Chapter 9 Perfect Competition Thus far we have

Chapter 9: Perfect Competition • Thus far we have examined how the consumer and firm attempt to optimize their decisions • The results of this optimization depend on the set-up of the economy • In this course we will examine the extreme set-ups: Perfect Competition and Monopoly 1

Chapter 9: Perfect Competition In this chapter we will cover: 9. 1 Perfect Competition Characteristics 9. 2 Economic and Accounting Profit 9. 3 PC Profit Maximization 9. 4 PC Short Run Supply and Equilibrium 9. 5 PC Long Run Supply and Equilibrium 9. 6 PC Costs 9. 7 Economic Rent 9. 8 Producer Surplus 2

1) Fragmented Industry -Many buyers and sellers -No one buyer or seller has an effect on the industry -Each firm and consumer is a price taker (uses market price) 2) Homogeneous products -All firms produce identical products -No quality differences, no brand loyalty 3

3) Perfect Information -Buyers and sellers have full information, especially regarding prices 4) No barriers to entry or exit -No input is restricted to potential customers or firms -Any firm or customer can enter or exit the market in the long run 4

As a result, we have: • Many buyers and sellers • Buying and selling identical goods At a given, set price. Note: although we are examining a market for outputs (goods and services), a similar analysis can apply to the market for inputs 5

As seen before, Accounting Costs = Explicit Costs Economic Costs = Explicit Costs + Implicit Costs Furthermore, Accounting Profit = Revenue – Explicit Costs Economic Profit = Revenue – Explicit Costs - Implicit Costs 6

Explicit Costs: Costs that involve an exchange of money -ie: Rent, Wages, Licence, Materials Implicit Costs = Opportunity Costs: Costs that don’t involve an exchange of money; Cost of giving up the next best opportunity -ie: Wage that could have been earned working elsewhere; profitability of a goat if 7 used mowing lawns instead of for meat

7. 1. 3 Economic and Accounting Costs Economists are interested in studying how firms make production & pricing decisions. They include all costs. Economic Costs = Explicit + Implicit Costs Accountants are responsible for keeping track of the money that flows into and out of firms. They focus on explicit costs. Accounting Costs = Explicit Costs Note: Different textbooks define costs differently. Refer to these notes for our class’ definitions. 8

Implicit Costs are the BEST ALTERNATIVE return of ALL of an agent’s input (time, money, etc). Alternately, an agent’s time could earn a wage elsewhere. (ie: Work at Simtech for $3000 a month) An agent’s money both isn’t used currently and can be used elsewhere. (ie: Investing $5, 000 @ 10% instead of using it 9 to start a business gives an implicit cost of $500)

Profit: Economists vs Accountants Revenue Economist’s View Accountant’s View Economic Profit Accounting Profit Implicit Costs Explicit Costs Revenue Economic Costs Explicit Costs 10

Buck opens his own Bait shop in a store he owns, which cost $5, 000 per month to run, but he makes $10, 000 a month. Buck could have worked for Worms R Us for $2, 000 per month, or rented out the store for $1, 500 per month. Explicit Costs = $5, 000 Accounting Profit = Revenue – Explicit Costs Accounting Profit = $10, 000 - $5, 000 Accounting Profit = $5, 000 11

Buck opens his own Bait shop in a store he owns, which cost $5, 000 per month to run, but he makes $10, 000 a month. Buck could have worked for Worms R Us for $2, 000 per month, or rented out the store for $1, 500 per month. Implicit Costs = $2, 000 (labour) + $1, 500 (capital) Implicit Costs = $3, 500 Econ Profit = Revenue – Explicit Costs – Implicit Costs Econ Profit = $10, 000 - $5, 000 - $3, 500 12 Econ Profit = $1, 500

Sunk Costs are costs that must be incurred no matter what the decision. These costs are not considered when making a future decision. The Talus Dome was built in 2011 for $600, 000. That cost is now SUNK, and shouldn’t be considered in any further analysis. (ie: Keep cleaning it or get Picture Source: City of Edmonton Webpage (www. edmonton. ca) rid of it) Price Source: Edmonton Journal 13

While previously we studied cost minimizing, in reality a firm is more concerned with maximizing its profits. Total Revenue: TR(Q)=PQ Total Cost: TC(Q) as found in previous chapters ie: TC(Q)=100+2 Q Profit =Total Revenue – Total Cost: π(Q)=TR(Q)-TC(Q) 14

TC(Q) in general is derived as follows: Originally: Tangency Condition: Production Function: (2) + (3) (2) + (4) (1) + (4) + (5) TC=w. L+r. K (1) L=f(K) (2) Q=f(L, K) (3) Q=f(L) and L=f(Q) (4) K=f(Q) (5) TC=wf(Q)+rf(Q) TC=f(Q) 15

For Example: Originally: Tangency Condition: Production Function: (2) + (3) (2) + (4) (1) + (4) + (5) TC=w. L+r. K (1) L=K (2) Q=2(LK)1/2 (3) Q=2 L and L=Q/2 (4) K=Q/2 (5) TC=w. Q/2+r. Q/2 TC=(w+r)Q/2 16

Definition: Marginal revenue is the change in revenue when output changes Marginal revenue is the slope of the total revenue curve. Since the PC firm is a price taker, the additional revenue gained from 1 additional output is EQUAL TO PRICE. 17

As seen previously, marginal cost changes as production increases. If for the next unit, MR>MC, that unit should be produced, as it yields profit. If for the last unit, MC>MR, that unit should not have been produced, as it decreases profit. Therefore profit is maximized where MC=MR=P 18

Total Cost, Total Revenue, Total Profit ($/yr) Total revenue = pq Total Cost Example: Profit Maximization Condition Total profit 15 q (units per year) MC P, MR 15 6 30 q (units per year) 19

The previous curves are expressed by: TC(q) = 242 q -. 9 q 2 + (. 05/3)q 3 MC(q) = 242 - 1. 8 q +. 05 q 2 P = 15 At profit maximizing point: 1) P = MC But this occurs twice. At one point, profit is maximized, at another minimized. Therefore, in order to MAXIMIZE profit: 2) MC must be rising 20

In the paper industry, MC=20+2 Q (which is always rising), where Q=100 reams of paper. Find the costmaximizing quantity if P=30 or P=40 Solution: P=MC 30=20+2 Q 5=Q P=MC 40=20+2 Q 10=Q 21

In the short run, the firm either produces or temporarily shuts down, thus facing costs: STC(Q) = SFC + NSFC + TVC(q) when q > 0 = SFC when q = 0 SFC: Sunk Fixed costs – unavoidable sunk costs NSFC: Non-sunk Fixed costs – fixed costs that are avoidable if the firm temporarily shuts down TVC: Total Variable Costs; depends on output 22

Definition: The firm’s Short run supply curve tells us how the profit maximizing output changes as the market price changes. HOWEVER, if the market price is too low, the firm will not operate in the short run. Ps = Shut down price (minimum market price where a firm will still operate) 23

A firm will only operate if it can cover its NON SUNK COSTS. -ie: A sandwich shop will only stay open if it can pay its employees cover daily operating costs. 3 Cases: Case 1: all fixed costs are sunk Case 2: all fixed costs are non-sunk Case 3: some fixed costs are sunk 24

$/yr Case 1: Shut down price where SMC=AVC (all fixed costs are sunk – worst situation) SMC SAC AVC Ps 25 Quantity (units/yr)

$/yr This firm may operate at a loss if P<SAC (Because operating has less loss than shutting down) SMC SAC AVC Ps 26 Quantity (units/yr)

$/yr Case 2: Shut down Price where SMC=SAC (all costs are non-sunk – best case scenario) (This firm will never operate at a loss) SMC SAC Ps AVC Quantity (units/yr) 27

$/yr Case 3: Shut down price between SAC and AVC (sometimes called ANSC – Average non-sunk cost) (This firm operates at a loss if P<SAC) SMC SAC ANSC AVC Ps 28 Quantity (units/yr)

At prices below SAC but above AVC, profits are negative if the firm produces…but the firm loses less by producing than by shutting down because of sunk costs. Example: STC(q) = 100 + 20 q + q 2 SFC = 100 (nb: this is sunk) TVC(q) = 20 q + q 2 AVC(q) = 20 + q SMC(q) = 20 + 2 q 29

a. Calculate The Firm’s Supply Curve, P = SMC P = 20+2 q qs = ½P - 10 b. If Market Price=$25, calculate firm production qs = ½P - 10 qs = ½(25) – 10 qs = 2. 5 30

b. If Market Price=$25, calculate firm profit/losses qs = 2. 5 π=TR-TC π=Pq-(100 + 20 q + q 2) π=($25)2. 5 -(100 + 20(2. 5) + (2. 5)2) π=62. 5 -(100 + 50 + 6. 25) b. π=-$93. 75 c. (remember that shutting down would have fixed costs of $100. ) 31

P SMC SAC AVC Loss = $93. 75 P* = $25 Ps = $20 q* = 2. 5 Q 32

A firm will produce If It can cover its Non-Sunk Costs 33

Thus far we have seen that the individual firm’s short run supply curve comes from their marginal cost curve. Definition: The market supply at any price is the sum of the quantities each firm supplies at that price. The short run market supply curve is the HORIZONTAL sum of the individual firm supply curves. (Just as market demand is the 34 HORIZONTAL sum of individual demand curves)

Example: From Short Run Firm Supply Curve to Short Run Market Supply Curve Typical firm: Individual supply curves per firm. 1000 firms of each type SMC 3 SMC 2 $/unit Market: SMC 1 Market supply 30 24 22 20 0 300 400 500 q (units/yr) 0 1. 2 35 mill Q (m units/yr)

Definition: A short run perfectly competitive equilibrium occurs when the market quantity demanded equals the market quantity supplied. ni=1 qs(P) = Qd(P) Qs(P)= Qd(P) and qs(P) is determined by the firm's individual profit maximization condition. 36

Example: Short Run Perfectly Competitive Equilibrium Typical firm: Market: $/unit Supply SMC P* SAC AVC Demand Ps q* Units/yr Q* 37 m. units/yr

300 identical firms Qd(P) = 60 – P STC(q) = 0. 1 + 150 q 2 SMC(q) = 300 q NSFC = 0 AVC(q) = 150 q 38

a. Short Run Equilibrium Individual Firm: P = SMC P = 300 q qs= P/300 Industry: Qs = 300(qs) Qs = P (for industry) 39

a. Short Run Equilibrium Market Price: Qs(P) = Qd(P) P = 60 – P P*= 30 Quantities: q* = P/300= 30/300 q* = 0. 1 Q* = P Q* = 30 40

b. Do firms make positive profits at the market equilibrium? SAC SAC = = STC/q 0. 1/q + 150 q 0. 1/0. 1 + 150(0. 1) 16 Therefore, P* > SAC so profits are positive. 41

Comparative Statics in the Short Run • As seen in previous chapters, the entry or exit of firms or consumers, among other things, can shift the market demand supply curves • Shifts in the market demand supply curves will shift the equilibrium quantity as seen in chapters 1 and 2 42

In the short run, capital is fixed and firms may temporarily operate under an economic profit or loss. In the long run, capital can change and firms can enter and leave the market, resulting in zero economic profit. Remember that in the long run, all costs are nonsunk (they are all avoidable at zero output) 43

Just as in the short run the firm operated at: P=SMC In the long run the firm operates at P=MC SMC≠MC (in general) since costs are reduced in the long run. Only at LR profit maximization is SMC=MC (because the short run is operating at the LR 44 optimal capital point: Point A next slide)

$/unit P In the long run, this firm has an incentive to change plant size to level K 1 from K 0: MC SMC 0 SAC 0 A • AC SAC 1 SMC 1 1. 8 6 45 q (000 units/yr)

In the long run, a firms supply curve is The firm’s LR MC curve above AC. For if P>AC, Profits>0. Since Profits = (Px. Q)-(ACx. Q) As in the short run, market supply is the horizontal sum of individual firm supply. 46

$/unit Long Run Supply Curve: MC S P AC SMC 1 1. 8 6 47 q (000 units/yr)

Long Run Perfectly Competitive Equilibrium occurs when: 1) Each firm maximizes profit with regards to output and capital (P=MC) 2) Each firm’s economic profit is zero (as firms keep entering until the price is pushed down to zero profits) (P=AC) 3) Market Demand=Market Supply 48

Long Run Perfectly Competitive Equilibrium Typical Firm $/unit SAC Market $/unit MC Market demand AC P* SMC q*=50, 000 q Q*=10 M. 49 Q

• to increase production, a firm must increase inputs • Increasing MARKET output could change costs, therefore changing equilibrium price • A CONSTANT COST INDUSTRY is an industry where changes in output do not affect the price of inputs 50

-Demand increases to D 2, Price rises to P 2 -New firms enter, Supply increases to S 2, lowering price back to P 1 $/unit S 1 SMC S 2 SAC P 2 P 1 D 2 D 1 Typical Firm q Market 51 Q

• Industry-specific inputs are scarce inputs used primarily by one industry -ie: Plutonium is only used in the nuclear industry • Changes in production will have an impact on the market for industry-specific inputs • An INCREASING COST INDUSTRY is an industry where increases in output increase the 52 price of inputs

-Demand increases to D 2, Price rises to P 2 -New firms enter, Supply increases to S 2, increasing costs and lowering price to P 3 (>P 1) $/unit SMC 3 SMC 1 SAC 3 S 1 S 2 P 3 P 1 SAC 1 D 2 D 1 Typical Firm q Market 53 Q

• Some industries require a small amount of an expensive/rare input -ie: Liquid Nitrogen computer cooling • An increase in input demand may drive down input prices by reducing input AC • A DECREASING COST INDUSTRY is an industry where increases in output decrease the 54 price of inputs

-Demand increases to D 2, Price rises to P 2 -New firms enter, Supply increases to S 2, decreasing costs and lowering price to P 3 (<P 1) $/unit S 1 SMC 3 P 2 SAC 1 S 2 SAC 3 P 1 P 3 D 2 D 1 Typical Firm q Market 55 Q

Although economic profit is possible in the short run, In the long run the entry of firms will push economic profit to zero This entry could increase, decrease, or not change the equilibrium price. 56

• In general, we assume that all workers are identical. • In reality, some workers are masters; they are more productive than their peers. • The cost savings of a master worker is their ECONOMIC RENT 57

Joe is an amazing worker that works in a button factory. While most workers can only press one or two buttons at a time, Joe can press a dozen. A normal worker produces buttons at an average cost of 5 cents, but Joe can make buttons at an average cost of 1 cent each. If Joe produced buttons at a cost of 5 cents each, he’d be hired to produce 900 a day. 58

Economic Rent = Cost Savings ER = (0. 05 -0. 01)900 ER = $36 The economic rent from a master worker (Joe) is $36 a day. 59

• If a firm is able to employ a master worker at a normal worker’s wage, that worker’s economic rent becomes the firm’s economic profit • In a perfectly competitive industry, in all likelihood a master worker will be stolen by other firms at higher wages until his wage matches his productivity • Master workers therefore often provide no profit in perfect competition 60

Definition: Producer Surplus is the area above the supply curve and below the price. It is a monetary measure of the benefit that producers derive from producing a good at a particular price. Note that the producer earns the price for every unit sold, but only incurs the SMC for each unit. This is why the difference between the P and SMC curve measures the total benefit derived from production. 61

$/yr Producer Surplus, Individual Firm SMC ANSC Producer Surplus P 62 Quantity (units/yr)

Further, since the market supply curve is simply the sum of the individual supply curves…which equal the marginal cost curves…the difference between price and the market supply curve measures the surplus of all producers in the market. Note that producer’s surplus does not deduct fixed costs, so it does not equal profit! 63

Market Producer Surplus P Market Supply Curve 50 Producer Surplus = (1/2)BH PS=(1/2)800(40) PS=16, 000 10 800 Q 64

Producer surplus is the difference between total revenue and total nonsunk costs; Producer Surplus=TR-NSFC-TVC In the short run, if Producer Surplus>SFC, economic profit is possible. 65

In the long run, no costs are fixed, Therefore Producer Surplus = Economic Profit BUT In the long run, Economic Profit=0 How? 66

An industry has an upward sloping supply if it employs scarce resources (increasing cost industry – master growers) Producer Surplus is therefore the economic rent captured by the master worker or owner of the input In the LR PC: Producer Surplus=Economic Rent 67

P Long Run Producer Surplus = Economic Rent LS 50 Economic Rent D 10 800 Q 68

Chapter 9 Key Concepts ØPerfect competition features: ØMany buyers and sellers ØHomogeneous products ØPerfect Information ØNo Barriers to Entry ØPerfect competition results in a single, equilibrium price that no one consumer or firm can influence ØEconomists include implicit costs in their economic profits (Accountants do not) 69

Chapter 9 Key Concepts ØTotal cost (TC) depends on total output (Q) ØMarginal revenue is the change in total revenue from one additional output (Q) ØA firm will produce where MR=MC ØMR=P in Perfect Competition ØA firm’s supply curve is its MC curve above its shut-down point ØA firm will operate if it can cover its variable costs ØIn the SR, this could cause a loss 70

Chapter 9 Key Concepts ØIn the LR, costs can vary with the entry of firms ØThis can affect equilibrium price ØSkilled workers produce economic rent, which is often captured by higher wages ØProducer Surplus is the area between price and the supply curve ØThis is before fixed costs ØIn the long run, Producer Surplus is captured by skilled workers ØEconomics > Accounting 71