Perfect competition iimm


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Perfect competition iimm

  1. 1. Market structures – Perfect competition
  2. 2. Market Structures <ul><li>Market structure refers to the number and size of buyers and sellers in the market for a good or service. </li></ul><ul><li>A market can be defined as a group of firms willing and able to sell a similar product or service to the same potential buyers. </li></ul>
  3. 3. Classification of market structures <ul><li>4 broad categories – </li></ul><ul><li>Perfect competition </li></ul><ul><li>Monopoly </li></ul><ul><li>Monopolistic competition </li></ul><ul><li>Oligopoly </li></ul>
  4. 4. Major features that determine market structure <ul><li>Number of sellers </li></ul><ul><li>Product differentiation </li></ul><ul><li>Entry and exit conditions </li></ul>
  5. 5. What we analyze in all Market Structures… <ul><li>AR, MR </li></ul><ul><li>AC, MC </li></ul><ul><li>The point where MR = MC ( Profit maximum ) </li></ul><ul><li>Q* ( Equilibrium Output ) </li></ul><ul><li>P* ( Equilibrium Price ) </li></ul>
  6. 6. Profit <ul><li>Normal Profit : That part of the cost that is paid to the entrepreneur as a part of his compensation. </li></ul><ul><li>Super-normal Profit : The profit that the entrepreneur may get over and above the compensation he gets from the firm, for his contribution. </li></ul>
  7. 7. Perfect competition <ul><li>Features – </li></ul><ul><li>Large number of buyers and sellers </li></ul><ul><li>Products are perfect substitutes of each other; homogeneous products </li></ul><ul><li>Free entry and exit from the market </li></ul><ul><li>Perfect knowledge of the market to both buyers and sellers </li></ul><ul><li>No govt. intervention </li></ul><ul><li>Transport cost are negligible hence don’t affect pricing. </li></ul>
  8. 8. The Meaning of Competition <ul><li>As a result of its characteristics, the perfectly competitive market has the following outcomes: </li></ul><ul><ul><li>The actions of any single buyer or seller in the market have a negligible impact on the market price. </li></ul></ul><ul><ul><li>Each buyer and seller takes the market price as given. </li></ul></ul>
  9. 9. The Meaning of Competition <ul><li>Buyers and sellers in competitive markets are said to be price takers. </li></ul><ul><ul><li>Buyers and sellers must accept the price determined by the market. </li></ul></ul>
  10. 10. Revenue of a Competitive Firm <ul><li>Total revenue for a firm is the selling price times the quantity sold . </li></ul><ul><li>TR = (P X Q) </li></ul>
  11. 11. Revenue of a Competitive Firm <ul><li>Average revenue tells us how much revenue a firm receives for the typical unit sold. </li></ul>
  12. 12. Revenue of a Competitive Firm <ul><li>In perfect competition, average revenue equals the price of the good. </li></ul>
  13. 13. Revenue of a Competitive Firm <ul><li>Marginal revenue is the change in total revenue from an additional unit sold. </li></ul><ul><li>MR =  TR/  Q </li></ul>
  14. 14. Revenue of a Competitive Firm <ul><li>For competitive firms, marginal revenue equals the price of the good. </li></ul>
  15. 15. Total, Average, and Marginal Revenue for a Competitive Firm
  16. 16. Profit Maximization for the Competitive Firm <ul><li>The goal of a competitive firm is to maximize profit. </li></ul><ul><li>This means that the firm will want to produce the quantity that maximizes the difference between total revenue and total cost . </li></ul>
  17. 17. Short run price and output determination <ul><li>In SR a firm has to decide about the output it should produce at the market price so that profit is maximum. </li></ul><ul><li>Some inputs are fixed=> fixed costs </li></ul><ul><li>A firm may stay in business to cover these costs even if it incurs losses in SR </li></ul><ul><li>Cost functions of firms are different as factors of production are not homogeneous </li></ul><ul><li>Hence each firm has different profit levels. </li></ul>
  18. 18. Revenue Concepts <ul><li>Total Revenue (TR) = Price X Quantity </li></ul><ul><li>Average Revenue ( AR ) = TR / Q = PQ / Q = P </li></ul><ul><li>Marginal Revenue = TR </li></ul>Q
  19. 19. Conditions for Profit Maximization <ul><li>MR = MC ( Necessary condition ) </li></ul><ul><li>MCC should intersect MRC from below or MCC should be rising </li></ul>
  20. 20. Price and output determination for a perfectly competitive firm D S Q Q P P Industry Firm P * P * AC MC Q * Q * E C B A AR = MR
  21. 21. <ul><li>Firm has to take the price as given by the market </li></ul><ul><li>At the ruling price firm can sell any amount of its product </li></ul><ul><li>Demand is perfectly elastic </li></ul><ul><li>AR is parallel to X axis </li></ul><ul><li>Equilibrium is at pt. E where demand is equal to supply </li></ul><ul><li>This determines the price P * </li></ul><ul><li>This price is taken by the individual firm </li></ul>
  22. 22. <ul><li>Equilibrium for the firm is where MR =MC and MC curve cuts MR curve from below. I.e. at point A </li></ul><ul><li>Profit in the short run is the P * ABC </li></ul><ul><li>The firm may incur short run losses also. If the AC curve lies above the AR=MR curve the firm in the short run will incur losses. </li></ul>
  23. 23. Measuring Profit in the Graph for the Competitive Firm... Quantity 0 Price P = AR = MR ATC MC P Profit-maximizing quantity A Firm with Profits Profit Q ATC
  24. 24. Measuring Profit in the Graph for the Competitive Firm... Quantity 0 Price P = AR = MR ATC MC P Q Loss-minimizing quantity A Firm with Losses Loss ATC
  25. 25. Long run equilibrium of the firm and industry <ul><li>All factors are variable in the long run </li></ul><ul><li>Hence all costs are variable </li></ul><ul><li>Firm can change the plant and adjust the capacity according to the requirements of production </li></ul><ul><li>If profits are supernormal, more firms enter the market and vice versa. </li></ul><ul><li>Entry and exit of firms is possible </li></ul>
  26. 26. Long run equilibrium of the firm and industry <ul><li>If the number of firms increase, ( because they might be attracted towards the supernormal profits ), or the same firms increase their production, the supply curve moves to the right. At the same demand, this results in a decrease in price. </li></ul><ul><li>If the number of firms decrease, ( because of losses ), or the same firms decrease production, the supply curve shifts to the left. At the same demand, this results in an increase in price. </li></ul>
  27. 27. Long run equilibrium of the firm and industry <ul><li>Hence, in the long run, supernormal profit is not possible and all firms have to survive at a Normal profit. </li></ul><ul><li>This means that all the firms will stop production at the point where AC is lowest. This is also the price they will sell the goods at. </li></ul><ul><li>Hence in the long run, firms have no incentive to expand or contract their production capacity or leave the industry and new firms have no incentive to enter the industry. </li></ul>
  28. 28. <ul><li>MR = MC in long run as well </li></ul><ul><li>Under perfect competition, since MR =AR, in equilibrium also MC is equal to AR </li></ul><ul><li>Price must also equal AC. </li></ul><ul><li>P > AC => supernormal profits </li></ul><ul><li>New firms enter the market </li></ul><ul><li>If there are losses, firms will leave the market. </li></ul><ul><li>Thus in the long run equality of P and AC becomes a necessary condition. </li></ul><ul><li>Thus, </li></ul><ul><li>P(AR) =MR =AC = MC in the long run </li></ul>
  29. 29. Long run