Perfect Competition-- --A A Perfect Competition Model of Markets - PDF document

Econ Dept, UMR Presents Perfect Competition-- --A A Perfect Competition Model of Markets Model of Markets

Starring Starring The Perfectly Competitive N The Perfectly Competitive N Firm Firm Profit Maximizing Decisions N Profit Maximizing Decisions N In the Short Run 7 In the Short Run 7 In the Long Run 7 In the Long Run 7

Featuring Featuring An Overview of Market Structures N An Overview of Market Structures N The Assumptions of the Perfectly N The Assumptions of the Perfectly N Competitive Model Competitive Model N The Marginal Cost = Marginal Revenue The Marginal Cost = Marginal Revenue N Rule Rule N Marginal Cost and Short Run Supply Marginal Cost and Short Run Supply N Social Surplus N Social Surplus N

Part III: Profit Maximization in the Part III: Profit Maximization in the Long Run Long Run N First, we review profits and losses in First, we review profits and losses in N the short run the short run N Second, we look at the implications of Second, we look at the implications of N the freedom of entry and exit the freedom of entry and exit assumption assumption N Third, we look at the long run supply Third, we look at the long run supply N curve curve

Output Decisions Output Decisions Question: How can we use How can we use Question: what we know about what we know about production technology, costs, production technology, costs, and competitive markets to and competitive markets to make output decisions in the make output decisions in the long run? long run?

Reminders... Reminders... N Firms operate in perfectly competitive Firms operate in perfectly competitive N output and input markets output and input markets N In perfectly competitive industries, prices In perfectly competitive industries, prices N are determined in the market and firms are determined in the market and firms are price takers are price takers N The demand curve for the firm’s product The demand curve for the firm’s product N is perceived to be perfectly elastic is perceived to be perfectly elastic N And, critical for the long run, there is And, critical for the long run, there is N freedom of entry and exit freedom of entry and exit N However, technology is assumed to be However, technology is assumed to be N fixed fixed

The firm maximizes profits, or minimizes losses by producing where MR = MC, or by shutting down Market Firm P P MC S $5 $5 P=MR D q Q/t q/t

Profit at P 1 Profit at P 1 S P P ATC ATC MC MC AVC AVC p 1 p p 1 p 1 1 atc 1 MR MR D q/t Q/t q 1 N Profit! (p Profit! (p 1 - atc atc 1 )*q 1 = 1 - 1 )*q 1 = N

Losses at P* Losses at P* ATC ATC S P P AVC AVC MC MC atc 1 p* p* p* p* MR MR D q/t Q/t q 1 N Loss! (atc Loss! (atc 1 - p*)*q p*)*q 1 = 1 - 1 = N

Losses but Operate since Losses but Operate since P > AVC P > AVC ATC ATC S P P AVC AVC MC MC atc 1 p 1 p 1 p p 1 1 MR MR avc 1 D q/t Q/t q 1 N Operate! Operate! Your loss, (atc Your loss, (atc 1 - p p 1 )*q 1 = 1 - 1 )*q 1 = N is less than loss by shutting down, FC is less than loss by shutting down, FC N FC = (atc FC = (atc 1 - avc avc 1 )*q 1 = 1 - 1 )*q 1 = N

Shut Down since P < AVC Shut Down since P < AVC ATC ATC P S MC P AVC MC AVC atc 1 avc 1 p 1 p 1 p p 1 1 MR MR D q/t Q/t q 1 N Shut down Shut down ! Your loss by shutting down, FC = ! Your loss by shutting down, FC = N (atc 1 (atc 1 - - avc avc 1 1 )*q )*q 1 1 = is less than by = is less than by operating at q 1 (atc 1 - p p 1 )*q 1 = operating at q 1 (atc 1 - 1 )*q 1 =

Market Supply Market Supply N Sum of Individual Firm's Supply Sum of Individual Firm's Supply N Curves Curves N Entry or exit, Entry or exit, in response to in response to N profits or losses , shifts market , shifts market profits or losses supply and thus price supply and thus price

The Long Run The Long Run N Recall that the long run is defined as the Recall that the long run is defined as the N time it takes for fixed costs to change.In time it takes for fixed costs to change.In other words - - all costs are variable. The all costs are variable. The other words ATC curve equals the AVC curve ATC curve equals the AVC curve N Also recall that Perfect Competition Also recall that Perfect Competition N assumes that there is costless entry and assumes that there is costless entry and exit. In other words people can start up exit. In other words people can start up firms, expand existing firms, or shut firms, expand existing firms, or shut down firms down firms

Perfect Competition in the Perfect Competition in the Long Run Long Run N If there are profits being made in an If there are profits being made in an N industry, firms will enter. industry, firms will enter. N If there are losses in an industry, firms If there are losses in an industry, firms N will leave will leave N But what happens to the market when But what happens to the market when N things like this happen? things like this happen? N Consider the previous example where Consider the previous example where N the typical firm was making profits in the typical firm was making profits in the short run the short run

Profit )=(p- -ATC)*q ATC)*q Profit )=(p p MC ATC p MR profit profit AVC ATC q/t q

Profit Maximizing in Long Profit Maximizing in Long Run Run N Firms see this profit and enter the industry Firms see this profit and enter the industry N N More firms in an industry means market More firms in an industry means market N supply increases supply increases N This drives price down and profits down This drives price down and profits down N N Firms continue to enter until the price is Firms continue to enter until the price is N driven down so low that profits are zero. driven down so low that profits are zero. Then no more firms want to enter and there is Then no more firms want to enter and there is a long run equilibrium a long run equilibrium

Profit Attracts Entry Profit Attracts Entry S P P S’ ATC ATC MC MC AVC AVC p 1 p p 1 p 1 1 MR MR P’ = atc min D q/t Q/t q 1 N Profit falls from (p Profit falls from (p 1 - atc atc 1 )*q 1 = 1 - 1 )*q 1 = N N To Zero, P’ = ATC To Zero, P’ = ATC N

Profit Maximizing in Long Profit Maximizing in Long Run Run N Note that price is driven down to the Note that price is driven down to the N bottom of the ATC curve bottom of the ATC curve N In the long run, since profits MUST be In the long run, since profits MUST be N zero, Average Revenue, AR = Average zero, Average Revenue, AR = Average Cost, AC, or since AR = P, P = AC Cost, AC, or since AR = P, P = AC N Profit maximization implies MC = MR Profit maximization implies MC = MR N in perfect competition P = MR thus in perfect competition P = MR thus N P = MC = AC and MC = AC at the P = MC = AC and MC = AC at the N minimum of the AC curve minimum of the AC curve

Losses in the Short Run Losses in the Short Run N But what if there are losses in the short But what if there are losses in the short N run? run? N If there are any losses in the short run, If there are any losses in the short run, N firms will want to leave the industry firms will want to leave the industry N When firms leave, market supply When firms leave, market supply N decreases decreases N This drives up price and drives down This drives up price and drives down N losses losses N Firms leave as long as there are losses. Firms leave as long as there are losses. N Once profits hit zero, firms stop leaving. Once profits hit zero, firms stop leaving. N Consider the earlier example Consider the earlier example N

Losses Lead to Exit Losses Lead to Exit S’ ATC ATC S P P AVC AVC MC MC P’ = atc min p 1 p p 1 p 1 1 MR MR D q/t Q/t q 1 N Loss fall from (atc Loss fall from (atc 1 - p p 1 )*q 1 = 1 - 1 )*q 1 = N N To Zero, where P’ = min ATC To Zero, where P’ = min ATC N

In the Long Run... In the Long Run... N In the Long Run in a perfectly In the Long Run in a perfectly N competitive market... competitive market... O there are ALWAYS zero profits there are ALWAYS zero profits O O P=MC=ATC P=MC=ATC O O The firm produces at the lowest possible The firm produces at the lowest possible O average cost average cost

Long Run Supply of the Firm Long Run Supply of the Firm Depends on Internal Depends on Internal Economies/Diseconomies of Scale Economies/Diseconomies of Scale N Remember the concept of Returns to Remember the concept of Returns to N Scale-- --The answer to the question The answer to the question Scale “What happens to output if all inputs “What happens to output if all inputs are scaled up or down proportionally?” are scaled up or down proportionally?” O Increasing Returns to Scale Increasing Returns to Scale-- --Output Output O changes proportionally more than inputs changes proportionally more than inputs O Constant Returns to Scale Constant Returns to Scale-- --Output changes Output changes O in the same proportion as inputs in the same proportion as inputs O Decreasing Returns to Scale Decreasing Returns to Scale-- --Output Output O changes proportionally less than inputs changes proportionally less than inputs