Eca iii – the price system perfect competition

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Eca iii – the price system perfect competition

  1. 1. ECA III – THE PRICE SYSTEM LECTURE: V PERFECT COMPETITION
  2. 2. I. GENERAL INTRODUCTIONA. Market Structure Theory 1. When the theory of “Micro Economics” was originally introduced (1881) there were only two alternative positions for a firm: • Perfect Competition • Monopoly 2. These Market Structures Theoretical &/or Philosophical counterparts 3. If fairness reigned, the market was “Good” & hence competitive (Perfectly)
  3. 3. I. GENERAL INTRODUCTIONAccording to general precepts of our economic system {Capitalism}, the most efficient allocation of scarce resources is the Perfectly {Unrestricted – Governmentally; Geographically} Competitive Market.4. If these (above) conditions were not met; the market would be Imperfect (& therefore at the time) Monopolistic, i.e. “BAD” – There are definite political & indeed physichological overtones (i.e. Control) present
  4. 4. I. GENERAL INTRODUCTION5. At that time, from a purely economical perspective, the distinction between the two markets was the # of firms – Perfect Competition :∞ – Monopoly :16. As time progressed markets developed beyond these two markets. • Early 1900’s: Oligopoly • 1930’s: Monopolistic Competition7. Once these markets evolved. It became problematic to try and distinguish all of these new markets from those already established
  5. 5. I. GENERAL INTRODUCTION Perfect Monopolistic Monopolistic Oligopoly Competition Competition Competition ∞Number 6 – [∞-1] 2 or 3 - 5 1of Firms Homogeneous HeterogeneousNature of Homogeneous ↓ ↓ Heterogeneous Product Heterogeneous Homogeneous Perfectly Perfectly Imperfect Competition Non - Competitive Competitive
  6. 6. II. BASIC MODEL OF THE FIRM (REV. & COST)A. Motivations for the firm – Profit – Stock Price Maximization – “Green” • Environmentally Friendly • Produce Products to help other firms (Air Filters; Sewage Treatment Plants) – Social Conscience – Maximize Market Share (Product Markets)B. Here, we focus on Profit Vs Accounting Profit
  7. 7. II. BASIC MODEL OF THE FIRM (REV. & COST)C. Economic Profit Vs Accounting Profit – Economic Cost: Value of all resources used in production (Opportunity Cost) – Explicit Cost: Out of pocket cost (Specific Payment) – Implicit Cost: Foregone Opportunities – Economic Profit: (Total Rev.) – (Total Economic Cost) Example Total Revenue Merchandise Sold - Explicit Costs Wages Rent Taxes Accounting Profit - Implicit Costs Owners Wages (ie. % of Profit), Act. Yield Economic Profit
  8. 8. II. BASIC MODEL OF THE FIRM (REV. & COST)Profit Maximization 1. Total Revenue (TR) = Price x Quantity Total Revenue 2. Average Revenue (AR) = Output Quantity Change in Total Revenue3. Marginal Revenue (MR) = Change in Quantity Change in Total Cost 4. Marginal Cost (MC) = Change in QuanityRelative Positions:MR > MC → ↑ OutputMR < MC → ↓ OutputMR = MC → Equilibrium
  9. 9. II. BASIC MODEL OF THE FIRM (REV. & COST)Graphically General Model MC R A E AC C T Demand = Average Revenue O Q Output Marginal Revenue
  10. 10. II. BASIC MODEL OF THE FIRM (REV. & COST)Total Revenue: OQRATotal Cost: OQTCAbnormality or Economic Profit: Because AR > AC atEquilibrium & is specifically determined∏ = TR – TC∏ = OQRA - OQTC∏ = CTRA
  11. 11. II. PERFECT COMPETITIONA. Basic Logic 1. Demand establishes Revenues (TR = P X Q) 2. Production & Cost establish Supply 3. Profit Maximization at MARGINAL REVENUE = MARGINAL COSTB. Assumptions 1. Markets are unrestricted (i.e. Open Exit & Open Entry) 2. Infinite number of Buyers & Sellers 3. Homogeneous Product 4. Free Mobility of Factors 5. Perfect Price Knowledge
  12. 12. II. PERFECT COMPETITIONC. Equilibrium (Short Run) [Price Takers] Equilibrium Output: oq* Equilibrium Price: op* Equilibrium Profits: ∏ = TR - TC
  13. 13. II. PERFECT COMPETITIOND. Conclusions: 1. Demand Curve for the firm is Infinitely Elastic (i.e. Flat) at The Market Price (p*) A. Firms are called Price Takers B. The only decision they make is what quantity to produce at p* C. If the firm ↑ P : No Sales D. If the firm ↓ P : Needless loss of Revenues
  14. 14. II. PERFECT COMPETITION2. Three (Statistically) possible S/T Alternatives MC P Normal Profits: AR = AC Profit Earned (What Kind?) AC (Where?) P* AR=MR O q* q
  15. 15. II. PERFECT COMPETITION MC P Abnormal: AR > AC (Economic) Profit Earned AC (Not Possible) P* AR=MR (Why Not?) O q* qAny attempt by the Firm to lower costs will be copied immediately, so that there is noadvantage to do it in the first place.
  16. 16. II. PERFECT COMPETITION MC P AC Loss Incurred Loss P* E AR=MR O q* q3. The two decisions that the firm must make – How much to produce @ P*? – Shut Down or Stay Open?4. On the surface it appears that if the firm is incurring a loss, it should always & immediately shut down, not necessarily true.
  17. 17. II. PERFECT COMPETITION5. Total Costs = Fixed Cost + Variable Costs – Variable costs = F (Output) VC = O Output = O – Fixed Costs = F (Time) Even if Output = O FC = “+” (Must be paid, even if output=O6. Therefore, a perfectly competitive firm will continue to produce, even if there is a loss, as long as The Operating Loss < The shutdown Loss.7. This usually occurs at TR > TVC Price←Average Revenue > Average Variable Cost or Total Revenue > Total Variable Cost
  18. 18. II. PERFECT COMPETITIONE. Equilibrium (Long Run) 3 Possibilities – Constant/Increasing/Decreasing1. CONSTANT COSTS
  19. 19. II. PERFECT COMPETITIONA. Start at equilibrium (S/T) [E1 & e1] At Q1 (Industry) q1 (Firm) charging P1 (for both the industry and the firm)B. Something happens to the change (↑) Demands (into L/T) and D1 shifts to D2, resulting in new equilibrium point (at E2 & e2) Price has increased (P1 to P2), therefore the firms demand curve ↑s to D2 = AR2 & the firms equilibrium point is now at e2 (at q2 and P2)C. This results in abnormal profit because AR > AC at P2,q2. This causes more firms to enter the market and supply curve shifts to S2.
  20. 20. II. PERFECT COMPETITIOND. This results in a new equilibrium point at E3 (at Q3, P1)E. Abnormal Profits have been eliminated and system reestablishes equilibrium at e1 (for the firm) Q: If the firms quantity ends at q1, how is it possible for the industry to be producing at Q3?Conclusion:For perfect competition (L/T) with constant costIf demand ↑ with constant costs, P ↑ and then returns to its original level
  21. 21. II. PERFECT COMPETITION2. INCREASING COSTS
  22. 22. II. PERFECT COMPETITIONA. Start at equilibrium (S/T) (at e,E1) Q: What is original output and price for industry and firm?B. Demand into L/T ↑’s (D1 → D2) intersecting original supply curve at E2. This causes an increase in the market price which is carried over to each firm.C. The firm is now earning abnormal (or economic) profits, which causes more firms to enter the industryD. Since more firms are entering the industry this causes two things to occur simultaneously. 1. Since Factors are limited, this causes a “Bidding War” which increases the firms cost (AC1 → AC2 & MC1 → MC2)
  23. 23. II. PERFECT COMPETITION2. This causes the market supply curve to shift to S23. L/T Equilibrium is reestablished at (e3,E3)4. S* represents the L/T Market supply curve for increasing cost industriesConclusion: Perfect Competition (L/T) with the increasing cost. As Demand in the ling term increases (with increasing cost industries), Price ↑&↓ but not to its original level.

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