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Chap5 Chap5 Presentation Transcript

  • CHAPTER 5 MARKET STRUCTURE: PERFECT COMPETITION
  • Chapter Outline
    • 5.1 Characteristic
    • 5.2 Short-run Decision: Profit Maximization
    • 5.3 Short-run Decision: Minimizing Loss
    • 5.4 Long-run Adjustment
    • 5.5 External Changes:
    • Consumer Preference & Technology
    • 5.6 Efficiency of Perfect Competition
  • Perfect Competition
    • Definition:
      • A market structure with many fully informed buyers and sellers of standardized product and no obstacles to entry or exit of firms in the long run.
      • For example: hypermarket (Giant, Carrefour, Tesco).
  • 5.1 Characteristic
    • Many firms
      • A single firm’s production is relatively very small compare to the market demand. T herefore, cannot influence market price.
      • Each firm takes market price as given -> price taker
    • Homogenous product
      • product/service has no unique characteristic, so consumers don’t care which firm they buy from.
      • Example: Agricultural products such as oil, iron and others.
  • 5.1 Characteristic
    • Perfect information
      • Firms are price taker because buyers & sellers are well informs about price.
      • No transaction cost assumed.
      • Firm only decide how much to produce.
    • Free entry / exit
      • No legal, technology, capital, incumbent advantage or others constraint to entry/exit.
      • New firms enter (existing firms exit) if industry earning above (negative) normal profit.
  • Firm Industry 100 Figure: Market Equilibrium and Firm’s Demand Curve Price taker d $4 Output (bushels) Price $ per bushel D $4 S Price $ per bushel Output (millions of bushels)
    • Example: The market price of corn of $4 per bushel is determined by the market intersection of the market demand and supply curve.
      • Each firm is so small relative to the market that each has no impact on the market price.
      • Anyone who charges more than the market price sell no corn because find no buyers.
    • The goal of a competitive firm is to maximize profit.
    • How the firm maximize profit?
      • 1. Total Approach :
      • Maximizing the Positive difference between TR – TC.
      • 2. Marginal Approach :
      • MR = MC
      • ( profit maximizing condition )
  • Profit-Maximizing Level of Output
    • If q is output of the firm, then total revenue is price of the good times quantity
      • Total Revenue (TR) = P x Q
    • Costs of production depends on output
      • Total Cost (TC) = TC x Q
    • Profit (  ) = Total Revenue - Total Cost
    • The goal of the firm is to maximize profits, the difference between total revenue and total cost.
    • A firm maximizes profit when MR = MC.
      • Marginal revenue (MR) -----the change in total revenue associated with a change in quantity.
      • Marginal cost (MC) ----- the change in total cost associated with a change in quantity.
  • 5.2 Short-run Decision: Profit Maximization
    • Profit:
    Π maximize when MR = MC = P (one price for every level of output & the whole market/industry ) » Profit maximization condition Firm will produce up to the point where the price of its output is just equal to short-run MC (P=MC)
  • Total Revenue, Average Revenue and Marginal Revenue for a competitive firm Quantity sold Price (RM) TR (RM) AR (RM) MR (RM) 0 20 0 20 20 1 20 20 20 20 2 20 40 20 20 3 20 60 20 20 4 20 80 20 20 5 20 100 20 20 6 20 120 20 20 7 20 140 20 20 8 20 160 20 20
  • Graphical Illustration of TR, AR and MR for a Competitive Firm TR AR = MR=D 1 2 3 4 5 6 7 8 9 10 160 140 120 100 80 60 40 20 0 Price and revenue Quantity Demanded (sold)
  • Profit maximization – Numerical example Quantity TR (RM) TC (RM) PROFIT (RM) MR (RM) MC (RM) 0 0 10 -10 - - 1 20 14 6 20 4 2 40 22 18 20 8 3 60 34 26 20 12 4 80 50 30 20 16 5 100 70 30 20 20 6 120 94 26 20 24 7 140 122 18 20 28 8 160 154 6 20 32
  • 160 140 120 100 80 60 40 20 0 Total revenue and total cost Total Revenue Total Cost Maximum Economic Profits RM30 Break-Even Point (Normal Profit) Break-Even Point (Normal Profit) 1 2 3 4 5 6 7 8 1. TOTAL REVENUE-TOTAL COST APPROACH
  • TOTAL REVENUE- TOTAL COST APPROACH
    • Firm selects output to maximize the difference between revenue and cost
    • We can graph the total revenue and total cost curves to show maximizing profits for the firm
    • Distance between revenues and costs show profits
  • 2. MARGINAL REVENUE- MARGINAL COST APPROACH A q 1 : MR > MC; ↑ output q 2 : MR < MC; ↓ output q * : MR = MC Profit is maximized where MR = MC Profit increases until it is maxed at q* q 2 10 20 30 40 Price 50 MC 0 1 2 3 4 5 6 7 8 9 10 11 Output q * AR=MR=P q 1 Lost Profit for q 2 > q* Lost Profit for q 1 < q*
  • Choosing Output: Short Run
    • The point where MR = MC, the profit maximizing output is chosen
      • MR=MC at quantity of 8
      • At a quantity less than 8, MR>MC so more profit can be gained by increasing output
      • At a quantity greater than 8, MC>MR , increasing output will decrease profits
  • The Relationship Between MR and MC:
    • -> A firm can increase its profit by increasing output.
    • -> A firm can reduce its losses by decreasing output.
    • -> Profits are at a maximum
    MR > MC MR < MC MR = MC
  • Short Run Equilibrium
      • Supernormal profits
      • economic profits
      • (P > ATC) or (TR > TC)
      • 2. Normal profits
      • Breakeven or zero profit
      • (P = ATC) or (TR = TC)
      • 3. Subnormal profits
      • Economic losses
      • (P < ATC) or (TR < TC)
      • continue the production if (ATC > P > AVC)
      • Shut down the operation if (ATC > P < AVC)
  • Supernormal Profit (Economic Profit)
    • Definition
      • Profit earned by a competitive firm when its total revenue is more than total cost (TR>TC) or price is greater than ATC (P>ATC).
    • Calculation:
    • TR = 5 x 9 = 45
    • TC = 3 x 9 = 27
    •  = (TR – TC) = (45 – 27) = 18
  • Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR=P ATC Economic Profit RM5 RM3 Supernormal Profit/ Economic Profit Minimum point of ATC
  • Breakeven/ Normal Profit
    • Definition
      • When total revenue is equal to total cost (TR=TC) or price equal to ATC (P=ATC), there are no profit or no losses.
        • Firm has only able to cover its costs.
    • Calculation :
    • TR = 5 x 9 = 45
    • TC = 5 x 9 = 45
    •  = (TR – TC) = (45 – 45) = 0
  • Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR ATC RM5 Breakeven/ Normal Profit Minimum point of ATC
  • Economic losses/ Subnormal profit
    • Definition
      • Losses incurred by a competitive firm when total revenue is less than total cost (TR < TC) or when the equilibrium price falls below ATC (P < ATC.
      • The firm incurs losses because would not able to cover its costs.
      • Calculation :
    • TR = 5 x 6 = 30
    • TC = 7 x 6 = 42
    •  = (TR – TC) = (30 – 42) = -12
  • Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR ATC Economic Loss RM5 RM7 Economic losses/ Subnormal profit
    • 5.3 Short Run Decision: Minimizing Loss
    • Losses
      • If (TR<TC) or (P>ATC)
    • Two conditions:
      • Keep operating (ATC>P>AVC)
      • If the operating profit is positive (TR – TVC > 0), the firm can use this operating profit to offset fixed costs and reduce total losses.
      • Shut down (ATC>P<AVC)
      • If the operating profit is negative (TR – TVC < 0), the firm suffers operating losses that push total losses above fixed costs.
  • Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR AVC ATC Economic Loss P ATC Subnormal Profit (ATC>P>AVC)): (i) Keep Operating AVC
  • Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR AVC ATC Economic Loss P ATC Subnormal Profits (ATC>P<AVC): (ii) Shutdown AVC
  • Shutting Down in the Short Run
    • Shutting down is not the same as going out of business.
    • In the short run, even a firm that shuts down keeps its productive capacity intact  that when demand increases enough, the firm will resume operation.
    • If market conditions look grim and are not expected to increase, the firm may decide to leave the market  a long run decision
  • Summary: Firm Decisions in the Long Run & Short Run
    • In the SR, firms have to decide how much to produce in the current scale of plant.
    • In the LR, firms have to choose among many potential scales of plant.
    SR CONDITION SR DECISION LR DECISION Profits TR > TC operate Expand + new firms enter Losses 1. With operating profit operate Contract + firms exit ( TR  TVC ) (losses < FC) 2. With operating losses shut down: Contract + firms exit ( TR < TVC ) losses = FC
  • Short Run Supply Curve
    • Competitive firms determine the quantity to produce where P = MC
    • Competitive firms supply curve is portion of the marginal cost curve above the AVC curve
  • Cost and Revenue, (dollars) MC AVC ATC Quantity Supplied P 1 P 2 P 3 P 4 P 5 Q 2 Q 3 Q 4 Q 5 Marginal Cost & Short-Run Supply Do not Produce Below AVC(< P 2 ) Normal Profit Shut down point Subnormal profit Supernormal profit
  • Cost and Revenue, (dollars) MR 1 Quantity Supplied MR 2 MR 3 MR 4 MR 5 P 1 P 2 P 3 P 4 P 5 Q 2 Q 3 Q 4 Q 5 Marginal Cost & Short-Run Supply Short-Run Supply Curve Supply No Production Below AVC
  • Short-Run Supply Curve
    • As long as the price covers average variable cost , the firm will supply the quantity resulting from the intersection of its upward-sloping marginal cost curve and its marginal revenue, or demand curve.
    • Thus, that portion of the firm’s marginal cost curve that rises above the lowest point on its average variable cost curve becomes the short-run firm supply curve.
  • 5.4 Long Run Adjustment
    • In the long run, there is an adequate time for the firm to make changes and adjustment to the production process.
    • All inputs are variable in the long run.
    • Perfect competitive firm only earn zero economic profit (normal profit) .
    • Its mean that TR is just enough to cover TC (  = TR – TC = 0)
    • This is due to the effect of free entry and exit.
  • Profit maximization in the LR
    • Free entry :
      • When firm earn economic profit > 0 in the SR:
        • Encourage NEW firms to enter the market.
        • Market supply increase (SS curve shift rightward).
        • Equilibrium price drop >> individual firm will also lower their price (price taker) until profit is eliminated.
        • When economic profit = 0 , no incentive for firm to come in.
  • Try this!!
  • Profit Maximization in the LR
    • Free exit :
      • When firm earn economic profit < 0 in the SR:
        • Incentive for existing (losing) firms to exit the market.
        • Market supply drop (SS curve shift leftward).
        • Equilibrium price rise >> individual firm will also increase their price (price taker) until profit is eliminated.
        • When economic profit = 0 , no incentive for firm to come in.
  • Try this!!
  • 5.5 External Changes: Consumer Preference & Technology
    • Changing preference:
      • Increase in Demand
      • Decrease in Demand
  • (1) Changing Preference Increase in demand Firm Industry
    • When preference increase :
      • DD curve shift rightward , quantity & price increase.
      • Existing firm gain positive economic profit .
      • Incentive for expansion or new firms entry .
      • Market SS increase : SS curve shift rightward, qty increase but price drop until each firm earn zero economic profit .
  • S 1 MC ATC MR D 1 Before Increase in Demand P Q q1 P Q Q1 Industry Firm (price taker) P1 P1
  • DD increases – DD curve shift left – P ↑ - Q ↑ - supernormal profit – new firms enter MR D 1 MC ATC D 2 Economic Profits S 1 MR 1 P Q q1 q2 P Q Q1 Q2 Industry Firm (price taker) P2 P1 P2 P1
  • New entry – SS ↑ - Q↑ - P↓ - (P = ATC) normal profit MR D 1 MC ATC D 2 Zero Economic Profits S 1 S 2 q2 Q1Q2Q3 IMPORTANT!! P Q q1 P Q Industry Firm (price taker) P2 P1 P2 P1
  • Changing Preference : Decrease in demand Industry Firm
    • When preference drop:
      • DD curve shift leftward , quantity & price decrease.
      • Existing firm suffer economic losses .
      • Incentive for contraction or exit .
      • Market SS decrease : SS curve shift leftward, qty drop but price increase until each firm earn zero economic profit.
  • Before decrease in demand: S 1 MC ATC D 1 MR P Q q1 P Q Q1 Industry Firm (price taker) P1 P1
  • MR D 1 MC ATC D 2 Economic Losses S 1 q2 DD decreases – DD curve shift right – P ↓ - Q ↓ - subnormal profit – existing firms exit P Q q1 P Q Q2Q1 Industry Firm (price taker) P1 P2 P1 P2
  • MR D 1 MC ATC D 2 Zero Economic Profits S 1 S 3 Q3 q2 Existing firms exit – SS ↓ - Q↓ - P↑: (P = ATC) normal profit IMPORTANT!! P Q q1 P Q Q2 Q1 Industry Firm (price taker) $60 50 40 $60 50 40
  • (2) Advancing Technology: Technology Improvements (a) Adopt new technology (b) Old technology firm Economic loss Positive economic profit New firms entry SS up, P down Profit reducing Produce at lower cost Exit Adopt new technology SS down, P up Zero economic profit
  • 5.6 Efficiency of Perfect Competition
    • What will be produced?
      • Efficient allocation of resources among firm.
    • How will it be produced?
      • Efficient distribution of outputs among households.
    • Who will get what is produced?
      • Producing what people want: The efficient mix of output.
    • Efficient Allocation of Resources Among Firm
      • Producing allocation using the best available-lowest cost - technology.
        • If more output can be produced with the same amount of inputs; it would make some people better off .
      • Inputs allocated across firms in the best possible way.
      • The assumptions that factor markets are competitive and open , that all firms pay the same prices for inputs, and that all firms maximize profits leads to the conclusion that the allocation of resources among firms is efficient.
    • Efficient Distribution of Outputs Among Households:
      • Household are free to choose among all the goods and services in the market.
        • Subject to purchasing power constraint (income & wealth).
        • Depend on the budget constraint.
      • As long as everyone shops freely in the same markets, no redistribution of final output among people will make them better off .
    • Producing What People Want (The Efficient Mix of Output):
      • Produce at P = MC .
      • Price reflects households’ willingness to pay.
        • By purchasing a product, individual reveal that it is worth as least as much as the other things that the same money could buy.
      • Marginal cost reflects the opportunity cost of the resources needed to produce a good .
        • Society will produce the efficient mix output if all firms equate price and marginal cost.
  • Summary: Firm Decisions in the Long Run & Short Run
    • In the SR, firms have to decide how much to produce in the current scale of plant.
    • In the LR, firms have to choose among many potential scales of plant.
    SR CONDITION SR DECISION LR DECISION Profits TR > TC operate Expand + new firms enter Losses 1. With operating profit operate Contract + firms exit ( TR  TVC ) (losses < FC) 2. With operating losses shut down: Contract + firms exit ( TR < TVC ) losses = FC
  • LETS DO IT
  • Output (unit) Total cost (RM) Variable cost (RM) 1 15 10 2 21 16 3 28 23 4 37 32 5 50 45 6 68 63
    • Calculate the equilibrium output if the price of the product is RM9 per unit.
    • Calculate the total profit or loss at the equilibrium output.
    • What is the condition for this firm?
    QUESTIONS:
  • THANK YOU