OutlineI. IntroductionII. Perfect Competition in the Short-Run A. Demand B. Supply C. Profit Maximization
Introduction• Characteristics of Perfect Competition • Large number of buyers and sellers. • Firms sell identical product. • No barriers to entry or exit. • Buyers and sellers have perfect information• Perfect Comp. is our "Benchmark" Model – meaning it is not very realistic, but will be used to compare with more realistic models
Firms Demand Curve• Consumer Price Taking • Take market price as given and purchase according to their demand curve.• Firms • Because a firm makes the same thing as so many other firms, if an individual firm changes their price, they will lose ALL of their business. So they have to sell the product at the market price. Note that they can sell as much as they want at that price
Firm’s Demand Curve$p* D0 Q
Firms Horizontal Demand Curve• At P > p*, Sales = 0• At P < p*, Less Profits then if Sell at p*• p* found from Market Equilibrium Price
Market Demand Curve• Downward Sloping• Obeys Law of Demand
Marginal Revenue• Marginal Revenue is the increase in revenue from selling one more unit• If the firm gets price p* for every unit it sells, then p* is the marginal revenue at all quantities. • MR = ∆ in TR ∆ in Q• Horizontal Demand Curve means MR = P
Profit Maximization• We assume that the firm is profit maximizing.• Profit = Total Revenue - Total Cost• Total Revenue is P*Q.• We know what the Total Cost curve looks like, so let’s graph both
Total Revenue and Total Cost TR$ TC Q
Profit Maximizing• Since the perfectly competitive firm cannot choose the price, the only choice left for the firm is to choose how much to produce.• The firm will choose the quantity where TR-TC is the largest, in other words - where the difference between the TR and TC curves is the biggest
Total Revenue and Total Cost TR$ TC Q* Q
Profit Maximizing• Note that the slope of the TR and TC curves are the same at this quantity.• This means the the derivative of TR is the same as the derivative of TC at Q*.• There is a way we can find Q* without calculus, though.• We will need to graph the MR and MC curves
Profit Max without Calculus$ MC MR Q1 Q2 Q3Q4 Q
Profit Maximizing• Consider the quantity Q1 in the previous graph• At that quantity MR>MC, meaning that the additional revenue from selling one more is greater than the cost of making one more.• This means the firm will make more profit by making one more, so they will• The same is true at Q2
Profit Maximizing• But at Q3, MR=MC, meaning that the firm will gewt exactly as much money from selling one more as it cost them to make one more.• So the firm has no interest in making one more
Profit Maximizing• And at Q4, MR<MC, meaning that it costs more to make one more than it will bring in when it is sold. This means the firm will lose money.• So the firm would want to decrease production to bring MC down
The Golden Rule• A profit maximizing firm will always produce where MC=MR.• In the case of Perfect Competition, we know MR=P, so we could also say that a profit maximizing firm produces where P=MC.
Firm’s Supply Curve• In other words, given a price, the firm looks to the MC curve and produces that quantity. This is a supply curve. The Perfectly Competitive firm’s MC curve (the upward sloping portion of it, at least) is its Supply Curve
Profit• We can also determine exactly how much profit the firm is making.• We know profit = total revenue - total cost• Since ATC=TC/Q, we know ATC*Q=Total Cost• We also knoe that total revenue = price*Q• So Profit=(p*Q)-(ATC*Q)=(p-ATC)*Q, or graphically...
Profitp MC ATCp* MR AVCatc Q* Q
Profitp MC ATCp* MR The Area of this AVC Rectangle is the Profitatc Q* Q
Loss• Note that as long as p>ATC at q*, there will be a profit.• But it may be possible that no matter how much is produced, the firm will still lose money• In this case the Q* is the quantity where the firm loses the least amount of money• For example...
Lossp MC ATC AVCatcp* MR Q* Q
Lossp MC ATC AVCatc The area is the lossp* MR Q* Q
The decision of whether to stay open• Just because a firm is losing money in the short run doesn’t mean it should close its doors. Often we hear of major firms like IBM posting a loss, but they stay open• When does a firm shut down?• Break Even Point - P = ATC • Firm is earning normal profits.
The decision of whether to stay open• If AVC<P*<ATC, then the firm is losing money, BUT they are getting enough revenue to pay all of the variable cost and some of the fixed cost. If they shut down, they will have to pay all of the fixed cost with no revenue. So they are better off staying open and being able to pay some of the fixed costs than shutting down and not being able to pay ALL of the fixed cost.
The Shut Down Point• Shut-down Point - P = min AVC • Firm is indifferent between staying in business and going out of business.• Firm Supply Curve • MC curve at or above the Shut-down Point
Market Supply• Sum of Individual Firms Supply Curves• Upward Sloping - Obeys Law of Supply
Profit Maximizing in the Short Run• In the short run, the firm takes the market price, given by the intersection of the market supply and demand curves.• The firm then produces where MC=MR and takes a profit or loss as long as P>AVC
Profit Maximizing in Short RunP P S D Firm Q Market Q
Profit Maximizing in Short RunP P S p* D Firm Q Market Q
Profit Maximizing in Short RunP P S MR p* D Firm Q Market Q
Profit Maximizing in Short RunP MC P S MR p* D Firm Q Market Q
Profit Maximizing in Short RunP MC P S MR p* ATC D Firm Q Market Q
Profit Maximizing in Short RunP MC P S MR p* ATC AVC D Firm Q* Q Market Q
Profit Maximizing in Short RunP MC P S MR p* ATC AVC D Firm Q* Q Market Q
Profit Maximizing in Short RunP MC P S MR p* Profit ATC AVC D Firm Q* Q Market Q
Profit Maximizing in Short Run• It is also possible that the market price is so low (of the ATC is so hight) that the firm will lose money
Profit Maximizing in Short Run (Losses)P MC P S ATC Loss AVC p* MR D Firm Q* Q Market Q
The Long Run• Recall that the long run is defined as the time it takes for fixed costs to change.In other words - all costs are variable. The ATC curve equals the AVC curve• Also recall that Perfect Competition assumes that there is costless and entry and exit. In other words people can start up firms or shut down firms without any cost whatsoever
Perfect Comp. in the Long Run• If there are profits being made in an industry, firms will enter.• If there are losses in an industry, firms will leave• But what happens to the market when things like this happen?• Consider the previous example where the firm was making profits in the short run
Profit Maximizing in Short RunP MC P S MR p* Profit ATC D Firm Q* Q Market Q
Profit Maximizing in Long Run• Firms see this profit and enter the industry• More firms in an industry means market supply increases• This drive price down and profits down• Firms continue to enter until the price is driven down so low that profits are zero. Then no more firms want to enter and there is a long run equilbrium
Profit Maximizing in Long RunP MC P SS MR p* ATC MR D Firm Q*Q* Q Market Q
Profit Maximizing in Long Run• Note that price is driven down to the bottom of the ATC curve• In the long run, since profits MUST be zero, MR (price) will have to cross the MC curve where it intersects the ATC curve.
Losses in the Long Run• But what if there are losses in the long run?• If there are any losses in the long run, firms will want to leave the industry• When firms leave, market supply decreases• This drives up price and drives down losses• Firms leave as long as there are losses. Once profits hit zero, firms stop leaving.• Consider the example from earlier...
Losses in the Long RunP MC P S S ATC MR p* MR D Firm Q* Q Market Q
In the Long Run...• In the Long Run in a perfectly competitive market... – there are ALWAYS zero profits – P=MC=ATC – The firm produces at the lowest possible cost
Long Run Supply• Let’s say that we have been discussing the PB&J market as perfectly competitive• If there are profits being made, firms enter and drive profits down.• But as firms enter the PBJ industry, what is happening to the jelly industry?• Demand for jelly is rising and the price of jelly is rising
Long Run Supply• If the price of jelly is rising, all of the cost curves in the PBJ industry will rise• Which means the bottom of the ATC curve is rising• Which, in turn, means that the zero profit price has gone up
Increasing Cost Industries• Thus the PBJ indsutry is called an increasing cost industry, because as more firms enter the industry and the market quantity rises, the zero profit price rises• We can draw a Long Run Supply Curve which demonstrates the relationship between the long run quantity supplied and the zero profit price
Increasing Cost Industries• If the industry is an increasing cost industry, the long run supply curve will be upward sloping - indicating that as the long run quantity increases, the zero profit price increases
Constant Cost Industries• But what if costs do not change as firms enter and leave the industry?• Then the zero profit price will not change as quantity supplied in the long run changes.• In this case the Long Run Supply Curve is flat
Decreasing Cost Industries• What if more firm enter the industry and that allows Jelly Makers to take advantage of economies of scale and make jelly cheaper.• Then as the long run quantity supplied increases, costs for the firms go down and thus the zero profit price is going down.• This means the long run supply curve will be downward sloping
Long Run Supply Curves$ S (increasing cost) S (constant cost) S (decreasing cost) Q
The Benefits of Perfect Competition• Recall in the beginning of the semester we discussed Productive Efficiency - producing as much as possible with a given amount of recources.• In order to do that the firm must produce at its lowest cost point. Any higher cost per unit will not allow the firm to make as much with the same resources
Productive Efficiency• Therefore, a perfectly competitive market, in the long run, will always be productively efficient• This is because, in the long run, a perfectly competitive firm always produces at the bottom of the ATC curve
Allocative Efficiency• We will now introduce another type of efficiency - Allocative Efficiency• Allocative Efficiency asks the question - “Are we making sure everyone who is willing to buy the good has got together with everyone who is willing to sell them the good?”
Allocative Efficiency• In the context of perfect competition, we are asking if, given the quantity produced is the amount people are willing to pay (the demand curve) equal to the amount people are willing to sell for (the MC curve)?• The answer is yes, so a perfectly competitive market is allocatively efficient as well.
Allocative Efficiency• Note that at any quantity less than the equilibrium Q*, the amount people are willing to pay is more than the MC, meaning that it will cost firms less to make one more than people are willling to pay.• If the market produces less than Q*, it is then inefficient, since the firm could sell one for more than cost and someone would buy it. Both parties win.
A Note on Efficiency and Perfect Competition• Note that a perfectly competitive market in the long run is both allocative and productively efficient• That is to say, the market makes as much as it possibly could and makes sure everyone who is willing to buy a good gets together with everyone who is selling.• This is done without any government interference. Why do we need a govt?