Perfect Competition

Perfect Competition NAMES PROJECT FOR ROLL NOS

© 2006 Thomson/South-Western

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Market structure

 Many of the firm’s decisions depend on the structure of the market in which it operates  Market structure describes the important features of a market

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How is Market Structure determined?  Number of suppliers  Product’s degree of uniformity  Do

firms in the market supply identical products or are there differences across firms?

 Ease of entry into the market  Can

new firms enter easily or are they blocked by natural or artificial barriers?

 Forms of competition among firms  Do

firms compete only through prices or are advertising and product differences common as well? 3

Perfect Competition  Individual participants have no control over the price  Price is determined by market supply and demand  the perfectly competitive firm is a price taker  it must “take” or accept, the market price  Firm is free to produce whatever quantity maximizes profit

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Perfectly Competitive Market Structure ● Both

buyers and sellers are price takers. ● The number of firms is large. ● There are no barriers to entry. ● The firms’ products are identical. ● There is complete information. ● Firms are profit maximizers.

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Price takers Both buyers and sellers are price takers. A price taker is a firm or individual who takes the market price as given. In most markets, households are price takers – they accept the price offered in stores.

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The Number of firms is large. Is nothing but that perfect competition comprises of large number of firm in the market.

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There are no barriers to entry. ● Barriers

to entry are social, political, or economic impediments that prevent other firms from entering the market. ● Barriers sometimes take the form of patents granted to produce a certain good. ● Technology may prevent some firms from entering the market. ● Social forces such as bankers only lending to certain people may create barriers.

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The firms' products are identical or homogenous This requirement means that each firm's output is indistinguishable from any competitor's product.

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There's complete information ● Firms

and consumers know all there is to know about the market – prices, products, and available technology. ● Any technological breakthrough would be instantly known to all in the market.

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Firms are profit maximizers. ● The

goal of all firms in a perfectly competitive market is profit and only profit. ● The only compensation firm owners receive is profit, not salaries.

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Exhibit 1: Market Equilibrium and the Firm’s Demand Curve in Perfect Competition Market price of wheat of $5 per bushel is determined in the left panel by the intersection of the market demand curve and the market supply curve. Once the market price is established, farmer can sell all he or she wants at that market price  price taker

(b) Firm’s Demand

Price per bushel

S

$5

Price per bushel

(a) Market Equilibrium

d

$5

D 0

1,200,000

Bushels of wheat per day

0

5

10

15

Bushels of wheat per day

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Short-Run (b) Marginal Cost Equals Marginal Revenue

Marginal cost Average total cost

Dollars per unit

The Mc curve is the supply curve. The MC curve intersects the MR curve at point e, At rates of output less than 12 bushels, MR > MC – firm can increase profit by expanding output At higher rates of output MC > MR – firm can increase profits by reducing output Profit appears in the blue shaded rectangle and equals the price of $5 minus the average cost of $4, or $1 per bushel

e

$5

d = Marginal revenue = average revenue

Profit 4

a

0

5

10

12

15

Bushels of wheat per day 13

The demand curve

 Since the firm in perfect competition is a price taker, marginal revenue from selling one more unit is the market price  MR = P  Because the perfectly competitive firm can sell any quantity for the same price per unit, marginal revenue is also average revenue  Average

revenue, AR, equals total revenue divided by quantity  AR = TR / q  Thus the demand curve is Market price = marginal revenue = average revenue

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Profit Maximization: MC = MR  Golden rule of profit maximization: a firm should expand output as long as marginal revenue exceeds marginal cost and will stop expanding output before marginal cost exceeds marginal revenue. • Thus to maximize profits, a firm should produce where marginal cost equals marginal revenue

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How to maximize profit If marginal revenue does not equal marginal cost, a firm can increase profit by changing output. The supplier will continue to produce as long as marginal cost is less than marginal revenue. The supplier will cut back on production if marginal cost is greater than marginal revenue.

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Shutting Down in the Short Run  The shutdown point is the point at which the firm will be better off it shuts down than it will if it stays in business.  The firm should shut down if it cannot cover average variable costs.  A firm should continue to produce as long as price is greater than average variable cost.

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Contd.. • • •

If price falls below that point it makes sense to shut down temporarily and save the variable costs. If total revenue is more than total variable cost, the firm’s best strategy is to temporarily produce at a loss. It is taking less of a loss than it would by shutting down.

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The Shutdown Decision •MC

•Price •60

•ATC

•50 •40

•Loss •P = MR

•30

•AVC

•20 •$17.80

•A

•10 •0

•2

•4

•6

•8

•Quantity

Normal and abnormal profits Normal profit- is profit just sufficient to keep that firm in operation. Abnormal profit-profit earned by firms over and above normal profits.

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Short run-abnormal profits Abnormal profits are the main reason why firms enter into market. Firms can easily enter and leave the market due to less barriers This means the higher the existence of abnormal profits more firms will be attracted in the short run. Thus increasing overall market supply in that industry

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LONG RUN-NORMAL PROFITS

In the long run there is intense competition due to new entrants of firms This reduces the market price and thus firms face diminishing abnormal profits Due to which some firms may leave the market in the long run and aim at other abnormal profit markets. 22

contd…. The long run is therefore where the only firms left are the most efficient ones, making a normal profit. The long run equilibrium is where MC=ATC=AR=MR Thus in perfect competition firms enjoy abnormal profits in the short run and settle down with normal profits in the long run.

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Long Run Equilibrium for the Firm and the Industry

(a) Firm

(b) Industry, or market S ATC

p

e

d

Price per unit

Dollars per unit

MC

p D

•P1

0

q

Quantity per period

0

Q

•Q2

Quantity per period

CONCLUSION

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THANK YOU

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