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Chap5

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Chap5

  1. 1. CHAPTER 5 MARKET STRUCTURE: PERFECT COMPETITION
  2. 2. Chapter Outline <ul><li>5.1 Characteristic </li></ul><ul><li>5.2 Short-run Decision: Profit Maximization </li></ul><ul><li>5.3 Short-run Decision: Minimizing Loss </li></ul><ul><li>5.4 Long-run Adjustment </li></ul><ul><li>5.5 External Changes: </li></ul><ul><li>Consumer Preference & Technology </li></ul><ul><li>5.6 Efficiency of Perfect Competition </li></ul>
  3. 3. Perfect Competition <ul><li>Definition: </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>For example: hypermarket (Giant, Carrefour, Tesco). </li></ul></ul>
  4. 4. 5.1 Characteristic <ul><li>Many firms </li></ul><ul><ul><li>A single firm’s production is relatively very small compare to the market demand. T herefore, cannot influence market price. </li></ul></ul><ul><ul><li>Each firm takes market price as given -> price taker </li></ul></ul><ul><li>Homogenous product </li></ul><ul><ul><li>product/service has no unique characteristic, so consumers don’t care which firm they buy from. </li></ul></ul><ul><ul><li>Example: Agricultural products such as oil, iron and others. </li></ul></ul>
  5. 5. 5.1 Characteristic <ul><li>Perfect information </li></ul><ul><ul><li>Firms are price taker because buyers & sellers are well informs about price. </li></ul></ul><ul><ul><li>No transaction cost assumed. </li></ul></ul><ul><ul><li>Firm only decide how much to produce. </li></ul></ul><ul><li>Free entry / exit </li></ul><ul><ul><li>No legal, technology, capital, incumbent advantage or others constraint to entry/exit. </li></ul></ul><ul><ul><li>New firms enter (existing firms exit) if industry earning above (negative) normal profit. </li></ul></ul>
  6. 6. 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)
  7. 7. <ul><li>Example: The market price of corn of $4 per bushel is determined by the market intersection of the market demand and supply curve. </li></ul><ul><ul><li>Each firm is so small relative to the market that each has no impact on the market price. </li></ul></ul><ul><ul><li>Anyone who charges more than the market price sell no corn because find no buyers. </li></ul></ul>
  8. 8. <ul><li>The goal of a competitive firm is to maximize profit. </li></ul><ul><li>How the firm maximize profit? </li></ul><ul><ul><li>1. Total Approach : </li></ul></ul><ul><ul><li>Maximizing the Positive difference between TR – TC. </li></ul></ul><ul><ul><li>2. Marginal Approach : </li></ul></ul><ul><ul><li>MR = MC </li></ul></ul><ul><ul><li>( profit maximizing condition ) </li></ul></ul>
  9. 9. Profit-Maximizing Level of Output <ul><li>If q is output of the firm, then total revenue is price of the good times quantity </li></ul><ul><ul><li>Total Revenue (TR) = P x Q </li></ul></ul><ul><li>Costs of production depends on output </li></ul><ul><ul><li>Total Cost (TC) = TC x Q </li></ul></ul><ul><li>Profit (  ) = Total Revenue - Total Cost </li></ul>
  10. 10. <ul><li>The goal of the firm is to maximize profits, the difference between total revenue and total cost. </li></ul><ul><li>A firm maximizes profit when MR = MC. </li></ul><ul><ul><li>Marginal revenue (MR) -----the change in total revenue associated with a change in quantity. </li></ul></ul><ul><ul><li>Marginal cost (MC) ----- the change in total cost associated with a change in quantity. </li></ul></ul>
  11. 11. 5.2 Short-run Decision: Profit Maximization <ul><li>Profit: </li></ul>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)
  12. 12. 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
  13. 13. 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)
  14. 14. 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
  15. 15. 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
  16. 16. TOTAL REVENUE- TOTAL COST APPROACH <ul><li>Firm selects output to maximize the difference between revenue and cost </li></ul><ul><li>We can graph the total revenue and total cost curves to show maximizing profits for the firm </li></ul><ul><li>Distance between revenues and costs show profits </li></ul>
  17. 17. 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*
  18. 18. Choosing Output: Short Run <ul><li>The point where MR = MC, the profit maximizing output is chosen </li></ul><ul><ul><li>MR=MC at quantity of 8 </li></ul></ul><ul><ul><li>At a quantity less than 8, MR>MC so more profit can be gained by increasing output </li></ul></ul><ul><ul><li>At a quantity greater than 8, MC>MR , increasing output will decrease profits </li></ul></ul>
  19. 19. The Relationship Between MR and MC: <ul><li>-> A firm can increase its profit by increasing output. </li></ul><ul><li>-> A firm can reduce its losses by decreasing output. </li></ul><ul><li>-> Profits are at a maximum </li></ul>MR > MC MR < MC MR = MC
  20. 20. Short Run Equilibrium <ul><ul><li>Supernormal profits </li></ul></ul><ul><ul><li>economic profits </li></ul></ul><ul><ul><li>(P > ATC) or (TR > TC) </li></ul></ul><ul><ul><li>2. Normal profits </li></ul></ul><ul><ul><li>Breakeven or zero profit </li></ul></ul><ul><ul><li>(P = ATC) or (TR = TC) </li></ul></ul><ul><ul><li>3. Subnormal profits </li></ul></ul><ul><ul><li>Economic losses </li></ul></ul><ul><ul><li>(P < ATC) or (TR < TC) </li></ul></ul><ul><ul><li>continue the production if (ATC > P > AVC) </li></ul></ul><ul><ul><li>Shut down the operation if (ATC > P < AVC) </li></ul></ul>
  21. 21. Supernormal Profit (Economic Profit) <ul><li>Definition </li></ul><ul><ul><li>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). </li></ul></ul><ul><li>Calculation: </li></ul><ul><li>TR = 5 x 9 = 45 </li></ul><ul><li>TC = 3 x 9 = 27 </li></ul><ul><li>  = (TR – TC) = (45 – 27) = 18 </li></ul>
  22. 22. 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
  23. 23. Breakeven/ Normal Profit <ul><li>Definition </li></ul><ul><ul><li>When total revenue is equal to total cost (TR=TC) or price equal to ATC (P=ATC), there are no profit or no losses. </li></ul></ul><ul><ul><ul><li>Firm has only able to cover its costs. </li></ul></ul></ul><ul><li>Calculation : </li></ul><ul><li>TR = 5 x 9 = 45 </li></ul><ul><li>TC = 5 x 9 = 45 </li></ul><ul><li>  = (TR – TC) = (45 – 45) = 0 </li></ul>
  24. 24. 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
  25. 25. Economic losses/ Subnormal profit <ul><li>Definition </li></ul><ul><ul><li>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. </li></ul></ul><ul><ul><li>The firm incurs losses because would not able to cover its costs. </li></ul></ul><ul><ul><li>Calculation : </li></ul></ul><ul><li> TR = 5 x 6 = 30 </li></ul><ul><li> TC = 7 x 6 = 42 </li></ul><ul><li>  = (TR – TC) = (30 – 42) = -12 </li></ul>
  26. 26. 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
  27. 27. <ul><li>5.3 Short Run Decision: Minimizing Loss </li></ul><ul><li>Losses </li></ul><ul><ul><li>If (TR<TC) or (P>ATC) </li></ul></ul><ul><li>Two conditions: </li></ul><ul><ul><li>Keep operating (ATC>P>AVC) </li></ul></ul><ul><ul><li>If the operating profit is positive (TR – TVC > 0), the firm can use this operating profit to offset fixed costs and reduce total losses. </li></ul></ul><ul><ul><li>Shut down (ATC>P<AVC) </li></ul></ul><ul><ul><li>If the operating profit is negative (TR – TVC < 0), the firm suffers operating losses that push total losses above fixed costs. </li></ul></ul>
  28. 28. 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
  29. 29. 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
  30. 30. Shutting Down in the Short Run <ul><li>Shutting down is not the same as going out of business. </li></ul><ul><li>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. </li></ul><ul><li>If market conditions look grim and are not expected to increase, the firm may decide to leave the market  a long run decision </li></ul>
  31. 31. Summary: Firm Decisions in the Long Run & Short Run <ul><li>In the SR, firms have to decide how much to produce in the current scale of plant. </li></ul><ul><li>In the LR, firms have to choose among many potential scales of plant. </li></ul>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
  32. 32. Short Run Supply Curve <ul><li>Competitive firms determine the quantity to produce where P = MC </li></ul><ul><li>Competitive firms supply curve is portion of the marginal cost curve above the AVC curve </li></ul>
  33. 33. 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
  34. 34. 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
  35. 35. Short-Run Supply Curve <ul><li>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. </li></ul><ul><li>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. </li></ul>
  36. 36. 5.4 Long Run Adjustment <ul><li>In the long run, there is an adequate time for the firm to make changes and adjustment to the production process. </li></ul><ul><li>All inputs are variable in the long run. </li></ul><ul><li>Perfect competitive firm only earn zero economic profit (normal profit) . </li></ul><ul><li>Its mean that TR is just enough to cover TC (  = TR – TC = 0) </li></ul><ul><li>This is due to the effect of free entry and exit. </li></ul>
  37. 37. Profit maximization in the LR <ul><li>Free entry : </li></ul><ul><ul><li>When firm earn economic profit > 0 in the SR: </li></ul></ul><ul><ul><ul><li>Encourage NEW firms to enter the market. </li></ul></ul></ul><ul><ul><ul><li>Market supply increase (SS curve shift rightward). </li></ul></ul></ul><ul><ul><ul><li>Equilibrium price drop >> individual firm will also lower their price (price taker) until profit is eliminated. </li></ul></ul></ul><ul><ul><ul><li>When economic profit = 0 , no incentive for firm to come in. </li></ul></ul></ul>
  38. 38. Try this!!
  39. 39. Profit Maximization in the LR <ul><li>Free exit : </li></ul><ul><ul><li>When firm earn economic profit < 0 in the SR: </li></ul></ul><ul><ul><ul><li>Incentive for existing (losing) firms to exit the market. </li></ul></ul></ul><ul><ul><ul><li>Market supply drop (SS curve shift leftward). </li></ul></ul></ul><ul><ul><ul><li>Equilibrium price rise >> individual firm will also increase their price (price taker) until profit is eliminated. </li></ul></ul></ul><ul><ul><ul><li>When economic profit = 0 , no incentive for firm to come in. </li></ul></ul></ul>
  40. 40. Try this!!
  41. 41. 5.5 External Changes: Consumer Preference & Technology <ul><li>Changing preference: </li></ul><ul><ul><li>Increase in Demand </li></ul></ul><ul><ul><li>Decrease in Demand </li></ul></ul>
  42. 42. (1) Changing Preference Increase in demand Firm Industry
  43. 43. <ul><li>When preference increase : </li></ul><ul><ul><li>DD curve shift rightward , quantity & price increase. </li></ul></ul><ul><ul><li>Existing firm gain positive economic profit . </li></ul></ul><ul><ul><li>Incentive for expansion or new firms entry . </li></ul></ul><ul><ul><li>Market SS increase : SS curve shift rightward, qty increase but price drop until each firm earn zero economic profit . </li></ul></ul>
  44. 44. S 1 MC ATC MR D 1 Before Increase in Demand P Q q1 P Q Q1 Industry Firm (price taker) P1 P1
  45. 45. 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
  46. 46. 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
  47. 47. Changing Preference : Decrease in demand Industry Firm
  48. 48. <ul><li>When preference drop: </li></ul><ul><ul><li>DD curve shift leftward , quantity & price decrease. </li></ul></ul><ul><ul><li>Existing firm suffer economic losses . </li></ul></ul><ul><ul><li>Incentive for contraction or exit . </li></ul></ul><ul><ul><li>Market SS decrease : SS curve shift leftward, qty drop but price increase until each firm earn zero economic profit. </li></ul></ul>
  49. 49. Before decrease in demand: S 1 MC ATC D 1 MR P Q q1 P Q Q1 Industry Firm (price taker) P1 P1
  50. 50. 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
  51. 51. 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
  52. 52. (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
  53. 53. 5.6 Efficiency of Perfect Competition <ul><li>What will be produced? </li></ul><ul><ul><li>Efficient allocation of resources among firm. </li></ul></ul><ul><li>How will it be produced? </li></ul><ul><ul><li>Efficient distribution of outputs among households. </li></ul></ul><ul><li>Who will get what is produced? </li></ul><ul><ul><li>Producing what people want: The efficient mix of output. </li></ul></ul>
  54. 54. <ul><li>Efficient Allocation of Resources Among Firm </li></ul><ul><ul><li>Producing allocation using the best available-lowest cost - technology. </li></ul></ul><ul><ul><ul><li>If more output can be produced with the same amount of inputs; it would make some people better off . </li></ul></ul></ul><ul><ul><li>Inputs allocated across firms in the best possible way. </li></ul></ul><ul><ul><li>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. </li></ul></ul>
  55. 55. <ul><li>Efficient Distribution of Outputs Among Households: </li></ul><ul><ul><li>Household are free to choose among all the goods and services in the market. </li></ul></ul><ul><ul><ul><li>Subject to purchasing power constraint (income & wealth). </li></ul></ul></ul><ul><ul><ul><li>Depend on the budget constraint. </li></ul></ul></ul><ul><ul><li>As long as everyone shops freely in the same markets, no redistribution of final output among people will make them better off . </li></ul></ul>
  56. 56. <ul><li>Producing What People Want (The Efficient Mix of Output): </li></ul><ul><ul><li>Produce at P = MC . </li></ul></ul><ul><ul><li>Price reflects households’ willingness to pay. </li></ul></ul><ul><ul><ul><li>By purchasing a product, individual reveal that it is worth as least as much as the other things that the same money could buy. </li></ul></ul></ul><ul><ul><li>Marginal cost reflects the opportunity cost of the resources needed to produce a good . </li></ul></ul><ul><ul><ul><li>Society will produce the efficient mix output if all firms equate price and marginal cost. </li></ul></ul></ul>
  57. 57. Summary: Firm Decisions in the Long Run & Short Run <ul><li>In the SR, firms have to decide how much to produce in the current scale of plant. </li></ul><ul><li>In the LR, firms have to choose among many potential scales of plant. </li></ul>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
  58. 58. LETS DO IT
  59. 59. 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
  60. 60. <ul><li>Calculate the equilibrium output if the price of the product is RM9 per unit. </li></ul><ul><li>Calculate the total profit or loss at the equilibrium output. </li></ul><ul><li>What is the condition for this firm? </li></ul>QUESTIONS:
  61. 61. THANK YOU

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