Perfectly Competitive Markets n Market Characteristics 1 Price

Perfectly Competitive Markets n Market Characteristics 1) Price taking: the individual firm sells a very small share of total market output and so cannot influence market price. The individual consumer buys too small a share of output to have any impact on the price. 2) Product homogeneity: the products of all firms are perfect substitutes. 3) Free entry and exit: Buyers can easily switch from one supplier to another. Suppliers can easily enter or exit a market. Chapter 8 1

Profit Maximization n Do firms maximize profits? l Possibility of other objectives u Revenue maximization u Dividend maximization u Short-run profit maximization l Implications of non-profit objective u Over the long-run investors would not support the company u Without profits, survival unlikely Chapter 8 2

Marginal Revenue, Marginal Cost and π Maximization n Determining the profit maximizing level of output l Profit ( l Total Revenue (R) = Pq l Total Cost (C) = Cq l Therefore: Chapter 8 ) = Total Revenue - Total Cost 3

Profit Maximization in the Short Run Total Revenue Cost, Revenue, Profit ($s per year) R(q) Slope of R(q) = MR 0 Output (units per year) Chapter 8 4

Profit Maximization in the Short Run C(q) Cost, Revenue, Profit $ (per year) Total Cost Slope of C(q) = MC Why is cost positive when q is zero? 0 Output (units per year) Chapter 8 5

Marginal Revenue, Marginal Cost and π Maximization n Comparing R(q) and C(q) l l Output levels: 0 - q 0: u C(q)> R(q): negative profit u FC + VC > R(q) u MR > MC Cost, Revenue, Profit ($s per year) C(q) R(q) A Output levels: q 0 - q* u R(q)> C(q) u MR > MC: higher profit at higher output. Profit is increasing B 0 q* Output (units per year) Chapter 8 6

Marginal Revenue, Marginal Cost and π Maximization n Comparing R(q) and C(q) l Output level: q* u R(q)= C(q) u MR = MC u Profit is maximized Cost, Revenue, Profit $ (per year) C(q) R(q) A B 0 q* Output (units per year) Chapter 8 7

Demand MR Faced by a Competitive Firm Price $ per bushel Firm $4 d Industry $4 D 100 Chapter 8 200 Output (bushels) 100 Output (millions of bushels) 8

Marginal Revenue, Marginal Cost and π Maximization n The competitive firm’s demand u u u Individual firm sells all units for $4 regardless of their level of output. If the firm tries to raise price, sales are zero. If the firm tries to lower price, he cannot increase sales u P = D = MR = AR u Profit Maximization: MC(q) = MR = P Chapter 8 9

A Competitive Firm making a Positive Profit: SR MC Price 60 ($ per unit) 50 40 Lost profit for q 1 < q * A D Lost profit for q 2 > q * ATC C B 30 AVC At q*: MR = MC and P > ATC q 1 : MR > MC and q 2: MC > MR 20 and q 0: MC = MR but MC falling 10 0 Chapter 8 AR=MR=P 1 q 0 2 3 4 5 6 7 q 1 8 q* 9 q 2 10 11 Output 10

A Competitive Firm Incurring Losses: SR MC Price ($ per unit) C D At q*: MR = MC and P < ATC Losses = (P- AC) q* or ABCD F B A P = MR AVC E q* Chapter 8 ATC Would this producer continue to produce with a loss? Output 11

Choosing Output in the Short Run n Summary of Production Decisions l Profit l If is maximized when MC = MR P > ATC the firm is making profits. l If AVC < P < ATC the firm should produce at a loss. l If P < AVC < ATC the firm should -down. Chapter 8 shut 12

A Competitive Firm’s Short-Run Supply Curve Price ($ per unit) The firm chooses the output level where MR = MC, as long as the firm is able to cover its variable cost of production. MC P 2 ATC P 1 AVC What happens if P < AVC? P = AVC q 1 Chapter 8 q 2 Output 13

A Competitive Firm’s Short-Run Supply Curve Price ($ per unit) S = MC above AVC MC P 2 ATC P 1 AVC P = AVC Shut-down q 1 Chapter 8 q 2 Output 14

The Response of a Firm to a Change in Input Price ($ per unit) MC 2 Savings to the firm from reducing output Input cost increases and MC shifts to MC 2 and q falls to q 2. MC 1 $5 q 2 Chapter 8 q 1 Output 15

Industry Supply in the Short Run MC 1 MC 2 $ per unit MC 3 S The short-run industry supply curve is the horizontal summation of the supply curves of the firms. P 3 P 2 P 1 0 Chapter 8 Question: If increasing output raises input costs, what impact would it have on market supply? 2 4 5 7 8 10 15 Quantity 21 16

The Short-Run Market Supply Curve n Elasticity of Market Supply n Perfectly inelastic short-run supply arises when the industry’s plant and equipment are so fully utilized that new plants must be built to achieve greater output. n Perfectly elastic short-run supply arises when marginal costs are constant. Chapter 8 17

Producer Surplus for a Firm Price ($ per unit of output) At q* MC = MR. Between 0 and q , MR > MC for all units. Producer Surplus MC AVC B A D 0 Chapter 8 P C q* Alternatively, VC is the sum of MC or ODCq*. R is P x q* or OABq*. Producer surplus = R - VC or ABCD. Output 18

The Short-Run Market Supply Curve n Producer Surplus in the Short-Run Chapter 8 19

Producer Surplus for a Market Price ($ per unit of output) S Market producer surplus is the difference between P* and S from 0 to Q*. P* Producer Surplus D Q* Chapter 8 Output 20

Output Choice in the Long Run Price ($ per unit of output) In the long run, the plant size will be increased and output increased to q 3. Long-run profit, EFGD > short run profit ABCD. LMC LAC SMC D $40 SAC A C G E B P = MR F $30 In the short run, the firm is faced with fixed inputs. P = $40 > ATC. Profit is equal to ABCD. q 1 Chapter 8 q 2 q 3 Output 21

Output Choice in the Long Run Price ($ per unit of output) Question: Is the producer making a profit after increased output lowers the price to $30? LMC LAC SMC D $40 SAC A C G E B P = MR F $30 q 1 Chapter 8 q 2 q 3 Output 22

Choosing Output in the Long Run Long-Run Competitive Equilibrium n Zero-Profit l If R > w. L + r. K, economic profits are positive l If R = w. L + r. K, zero economic profits, but the firm is earning a normal rate of return; indicating the industry is competitive l If R < w. L + r. K, consider going out of business Chapter 8 23

Long-Run Competitive Equilibrium • Profit attracts firms • Supply increases until profit = 0 $ per unit of output Firm Industry S 1 LMC $40 LAC $30 P 1 S 2 P 2 D q 2 Chapter 8 Output Q 1 Q 2 Output 24

Choosing Output in the Long Run n Long-Run Competitive Equilibrium 1) MC = MR 2) P = LAC u No incentive to leave or enter u Profit = 0 3) Equilibrium Market Price Chapter 8 25

Choosing Output in the Long Run n Questions 1) Explain the market adjustment when P < LAC and firms have identical costs. 2) Explain the market adjustment when firms have different costs. 3) What is the opportunity cost of land? Chapter 8 26

Choosing Output in the Long Run n Economic Rent = the difference between what firms are willing to pay for an input minus the minimum amount necessary to obtain it. n An Example: Two firms, A & B, both own their land l A is located on a river which lowers A’s shipping cost by $10, 000 compared to B. The demand for A’s river location will increase the price of A’s land to $10, 000 l Economic rent = $10, 000 u l $10, 000 - zero cost for the land Economic rent increases; Economic profit of A = 0 Chapter 8 27

The Industry’s Long-Run Supply Curve n The shape of the long-run supply curve depends on the extent to which changes in industry output affect the prices the firms must pay for inputs. n To determine long-run supply, we assume: l All firms have access to the available production technology. l Output is increased by using more inputs, not by invention. l The market for inputs does not change with expansions and contractions of the industry. Chapter 8 28

LR Supply in a Constant-Cost Industry $ per unit of output Economic profits attract new firms. Supply increases to S 2 and the market returns to long-run equilibrium. MC AC $ per unit of output P 2 Q 1 increase to Q 2. Long-run supply = SL = LRAC. Change in output has no impact on input cost. S 1 S 2 C P 2 A P 1 B SL P 1 D 1 q 2 Chapter 8 Output Q 1 Q 2 D 2 Output 29

LR Supply in an Increasing-Cost Industry $ per unit of output SMC 2 SMC 1 LAC 2 LAC 1 P 2 $ per unit of output Due to the increase in input prices, long-run equilibrium occurs at a higher price. S 1 S 2 P 3 P 1 P 1 B A D 1 q 1 Chapter 8 q 2 Output SL Q 1 Q 2 Q 3 D 1 Output 30

LR Supply in a Decreasing-Cost Industry $ per unit of output Due to the decrease in input prices, long-run equilibrium occurs at a lower price. $ per unit of output SMC 1 S 2 SMC 2 LAC 1 P 2 LAC 2 P 1 P 3 A B SL D 1 q 1 Chapter 8 q 2 Output Q 1 Q 2 Q 3 D 2 Output 31