Perfect Competition Markets PDF

Relationships between the short-run and the long-run average costs Costs Q 1  Relationships between the short-run and the long-run marginal costs Costs Q...

Relationships between the short-run and the long-run average costs Costs Q 1  Relationships between the short-run and the long-run marginal costs Costs Q 2  PERFECTLY COMPETITIVE MARKETS Chapter 9 Chapter outline Assumptions for perfect competition Firm supply decision Short-run equilibrium Short-run market supply curve Long-run equilibrium Long-run supply curve Economic rent Producer surplus 4 Assumptions of perfect competition 1. Fragmented industry: ▪ The market consists of many buyers and sellers. Each buyer and seller's transactions are too small to influence the market price. 2. Undifferentiated goods: ▪ Consumers perceive the product to be identical no matter who produces them. 3. Full information about prices ▪ Consumers are fully informed about prices offered by all sellers in the market. 4. Equal access to resources (also referred to as “free entry and exit”) ▪ Firms, including potential new entrants, have equal access to inputs and technology. 5 Implications of assumptions Assumption 1  sellers and buyers act as price takers. Firms take the prices of inputs and outputs as given when making production decisions. Consumers accept the market price of a product when making purchasing decisions. Assumptions 2 and 3  Law of one price. All transactions between buyers and sellers occur at a single market price. Buyers are fully informed of all sellers' prices and will purchase at the lowest available price. Assumption 4  Free entry into the industry. New firms will enter the industry if it is profitable to do so. 6 Profit-maximizing output choice for a price-taking firm Firms maximize profits where marginal revenue equals marginal cost (MR = MC). Profit : π = TR (Q) – TC(Q) For a price-taker firm: TR = P*Q π π = P*Q – TC(Q) Q 7 Profit-maximizing output choice for a price-taking firm Question: If the firm produces, what output level (Q) maximizes its profit? Firms selects the profit maximizing amount of Q. They maximize profits where marginal revenue equals marginal cost (MR = MC). Profit : π = TR (Q) – TC(Q) π For a price-taker firm: TR = P*Q π = P*Q – TC(Q) Δπ/ ΔQ = P * ΔQ/ ΔQ – ΔTC/ ΔQ Δπ/ ΔQ = P – MC = 0 P = MC Q 8  TR, Profit-maximizing output TC, π Two conditions for profit maximization in a perfectly competitive market: 1. P = MC 2. MC must be increasing. Q MR, MC Q 9 Example: Profit Maximization in a Perfectly Competitive Market A firm operates in a perfectly competitive market and sells its product at a price of $50. The firm has a fixed cost of $30. Based on the provided data, determine the profit- maximizing quantity of output. Price Output Total Revenue Total Cost Profit Marginal Revenue Marginal Cost (Units) ($/unit) ($/unit) ($) ($/unit) ($/unit) $50 0 0 30 -30 50 $50 1 50 80 -30 50 50 $50 2 100 100 0 50 20 $50 3 150 130 20 50 30 $50 4 200 172 28 50 42 $50 5 250 226 24 50 54 $50 6 300 296 4 50 70 10 Short-run supply curves What is the short run? The number of firms in the industry is fixed. At least one input for each firm is held constant. Short-run total cost of producing Q STC (Q) = SFC + NSFC + TVC (Q) Sunk Fixed Costs (SFC): Costs that cannot be avoided, even if output is reduced to zero. Nonsunk Fixed Costs (NSFC): Costs that can be avoided if output is reduced to zero. Total Variable Costs (TVC): Costs that vary with the level of output. 11 Short-run firm supply A firm will produce the profit-maximizing quantity where P=MC. Three cases 1. All Fixed Costs Are Sunk (NSFC = 0): None of the fixed costs can be avoided, even if output is zero. 2. Some Fixed Costs Are Nonsunk (NSFC ≠ 0): A portion of the fixed costs can be avoided if the firm reduces output to zero. 3. All Fixed Costs Are Nonsunk (SFC = 0): All fixed costs can be avoided if the firm shuts down production entirely. 12 Chapter outline Assumptions for perfect competition Firm supply decision Short-run equilibrium Short-run market supply curve Long-run equilibrium Long-run supply curve Economic rent Producer surplus 1 Short-run supply curves What is the short run? The number of firms in the industry is fixed. At least one input for each firm is held constant. Short-run total cost of producing Q STC (Q) = SFC + NSFC + TVC (Q) Sunk Fixed Costs (SFC): Costs that cannot be avoided, even if output is reduced to zero. Nonsunk Fixed Costs (NSFC): Costs that can be avoided if output is reduced to zero. Total Variable Costs (TVC): Costs that vary with the level of output. 2 Short-run firm supply A firm will produce the profit-maximizing quantity where P=MC. Three cases 1. All Fixed Costs Are Sunk (NSFC = 0): None of the fixed costs can be avoided, even if output is zero. 2. Some Fixed Costs Are Nonsunk (NSFC ≠ 0): A portion of the fixed costs can be avoided if the firm reduces output to zero. 3. All Fixed Costs Are Nonsunk (SFC = 0): All fixed costs can be avoided if the firm shuts down production entirely. 3 1. All fixed costs are sunk (NSFC = 0) 4 1. Shut-down decision (NSFC = 0) Is it More Profitable to Stay Open or to Shut Down? Produce: If TR ≥ VC (Total Revenue is greater than Variable Costs) Shut Down: If TR < VC (Total Revenue is less than Variable Costs) Conditions for Decision: TR = P × Q ≥ VC Dividing through by Q: P > AVC (Average Revenue exceeds Average Variable Costs) Stay Open: If P ≥ AVC Shut Down: If P < AVC Short-Run Supply Curve: S(P) = 0 if P < Minimum AVC S(P) = MC if P ≥ Minimum AVC An individual firm’s short-run supply curve is derived from its marginal cost curve above the 5 minimum AVC. 2. Some fixed costs are nonsunk (NSFC ≠ 0) Is it More Profitable to Stay Open or to Shut Down? Produce: If TR ≥ NSC (Total Revenue is greater than Nonsunk fixed Costs) Shut Down: If TR < NSC Conditions for Decision: TR = P × Q ≥ NSC Dividing through by Q: P > ANSC (Average Revenue exceeds Average Variable Costs) Stay Open: If P ≥ ANSC Shut Down: If P < ANSC Short-Run Supply Curve: S(P) = 0 if P < Minimum ANSC S(P) = MC if P ≥ Minimum ANSC An individual firm’s short-run supply curve is derived from its marginal cost curve above the minimum ANSC. 6 3. All fixed costs are nonsunk (SFC = 0) 7 3. Shut-down decision (SFC = 0) Is it More Profitable to Stay Open or to Shut Down? Produce if TR ≥ Minimum TC (Total Revenue is greater than or equal to Total Cost) Shut Down if TR < Minimum TC (Total Revenue is less than Total Cost) Conditions for Decision: TR = P × Q ≥ TC Dividing through by Q: P ≥ ATC (Price is greater than or equal to Average Total Cost) Stay Open if P ≥ Minimum ATC Shut Down if P < Minimum ATC Short-Run Supply Curve: S(P) = 0 if P < Minimum ATC S(P) = MC if P ≥ Minimum ATC An individual firm’s short-run supply curve is derived from its marginal cost curve above the 8 minimum ATC. 9 Market supply 10 Chapter outline Assumptions for perfect competition Firm supply decision Short-run equilibrium Short-run market supply curve Long-run equilibrium Long-run supply curve Economic rent Producer surplus 1 Short-run perfectly competitive equilibrium Assume there are 100 firms each supplying Q* level of output at P*. Perfectly competitive market equilibrium occurs when QD by all consumers = QS by all firms Typical firm Market P P Q Q 2  Long-run output and plant-size adjustment by established firms Short-Run Profit Maximization: In the short run, firms maximize profit where P = MC (Price equals Marginal Cost). Firms operate with a given plant size, as capital is fixed. Long-Run Profit Maximization: In the long run, firms also maximize profit where P = MC. However, in the long run, firms can adjust their plant size to optimize production. If firms make positive economic profits, new firms will enter the industry, increasing supply and causing prices to fall. This process continues until economic profit is zero. If firms make negative economic profits, some firms will exit the industry, reducing supply and causing prices to rise. This process continues until economic profit is zero. Shutdown Condition in the Long Run: If P < ACmin (Price is less than the minimum Average Cost), the firm will incur negative economic profits and will not produce. Firms will only operate when P ≥ ACmin. 3  Long-run output and plant-size adjustment by established firms In the short run firms operate with a given plant size (capital fixed) In the long run, firms can adjustment plant size 4 Long-run supply curve Is it More Profitable to Stay Open or to Shut Down? In the long run, all costs can be avoided, so there are no sunk costs. Shutdown Rule in the Long Run: Produce if P ≥ ACmin (Price is greater than or equal to the minimum Average Cost). Shut Down if P < ACmin (Price is less than the minimum Average Cost). Exit Rule in the Long Run: If the firm anticipates that P < ACmin for the foreseeable future, it will exit the industry. Long-Run Supply Curve: S(P) = 0 if P < ACmin (Price is less than the minimum Average Cost). S(P) = MC if P ≥ ACmin (Price is greater than or equal to the minimum Average Cost). An individual firm’s long-run supply curve is derived from its marginal cost curve above the minimum AC. 5 6 Long-run market supply curve The long-run market supply curve shows the total quantity of output that will be supplied in the market at various prices, assuming that all long-run adjustments, such as changes in plant size and new firm entry, take place. Unlike the short run, the long-run market supply curve cannot be derived by simply adding individual firms' supply curves, as the number of firms in the market is not fixed in the long run. While increases in demand may temporarily raise prices in the short run, entry of new firms (or expansion of existing ones) in the long run ensures prices return to the minimum point of the average cost curve. This adjustment leads to zero economic profits for firms in equilibrium. 7  A constant-cost industry is an industry in which the increase or Long-run market supply curve decrease of industry output does not affect the prices of inputs. in constant-cost industries This occurs if inputs are neither scarce nor industry-specific and can be used in other industries. The supply curve is horizontal. 8  An increasing-cost industry is an industry in which Long-run market supply curve in increases of industry output increases prices of inputs. increasing-cost industries This occurs if inputs are industry-specific and scarce. The supply curve is upward sloping. 9