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Understanding Perfectly Competitive Markets: Pricing and Profit Maximization

This chapter explores the characteristics of a perfectly competitive market and how firms determine pricing and output levels for maximum profitability.

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Understanding Perfectly Competitive Markets: Pricing and Profit Maximization

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  1. Chapter 24 Perfect Competition

  2. A relatively new health care product offered for sale is the full-body CT scan. There are many firms offering this service, and yet they all charge nearly identical prices. Why would such a personal service not vary in price much between different providers? Introduction

  3. Learning Objectives • Identify the characteristics of a perfectly competitive market structure • Discuss the process by which a perfectly competitive firm decides how much output to produce • Understand how the short-run supply curve for a perfectly competitive firm is determined

  4. Learning Objectives • Explain how the equilibrium price is determined in a perfectly competitive market • Describe what factors induce firms to enter or exit a perfectly competitive industry • Distinguish among constant-, increasing-, and decreasing-cost industries based on the shape of the long-run industry supply curve

  5. Chapter Outline • Characteristics of a Perfectly Competitive Market Structure • The Demand Curve of the Perfect Competitor • How Much Should the Perfect Competitor Produce?

  6. Chapter Outline • Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production • Short-Run Profits • The Short-Run Shutdown Price • The Perfect Competitor’s Short-Run Supply Curve

  7. Chapter Outline • Competitive Price Determination • The Long-Run Industry Situation: Exit and Entry • Long-Run Equilibrium • Competitive Pricing: Marginal Cost Pricing

  8. Did You Know That... • Clothing retailers commonly cite bad weather as the reason for poor profit performance? • The competitive nature of this market best explains why profits are kept to a modest level?

  9. Characteristics of a Perfectly Competitive Market Structure • Perfect Competition • A market structure in which the decisions of individual buyers and sellers have no effect on market price

  10. Characteristics of a Perfectly Competitive Market Structure • Perfectly Competitive Firm • A firm that is such a small part of the total industry that it cannot affect the price of the product or service that it sells

  11. Characteristics of a Perfectly Competitive Market Structure • Price Taker • A competitive firm that must take the price of its product as given because the firm cannot influence its price

  12. International Example:How Free Entry Can Shift Resources • In 1981, Chile began offering a program of school choice. • If parents decided to enroll their children in a private school, public funds would be made available to that school to cover all or part of tuition.

  13. International Example:How Free Entry Can Shift Resources • Such a program reorders the incentives both for parents and schools. • Since inception of the program, more than 1,200 new private schools have been formed.

  14. Characteristics of a Perfectly Competitive Market Structure • Price taker: • A firm can sell as much as wants at the going market price. • There is no incentive to sell for a lower price. • Attempts to charge a higher price will result in no sales.

  15. Characteristics of a Perfectly Competitive Market Structure • Characteristics of perfect competition • Large number of buyers and sellers • Homogenous products • When you buy a head of lettuce do you ask what farm it came from? • No barriers to entry or exit • Buyers and sellers have equal access to information

  16. The Demand Curve of the Perfect Competitor • Question • If the perfectly competitive firm is a price taker, who or what sets the price?

  17. S E 5 D The Demand Curvefor Recordable DVDs Neither an individual buyer nor seller can influence the price The interaction of market supply and demand yields an equilibrium price of $5 and quantity of 30,000 units Price per DVD 0 10,000 20,000 30,000 40,000 50,000 DVDs per Day Figure 24-1, Panel (a)

  18. The Demand Curve of the Perfect Competitor • The perfectly competitive firm: • Is a price taker (i.e., must sell for $5) • Will sell all units for $5 • Will not be able to sell at a higher price • Will not choose to sell more units at a lower price

  19. The Demand Curve Facing the Perfectly Competitive Firm Figure 24-1, Panels (a) and (b)

  20. How Much Should the Perfect Competitor Produce? • The firm will produce the level of output that will maximize profits given the market price. • Total Revenues • The price per unit times the total quantity sold Economic profit = total revenue (TR) - total cost (TC)

  21. P determined by the market in perfect competition Q determined by the producer to maximize profit How Much Should the Perfect Competitor Produce? Economic profit = total revenue (TR) - total cost (TC) TR = P x Q

  22. TC  explicit + opportunity cost How Much Should the Perfect Competitor Produce? Economic profit = total revenue (TR) - total cost (TC)

  23. Profit Maximization Figure 24-2, Panel (a)

  24. Profit Maximization Total Output/ Sales/ Total Market Total Total day Costs Price Revenue Profit 0 $10 $5 $0 $10 1 15 5 5 10 2 18 5 10 8 3 20 5 15 5 4 21 5 20 1 5 23 5 25 2 6 26 5 30 4 7 30 5 35 5 8 35 5 40 5 9 41 5 45 4 10 48 5 50 2 11 56 5 55 1 Figure 24-2, Panel (b)

  25. How Much Should the Perfect Competitor Produce? • Profit-maximizing rate of production • The rate of production that maximizes total profits, or the difference between total revenues and total costs • Also, the rate of production at which marginal revenue equals marginal cost

  26. Profit Maximization Total Output/ Sales/ Market Marginal Marginal day Price Cost Revenue 0 $5 1 5 2 5 3 5 4 5 5 5 6 5 7 5 8 5 9 5 10 5 11 5 $5 $5 3 5 2 5 1 5 2 5 3 5 4 5 5 5 6 5 7 5 8 5 Figure 24-2, Panel (c)

  27. Using Marginal Analysis to Determinethe Profit-Maximizing Rate of Production • Marginal revenue is the change in total revenue divided by the change in output • Marginal cost is the change in total cost divided by the change in output

  28. Using Marginal Analysis to Determinethe Profit-Maximizing Rate of Production • Profit maximization • Economic profits = TR  TC • Profit-maximizing output occurs when MC = MR • For a perfectly competitive firm, this is at the intersection of the firm’s demand schedule and its marginal cost curve

  29. Short-Run Profits • To find out what our competitive individual DVD producer is making in terms of profits in the short run, we have to determine the excess of price above average total cost

  30. 1 2 3 4 5 6 7 8 9 10 11 12 Short-Run Profits 14 13 12 11 10 • Recall: Profits are maximized at 7.5 units where MC = MR. • How do we measure profits? 9 8 Price and Cost per Unit ($) 7 6 5 4 3 2 1 0 DVDs per Day

  31. 1 2 3 4 5 6 7 8 9 10 11 12 Short-Run Profits 14 • Profit is maximized where MR = MC • ATC = TC/output • TC = ATC output • TR = P output • Profit = (P - ATC)  output 13 12 11 MC 10 9 8 Price and Cost per Unit ($) 7 ATC Profits 6 d 5 P = MR = AR 4 3 2 1 0 DVDs per Day Figure 24-3

  32. 1 2 3 4 5 6 7 8 9 10 11 12 Minimization of Short-Run Losses 14 • Losses are minimized where MR = MC • Loss = ($3 - 4.35)  5.5 or $7.43 13 12 11 MC 10 9 8 Price and Cost per Unit ($) 7 ATC 6 Losses d1 5 4 d2 3 P = MR = AR 2 1 0 DVDs per Day Figure 24-4

  33. Short-Run Profits • Short-run average profits or average losses are determined by comparing average total costs with price (average revenue) at the profit-maximizing rate of output. • In the short run, the perfectly competitive firm can make economic profits or economic losses.

  34. The Short-Run Shutdown Price • What do you think? • Would you continue to produce if you were incurring a loss? • In the short run? • In the long run?

  35. Short-Run Shutdownand Break-Even Price Figure 24-5

  36. The Short-Run Shutdown Price • What do you think? • Would you continue to produce if you were incurring a loss? • In the short run? • In the long run?

  37. The Short-Run Shutdown Price • As long as the price per unit sold exceeds the average variable cost per unit produced, the firm will be covering at least part of the opportunity cost of the investment in the business—that is, part of its fixed costs.

  38. The Short-Run Shutdown Price • Short-Run Break-Even Price • The price at which a firm’s total revenues equal its costs • At the break-even price, the firm is just making a normal rate of return on its capital investment • Short-Run Shutdown Price • The price that just covers average variable costs • It occurs just below the intersection of the marginal cost curve and the average variable cost curve

  39. The Meaning of Zero Economic Profits • Why produce if you are not making a profit? • Hint: • Distinguish between economic profits and accounting profits • When economic profits are zero, accounting profits are positive

  40. The Perfect Competitor’s Short-Run Supply Curve • Question • What does the supply curve for the individual firm look like? • Answer • The firm’s supply curve is the marginal cost curve above the short-run shutdown point. • Thus, the competitive firm’s short-run supply curve is its marginal costs curve equal to and above the point of intersection with the average variable cost curve.

  41. The Individual Firm’sShort-Run Supply Curve • Given the price, the quantity is determined where MC = MR • Short-run supply = MC above minimum AVC Figure 24-6

  42. The Perfect Competitor’s Short-Run Supply Curve • The Industry Supply Curve • The locus of points showing the minimum prices at which given quantities will be forthcoming

  43. S = ΣMC MC MC A B G F Deriving the Industry Supply Curve Panel (a) Panel (b) Panel (c) P P P 2 2 2 Price and Marginal Cost per Unit Price and Marginal Cost per Unit Price and Marginal Cost per Unit P P P 1 1 1 q q q q ( q + q ) ( q + q ) A1 A2 B1 B2 A1 B1 A2 B2 Quantity per Time Period Quantity per Time Period Quantity per Time Period Figure 24-7, Panels (a), (b), and (c)

  44. The Perfect Competitor’s Short-Run Supply Curve • Factors that influence the industry supply curve (determinants of supply) • Firm’s productivity • Factor costs • Taxes and subsidies • Number of firms

  45. Competitive Price Determination • Question • How is the market, or “going,” price established in a competitive market? • Answer • This price is established by the interaction of all the suppliers (firms) and all the demanders.

  46. Competitive Price Determination • The competitive price is determined by the intersection of the market demand curve and the market supply curve • The market supply curve is equal to the horizontal summation of the supply curves of the individual firms

  47. Competitive Price Determination Pe is the price the firm must take Peand Qedetermined by the interaction of the industry S and market D Figure 24-8, Panel (a)

  48. Competitive Price Determination Given Pe, firm produces qe where MC = MR -If AC = AC1, break-even -If AC = AC2, losses -If AC = AC3, economic profit Figure 24-8, Panel (b)

  49. The Long-Run Industry Situation: Exit and Entry • Profits and losses act as signals for resources to enter an industry or to leave an industry.

  50. The Long-Run Industry Situation: Exit and Entry • Signals • Compact ways of conveying to economic decision makers information needed to make decisions • A true signal not only conveys information but also provides the incentive to react appropriately

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