Chapter 9 Perfect Competition PDF

CHAPTER 9 Perfect Competition in the Short Run FOUR MARKET STRUCTURES Economists classify industries based on how competitive they are. They look at four main factors: 1. Number of Firms: How many companies are in the industry? 2. Type of Product: Are the products standardized (exactly the...

CHAPTER 9 Perfect Competition in the Short Run FOUR MARKET STRUCTURES Economists classify industries based on how competitive they are. They look at four main factors: 1. Number of Firms: How many companies are in the industry? 2. Type of Product: Are the products standardized (exactly the same) or differentiated (unique in some way)? 3. Ease of Entry: Is it easy or hard for new firms to start up in the industry? 4. Control Over Price: Do companies have any power to set their own prices? Based on these factors, industries are grouped into four market structures from most competitive to least competitive: 1. Perfect Competition (Most Competitive) Number of Firms: Many small firms. Type of Product: Standardized products (identical, like wheat or milk). Ease of Entry: Very easy; new companies can join without much trouble. Control Over Price: None; firms are price takers (they accept the market price). Example: Agriculture, where farmers grow identical crops like wheat or corn. 2. Monopolistic Competition Number of Firms: Many firms, but fewer than in perfect competition. Type of Product: Differentiated products (slightly unique, like different brands of shampoo). Ease of Entry: Fairly easy for new companies to enter. Control Over Price: Some control; firms can set slightly different prices based on product uniqueness. Example: Clothing brands, where companies offer unique styles and branding. 3. Oligopoly Number of Firms: A few large firms dominate the industry. Type of Product: Either standardized or differentiated. Ease of Entry: Hard; large firms make it difficult for new companies to enter. Control Over Price: Significant control, often influenced by other firms in the industry. Example: The automobile industry, where a few large companies control most of the market. 4. Monopoly (Least Competitive) Number of Firms: One single firm. Type of Product: Unique product with no close substitutes. Ease of Entry: Extremely difficult or impossible for others to enter. Control Over Price: Total control over price; the firm is a price maker. Example: Utility companies (like water supply) in certain areas, where one company provides all the service. Conditions Required for Perfectly Competitive Markets A perfectly competitive market is a market that is as competitive as possible, with lots of buyers and sellers all offering the same product. For a market to be perfectly competitive, it needs to meet these four main conditions: 1. Very Large Numbers: There are many small firms in the market, each producing the same product. Each firm’s share of the market is so small that it doesn’t have any impact on the overall market. 2. Standardized Product: All firms produce a standardized product — meaning the products are identical and there’s no difference between them. This means that each firm’s product is a perfect substitute for the others. For example, one farmer’s wheat is the same as another’s. 3. Price-Takers: Firms in a perfectly competitive market are price-takers, meaning they have no control over the price of their product. The price is set by market supply and demand, and each firm just accepts it because their share of the market is too small to influence prices. 4. Easy Entry and Exit: It’s very easy for new firms to enter the market and for existing firms to exit if they want to. There are no big barriers like high costs or strict regulations stopping companies from joining or leaving the industry. Example: Farming Think of a market where lots of farmers grow the same type of wheat. Each farmer is small compared to the whole market, the wheat is identical, they can’t set their own prices, and it’s easy to start or stop farming wheat. Perfectly Elastic Demand in a Perfectly Competitive Market In a perfectly competitive market, each firm faces perfectly elastic demand. This means that the firm can sell as much or as little as it wants at the market price without changing the price. Key Points of Perfectly Elastic Demand: 1. Firm Produces at Market Price: ○ The firm can produce as much or as little as it wants, but it can only sell its product at the market price. ○ The firm cannot raise the price by reducing its output (making less of the product). ○ The firm doesn’t need to lower the price to sell more; it can sell as much as it wants at the market price. 2. Horizontal Demand Curve for Individual Firms: ○ For each individual firm, the demand curve is a horizontal line. This means the price stays the same no matter how much they sell. ○ This happens because the firm is too small to affect the overall market price. They simply produce at the price set by the whole market. 3. Downward Sloping Market Demand Curve: ○ For the entire market, the demand curve is downward sloping because, in general, consumers buy more when prices are lower and less when prices are higher. ○ This curve shows the overall demand for the product across all firms, not just one small firm. Example: Imagine a wheat farmer in a perfectly competitive market: The market price of wheat is set, let’s say, at $5 per bushel. The farmer can sell any amount of wheat at $5, but can’t charge more, because other farmers are selling the same wheat at $5. The demand curve for this individual farmer is flat (horizontal) at $5, meaning they can sell as much wheat as they produce at that price. Average Revenue – Revenue per unit Total Revenue Marginal Revenue – Extra revenue from 1 more unit 𝑨𝑹 = 𝑻𝑹/𝑸 = 𝑷 𝑻𝑹 = 𝑷 × 𝑸 𝑴𝑹 = ∆𝑻𝑹/ ∆𝑸 In a perfectly competitive market, a firm is a price-taker—it can only sell its product at the market price and can’t change the price. So, to make the most profit (or minimize losses), the firm has to focus on adjusting its output (how much it produces) instead of changing prices. Profit Maximization Two Approaches to Maximizing Profit: The firm can decide the best amount to produce using two different approaches. Both approaches lead to the same answer about the most profitable output level, but they look at the problem in slightly different ways: 1. Total Revenue – Total Cost Approach: ○ In this approach, the firm finds the level of output where the difference between total revenue and total cost is the biggest. This difference is the maximum profit. 2. Marginal Revenue – Marginal Cost Approach: ○ In this approach, the firm produces up to the point where MR = MC. This is the point where producing one more unit wouldn’t add to profit because the extra cost would equal the extra revenue. Short-Run Loss-Minimizing Case for a Perfectly Competitive Firm (Explained for a 15-Year-Old) Sometimes, a firm in a perfectly competitive market faces a situation where the market price is lower than what would typically bring profit. Even if it can't make a profit, the firm may choose to minimize its losses in the short run by continuing to produce, instead of shutting down. Key Points in a Loss-Minimizing Situation: 1. Market Price is Low: ○ Imagine the market price has dropped to $81 instead of $131. ○ At this price, the firm isn’t able to cover all its costs, but it can still cover some. 2. Check if Price > Minimum AVC: ○ AVC is the Average Variable Cost (the cost per unit for things that vary with output, like materials and labor).  ○ The firm will continue producing if the price is greater than the minimum AVC. In this case, $81 is higher than the minimum AVC, so it’s better to produce than shut down. ○ Why? Because by producing, the firm can cover its variable costs and contribute toward its fixed costs, even if it’s not making a profit. 3. Minimizing Losses: ○ Even though the firm is making a loss, this loss is less than the fixed costs (the costs that don’t change with output, like rent). ○ The best output level to minimize losses is where MR = MC. This is where Marginal Revenue (extra revenue from selling one more unit) equals Marginal Cost (extra cost of producing one more unit). 4. Comparing MR with the Rising Portion of the MC Curve: ○ In perfect competition, MR = Price, so the firm compares the market price with the rising portion of the MC curve. ○ By producing at the level where MR = MC, the firm keeps its losses as low as possible. Marginal Cost and the Short-Run Supply Curve In a perfectly competitive market, a firm’s short-run supply curve is based on its marginal cost (MC) and average variable cost (AVC). Key Points: 1. Supply Curve and Marginal Cost (MC): ○ The firm’s short-run supply curve is the part of its MC curve that lies above the minimum AVC. ○ This is because the firm will only produce and supply products if the price is high enough to cover at least its variable costs. Below that point, it would shut down rather than produce at a loss. 2. Minimum AVC and Production: ○ The firm will not produce if the market price is below the minimum AVC. In that case, producing would mean losing more money than simply shutting down, because the firm wouldn’t even cover its variable costs. 3. Quantity Supplied Increases with Price: ○ As the price increases, the quantity supplied by the firm also increases. This is because higher prices cover more costs and allow the firm to make higher profits, encouraging more production. 4. Economic Profit and Higher Prices: ○ At higher prices, the firm’s economic profit (total revenue minus total cost) is also higher, which provides more incentive for the firm to produce more. 5. The P=MC Rule:  ○ In a perfectly competitive market, the firm maximizes profit by following the P=MC rule. This means that the firm will produce at the level where price (P) equals marginal cost (MC), as this is the point where it earns the most profit for each additional unit produced. Example: If a firm’s minimum AVC is $50: The firm will only start producing and supplying goods if the price is at least $50. If the price rises to $60, the firm will increase production to meet the higher price. The P=MC rule guides how much the firm should produce to maximize profit, producing where price equals marginal cost. Should the Firm Produce? 1. Decision to Produce: ○ The firm should decide to produce its goods if the price (P) it can sell them for is greater than or equal to its minimum average total cost (ATC). ○ This means the firm is either making money (profitable) or losing less money than it has to pay for things it can’t change (like rent or equipment). What Quantity Should the Firm Produce? 2. Finding the Right Amount to Make: ○ The firm should produce the amount where Marginal Revenue (MR) is equal to the Marginal Cost (MC). ○ Marginal Revenue is how much money the firm makes from selling one more item, and Marginal Cost is how much it costs to make one more item. ○ When MR equals MC, the firm is making the most profit or losing the least amount of money. Will Production Result in Economic Profits? 3. Checking for Profits: ○ The firm will make economic profits if the price (P) it sells its product for is greater than the average total cost (ATC). ○ If the price is higher than the average total cost, it means the firm’s total revenue (money coming in from sales) is greater than its total cost (money spent on making and selling the products). Supply Curve Shifts 1. What is a Supply Curve?: ○ The supply curve is a graph that shows how much of a product producers are willing to sell at different prices. It usually goes up from left to right, meaning that as prices increase, producers want to supply more of the product. 2. When Wages Increase: ○ If workers get paid more (wage increase), it costs the company more to produce their products. ○ This makes it less profitable for the company to produce as much, so the supply curve shifts upward and to the left. This means there’s less supply available at each price level. 3. When Technology Improves: ○ If a company gets new technology that helps them produce things more efficiently (like faster machines), it costs them less to make each product. ○ This is a good thing for the company! The supply curve shifts downward and to the right, meaning there’s more supply available at each price level.