Perfect Competition 14 CHAPTER 14 Perfect Competition Theres

Perfect Competition 14 CHAPTER 14 Perfect Competition There’s no resting place for an enterprise in a competitive economy. — Alfred P. Sloan Mc. Graw-Hill/Irwin Copyright © 2010 by the Mc. Graw-Hill Companies, Inc. All rights reserved.

Perfect Competition 14 Chapter Goals • Discuss the six conditions for a perfectly competitive market • Explain why producing an output at which marginal cost equals price maximizes total profit for a perfect competitor • Demonstrate why the marginal cost curve is the supply curve for a perfectly competitive firm • Determine the output and profit of a perfect competitor graphically and numerically 14 -2

Perfect Competition 14 Chapter Goals • Construct a market supply curve by adding together individual firms’ marginal cost curves • Explain why perfectly competitive firms make zero economic profit in the long run • Explain the adjustment process from short-run equilibrium to long-run equilibrium 14 -3

Perfect Competition 14 A Perfectly Competitive Market • A perfectly competitive market is a market in which economic forces operate unimpeded • For a market to be perfectly competitive, six conditions must be met: 1. Both buyers and sellers are price takers – a price taker is a firm or individual who takes the price determined by market supply and demand as given 2. The number of firms is large – any one firm’s output compared to the market output is imperceptible and what one firm does has no influence on other firms 14 -4

Perfect Competition 14 A Perfectly Competitive Market 3. There are no barriers to entry – barriers to entry are social, political, or economic impediments that prevent firms from entering a market 4. Firms’ products are identical – this requirement means that each firm’s output is indistinguishable from any other firm’s output 5. There is complete information – all consumers know all about the market such as prices, products, and available technology 6. Selling firms are profit-maximizing entrepreneurial firms – firms must seek maximum profit and only profit 14 -5

Perfect Competition 14 The Definition of Supply and Perfect Competition • These strong six conditions are seldom met simultaneously, but are necessary for a perfectly competitive market to exist • Supply is a schedule of quantities of goods that will be offered to the market at various prices • When a firm operates in a perfectly competitive market, its supply curve is its short-run marginal cost curve above average variable cost 14 -6

Perfect Competition 14 Demand Curves for the Firm and the Industry Market demand is downward sloping Firm demand is perfectly elastic (horizontal) P P Market Supply P 0 Firm Demand P = D = MR P 0 Market Demand Q Q 1 Q 2 Q 3 Q 14 -7

Perfect Competition 14 Profit Maximizing Level of Output • The goal of the firm is to maximize profits, the difference between total revenue and total cost • A firm maximizes profit when marginal revenue equals marginal cost • Marginal revenue (MR) is the change in total revenue associated with a change in quantity • Marginal cost (MC) is the change in total cost associated with a change in quantity 14 -8

Perfect Competition 14 Profit Maximizing Level of Output • The profit-maximizing condition of a competitive firm is: MR = MC • For a competitive firm, MR = P • A firm maximizes total profit, not profit per unit If MR > MC, • a firm can increase profit by increasing output If MR < MC, • a firm can increase profit by decreasing its output 14 -9

Perfect Competition 14 Marginal Cost, Marginal Revenue, and Price Table Price = MR ($) Q 35 0 35 1 35 2 35 3 35 4 35 5 35 6 35 7 35 8 35 9 35 10 Marginal Cost ($) 28 20 16 14 12 17 22 30 40 The profit-maximizing condition of a competitive firm is: MC = MR = P If MC < P, increase production Profit maximizing quantity is where MC = P If MC > P, decrease production 54 14 -10

Perfect Competition 14 Marginal Cost, Marginal Revenue, and Price Graph Marginal Cost P MC = P $35 MC > P, decrease output to increase total profit P = D = MR MC < P, increase output to increase total profit MC = P at 8 units, total profit is maximized Q 14 -11

Perfect Competition 14 The Marginal Cost Curve is the Supply Curve Marginal Cost P $61 = Firm’s Supply Curve Because the marginal cost curve tells us how much of a good a firm will supply at a given price, the marginal cost curve is the firm’s supply curve $35 $19. 50 6 8 10 Q 14 -12

Perfect Competition 14 Profit Maximization using Total Revenue and Total Cost • An alternative method to determine the profit-maximizing level of output is to look at the total and total cost curves • Total cost is the cumulative sum of the marginal costs, plus the fixed costs • Total profit is the difference between total revenue and total cost curves 14 -13

Perfect Competition 14 Total Revenue and Total Cost Table Q Total Revenue ($) Total Cost ($) Total Profit ($) 0 0 40 -40 1 35 68 -33 2 70 88 -18 3 105 104 1 4 140 118 22 5 175 130 45 6 210 147 63 7 245 169 76 8 280 199 81 9 315 239 76 10 350 293 57 Total profit is maximized at 8 units of output 14 -14

Perfect Competition 14 Total Revenue and Total Cost Table Total Cost, Total Revenue TC TR Max profit = $81 at 8 units of output The total cost curve is bowed upward at most quantities reflecting increasing marginal cost $280 $175 $130 Losses Profits 3 5 The total revenue curve is a straight line 8 Q Profits are maximized when the vertical distance between TR and TC is greatest 14 -15

Perfect Competition 14 Determining Profits Graphically: A Firm with Profit P Find output where MC = MR, this is the profit maximizing Q MC MC = MR P ATC Profits ATC P = D = MR AVC ATC at Qprofit max Q Find profit per unit where the profit max Q intersects ATC Since P>ATC at the profit maximizing quantity, this firm is earning profits 14 -16

Perfect Competition 14 Determining Profits Graphically: A Firm with Zero Profit or Losses Find output where MC = MR, this is the profit maximizing Q P MC ATC Find profit per unit where the profit max Q intersects ATC Since P=ATC at the profit maximizing quantity, this firm is earning zero profit or loss MC = MR AVC P =ATC P = D = MR ATC at Qprofit max Q 14 -17

Perfect Competition 14 Determining Profits Graphically: A Firm with Losses P Find output where MC = MR, this is the profit maximizing Q MC ATC at Qprofit max ATC P AVC P = D = MR Losses MC = MR Qprofit max Q Find profit per unit where the profit max Q intersects ATC Since P<ATC at the profit maximizing quantity, this firm is earning losses 14 -18

Perfect Competition 14 Determining Profits Graphically: The Shutdown Decision • The shutdown point is the point below which the firm will be better off if it shuts down than it will if it stays in business • If P>min of AVC, then the firm will still produce, but earn a loss • If P<min of AVC, the firm will shut down • If a firm shuts down, it still has to pay its fixed costs P MC ATC AVC PShut P = D = MR down Qprofit max Q 14 -19

Perfect Competition 14 Short-Run Market Supply and Demand • While the firm’s demand curve is perfectly elastic, the industry’s demand curve is downward sloping • The market (industry) supply curve is the horizontal sum of all the firms’ marginal cost curves • The market supply curve takes into account any changes in input prices that might occur 14 -20

Perfect Competition 14 Short-Run Market Supply and Demand Graph P P Market Firm MC Market Supply ATC P P ATC P = D = MR Profits Market Demand Q Qprofit max Q 14 -21

Perfect Competition 14 Long-Run Competitive Equilibrium • At long run equilibrium, economic profits are zero • Profits create incentives for new firms to enter, market supply will increase, and the price will fall until zero profits are made • The existence of losses will cause firms to leave the industry, market supply will decrease, and the price will increase until losses are zero 14 -22

Perfect Competition 14 Long-Run Competitive Equilibrium • Zero profit does not mean that the entrepreneur does not get anything for his efforts • Normal profit is the amount the owners would have received in their next best alternative • Economic profits are profits above normal profits 14 -23

Perfect Competition 14 Long-Run Competitive Equilibrium Graph P At long-run equilibrium, economic profits are zero MC LRATC SRATC P = D = MR Q 14 -24

Perfect Competition 14 Market Response to an Increase in Demand Graph P P Market Firm MC S 0(SR) P 1 P 0 S 1(SR) 2 1 1 2 Q 0 Q 1 Q 2 S(LR) D 1 D 0 ATC P 1 P 0 SR Profits 1 2 Q Q 0, 2 Q 14 -25

Perfect Competition 14 Long-Run Market Supply • If the long-run industry supply curve is perfectly elastic, the market is a constant-cost industry • If the long-run industry supply curve is upward sloping, the market is an increasing-cost industry • If the long-run industry supply curve is downward sloping, the market is a decreasing-cost industry • In the short run, the price does more of the adjusting, and in the long run, more of the adjustment is done by quantity 14 -26

Perfect Competition 14 Application: Kmart • Although Kmart was making losses, Kmart decided to keep 300 stores open because P>AVC • After 2 years of losses, Kmart realized that the decrease in demand was permanent • They moved from the short run to the long run and closed the stores because prices had fallen below their long-run average costs 14 -27

Perfect Competition 14 Chapter Summary • The necessary conditions for perfect competition are: 1. Buyers and sellers are price takers 2. The number of firms is large 3. There are no barriers to entry 4. Firms’ products are identical 5. There is complete information 6. Sellers are profit-maximizing entrepreneurial firms 14 -28

Perfect Competition 14 Chapter Summary • Competitive firms maximize profit where MR = MC • Profit is (P – ATC)(Q) at the profit-maximizing level of output • Perfectly competitive firms shut down if P < AVC • The supply curve of a competitive firm is its MC curve above minimum AVC • The short-run market supply curve is the horizontal sum of the MC curves above AVC for all the firms in the market 14 -29

Perfect Competition 14 Chapter Summary • In the short run, competitive firms can make a profit or loss. In the long run they make zero profits. • If there are profits: • Firms enter the industry • Supply increases • Price decreases, eliminating profit • If there are losses: • Firms leave the industry • Supply decreases • Price increases, eliminating losses 14 -30

Perfect Competition 14 Chapter Summary • The long-run industry supply curve is a schedule of quantities supplied where firms are making zero profit • Constant-cost industries have horizontal long-run supply curves • Increasing-cost industries have upward sloping long-run supply curves • Decreasing-cost industries have downward sloping supply curves • The slope of the long-run supply curve depends on what happens to factor costs when output increases 14 -31

Perfect Competition 14 Preview of Chapter 15: Monopoly • Summarize how and why the decisions facing a monopolist differ from the collective decisions of competing firms • Explain why MR = MC maximizes total profit for a monopolist • Determine a monopolist’s price, output, and profit graphically and numerically • Show graphically the welfare loss from monopoly • Explain why a price-discriminating monopolist will earn more profit than a normal monopolist • Explain why there would be no monopoly without barriers to entry • Discuss three normative arguments against monopoly 14 -32