Perfect Competition and Firm Equilibrium

1. ECONOMICS ELEVENTHEDITION LIPSEY & CHRYSTAL Chapter 7 PERFECT COMPETITION Slides by Alex Stojanovic

2. Learning Outcomes • The impact of the product market on firms’ prices and output choices is determined by the nature of the product and the market structure in which they operate • In perfect competition firms produce a homogeneous product and are price-takers in their output markets • All profit-maximising firms choose their output to equate marginal cost and marginal revenue

3. Learning Outcomes • Under perfect competition marginal cost will equal the market price, and so the supply curve of firms is determined by the marginal cost curve • The long-run supply curve of a competitive industry may be positively sloped, horizontal, or negatively sloped depending on how input prices are affected by the industry’s expansion • Perfect competition maximizes benefits that consumers receive from the output of the product in question

4. The Demand Curve for a Competitive Industry and for One Firm 5 5 S 4 4 Dfirm Price [£] Price [£] 3 3 2 2 1 1 D 100 200 300 400 10 20 30 40 50 60 Quantity [millions of tons] Quantity [thousands of tons] [i] Competitive industry’s demand curve [ii] Competitive firm’s demand curve

5. The Demand Curve for a Competitive Industry and for One Firm • The industry’s demand curve is negatively sloped, the firm’s demand curve is virtually horizontal. • The competitive industry has output of 200 million tonnes when the price is £3. • The individual firm takes that market price as given and considers producing up to say, 60,000 tonnes. • The firm’s demand curve in part (ii) is horizontal because any change in output that this one firm could manage would leave price virtually unchanged at £3.

6. Revenue Concepts for a Price-taking Firm Quantity sold [units] Price TR = p*q AR = TR/q MR = TR/q [q] [p] 10 £3,00 £30,00 £3,00 £3,00 11 3,00 33,00 3,00 3,00 12 3,00 36,00 3,00 3,00 13 3,00 39,00 3,00

7. Revenue Concepts for a Price-taking Firm • The table shows the calculation of total (TR) average (AR) and marginal revenue (MR) when market price is £3.00. • For example when sales rise from 11 to 12 units, revenue rises form £33 to £36 making marginal revenue equal to £3. • The table illustrates the general result that when price I fixed average revenue, marginal revenue, and price are all equal.

8. Revenue Curve for a Firm TR AR = MP = p £ per unit 3 £’ 39 30 10 13 0 10 0 Output Output [i] Average and marginal revenue [ii] Total revenue

9. Revenue Curve for a Firm • The graph shows the data in the table (slide 6). • Because price does not change as the firm varies its output, neither marginal nor average revenue varies with outputboth are equal to price. • When price is constant, total revenue is a straight line through the origin whose constant positive slope is the price per unit.

10. The Short-run Equilibrium of a Firm in Perfect Competition £ per unit AVC Output

11. The Short-run Equilibrium of a Firm in Perfect Competition £ per unit MC AVC Output

12. The Short-run Equilibrium of a Firm in Perfect Competition £ per unit MC AVC E p=MR=AR q2 qE q1 Output

13. The Short-run Equilibrium of a Firm in Perfect Competition • The firm chooses the output for which p=MC above the level of AVC. • When price equals marginal cost, as at output qE, the firm loses profits if it either increases or decreases its output. • At any point left of qE, say q2, price is greater than the marginal cost, and it pays to increase output (as indicated by the left-hand arrow). • At any point to the right of qE, say q1, price is less than the marginal cost, and it pays to reduce output (as indicated by the right-hand arrow).

14. Total Cost and Revenue Curves TC TR £ 0 qE Output

15. Total Cost and Revenue Curves • At each output the vertical distance between the TR and TC curves shows by how much total revenue exceeds or falls short of total cost. • The gap is largest at output qEwhich is the profit-maximizing output.

16. The Supply Curve for a Price-taking Firm MC 5 5 4 4 AVC £ per nut Price [£] 3 3 E0 p0 2 2 1 1 q0 Output Quantity [i] Marginal cost and average variable cost curves [ii] The supply curve

17. The Supply Curve for a Price-taking Firm MC 5 5 4 4 AVC £ per nut Price [£] E1 p1 3 3 E0 p0 2 2 1 1 q0 q1 Output Quantity [i] Marginal cost and average variable cost curves [ii] The supply curve

18. The Supply Curve for a Price-taking Firm MC 5 5 E2 p2 4 4 AVC £ per nut Price [£] E1 p1 3 3 E0 p0 2 2 1 1 q0 q1 q2 Output Quantity [i] Marginal cost and average variable cost curves [ii] The supply curve

19. The Supply Curve for a Price-taking Firm MC S E3 p3 5 5 E2 p2 4 4 AVC £ per nut Price [£] E1 p1 3 3 E0 p0 2 2 1 1 q0 q1 q2 q3 Output Quantity [i] Marginal cost and average variable cost curves [ii] The supply curve

20. The Supply Curve for a Price-taking Firm • For a price-taking firm the supply curve has the same shape as its MC curve above the level of AVC. • The point E0, where price, p0, equals AVC is the shutdown point. • As price rises from £2 to £3 to £4 to £5, the firm increases its production from q0to q1 to q2to q3. • For example at a price of £3, the firm produces output q1and earns the contribution to fixed costs shown by the dark blue shaded rectangle. • The firm’s supply curve is shown in part (ii). • It relates market price to the quantity the firm will produce and offer for sale. • It has the same shape as the firm’s MC curve for all prices above AVC.

21. Alternative Short-run Equilibrium Positions for a Firm in Perfect Competition SRATC £ per unit £ per unit MC MC SRATC E E p1 p2 SARVC 0 q1 Output q2 Output 0 [i] [ii] MC SRATC £ per unit E p3 q3 0 Output [iii]

22. Short-run Equilibrium Positions for a Firm in Perfect Competition (i) The firm is making losses • The market price is p1. • Because this price is below average total cost, the firm is suffering losses shown by the light blue area. • Because price exceeds average variable cost, the firm continues to produce in the short run. • Because price is less than ATC, the firm will not replace its capital as it wears out.

23. Short-run Equilibrium Positions for a Firm in Perfect Competition (ii) The firm is just covering all its costs • The market price is p2. • The firm is just covering its total costs. • It will replace its capital as it wears out since its revenue is covering the full opportunity cost of its capital.

24. Short-run Equilibrium Positions for a Firm in Perfect Competition (iii) The firm is making pure profits • The market price is p3. • The firm is earning pure (or economic) profits in excess of all its costs, as shown by the dark blue area. • The firm will replace its capital as it wears out.

25. Consumers’ and Producers’ Surplus S Price E Consumer surplus Market price p0 Producers surplus D Total variable cost 0 q0 Quantity

26. Consumers’ and Producers’ Surplus • Consumers’ surplus is the area under the demand curve and above the market price line. • The equilibrium price and quantity are p0 and q0. • The total value that consumers place on q0units of the product is given by the sum of the dark yellow, light yellow, and light blue areas. • The amount that they pay is p0q0, the rectangle that consists of the light yellow and light blue areas. • The difference, shown as the dark yellow area, is consumers’ surplus.

27. Consumers’ and Producers’ Surplus • Producers surplus is the area above the supply curve and below the market price line. • The receipts of producers from the sale of q0units are also p0q0. • The area under the supply curve, the blue-shaded area, is total variable cost, which is the minimum amount that producers must receive to induce them to supply the output. • The difference, shown as the light yellow area, is producers’ surplus.

28. 1 3 4 2 The Allocative Efficiency of Perfect Competition S Price E Competitive market price p0 D 0 q1 q0 q2 Quantity

29. The Allocative Efficiency of Perfect Competition • At the competitive equilibrium E consumers’ surplus is the dark yellow area above the price line. • Producers’ surplus is the light yellow area below the price line. • Reducing the output to q1 but keeping price at p0 lowers consumers surplus by area 1. • It lowers producers’ surplus by area 2.

30. The Allocative Efficiency of Perfect Competition • Assume that producers are forced to produce output q2and to sell it to consumers, who are in turn forced to buy it at price p0. • Producers’ surplus is reduced by area 3 (the amount by which variable costs exceed revenue on those units). • Consumers’ surplus is reduced by area 4 (the amount by which expenditure exceeds consumers’ satisfactions on those units). • Only at the competitive output, q0, is the sum of the two surpluses maximized.

31. Short-run and Long-run Equilibrium of a Firm in Perfect Competition SRATC0 MC0 £ per unit p0 MC* c0 SRATC* LRAC p* 0 q0 q*

32. Short-run and Long-run Equilibrium of a Firm in Perfect Competition • The firm’s existing plant has short-run cost curves SRATC0 and MC0 while market price is p0. • The firm produces q0, where MC0 equals price and total costs are just being covered. • Although the firm is in short-run equilibrium, it can earn profits by building a larger plant and so moving downwards along its LRAC curve.

33. Short-run and Long-run Equilibrium of a Firm in Perfect Competition • Thus the firm cannot be in long-run equilibrium at any output below q*, because average total costs can be reduced by building a larger plant. • If all firms do this, industry output will increase and price will fall until long-run equilibrium is reached at price p*. • Each firm is then in short-run equilibrium with a plant whose average cost curve is SRATC* and whose short-run marginal cost curve, MC*, intersects the price line p at an output of q*. • Because the LRAC curve lies above p* everywhere except at q*, the firm has no incentive to move to another point on its LRAC curve by altering the size of its plant. • Thus a perfectly competitive firm that is not at the minimum point on its LRAC curve cannot be in long-run equilibrium.

34. Long-run Industry Supply Curves S0 S0 Price Price Quantity Quantity D0 Price Quantity

35. Long-run Industry Supply Curves S0 D0 S0 D0 Price E0 E0 p0 p0 Price q1 q1 S0 Quantity Quantity D0 p0 E0 Price q1 Quantity

36. Long-run Industry Supply Curves D1 D1 S0 D0 S0 D0 E1 Price E1 E0 p0 Price E0 p0 q1 q1 D1 S0 Quantity Quantity D0 E1 E0 p0 Price q1 Quantity

37. Long-run Industry Supply Curves D1 D1 S0 D0 S0 D0 E1 Price E2 E1 p0 LRS E0 E2 p0 Price E0 LRS p0 = p2 q1 q2 q1 q2 D1 S0 (ii) Quantity (i) Quantity D0 E1 E0 p0 Price E2 p0 LRS (iii) q1 q2 Quantity

38. (i) A constant long-run industry supply curve • The initial curves are at D0 and S0. • Equilibrium is at E0with price p0and quantity q0. • A rise in demand shifts the demand curve to D1, taking the short-run equilibrium to E1. • New firms now enter the industry, shifting the short-run supply curve outwards. • Price is pushed down until pure profits are no longer being earned. • At this point the supply curve is S1. • The new equilibrium is E2 with price at p2and quantity q2. • The curves shift so that price returns to its original level, making the long-run supply curve horizontal.

39. (ii) A Rising long-run industry supply curve • The initial curves are at D0 and S0. • Equilibrium is at E0with price p0and quantity q0. • A rise in demand shifts the demand curve to D1, taking the short-run equilibrium to E1. • New firms now enter the industry, shifting the short-run supply curve outwards. • Price is pushed down until pure profits are no longer being earned. • At this point the supply curve is S1. • The new equilibrium is E2 with price at p2and quantity q2. • Profits are eliminated and entry ceases before price falls to its original level, giving the LRS curve a positive slope.

40. (iii) A falling long-run industry supply curve • The initial curves are at D0 and S0. • Equilibrium is at E0with price p0and quantity q0. • A rise in demand shifts the demand curve to D1, taking the short-run equilibrium to E1. • New firms now enter the industry, shifting the short-run supply curve outwards. • Price is pushed down until pure profits are no longer being earned. • At this point the supply curve is S1. • The new equilibrium is E2 with price at p2and quantity q2. • The price falls below its original level before profits return to normal, giving the LRS curve a negative slope.

41. CHAPTER 7: PERFECT COMPETITION Market Structure and Firm Behaviour • Competitive behaviour refers to the extent to which individual firms compete with each other to sell their products. • Competitive market structure refers to the power that individual firms have over the market - perfect competition occurring where firms have no market power and hence no need to react to each other. Perfectly Competitive Markets • The theory of perfect competition is based on the following assumptions: firms sell a homogenous product; customers are well informed; each firm is a price-taker; the industry can support many firms, which are free to enter or leave the industry.

42. CHAPTER 7: PERFECT COMPETITION Short-run Equilibrium • Any firm maximises profits producing the output where its marginal cost curve intersects the marginal revenue curve from below - or by producing nothing if average cost exceeds price at all outputs. • A perfectly competitive firm is a quantity-adjuster, facing a perfectly elastic demand curve at the given market price and maximising profits by choosing the output that equates its marginal cost to price. • The supply curve of a firm in perfect competition is its marginal cost curve, and the supply curve of a perfectly competitive industry is the sum of the marginal cost curves of all its firms. • The intersection of this curve with the market demand curve for the industry’s product determines market price.

43. CHAPTER 7: PERFECT COMPETITION Long-run Equilibrium • Long-run industry equilibrium requires that each individual firm be producing at the minimum point of its LRAC curve and be making zero profits. • The long-run industry supply curve for a perfectly competitive industry may be [i] positively sloped, if input prices are driven up by the industry’s expansion, [ii] horizontal, if plants can be replicated and factor prices remain constant, or [iii] negatively sloped, if some other industry that is not perfectly competitive produces an input under conditions of falling long-run costs. The Allocative Efficiency of Perfect Competition • Perfect competition produces an optimal allocation of resources because it maximises the sum of consumers’ and producers’ surplus by producing equilibrium where marginal cost equals price.