Lecture 11  market structure- perfect competition
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  • What do you think are possible effects of a merger on consumers?A merged company may have a higher market power and thus the ability to increase prices.Staple’s lawyer will argue that a merger will not necessarily increase price. Why will price not increase? Market share will not increase. What is Market Share? Share of Consumers purchasing from the firm. How do you know this? Who are its competitors etc.
  • Variants of CokeSpriteMinute Maid Juice
  • If it increases its price what would be the effect?- Remain same. Decrease. Increase.What is Coke’s market? How can consumer’s substitute?
  • 4 Firm Concentration Ratio is same for both but does that mean that X is equally concentrated as YWhat is the 3 Firm concentration ratio?
  • % of total industry sales attributed by the n largest firmsIdentical firms the curve is a straight lineIf curve of X is above that of Y. It is more concentrated than Y till 4 firms
  • http://mospi.nic.in/Mospi_New/upload/nic_alphabetic_5digit2004.html
  • http://mospi.nic.in/Mospi_New/upload/nic_alphabetic_5digit2004.html
  • 4 Firm Concentration Ratio is same for both but does that mean that X is equally concentrated as YWhat is the 3 Firm concentration ratio?
  • 4 Firm Concentration Ratio is same for both but does that mean that X is equally concentrated as YWhat is the 3 Firm concentration ratio?

Lecture 11  market structure- perfect competition Lecture 11 market structure- perfect competition Presentation Transcript

  • Chapter 8Profit Maximization and Competitive Supply
  • Staples and Office Depot Merger  1997, Staples and Office Depot wanted to merge  FTC analyzed the effect of proposed merger on consumers.  What would the decision be based on?©2005 Pearson Education, Inc.
  • Coca Cola Inc.©2005 Pearson Education, Inc.
  • Coca Cola Inc.  Coca Cola is reviewing price of Coke.  What should it expect revenue to be if it increased its price?©2005 Pearson Education, Inc.
  • MARKET STRUCTURE©2005 Pearson Education, Inc. Chapter 8 5
  • MARKET STRUCTURE  What determines concentration in a market?  Number of firms?  Number of firms is a good indicator if firms are homogeneous©2005 Pearson Education, Inc. Chapter 8 6
  • SEARCH ENGINES:  : 64.1% : 18.0% : 13.6%©2005 Pearson Education, Inc. Chapter 8 7
  • SODA COMPANIES   : 41.2% : 15.4%  : 33.6%©2005 Pearson Education, Inc. Chapter 8 8
  • Satellite TV Providers©2005 Pearson Education, Inc. Chapter 8 9
  • MEASURING MARKET CONCENTRATION©2005 Pearson Education, Inc. Chapter 8 10
  • CONCENTRATION INDEX  Measure ability of firms to raise price above competitive level.  Higher concentration index, greater likely hood to collude©2005 Pearson Education, Inc. Chapter 8 11
  • CONCENTRATION RATIO  m- Firm Concentration Ratio Sum total of share of total industry sales accounted by m largest firms©2005 Pearson Education, Inc. Chapter 8 12
  • m-Firm Concentration Ratio Firm Industry X Industry Y 1 20 60 2 20 10 3 20 5 4 20 5 5 20 5 Total 100 85©2005 Pearson Education, Inc. Chapter 8 13
  • m-Firm Concentration Ratio % of total industry o/p X Y 80 60 1 4 Number of Firms©2005 Pearson Education, Inc. Chapter 8 14
  • INDUSTRY CLASSIFICATION  US Bureau of Census has a classification of industries : Standard Industrial Classification  Number classification where each succeeding number represents a finer classification©2005 Pearson Education, Inc. Chapter 8 15
  • INDIAN INDUSTRY CLASSIFICATION  National Sample Survey Organization classifies industries in India in a similar fashion.  National Industrial Classification  5 Digit Index©2005 Pearson Education, Inc. Chapter 8 16
  • National Industry Classification  Section: e.g. Section C: Manufacturing  Division: e.g. 13, Manufacturing textiles  Group: e.g. 131, Spinning, weaving and finishing of textiles  Class: e.g. 1311, Preparation and Spinning of textiles  Sub-Class: e.g. 13111 Preparation and spinning of cotton fibre including blended cotton©2005 Pearson Education, Inc. Chapter 8 17
  • m-Firm Concentration Ratio Firm Industry X Industry Y 1 20 60 2 20 10 3 20 5 4 20 5 5 20 5 Total 100 85©2005 Pearson Education, Inc. Chapter 8 18
  • Herfindahl and Hirschman Index  Weighted average of market shares of firms N 2 HHI i 1 Si  An industry with only one firm will have HHI index of 10,000  As number of firms increases HHI decreases©2005 Pearson Education, Inc. Chapter 8 19
  • m-Firm Concentration Ratio Firm Industry X Industry Y 1 20 60 2 20 10 3 20 5 4 20 5 5 20 5 Total 100 85©2005 Pearson Education, Inc. Chapter 8 20
  • Herfindahl and Hirschman Index  HHI for Industry X= 2,000  HHI for Industry Y = 3,850©2005 Pearson Education, Inc. Chapter 8 21
  • TYPES OF MARKET STRUCTURE©2005 Pearson Education, Inc. Chapter 8 22
  • TYPES OF MARKET STRUCTURE  PERFECT COMPETITION  MONOPOLY  OLIGOPOLY©2005 Pearson Education, Inc. Chapter 8 23
  • PERFECT COMPETITION©2005 Pearson Education, Inc. Chapter 8 24
  • ASSUMPTIONS OF PERFECT COMPETITION 1. Price taking 2. Product homogeneity 3. Free entry and exit©2005 Pearson Education, Inc. Chapter 8 25
  • Perfectly Competitive Markets 1. Price Taking  The individual firm sells a very small share of the total market output and, therefore, cannot influence market price  Each firm takes market price as given – price taker  The individual consumer buys too small a share of industry output to have any impact on market price©2005 Pearson Education, Inc. Chapter 8 26
  • Perfectly Competitive Markets 2. Product Homogeneity  The products of all firms are perfect substitutes  Product quality is relatively similar as well as other product characteristics  Agricultural products, oil, copper, iron, lumber  Heterogeneous products, such as brand names, can charge higher prices because they are perceived as better©2005 Pearson Education, Inc. Chapter 8 27
  • Perfectly Competitive Markets 3. Free Entry and Exit  When there are no special costs that make it difficult for a firm to enter (or exit) an industry  Buyers can easily switch from one supplier to another  Suppliers can easily enter or exit a market  Pharmaceutical companies are not perfectly competitive because of the large costs of R&D required©2005 Pearson Education, Inc. Chapter 8 28
  • When are Markets Competitive?  Few real products are perfectly competitive  Many markets are, however, highly competitive They face relatively low entry and exit costs Highly elastic demand curves  No rule of thumb to determine whether a market is close to perfectly competitive Depends on how they behave in situations©2005 Pearson Education, Inc. Chapter 8 29
  • Do firms maximize profits? Managers in firms may be concerned with other objectives  Revenue maximization  Revenue growth  Dividend maximization  Short-run profit maximization (due to bonus or promotion incentive)  Could be at expense of long run profits©2005 Pearson Education, Inc. Chapter 8 30
  • Profit Maximization  Implications of non-profit objective Over the long run, investors would not support the company Without profits, survival is unlikely in competitive industries  Managers have constrained freedom to pursue goals other than long-run profit maximization©2005 Pearson Education, Inc. Chapter 8 31
  • OPTIMAL OUTPUT©2005 Pearson Education, Inc. Chapter 8 32
  • Marginal Revenue, Marginal Cost, and Profit Maximization  We can study profit maximizing output for any firm, whether perfectly competitive or not Profit ( ) = Total Revenue - Total Cost If q is output of the firm, then total revenue is price of the good times quantity Total Revenue (R) = Pq©2005 Pearson Education, Inc. Chapter 8 33
  • Marginal Revenue, Marginal Cost, and Profit Maximization  Costs of production depends on output Total Cost (C) = C(q)  Profit for the firm, , is difference between revenue and costs ( q ) R( q ) C ( q )©2005 Pearson Education, Inc. Chapter 8 34
  • Marginal Revenue, Marginal Cost, and Profit Maximization  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©2005 Pearson Education, Inc. Chapter 8 35
  • Profit Maximization – Short Run Profits are maximized where MR (slope Cost, at A) and MC (slope at B) are equal Revenue, Profit Profits are C(q) ($s per maximized year) where R(q) – A C(q) is R(q) maximized B 0 Output q0 q* (q)©2005 Pearson Education, Inc. Chapter 8 36
  • Marginal Revenue, Marginal Cost, and Profit Maximization  Slope of the revenue curve is the marginal revenue  Change in revenue resulting from a one-unit increase in output  Slope of the total cost curve is marginal cost  Additional cost of producing an additional unit of output©2005 Pearson Education, Inc. Chapter 8 37
  • Marginal Revenue, Marginal Cost, and Profit Maximization  Profit is negative to begin with, since revenue is not large enough to cover fixed and variable costs  As output rises, revenue rises faster than costs increasing profit  Profit increases until it is maxed at q*  Profit is maximized where MR = MC or where slopes of the R(q) and C(q) curves are equal©2005 Pearson Education, Inc. Chapter 8 38
  • Marginal Revenue, Marginal Cost, and Profit Maximization  Profit is maximized at the point at which an additional increment to output leaves profit unchanged R C R C 0 q q q MR MC 0 MR MC©2005 Pearson Education, Inc. Chapter 8 39
  • The Competitive FirmPrice$ per Firm Price Industrybushel $ per bushel S $4 d $4 D Output Output 100 200 (bushels) 100 (millions of bushels)©2005 Pearson Education, Inc. Chapter 8 40
  • The Competitive Firm  Demand curve faced by an individual firm is a horizontal line Firm’s sales have no effect on market price  Demand curve faced by whole market is downward sloping Shows amount of goods all consumers will purchase at different prices©2005 Pearson Education, Inc. Chapter 8 41
  • The Competitive Firm  The competitive firm’s demand Individual producer sells all units for $4 regardless of that producer’s level of output MR = P with the horizontal demand curve For a perfectly competitive firm, profit maximizing output occurs when MC(q) MR P AR©2005 Pearson Education, Inc. Chapter 8 42
  • SHORT RUN OPTIMAL OUTPUT©2005 Pearson Education, Inc. Chapter 8 43
  • Choosing Output: Short Run  In the short run, capital is fixed and firm must choose levels of variable inputs to maximize profits  We can look at the graph of MR, MC, ATC and AVC to determine profits©2005 Pearson Education, Inc. Chapter 8 44
  • A Competitive Firm Price MC Lost Profit 50 Lost Profit for q2>q* for q2>q* A 40 AR=MR=P ATC 30 AVC 20 q1 : MR > MC q2: MC > MR q*: MC = MR 10 0 1 2 3 4 5 6 7 8 9 10 11 q1 q* q2 Output©2005 Pearson Education, Inc. Chapter 8 45
  • Choosing Output: Short Run  The point where MR = MC, the profit maximizing output is chosen MR = MC at quantity, q*, 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©2005 Pearson Education, Inc. Chapter 8 46
  • A Competitive Firm – Positive Profits Price MC Total 50 Profit = ABCD D A 40 AR=MR=P ATC 30 C AVC Profits areProfit per B determinedunit = P-AC(q) = A by output perto B 20 unit times quantity 10 0 1 2 3 4 5 6 7 8 9 10 11 q1 q* q2 Output©2005 Pearson Education, Inc. Chapter 8 47
  • PROFITS AND LOSSES©2005 Pearson Education, Inc. Chapter 8 48
  • The Competitive Firm  A firm does not have to make profits  It is possible a firm will incur losses if the P < AC for the profit maximizing quantity Still measured by profit per unit times quantity Profit per unit is negative (P – AC < 0)©2005 Pearson Education, Inc. Chapter 8 49
  • A Competitive Firm – Losses MC ATC Price B C D P = MR AAtq *:MR =MC and P < AVCATCLosses =(P- AC) x q*or ABCD q* Output ©2005 Pearson Education, Inc. Chapter 8 50
  • Choosing Output in the Short Run  Summary of Production Decisions Profit is maximized when MC = MR If P > ATC the firm is making profits If P < ATC the firm is making losses©2005 Pearson Education, Inc. Chapter 8 51
  • SHUTDOWN OUTPUT©2005 Pearson Education, Inc. Chapter 8 52
  • Short Run Production  Why would a firm produce at a loss? Might think price will increase in near future Shutting down and starting up could be costly  Firm has two choices in short run Continue producing Shut down temporarily Will compare profitability of both choices©2005 Pearson Education, Inc. Chapter 8 53
  • Short Run Production  When should the firm shut down? If AVC < P < ATC, the firm should continue producing in the short run  Can cover all of its variable costs and some of its fixed costs If AVC > P < ATC, the firm should shut down  Cannot cover its variable costs or any of its fixed costs©2005 Pearson Education, Inc. Chapter 8 54
  • A Competitive Firm – Losses Price MC ATC Losses B C D P = MR AP < ATC butAVC so AVCfirm willcontinue to Fproduce in Eshort run q* Output ©2005 Pearson Education, Inc. Chapter 8 55
  • SHORT RUN SUPPLY CURVE©2005 Pearson Education, Inc. Chapter 8 56
  • Competitive Firm – Short Run Supply  Supply curve tells how much output will be produced at different prices  Competitive firms determine quantity to produce where P = MC Firm shuts down when P < AVC  Competitive firms’ supply curve is portion of the marginal cost curve above the AVC curve©2005 Pearson Education, Inc. Chapter 8 57
  • A Competitive Firm’s Short-Run Supply Curve Price ($ per The firm chooses the Supply is MC unit) output level where P = MR = MC, above AVC as long as P > AVC. MC S P2 ATC P1 AVC P = AVC q1 q2 Output©2005 Pearson Education, Inc. Chapter 8 58
  • A Competitive Firm’s Short-Run Supply Curve  Supply is upward sloping due to diminishing returns©2005 Pearson Education, Inc. Chapter 8 59
  • CHANGE IN COSTS AND SUPPLY CURVE©2005 Pearson Education, Inc. Chapter 8 60
  • A Competitive Firm’s Short-Run Supply Curve  Over time, prices of product and inputs can change  How does the firm’s output change in response to a change in the price of an input? We can show an increase in marginal costs and the change in the firm’s output decisions©2005 Pearson Education, Inc. Chapter 8 61
  • The Response of a Firm to a Change in Input Price Price ($ per MC2 Input cost increases unit) and MC shifts to MC2 Savings to the firm and q falls to q2. from reducing output MC1 $5 q2 q1 Output©2005 Pearson Education, Inc. Chapter 8 62
  • MARKET SUPPLY CURVE©2005 Pearson Education, Inc. Chapter 8 63
  • Short-Run Market Supply Curve  Shows the amount of product the whole market will produce at given prices  Is the sum of all the individual producers in the market  We can show graphically how we can sum the supply curves of individual producers©2005 Pearson Education, Inc. Chapter 8 64
  • Industry Supply in the Short Run The short-run S $ per industry supply curve unit is the horizontal summation of the supply curves of the firms. P3 P2 P1 Q 2 4 5 7 8 10 15 21©2005 Pearson Education, Inc. Chapter 8 65
  • ELASTICITY OF SUPPLY©2005 Pearson Education, Inc. Chapter 8 66
  • Elasticity of Market Supply  Elasticity of Market Supply Measures the sensitivity of industry output to market price The percentage change in quantity supplied, Q, in response to 1-percent change in price Es ( Q / Q ) /( P / P )©2005 Pearson Education, Inc. Chapter 8 67
  • Elasticity of Market Supply  When MC increases rapidly in response to increases in output, elasticity is low  When MC increases slowly, supply is relatively elastic  Perfectly inelastic short-run supply arises when the industry’s plant and equipment are so fully utilized that new plants must be built to achieve greater output  Perfectly elastic short-run supply arises when marginal costs are constant©2005 Pearson Education, Inc. Chapter 8 68
  • PRODUCER SURPLUS©2005 Pearson Education, Inc. Chapter 8 69
  • Producer Surplus in the Short Run  Price is greater than MC on all but the last unit of output  Therefore, surplus is earned on all but the last unit  The producer surplus is the sum over all units produced of the difference between the market price of the good and the marginal cost of production  Area above supply curve to the market price©2005 Pearson Education, Inc. Chapter 8 70
  • Producer Surplus for a Firm Price ($ per unit of Producer MC AVC output) Surplus B A P At q* MC = MR. Between 0 and q, MR > MC for all units. Producer surplus is area above MC to the price q* Output©2005 Pearson Education, Inc. Chapter 8 71
  • The Short-Run Market Supply Curve  Sum of MC from 0 to q*, it is the sum of the total variable cost of producing q*  Producer Surplus can be defined as the difference between the firm’s revenue and its total variable cost  We can show this graphically by the rectangle ABCD Revenue (0ABq*) minus variable cost (0DCq*)©2005 Pearson Education, Inc. Chapter 8 72
  • Producer Surplus for a Firm Price ($ per Producer MC AVC unit of Surplus output) B A P Producer surplus is also ABCD = Revenue minus D variable costs C q* Output©2005 Pearson Education, Inc. Chapter 8 73
  • Producer Surplus Versus Profit  Profit is revenue minus total cost (not just variable cost)  When fixed cost is positive, producer surplus is greater than profit Producer Surplus PS R - VC Profit R - VC - FC©2005 Pearson Education, Inc. Chapter 8 74
  • Producer Surplus Versus Profit  Costs of production determine magnitude of producer surplus Higher cost firms have less producer surplus Lower cost firms have more producer surplus Adding up surplus for all producers in the market given total market producer surplus Area below market price and above supply curve©2005 Pearson Education, Inc. Chapter 8 75
  • Producer Surplus for a Market Price S ($ per unit of output) Market producer surplus is P* the difference between P* and S from 0 to Q*. Producer Surplus D Q* Output©2005 Pearson Education, Inc. Chapter 8 76
  • LONG RUN OUTPUT DECISIONS©2005 Pearson Education, Inc. Chapter 8 77
  • Choosing Output in the Long Run  In short run, one or more inputs are fixed Depending on the time, it may limit the flexibility of the firm  In the long run, a firm can alter all its inputs, including the size of the plant  We assume free entry and free exit No legal restrictions or extra costs©2005 Pearson Education, Inc. Chapter 8 78
  • Output Choice in the Long Run Price LMC LAC SMC SAC D A $40 P = MR C B $30 In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD. q1 q2 q3 Output©2005 Pearson Education, Inc. Chapter 8 79
  • Choosing Output in the Long Run  In the short run, a firm faces a horizontal demand curve  Take market price as given  The short-run average cost curve (SAC) and short-run marginal cost curve (SMC) are low enough for firm to make positive profits (ABCD)  The long-run average cost curve (LRAC)  Economies of scale to q2  Diseconomies of scale after q2©2005 Pearson Education, Inc. Chapter 8 80
  • Output Choice in the Long Run In the long run, the plant size will be Price increased and output increased to q3. Long-run profit, EFGD > short run LMC profit ABCD. LAC SMC SAC D A $40 P = MR C B G F $30 Output q1 q2 q3©2005 Pearson Education, Inc. Chapter 8 81
  • Long-Run Competitive Equilibrium  For long run equilibrium, firms must have no desire to enter or leave the industry  We can relate economic profit to the incentive to enter and exit the market©2005 Pearson Education, Inc. Chapter 8 82
  • Long-Run Competitive Equilibrium  Zero-Profit A firm is earning a normal return on its investment Doing as well as it could by investing its money elsewhere Normal return is firm’s opportunity cost of using money to buy capital instead of investing elsewhere Competitive market long run equilibrium©2005 Pearson Education, Inc. Chapter 8 83
  • Long-Run Competitive Equilibrium  Entry and Exit The long-run response to short-run profits is to increase output and profits Profits will attract other producers More producers increase industry supply, which lowers the market price This continues until there are no more profits to be gained in the market – zero economic profits©2005 Pearson Education, Inc. Chapter 8 84
  • Long-Run Competitive Equilibrium – Profits •Profit attracts firms •Supply increases until profit = 0 $ per Firm $ per Industry unit of unit of S1 output output LMC $40 P1 LAC S2 $30 P2 D q2 Output Q1 Q2 Output©2005 Pearson Education, Inc. Chapter 8 85
  • Long-Run Competitive Equilibrium – Losses •Losses cause firms to leave •Supply decreases until profit = 0 $ per Firm $ per Industry unit of LMC unit of S2 output output LAC $30 P2 S1 $20 P1 D q2 Output Q2 Q1 Output©2005 Pearson Education, Inc. Chapter 8 86
  • Long-Run Competitive Equilibrium 1. All firms in industry are maximizing profits  MR = MC 2. No firm has incentive to enter or exit industry  Earning zero economic profits 3. Market is in equilibrium  QD = Q S©2005 Pearson Education, Inc. Chapter 8 87
  • Choosing Output in the Long Run  Economic Rent The difference between what firms are willing to pay for an input less the minimum amount necessary to obtain it When some have accounting profits that are larger than others, they still earn zero economic profits because of the willingness of other firms to use the factors of production that are in limited supply©2005 Pearson Education, Inc. Chapter 8 88
  • Choosing Output in the Long Run  An Example Two firms A & B that both own their land A is located on a river which lowers A’s shipping cost by $10,000 compared to B The demand for A’s river location will increase the price of A’s land to $10,000 = economic rent Although economic rent has increased, economic profit has become zero©2005 Pearson Education, Inc. Chapter 8 89
  • Firms Earn Zero Profit in Long-Run Equilibrium Ticket Price A baseball team in a moderate-sized city sells enough tickets so that price LMC LAC is equal to marginal and average cost (profit = 0). $7 Season Tickets Sales (millions) 1.0©2005 Pearson Education, Inc. Chapter 8 90
  • Firms Earn Zero Profit in Long-Run Equilibrium Ticket Price Economic Rent LMC LAC $10 $7.20 A team with the same cost in a larger city sells tickets for $10. Season Tickets Sales (millions) 1.3©2005 Pearson Education, Inc. Chapter 8 91
  • Firms Earn Zero Profit in Long-Run Equilibrium  With a fixed input such as a unique location, the difference between the cost of production (LAC = 7) and price ($10) is the value or opportunity cost of the input (location) and represents the economic rent from the input©2005 Pearson Education, Inc. Chapter 8 92
  • Firms Earn Zero Profit in Long-Run Equilibrium  If the opportunity cost of the input (rent) is not taken into consideration, it may appear that economic profits exist in the long run©2005 Pearson Education, Inc. Chapter 8 93