The Perfectly Competitive Market

LECTURE NOTES X THE PERFECTLY COMPETITIVE MARKET

OUTLINE: I. Introduction to Market Structure II. Characteristics of Perfect Competition III. Perfect Competition Graphically IV. Revenue for the Firm V. Short Run Equilibrium – Profit Maximization VI. Graphically A. A Profit B. A Loss C. Breaking even VII. The Shutdown Rule VIII. The Firm’s Short Run Supply Curve IX. Long-Run Equilibrium in a Perfectly Competitive Market X. Permanent Changes in Market Demand 1) An Increase in Market Demand 2) A Decrease in Market Demand

Productivity Product Curves

Short run

Firms (Choice of Q) Costs

Long run

Customer Demand Market Structures (4) (Market Conditions)

INTRODUCTION TO MARKET STRUCTURE

Market Spectrum

(Ch.11) (Ch.13) (Ch.13) (Ch.12) Perfect Monopolistic Oligopoly Pure Competition Competition Monopoly I. Perfect Competition – Characteristics: (Market forces to operate unimpeded)

1) all firms sell an identical (homogeneous) product 2) So consumers are indifferent to different sellers 3) Many sellers or firms – (LRATC hits low point at relatively small level of output) 4) Firms are price takers Their market share isn’t large enough to affect the market price NO MARKET POWER 5) Free entry and exit – no barriers to entry or exit such as - exclusive control of a resource - unusually high start up costs 6) Instantaneous entry and exit 7) Complete information 8) Firms maximize profits – no firms operating charitably

I. Perfect Competition Graphically Demand, Price, and Revenue in Perfect ) Competition) y y ) ) ) ) a r r a r r e e d d e e

t t t t r r a a a a e e e e TR

e TR e p p

w w w w s demand s s

s demand s s

50 r r r

50 a a l l e e S e e l curve l p p p p o o

d s s d s s ( ( r r r r

a a a a e e l l l l l l Market l l u u o o o o n MR n d d 25 25 225 a d

25 d e e

( demand ( demand ( (

v e e e e e e r c r c curve

curve c c

i i i l l r r r r a a P P t t P P o D o T T 0 9 20 0 9 20 0 10 20 Quantity (thousands Quantity (sweaters Quantity (sweaters of sweaters per day) per day) per day)

market Demand and total revenue marginal revenue

C o p y r i g h t © 2 0 0 0 P e a r s o n E d u c a t i o n C a n a d a I n c . S l i d e 1 2 - 1 0

Each firm’s demand curve is perfectly elastic

A change in q of any firm is not significant enough to change the market demand, D, so one firm can not impact the market price.

If a firm tries to increase its price, it will lose all of its customers II. Revenue for the firm Total Revenue = TR = Pe q Marginal Revenue: Revenue from selling one more unit of the good MR = Pe

III. Short-Run Equilibrium - Profit Maximizing Output levels Profit = TR – TC Total Revenue, Total Cost, and Economic Profit

TC t ) t ) y s s y TR a a o o c d c d

l l r r a a 300 e 300 e t t Economic p Economic p o o

s loss r loss r d d a a l n l n l

l 225 a a

o e e d

d Economic ( ( u u 183 n n profit = e e v v TR – TC e e r r

100 l l a a t t o o Economic T T loss 0 4 9 12 Quantity (sweaters per day)

C o p y r i g h t © 2 0 0 0 P e a r s o n E d u c a t i o n C a n a d a I n c . S l i d e 1 2 - 1 5 Total Revenue,Revenue, Total Cost,Cost, and Economic Profit

t ) t r ) r e e s y

s y TC e

e TC u u a a o o p TR p TR n n

c d c d

s s 300 l l r r v v a a a a e e t 225 t 225 l l r r l l o

o l l t t o o 183

a a d d t t d d ( ( o o n n 100 T a 100 T a

0 4 9 12 Quantity (sweaters per day) ) ) s s y y s s a a o o

l 42 l d d / /

t t r r i i Economic f f e e Economic o o p p profit

r r 20 loss s s P P r r a a l l l l 0 o o d d 4 9 12 Quantity (sweaters per day) ( ( -20 Profit- maximizing Profit/ -40 quantity loss C o p y r i g h t © 2 0 0 0 P e a r s o n E d u c a t i o n C a n a d a I n c . S l i d e 1 2 - 1 6 MR=MC The Profit Maximizing Condition

IV. Graphically – looking at profit A) A firm earning a positive economic profit As long as Pe > ATC where MR=MC, the firm is earning a positive economic profit

Economic Profit ) ) r r e e t t 30.00 a a e e MC ATC w w s s

r r e e p p 25.00

MR s s Economic r r a a l

l profit l l o o d d ( ( 20.33

t t s s o o c c

d d n n a a

15.00 e e c c i i r r P P 0 9 10 Quantity (sweaters per day) C o p y r i g h t © 2 0 0 0 P e a r s o n E d u c a t i o n C a n a d a I n c . S l i d e 1 2 - 2 4

Profit = TR – TC Profit = Pe*q – (ATC)q B) A firm earning zero economic profit (normal rate of return) may still be earning a positive accounting profit As long as Pe = ATC where MR=MC, the firm is earning zero economic profit

Normal Profit ) ) r r e e t t a a 30.00 MC e MC e w w ATC s s

Break-even r r e e point p p

25.00 s s r r a a l l l l o o d d ( (

t t 20.00 s s o o MR

c MR c

d d n n a a

e e 15.00 c c i i r r P P

0 8 10 Quantity (sweaters per day) C o p y r i g h t © 2 0 0 0 P e a r s o n E d u c a t i o n C a n a d a I n c . S l i d e 1 2 - 2 3

Profit = TR – TC Profit = Pe*q – (ATC)q

Normal rate of Return

C) A firm earning a negative economic profit (economic loss) If Pe < ATC where MR = MC, the firm is suffering an economic loss

Profit = TR – TC Profit = Pe*q – (ATC)q

V. The Shutdown Rule

How do you know when to shut down and when to keep producing? When Pe < ATC (LOSS) If Pe > AVC the firm will keep operating Even though suffering a loss, still paying some fixed costs If Pe < AVC the firm will shut down

The firm shuts down because it is not covering its fixed costs of production Shut down is a temporary decision – close down operation until market conditions look better If we expect P < ATC indefinitely we get out of business – this is a long run decision – getting out of business for good

Maximizing profit also means minimizing loss

VI. The firm’s short-run supply curve If D shifts in the market, Pe changes causing MR or d to shift. New output determined where MR1 = MC The part of MC curve above AVC is the firm’s short-run supply curve Shows relationship between P and q for the producer

A Firm’s Supply Curve t ) t ) r r s s e e

o MC o MC t t c c a a

e e d d w n w n s a s a 31 MR

2 r r e e e e c c i i p p r

s s P P r r a a l l l l o o MR1

d 1 d 25 ( ( Shutdown point AVC s 17 MR0

0 7 9 10 Quantity (sweaters per day)

The industry supply curve is the horizontal summation of the supply curves of individual firms.

VII.Review of the Perfect Competition and Long-Run Equilibrium in a Perfectly Competitive Market

1) QD = QS in the market no △P 2) Firms are breaking even or earning a normal rate of return no △ # firms a)Existing firms cannot be suffering losses (This would include exit from the market) b) Existing firms cannot be earning an economic profit (This would induce new entry into the market) This is called the zero profit condition 3) Allocative efficiency: (Pe = MC) (this implies that the firm is putting their resources into best paying use) for perfect competition this is also true in the short run no △ resource allocation 4) Productive efficiency: (Pe = min ATC) Must be at minimum of LRATC so that expansion of plant size will not lower costs Low point of LRATC is called minimum efficient scale So no incentive to change plant size. no △ plant size Economic or productive efficiency

VIII. Permanent changes in Market Demand 3) An increase in market demand

GRAPHS

Suppose D shifts from D0 to D1. a) In the short-run (a to b) As demand increases, (D0 to D1), the firms demand curve increases due to the higher equilibrium price, (d0 to d1) or (MR0 to MR1). The profit maximizing output increases from q0 to q1 as existing firms increase output and respond to the higher price level and the ability to earn greater profits. (by running factories overtime) Existing firms increase output by moving along up their supply curve (i.e. the marginal cost curve). As existing firms increase production, this is a short run response. Market output increases as we move along S0 from point a to point b. Is point b a long run equilibrium? No – P > min ATC b) In the short-run (a to c) In the long run – the profits of existing firms send a signal to new firms to enter the market. As new firms enter what happens to the market supply curve? It shifts out to the right As S0 shifts to S1, the market price falls hence pushing the firms demand curve back to its original level. The lower price encourages firms to cut production back to q0. So now we have more firms, but all producing at the old equilibrium output level. Point c is along run equilibrium. The long run market supply curve connects the dots representing the long run equilibrium. In this case it is perfectly flat. This shows that the industry has constant costs. There are also industries where the cost of inputs change when firms enter and exit the markets, however, we will not focus on such cases.

4) A decrease in the market demand A Decrease in Demand

Industry Firm t t s s e e S1 MC

1 o o c c S i S i

0 C C r r

P d P d n n a a

e ATC e c c i i r r P P

MR0 P0 P0

MR1 P1 P1

Quantity q q Quantity 0 Q2 Q1 Q0 Quantity q1 q0

Suppose D shifts from D0 to D1. c) In the short-run As demand decreases, (D0 to D1), the firms demand curve decreases due to the lower equilibrium price, (d0 to d1) or (MR0 to MR1). The profit maximizing output decreases from q0 to q1 as existing firms decrease output and respond to the lower price level and the ability to suffer greater losses. Existing firms decrease output by moving down their supply curve (i.e. the marginal cost curve). As existing firms decrease production, this is a short run response. Market output decreases as we move along S0 from point a to point b. Is point b a long run equilibrium? No – P > min ATC d) In the long run – the losses of existing firms send a signal to new firms to exit the market. As some firms exit the market supply curve shifts back to the left As S0 shifts to S1, the market price rises hence pushing the firms demand curve back to its original level. The higher price encourages firms to increase production back to q0. So now we have fewer firms, but all producing at the old equilibrium output level. Point c is a long run equilibrium. The long run market supply curve connects the dots representing the long run equilibrium. In this case it is perfectly flat. This shows that the industry has constant costs. There are also industries where the cost of inputs change when firms enter and exit the markets, however, we will not focus on such cases.