Understanding Perfect Competition in Managerial Decisions

1. Lecture 7 cont’d Managerial Decisions in Competitive Markets We discussed perfect competition in Lec 1

2. Managerial Decisions in Competitive Markets • What is perfect competition???? • What are the characteristics of perfect competition????

3. Market Structure • Perfect Competition: • Free entry and exit to industry • Homogenous product – identical so no consumer preference • Large number of buyers and sellers – no individual seller can influence price • Sellers are price takers – have to accept the market price • Perfect information available to buyers and sellers

4. Market Structure • Examples of perfect competition: • Financial markets – stock exchange, currency markets, bond markets? • Agriculture? • To what extent?

5. Market Structure • Advantages of Perfect Competition: • High degree of competition helps allocate resources to most efficient use • Price = marginal costs • Normal profit made in the long run • Firms operate at maximum efficiency • Consumers benefit

6. Market Structure • What happens in a competitive environment? • New idea? – firm makes short term abnormal profit • Other firms enter the industry to take advantage of abnormal profit • Supply increases – price falls • Long run – normal profit made • Choice for consumer • Price sufficient for normal profit to be made but no more!

7. Perfect Competition Diagrammatic representation Given the assumption of profit maximisation, the firm produces at an output where MC = MR (Q1). This output level is a fraction of the total industry supply. The average cost curve is the standard ‘U’ – shaped curve. MC cuts the AC curve at its lowest point because of the mathematical relationship between marginal and average values. At this output the firm is making normal profit. This is a long run equilibrium position. The MC is the cost of producing additional (marginal) units of output. It falls at first (due to the law of diminishing returns) then rises as output rises. The industry price is determined by the demand and supply of the industry as a whole. The firm is a very small supplier within the industry and has no control over price. They will sell each extra unit for the same price. Price therefore = MR and AR Cost/Revenue MC AC P = MR = AR Q1 Output/Sales

8. Profit Maximization in various market structures • What is perfectly elastic demand???? • The demand facing a price taking firm is horizontal or perfectly elastic at the price determined by the intersect of the market demand and supply curves. Since marginal revenue equals price for a competitive the demand curve is also simultaneously MR i.e D=MR

9. Profit Maximization in the SR • What is shut down???? • What is profit or economic profit????

10. Profit • Profit = TR – TC • The reward for enterprise • Profits help in the process of directing resources to alternative uses in free markets • Relating price to costs helps a firm to assess profitability in production

11. Profit Maximization in the SR • What is profit margin or average profit??? • Average profit = Π= (P – ATC)Q • Q Q • P – ATC = Profit margin

12. Profit Maximization in the SR • The output decision: • In the SR if a firms product is less than ATC thus P< ATC for all output levels then TR will be less than TC (ATC xQ) then firm will suffer a loss whatever it produces. Even if it shuts down. • Π= TR – TVC – TFC = 0 – 0 –TFC = - TFC

13. Profit Maximization in the SR • Principle in the SR the manager of a firm will choose to produce the output where P=SMC rather than shut down. As long as TR > or = TVC or P > or = AVC manager does not need to shut down.

14. Profit Maximization in the SR • What is shut down price for a firm???? • Refer Fig 11.5 Page 267

15. Profit Maximization in the SR • General rules for Firm to produce or shut down • A firm should produce as long as market price is greater than or equal to AVC or shutdown otherwise • If production occurs a firm produce output at which market price = MR is equal to MC.