the l ti t d t f t lt ti relative expected rates of return on alternative

investments.

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

t itiopportunities.



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

At b k ill t t it th 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 CurveLong Run Industry Supply Curve

A market supply curve showing the relationship b t i d titi ft fi h 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 depending on whether there have been positive or negative economic profits



• Constant-Cost IndustryConstant Cost Industry

An industry whose total output can be increased ith t i i l it twithout an increase in long-run per-unit costs

Its long-run supply curve is horizontal.


Figure 10A/23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries Panel (a)Decreasing-Cost Industries, Panel (a)



• Increasing-Cost IndustryIncreasing Cost Industry

An industry in which an increase in industry output is i d b i i l it accompanied by an increase in long-run per unit

costs

Its long-run industry supply curve slopes upward


Figure 10A/23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries Panel (b)Decreasing-Cost Industries, Panel (b)



• Decreasing-Cost IndustryDecreasing Cost Industry

An industry in which an increase in industry output l d t d ti i l it tleads to a reduction in long-run per-unit costs

Its long-run industry supply curve slopes downward.


Figure 10A/23-9 Constant-Cost, Increasing-Cost, and Decreasing-Cost Industries Panel (c)Decreasing-Cost Industries, Panel (c)


Long-Run Equilibriumg q

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

i i dare maximized

• In the long run, a competitive firm produces where i i l i l h price, marginal revenue, marginal cost, short-run

minimum average cost, and long-run minimum average cost are equalg q


Figure 10A/23-10 Long-Run Firm Competitive EquilibriumCompetitive Equilibrium


Why Not … eliminate economic profits entirely?

• If companies were prohibited from earning more than zero p p geconomic profits, entrepreneurs would have little incentive to try new ways of doing things in an effort to reduce costs and gain profits gain profits.

• There would also be no incentive for new firms to enter an industry experiencing growing demand.

• Thus, society benefits from the market signals created when firms experience positive short-run economic profits.


Competitive Pricing: Marginal Cost Pricing

• Marginal Cost PricingMarginal Cost Pricing

A system of pricing in which the price charged is l t th t it t t i t f equal to the opportunity cost to society of

producing one more unit of the good or service in questionquestion

The opportunity cost is the marginal cost to society.


Competitive Pricing: Marginal Cost Pricing (cont'd)(cont d)

• Market FailureMarket Failure

A situation in which an unrestrained market ti l d t ith t f t operation leads to either too few or too many

resources going to a specific economic activity


You Are There: The Coal Mining Industry Confronts a Changing Cost StructureChanging Cost Structure

• In past decades, coal mining was a decreasing-cost industry p , g g yand the market clearing price of coal steadily declined relative to other goods and services.

• Today, coal mining has become an increasing-cost industry as miners have to dig deeper and move more earth to extract coals from aging minescoals from aging mines.

• So, in the long run, the equilibrium price will rise as the demand for coal increases.demand for coal increases.


Issues & Applications: A Higher Price Sets Off a New California Gold RushCalifornia Gold Rush

• Since 2000, both the current dollar and the inflation-adjusted , jprice of gold have more than tripled.

• As the theory of perfect competition predicts, the increase in h i f ld h h d ff d i b i i the price of gold has touched off renewed interest by mining firms in trying to extract gold from California mines abandoned decades ago.


Issues & Applications: A Higher Price Sets Off a New California Gold Rush (cont’d)California Gold Rush (cont d)

• The gold mining industry satisfies the key characteristics of g g y yperfect competition: Units of each type of gold are homogeneous, even though it has

different qualitiesdifferent qualities

Many mining firms have the technology to extract gold from earth

The potential output of each mining firm is small relative to total gold d iproduction

It is easy to enter or leave the industry


Figure 10A/23-11 Index Measures of the Current-Dollar and Inflation-Adjusted Prices of GoldDollar and Inflation-Adjusted Prices of Gold


Summary Discussion of Learning Objectives

• The characteristics of a perfectly competitive market The characteristics of a perfectly competitive market structure

Large number of buyers and sellers1. 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)(cont d)

• How a perfectly competitive firm decides how much How a perfectly competitive firm decides how much to produce

E i fit i i d h i l t Economic profits are maximized when marginal cost equals marginal revenue as long as the market price is not below the short-run shutdown price, 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 The short run supply curve of a perfectly competitive firm The rising part of the marginal cost curve above g p g

minimum average variable cost

• The equilibrium price in a perfectly competitive The equilibrium price in a perfectly competitive market A price at which the total amount of output 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 Incentives to enter or exit a perfectly competitive industry

E i fit i d t f fi 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-, g y pp y , g ,and decreasing-cost industries

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

Constant-cost industry Horizontal long-run supply curveg pp y

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

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


MICROECONOMICS CHAPTER 10A/23 · 2012-04-24 · • The Short-Run Breakeven Price and the Short-Run...

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