Lecture 18 - Perfect Competition - Student Version (1) PDF

Perfect Competition The Economics of Business and Society (EC1006) Prof. Keith Bender  Overview Finally we are finished with all the setup - described the general operations of economy and thought about the basic costs of the firm Now want to start t...

Perfect Competition The Economics of Business and Society (EC1006) Prof. Keith Bender  Overview Finally we are finished with all the setup - described the general operations of economy and thought about the basic costs of the firm Now want to start to expand on that ‘simple story’. – Market structures – how firms compete – Evaluation of the market model – Other market issues Market Structure is a spectrum depending on level of competition Much competition No competition Perfect Monopolistic Oligopoly Monopoly Competition Competition  Overview con’d First topic is to take extreme case of where firms are in very competitive markets = ‘Perfect Competition’ Questions: – What do we mean by ‘Perfect Competition’? – What are the SR and LR outcomes in this market? – What happens when something changes (e.g. dynamics)?  Return of the KBLIEC! Economics is ‘Fun and Exciting’ The concept of ‘ceteris paribus’ helps economists simplify the world. Opportunity Cost is the basis of all decision making in economics (although other things matter too). Economists are obsessed with Efficiency. The ‘Law of Demand’ is the negative relationship between the OC and the quantity demanded of a good. The ‘Law of Supply’ is the positive relationship between the OC and quantity supplied of a good. The equilibrium concept is central to understanding markets. Elasticity is one of the most important economic concepts, particularly for economic policy. Markets are efficient – except when they aren’t! Perfect Competition generates the maximum amount of efficiency in a market (with certain assumptions).  Perfect Competition Key Characteristics (assumptions) – All behaviours mentioned so far (profit maximising, cost minimising, etc) – Many firms, selling identical products to many buyers – No restrictions to entry or exit market – Established firms have no advantage over new firms – Perfect information about everything (!) Means PC firms are ‘price takers’ – have no ability to affect price. They see the market price and that is what they charge (horizontal demand curve). Also key – markets with perfect competition are seen as most efficient (correspond to supply and demand curves from before)  PC and Production As with any firm, 𝑀𝑀𝑀𝑀, 𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀 production is determined by key equation: 𝑴𝑴𝑴𝑴 = 𝑴𝑴𝑴𝑴 𝑃𝑃∗ 𝑀𝑀𝑀𝑀 But here, the 𝑀𝑀𝑀𝑀 curve is flat at 𝑃𝑃∗ - the market price. Key question is whether it 𝑄𝑄 𝑞𝑞 ∗ wants to actually produce at 𝑞𝑞 ∗ – depends on 𝐴𝐴𝐴𝐴𝐴𝐴 and 𝐴𝐴𝐴𝐴𝐴𝐴 curve.  Three SR Cases: Case 1: 𝑃𝑃 > 𝐴𝐴𝐴𝐴𝐴𝐴 Case 2: 𝑃𝑃 < 𝐴𝐴𝐴𝐴𝐴𝐴, but 𝑃𝑃 > 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 𝑀𝑀𝑀𝑀, 𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀, 𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀 𝐴𝐴𝐴𝐴𝐴𝐴 profit 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 ∗ 𝑃𝑃∗ 𝑀𝑀𝑀𝑀 𝑃𝑃∗ 𝑀𝑀𝑀𝑀 𝐴𝐴𝐴𝐴𝐴𝐴 ∗ 𝐴𝐴𝐴𝐴𝐴𝐴 ∗ loss 𝑞𝑞 ∗ 𝑄𝑄 𝑞𝑞 ∗ 𝑄𝑄 Firm has loss Making profits as 𝐴𝐴𝐴𝐴 > Covering some of FC, so better than shutting down in SR 𝐴𝐴𝐴𝐴 But will shut down in LR unless something changes  Three Cases con’d: Case 3: 𝑃𝑃 < 𝐴𝐴𝐴𝐴𝐴𝐴 and 𝑃𝑃 < 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 𝑀𝑀𝑀𝑀, 𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝐴𝐴𝐴𝐴 ∗ Loss 𝐴𝐴𝐴𝐴𝐴𝐴 ∗ 𝑃𝑃∗ MR 𝑞𝑞 ∗ Q Firm has a loss Not even covering FC, so better to shutting down Shut down point happens where 𝑃𝑃 = 𝐴𝐴𝐴𝐴𝐴𝐴 – At 𝑃𝑃 < 𝐴𝐴𝐴𝐴𝐴𝐴, so don’t produce  Quick Summary In the Short run, perfectly competitive firms have the following choice: – If 𝑃𝑃 > 𝐴𝐴𝐴𝐴𝐴𝐴, then making a profit. HOORAY! – If 𝑃𝑃 < 𝐴𝐴𝐴𝐴𝐴𝐴, but 𝑃𝑃 > 𝐴𝐴𝐴𝐴𝐴𝐴, then making a loss, but since covering some of fixed costs, then continue to produce in SR. – If 𝑃𝑃 < 𝐴𝐴𝐴𝐴𝐴𝐴, then not covering fixed cost so better off not producing so just take ‘hit’ of loss of fixed cost (AKA – shut down)  LR Equilibrium Key point – free 𝑀𝑀𝑀𝑀, 𝑀𝑀𝑀𝑀 𝐴𝐴𝐴𝐴𝐴𝐴 entry and exit 𝑀𝑀𝑀𝑀 – Means that there can be no profit or 𝑃𝑃∗ 𝑀𝑀𝑀𝑀 = 𝐴𝐴𝐴𝐴𝐴𝐴 ∗ losses in LR Therefore, diagram for perfectly 𝑞𝑞 ∗ 𝑄𝑄 competitive firm in LR is: Dynamics in Perfectly Competitive Markets What actually happens in SR when there are profits or losses? Key to this is the competitive aspect – there are no costs to entry or exit. Thus – – If there are profits, firms from other markets enter – If there are losses, firms leave to find other (hopefully more profitable) markets  When there are profits… Firms are identical => if one earns profits, they all earn profits. Aggregating up, gets the market. Profits mean firms enter => supply increases Price drops to 𝑃𝑃′ where there are no profits as 𝑃𝑃′ = 𝑀𝑀𝑀𝑀 = 𝐴𝐴𝐴𝐴𝐴𝐴 – Minimum of 𝐴𝐴𝐴𝐴𝐴𝐴 – as cheap as it gets! – In equilibrium – no reason to change Market Firm 𝑃𝑃 𝐷𝐷 𝑆𝑆 𝑀𝑀𝑀𝑀, 𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀 𝑆𝑆 𝐴𝐴𝐴𝐴𝐴𝐴 𝑃𝑃∗ 𝑀𝑀𝑀𝑀 = 𝑃𝑃∗ 𝑃𝑃′ 𝑄𝑄 𝑞𝑞 ′ 𝑞𝑞 ∗ 𝑞𝑞  When there are losses… Firms are identical => if one earns losses, they all earn losses. Losses mean firms leave => supply decreases Price increases to 𝑃𝑃′′ where there are no profits as 𝑃𝑃′′ = 𝑀𝑀𝑀𝑀 = 𝐴𝐴𝐴𝐴𝐴𝐴 – Market quantity decreases (𝑄𝑄′′ ), though surviving firms’ output increases (𝑞𝑞 ′′ ) – In long run equilibrium – no reason to change 𝑆𝑆 ′′ Market Firm 𝑃𝑃 𝐷𝐷 𝑆𝑆 𝑀𝑀𝑀𝑀, 𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀 𝐴𝐴𝐴𝐴𝐴𝐴 𝐴𝐴𝑉𝑉𝐶𝐶 𝑃𝑃′′ 𝑃𝑃∗ 𝑀𝑀𝑀𝑀 = 𝑃𝑃∗ 𝑄𝑄′′ 𝑄𝑄 𝑞𝑞 ∗ 𝑞𝑞 ′′ 𝑞𝑞  What causes the profits and losses? Potentially many things. – Cost structure of firms (changes in input prices, increases in technology) – Taxes increasing or decreasing – Changes in market demand (e.g. preferences, consumer income, other nonprice determinants of demand)  For example – increase in demand Initially no profits or losses Then demand increases to 𝐷𝐷𝐷, raising price to 𝑃𝑃𝑃, where firms earn profits Profits cause firms to enter and shift supply to 𝑆𝑆𝑆𝑆 Note – back to same equilibrium for the firm - 𝑞𝑞 ∗ (since costs did not change), but market quantity is larger (𝑄𝑄 ′′ ) b/c more firms (leave for you to work out the other combinations) Market 𝑆𝑆 Firm 𝑃𝑃 𝐷𝐷 𝐷𝐷𝐷 𝑀𝑀𝑀𝑀, 𝑀𝑀𝑀𝑀 𝑀𝑀𝑀𝑀 𝐴𝐴𝐴𝐴𝐴𝐴 𝑆𝑆 ′′ 𝑃𝑃′ 𝑃𝑃∗ 𝐴𝐴𝐴𝐴𝐴𝐴 𝑄𝑄𝑄𝑄 𝑄𝑄 𝑞𝑞 ∗ 𝑞𝑞𝑞𝑞 𝑞𝑞  Summary Today – What do we mean by ‘Perfect Competition’? Markets where there are a lot of competitors, entry and exit is free and there is full information. – What are the SR and LR outcomes in this market? In SR – can earn profit, earn a (‘small’) loss or shut down (because can’t cover fixed cost) In LR, because of the free entry and exit, then firms enter if there are profits and leave if there are losses, so there are no economic profits – What happens when something changes (e.g. dynamics)? Adjustment happens in supply until profits are competed away by lower prices or losses are reduced as price increases  Next Time Monopoly MT Ch. 11 where we examine the other ‘extreme’ where there is only one firm that supplies goods and services in the market (that is, there is NO competition).