Profit Maximization in Pure Competition Perfect Competition Situation

Profit Maximization in Pure Competition

Perfect Competition • Situation: • Yves and Zoe are neighboring farmers and both grow organic tomatoes. • Both sell to the same grocery store chains that carry organic foods. • Do Yves and Zoe compete with each other? • YES! • Should Yves try to stop Zoe from growing tomatoes or should Yves and Zoe form an agreement to grow less? • NO!

Perfect Competition • In the real world (real in Economic Class world), there are tons upon tons of organic tomatoes farmers. • Yves and Zoe compete with each other but with all those other farmers • If one of them produced more or less, there would be no measurable effect on market prices!

Perfect Competition • Yves and Zoe are price-taking producers – A producers whose actions have no effect on the market price of the good or service it sells • Yves and Zoe are price-taking producers because their actions cannot affect the market price of the good or service they sell • When there is enough competition (when competition is “perfect”) every producer is a price-taker

Perfect Competition Now, what about consumers? A consumer whose actions have no effect on the market price of the good or service he buys is a price-taking consumer. • The market price is unaffected by how much or how little of the good the consumer buys • •

Defining Perfect Competition • In a perfectly competitive market, all market participants, both consumers and producers, are price-takers. – Neither consumption decisions by individual consumers nor production decisions by individual producers affect the market price of the good • The supply and demand model is a model of a perfectly competitive market. – Depends on the assumption that no individual buyer or seller of a good believes it is possible to individually affect the price at which he or she can buy or sell the good

Defining Perfect Competition • General rule: consumers are price-takers • Industry in which producers are price-takers is called a perfectly competitive industry – This is an industry in which producers are pricetakers • When are all producers price-takers? • There are two necessary conditions!

Two Necessary Conditions for Perfect Competition • 1. Must contain many producers but none of which whom have a large market share • 2. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent

Two Necessary Conditions for Perfect Competition • Example for explanation is the market for major grains, like wheat and corn • The market is perfectly competitive – individual wheat and corn farmers, as well as individual buyers of wheat and corn, take market prices as given • The markets for some of the good items make from these grains – breakfast cereals – are by no mean perfectly competitive • There is intense competition among cereal brands, but NOT PERFECT COMPETITION

1. Must contain many producers but none of which whom have a large market share • A producer’s market share is the fraction of the total industry output accounted for by that producer’s output • The distribution of the market share constitutes a major difference between the grain industry and the breakfast cereal industry – Thousands of wheat producers but four producers dominate the breakfast cereal industry (Kellogg’s – hold 1/3 of the market --, General Mills, Post, and Quaker Foods) – The breakfast producers know their actions influence market prices

2. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent • Not true in the case of the breakfast cereal market – consumers don’t consider Cap’n Crunch to be a good substitute for Wheaties – Maker of Wheaties has some ability to increase its price without fear that it will lose all its customers to the maker of Cap’n Crunch • Standardized Product is when a product that consumers regard as the same good even when it comes from a different producers, sometimes known as a commodity (something that is indistinguishable) – Example: Corn, Wheat, Pencils, Pen, lined paper, copy paper

2. An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent • With wheat being a standardized product, consumers regard the output of one wheat producer as a perfect substitute for that of another producer • BUT…. one farmer cannot increase the price for his wheat without losing all sales to other wheat farmers → second necessary condition for a competitive industry is that the industry output is a standardized product

Free Entry and Exit • Most perfectly competitive industries are also characterized by one more feature: it is easy for new firms to enter the industry and for firms already in the industry to leave • No obstacles in the form of government regulations or limited access to key resources prevent new producers from entering the market • No additional costs are associated with shutting down a company and leaving the industry

Free Entry and Exit • Free Entry and Exit in an industry is when new producers can easily enter into an industry and existing producers can easily leave that industry • This is a key factor in most competitive industries • It make sure that the numbers of producers in an industry can adjust to changing market conditions • Also ensures that producers in an industry cannot act to keep other firms out!