Firms in competitive marketsAn industry is a group of firms which produce similar products.The total output of an industry is the output of firms within thatindustry.A characteristic of an industry is they can have varying numbersof firms making up the output.Microsoft is the only supplier of ‘Windows’ products.However, the UK has over 100,000 farms producing agriculturalproducts.
In the next couple of lectures we will be examining why someindustries have many producers, some a few and others onlyone.Initially we will examine two special benchmark cases, which willhelp us understand what determines market structure and thebehaviour of sellers, perfect competition and monopoly.
Characteristics of a perfectly competitive market•there are many buyers and sellers in the market therefore actions of any single buyer or seller has no affect on marketprices• firms take the market price as given as a result have a horizontal demand curve• the product sold by all firms is the same – homogeneous• there is perfect customer information• firms can freely enter or exit the market
Objective of a perfectly competitive firm•The goal of a competitive firm is to maximise profits•Maximum profits are where the difference between total costsand total revenue is greatest•Profit maximisation is found where marginal costs equalsmarginal revenueΠ max where MC = MR
REVISIONMaximizing profitsOutputQ1EMC,MRMCMR0If MR > MC, an increasein output will increaseprofits.If MR < MC, a decreasein output will increaseprofits.So profits are maximizedwhen MR = MC at Q1(so long as the firmcovers variable costs)
The supply curve under perfect competition (1)• Above price P3 (pointC), the firm makes profitabove the opportunitycost of capital in theshort run• At price P3, (point C),the firm makesNORMAL PROFITSP1£OutputSAVCSMCQ1SATCP3ACQ3
The supply curve under perfect competition (2)• Between P1 and P3, (Aand C), the firm makesshort-run losses, butremains in the market• Below P1 (the SHUT-DOWN PRICE), the firmfails to cover SAVC, andexitsP1£OutputSAVCSMCQ1SATCP3ACQ3
The supply curve under perfect competition (3)– showing how much thefirm would produce ateach price level.P1£OutputSAVCSMCQ1SATCP3ACQ3• So the SMC curve above SAVCrepresents the firm’s SHORT-RUN SUPPLY CURVE
The firm and the industry in the short rununder perfect competition (1)INDUSTRYOutput£QPSRSSDFirmSACP£OutputSMCD=MR=ARq
The firm and the industry in the short rununder perfect competition (1)INDUSTRYOutput£QPSRSSDFirmMarket price is set at industry level at the intersection ofdemand and supply– the industry supply curve is the sum of the individual firm’ssupply curvesSACP£OutputSMCD=MR=ARq
The firm and the industry in the short rununder perfect competition (2)INDUSTRYFirmThe firm accepts price as given at P– and chooses output at q where SMC=MR to maximize profitsSACP£OutputSMCD=MR=ARqOutput£QPSRSSD
The firm and the industry in the short rununder perfect competition (3)INDUSTRYOutput£QPSRSSDAt this price, profits are shown by the shaded area.These profits attract new entrants into the industry.As more firms join the market, the industry supply curve shiftsto the right, and market price falls.SRSS1P1SACFirmP£OutputSMCD=MR=ARq Q1
Long-run equilibriumINDUSTRYFirmLACP*£OutputLMCD=MR=ARq*The market settles in long-run equilibrium when the typicalfirm just makes normal profit by setting LMC=MR at the minimumpoint of LAC. Long-run industry supply is horizontal.If the expansion of the industry pushes up input prices (e.g. wages)then the long-run supply curve will not be horizontal, but upward-sloping.SRSSDOutput£QP*LRSS
A Shift in Demand in the Short Run andLong Run• An increase in demand raises price and quantityin the short run.• Firms earn profits because price now exceedsaverage total cost.
An Increase in Demand in the Short Run and Long RunFirm(a) Initial ConditionQuantity (firm)0PriceMarketQuantity (market)Price0DDemand, 1SShort-run supply, 1P1ATCLong-runsupplyP11QAMC1q
Why the Long-Run Supply Curve Might Slope UpwardWhilst a constant Long-Run supply curve may exist other casesare possible.For example, when an industry expands its output, the increaseddemand for inputs (materials, labour etc.) may lead to anincrease in their prices.This shifts up the average cost curve, reducing profits, attractingfewer firms and price settles above P1 resulting in an upwardsloping long-run supply curve.If input costs fall as a result of increased demand, the long-runsupply curve may be downward sloping.