Firms in Perfect Competition PDF

Firms in Competitive Markets Instructor Dr. Abhisek Sur Email: [email protected] Assistant Professor Economics Jindal Global Law School The Four Market Structures MARKET STRUCTURE PERFECT MON...

Firms in Competitive Markets Instructor Dr. Abhisek Sur Email: [email protected] Assistant Professor Economics Jindal Global Law School The Four Market Structures MARKET STRUCTURE PERFECT MONOPOLISTIC CHARACTERISTIC COMPETITION COMPETITION OLIGOPOLY MONOPOLY Number of firms Many Many Few One Type of product Identical Differentiated Identical or Unique differentiated Ease of entry High High Low Significant barriers Examples of Vegetable Toothbrushes Air travel Patented industries Market (Haat) Music Stores Automobiles drugs Groceries Beverages Fast-food outlets Cigarettes Mobile phone service The impact of the product market on firms’ prices and output choices is determined by the nature of the product and the market structure in which they operate. Market Structure Less Competitive Perfect Competition More Competitive Monopolistic Competition Oligopoly Monopoly When Is a Market Highly Competitive? Because firms can implicitly or explicitly collude in setting prices, the presence of many firms is not sufficient for an industry to approximate perfect competition. Conversely, the presence of only a few firms in a market does not rule out competitive behavior. Perfect Competition  perfectly competitive market: A market with many sellers and buyers of a homogeneous product and no barriers to entry.  A market is perfectly competitive if each firm in the market is a price taker that cannot significantly affect the market price for its output or the prices at which it buys inputs. price taker: A buyer or seller that is unable to affect the market price, i.e. takes the market price as given. Why would a competitive firm be a price taker? Because it has no choice. The firm has to be a price taker if it faces a demand curve that is horizontal at the market price. If the demand curve is horizontal at the market price, the firm can sell as much as it wants at that price, so it has no incentive to lower its price. Similarly, the firm cannot increase the price at which it sells by restricting its output because it faces an infinitely elastic demand - a small increase in price results in its demand falling to zero. Perfect Competition  The features of a perfectly competitive market: There are many small buyers and sellers. Both buyers and sellers are price takers. The firms produce identical products, i.e. the product is homogeneous. Firms can easily enter and exit the market. All market participants have full information about price and product characteristics. Transaction costs are negligible. PERFECTLY COMPETITIVE MARKETS The model of perfect competition rests on three basic assumptions: (1) price taking (2) product homogeneity, and (3) free entry and exit. Price Taking Because each individual firm sells a sufficiently small proportion of total market output, its decisions have no impact on market price. Product Homogeneity When the products of all of the firms in a market are perfectly substitutable with one another—that is, when they are homogeneous—no firm can raise the price of its product above the price of other firms without losing most or all of its business. Free Entry and Exit Condition under which there are no special costs that make it difficult for a firm to enter (or exit) an industry. If new producers can easily enter and exit the market, existing firms may behave as though there are more firms than there appear to be, because there are more potential competitors. PERFECTLY COMPETITIVE MARKETS  Entry into a market can be deterred by barriers to entry. Important barriers to entry include: (a) High start-up costs. These may cause it to take a very long time for new firms to enter the market, during which time the market is less competitive than it otherwise would be. (b) Brand loyalty. If people are reluctant to consider new alternatives, the established firms in an industry face less of a threat from new competitors. (c) Government restrictions. These restrict the ability of competitors to contest the market. Examples include licensing of electricians, plumbers, doctors, etc.; patents; protectionist tariffs and quotas; and absolute limits on the number of suppliers (cabs).  The Revenue of a Competitive Firm ▪ Total revenue (TR) TR = P x Q TR ▪ Average revenue (AR) AR = =P Q ▪ Marginal Revenue (MR): ∆TR The change in TR from MR = ∆Q selling one more unit. 8  MR = P for a Competitive Firm ▪ A competitive firm can keep increasing its output without affecting the market price. ▪ So, each one-unit increase in Q causes revenue to rise by P, i.e., MR = P. MR = P is only true for firms in competitive markets. 9 A C T I V E L E A R N I N G 1: Exercise Fill in the empty spaces of the table. Q P TR AR MR 0 $10 n.a. 1 $10 $10 2 $10 3 $10 4 $10 $40 $10 5 $10 $50 10 A C T I V E L E A R N I N G 1: Answers Fill in the empty spaces of the table. TR ∆TR Q P TR = P x Q AR = MR = Q ∆Q 0 $10 $0 n.a. $10 1 $10 $10 $10 Notice that $10 2 $10 $20 $10 MR = P $10 3 $10 $30 $10 $10 4 $10 $40 $10 $10 5 $10 $50 $10 11 Perfectly Competitive Markets The Demand Curve for the Output of a Perfectly Competitive Firm The Market Demand for Wheat versus the Demand for One Farmer’s Wheat In a perfectly competitive market, price is determined by the intersection of market demand and market supply. In panel (a), the demand and supply curves for wheat intersect at a price of $4 per bushel. An individual wheat farmer like Farmer Parker cannot affect the market price for wheat. Therefore, as panel (b) shows, the demand curve for Farmer Parker’s wheat is a horizontal line. PROFIT MAXIMIZATION To maximize its profit, a firm must answer two questions: Output decision: If the firm produces, what output level, q*, maximizes its profit or minimizes its loss? Shutdown decision: Is it more profitable to produce q* or to shut down and produce no output? OUTPUT RULES A firm can use one of three equivalent rules to choose how much output to produce: Rule 1: The firm sets its output where its profit is maximized. Rule 2: A firm sets its output where its marginal profit is zero. Rule 3: A firm sets its output where its marginal revenue equals its marginal cost. How a Firm Maximizes Profit in a Perfectly Competitive Market Profit Total revenue minus total cost. Profit = TR – TC Revenue for a Firm in a Perfectly Competitive Market Average revenue (AR) Total revenue divided by the quantity of the product sold. Marginal revenue (MR) The change in total revenue from selling one more unit of a product. Change in total revenue TR Marginal Revenue = , or MR = Change in quantity Q MARGINAL REVENUE, MARGINAL COST, AND PROFIT MAXIMIZATION profit - Difference between total revenue and total cost. π(q) = R(q) − C(q) marginal revenue Change in revenue resulting from a one-unit increase in output. Profit Maximization in the Short Run A firm chooses output q*, so that profit, the difference AB between revenue R and cost C, is maximized. At that output, marginal revenue (the slope of the revenue curve) is equal to marginal cost (the slope of the cost curve). Δπ/Δq = ΔR/Δq − ΔC/Δq = 0 MR(q*) = MC(q*) The second-order condition: dMR(q*)/dq < dMC(q*)/dq Perfectly Competitive Markets The Demand Curve for the Output of a Perfectly Competitive Firm A Perfectly Competitive Firm Faces a Horizontal Demand Curve A firm in a perfectly competitive market is selling exactly the same product as many other firms. Therefore, it can sell as much as it wants at the current market price, but it cannot sell anything at all if it raises the price by even 1 cent. As a result, the demand curve for a perfectly competitive firm’s output is a horizontal line. In the figure, whether the wheat farmer sells 6,000 bushels per year or 15,000 bushels has no effect on the market price of $4.  Profit Maximization ▪ What Q maximizes the firm’s profit? ▪ To find the answer, “Think at the margin.” If increase Q by one unit, revenue rises by MR, cost rises by MC. ▪ If MR > MC, then increase Q to raise profit. ▪ If MR < MC, then reduce Q to raise profit. 17  MC and the Firm’s Supply Decision Rule: MR = MC at the profit-maximizing Q. At Qa, MC < MR. Costs So, increase Q MC to raise profit. At Qb, MC > MR. So, reduce Q to raise profit. P1 MR At Q1, MC = MR. Changing Q would lower profit. Q Qa Q1 Qb 18  MC and the Firm’s Supply Decision If price rises to P2, then the profit- Costs maximizing quantity MC rises to Q2. P2 MR2 The MC curve determines the firm’s Q at any price. P1 MR Hence, the MC curve is the firm’s supply curve. Q Q1 Q2 19  Profit Maximization (continued from earlier exercise) Q TR TC Profit MR MC  Profit = At any Q with MR – MC MR > MC, 0 $0 $5 –$5 increasing Q $10 $4 $6 raises profit. 1 10 9 1 10 6 4 2 20 15 5 At any Q with 10 8 2 MR < MC, 3 30 23 7 10 10 0 reducing Q 4 40 33 7 raises profit. 10 12 –2 5 50 45 5 20  Shutdown vs. Exit ▪ Shutdown: A short-run decision not to produce anything because of market conditions. ▪ Exit: A long-run decision to leave the market. A firm that shuts down temporarily must still pay its fixed costs. A firm that exits the market does not have to pay any costs at all, fixed or variable. 21 A Firm’s Short-run Decision to Shut Down ▪ If firm shuts down temporarily, revenue falls by TR costs fall by VC ▪ So, the firm should shut down if TR < VC. ▪ Divide both sides by Q: TR/Q < VC/Q ▪ So we can write the firm’s decision as: Shut down if P < AVC 22 A Competitive Firm’s SR Supply Curve The firm’s SR supply curve is Costs the portion of MC its MC curve If P > AVC, then above AVC. firm produces Q ATC where P = MC. AVC If P < AVC, then firm shuts down (produces Q = 0). Q 23  The Irrelevance of Sunk Costs ▪ Sunk cost: a cost that has already been committed and cannot be recovered ▪ Sunk costs should be irrelevant to decisions; you must pay them regardless of your choice. ▪ FC is a sunk cost: The firm must pay its fixed costs whether it produces or shuts down. ▪ So, FC should not matter in the decision to shut down. 24  A Firm’s Long-Run Decision to Exit ▪ If firm exits the market, revenue falls by TR costs fall by TC ▪ So, the firm should exit if TR < TC. ▪ Divide both sides by Q to rewrite the firm’s decision as: Exit if P < ATC 25  The Firm’s Long-run Decision to Exit or Enter a Market Why does a restaurant bother to stay open during lunch? In deciding whether to open for lunch, a restaurant owner must keep in mind the distinction between fixed and variable costs. Many of the restaurant’s costs (rent, kitchen equipment, tables, plates, silverware) are fixed. Shutting down would not reduce these costs. These Chapter 11: Firms in Perfectly Competitive Markets costs are sunk in the short-run. The owner shuts down the restaurant at lunchtime only if the revenue from the few lunchtime customers fails to cover the restaurant’s variable costs. Copyright © 2010 Pearson Education, Inc. Publishing as Prentice Hall · Microeconomics · R. Glenn Hubbard, Anthony Patrick O’Brien, 3e. 26 of 39 A New Firm’s Decision to Enter Market ▪ In the long run, a new firm will enter the market if it is profitable to do so: if TR > TC. ▪ Divide both sides by Q to express the firm’s entry decision as: Enter if P > ATC 27 Illustrating Profit or Loss on the Cost Curve Graph Illustrating When a Firm Is Breaking Even or Operating at a Loss 1. P > ATC, which means the firm makes a profit. 2. P = ATC, which means the firm breaks even (its total cost equals its total revenue). 3. P < ATC, which means the firm experiences losses. The Competitive Firm’s Supply Curve The firm’s Costs LR supply curve is the portion of MC its MC curve above LRATC. LRATC Q 29 Illustrating Profit or Loss on the Cost Curve Graph Profit = (P x Q) − TC Profit ( P  Q ) TC = − Q Q Q or Profit = P − ATC Q Profit = (P − ATC) x Q A C T I V E L E A R N I N G 2A: Identifying a firm’s profit A competitive firm Determine Costs, P this firm’s MC total profit. P = $10 MR Identify the ATC area on the graph that $6 represents the firm’s profit. Q 50 31 A C T I V E L E A R N I N G 2A: Answers A competitive firm Costs, P profit per unit MC = P – ATC P = $10 MR = $10 – 6 profit ATC = $4 $6 Total profit = (P – ATC) x Q = $4 x 50 Q = $200 50 32 A C T I V E L E A R N I N G 2 B: Identifying a firm’s loss A competitive firm Determine Costs, P this firm’s MC total loss. Identify the ATC area on the graph that $5 represents the firm’s P = $3 MR loss. Q 30 33 A C T I V E L E A R N I N G 2 B: Answers A competitive firm Costs, P MC Total loss = (ATC – P) x Q = $2 x 30 ATC = $60 $5 loss loss per unit = $2 P = $3 MR Q 30 34  Market Supply: Assumptions 1) All existing firms and potential entrants have identical costs. 2) Each firm’s costs do not change as other firms enter or exit the market. 3) The number of firms in the market is fixed in the short run (due to fixed costs) variable in the long run (due to free entry and exit) 35  The SR Market Supply Curve ▪ As long as P ≥ AVC, each firm will produce its profit-maximizing quantity, where MR = MC. ▪ Recall from Chapter 4: At each price, the market quantity supplied is the sum of quantity supplied by each firm. 36  The SR Market Supply Curve Example: 1000 identical firms. At each P, market Qs = 1000 x (one firm’s Qs) One firm Market P MC P S P3 P3 P2 P2 AVC P1 P1 Q Q 10 20 30 (firm) (market) 10,000 20,000 30,000 37  Entry & Exit in the Long Run ▪ In the LR, the number of firms can change due to entry & exit. ▪ If existing firms earn positive economic profit, New firms enter. SR market supply curve shifts right. P falls, reducing firms’ profits. Entry stops when firms’ economic profits have been driven to zero. 38  Entry & Exit in the Long Run ▪ In the LR, the number of firms can change due to entry & exit. ▪ If existing firms incur losses, Some will exit the market. SR market supply curve shifts left. P rises, reducing remaining firms’ losses. Exit stops when firms’ economic losses have been driven to zero. 39  The Zero-Profit Condition ▪ Long-run equilibrium: The process of entry or exit is complete – remaining firms earn zero economic profit. ▪ Zero economic profit occurs when P = ATC. ▪ Since firms produce where P = MR = MC, the zero-profit condition is P = MC = ATC. ▪ Recall that MC intersects ATC at minimum ATC. ▪ Hence, in the long run, P = minimum ATC. 40  The LR Market Supply Curve In the long run, The LR market supply the typical firm curve is horizontal at earns zero profit. P = minimum ATC. One firm Market P MC P LRATC P= long-run min. supply ATC Q Q (firm) (market) 41  Why Do Firms Stay in Business if Profit = 0? ▪ Recall, economic profit is revenue minus all costs – including implicit costs, like the opportunity cost of the owner’s time and money. ▪ In the zero-profit equilibrium, firms earn enough revenue to cover these costs. 42  SR & LR Effects of an Increase in Demand A firm begins in …but then an increase long-run to…driving …leadingeq’m… SR profits to zero Over time, profits in demandinduce entry, raises P,… andfirm. profits for the restoring long-run shifting eq’m. S to the right, reducing P… P One firm P Market MC S1 S2 Profit ATC B P2 P2 A C long-run P1 P1 supply D2 D1 Q Q (firm) Q1 Q2 Q3 (market) 43  Why the LR Supply Curve Might Slope Upward ▪ The LR market supply curve is horizontal if 1) all firms have identical costs, and 2) costs do not change as other firms enter or exit the market. ▪ If either of these assumptions is not true, then LR supply curve slopes upward. 44  1) Firms Have Different Costs ▪ As P rises, firms with lower costs enter the market before those with higher costs. ▪ Further increases in P make it worthwhile for higher-cost firms to enter the market, which increases market quantity supplied. ▪ Hence, LR market supply curve slopes upward. ▪ At any P, For the marginal firm, P = minimum ATC and profit = 0. For lower-cost firms, profit > 0. 45  2) Costs Rise as Firms Enter the Market ▪ In some industries, the supply of a key input is limited (e.g., there’s a fixed amount of land suitable for farming). ▪ The entry of new firms increases demand for this input, causing its price to rise. ▪ This increases all firms’ costs. ▪ Hence, an increase in P is required to increase the market quantity supplied, so the supply curve is upward-sloping. 46  CONCLUSION: The Efficiency of a Competitive Market ▪ Profit-maximization: MC = MR ▪ Perfect competition: P = MR ▪ So, in the competitive eq’m: P = MC ▪ Recall, MC is cost of producing the marginal unit. P is value to buyers of the marginal unit. ▪ So, the competitive eq’m is efficient, maximizes total surplus. ▪ In the next chapter, monopoly: pricing & production decisions, deadweight loss, regulation. 47 CHAPTER SUMMARY ▪ For a firm in a perfectly competitive market, price = marginal revenue = average revenue. ▪ If P > AVC, a firm maximizes profit by producing the quantity where MR = MC. If P < AVC, a firm will shut down in the short run. ▪ If P < ATC, a firm will exit in the long run. ▪ In the short run, entry is not possible, and an increase in demand increases firms’ profits. ▪ With free entry and exit, profits = 0 in the long run, and P = minimum ATC. 48