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Chapter 3 Perfect Competition. Outline. Firms in perfectly competitive markets The Short-Run Condition for Profit Maximisation Adjustments in the long run Applying the Perfect Competitive Model. The goal of profit maximisation. Firms' main objective is to maximise profit .
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Outline. • Firms in perfectly competitive markets • The Short-Run Condition for Profit Maximisation • Adjustments in the long run • Applying the Perfect Competitive Model
The goal of profit maximisation • Firms' main objective is to maximise profit. This assumption is not specific to perfect competition: it is made whatever the type of market structure that is considered • Economic profit is defined as the difference between total revenues and total costs. Total costs include opportunity and implicit costs. Example A firm produces 100 units of output per week using 10 units of capital and 10 units of labour. The capital belongs to the firm. The weekly price of each factor is 10$ per unit and output sells for 2,5$ per unit. • Total revenue per week is 250$. • Total cost is 100$ spent on labour (explicit cost) + 100$ spent on capital (opportunity cost) • Economic profit is 250 – 200 = 50$
The goal of profit maximisation (ctd) • If the opportunity cost of the resources owned by the firm are considered as generating a normal profit, the economic profit is the profit in excess to this normal profit • Economists assume that the goal of firms is to maximise profit. • Simplifying assumption • Numerous challenges • Idea: firms do their best to maximse profit
The four conditions for perfect competition • Four conditions • Firms sell a standardised product • Firms are price-takers: every individual firm considers the market price as given • Factors of production are perfectly mobile in the long run • Firms and consumers have perfect information • Do they make sense? • In most cases, strictly speaking: NO • But can tell us something
Outline. • The Short-Run Condition for Profit Maximisation • Adjustments in the long run • Applying the Perfect Competitive Model
Maximising profit in the short run • Example: Assume that a firm is characterised by the short-run total cost curve we saw in Chapter 2. • This firm experiences first increasing and then decreasing returns to is variable input. • Assume that it can sell its product at a price P0 = 18$/unit. • One characteristic of the competitive firm is that it considers the market price as given. • So, the total revenue of the firm is given by: TR = P0.Q • The profit of the firm is given by: P = TR – TC
Maximising profit in the short run (ctd1) • The firm's problem is to maximise profit P = TR – TC =P0.Q - TC • First-order condition: • Second-order condition:
Maximising profit in the short run (ctd2) • The firm maximises its profit when choosing a level of production such that its marginal revenue is strictly equal to its marginal cost
The shut-down condition • The market price must exceed the minimum value of the average variable cost. Otherwise the firm will do better, in the short-run, if shutting down. • Under perfect competition, the average revenue is: • If P0 is lower than the minimum of the average variable cost curve, losses are minimum if the firm shuts down
The shut-down condition (ctd2) • The 2 rules : • (i) price equals marginal cost on the rising portion of the marginal cost curve and • (ii) price must exceed the minimum value of the average variable cost curve define the short-run supply curveof the perfectly competitive firm. • Note that • For P below the minimum of the AVC, the firm will supply 0 output • For P between the minimum of the AVC and the minimum of the ATC, the firm will provide positive output • In this range of prices, the firm will lose money (make negative profits) because (P – ATC).Q = P < 0 • But covers its variable costs and even makes some money on top of it: (P – AVC).Q > 0
The short-run competitive industry supply • For any given level of price, it is the sum of the amounts that firms are willing to supply at this price. • When firms are identical: • If each firm has a supply curve Qi = a + b.P • If there are n firms in the industry • The total industry supply is just: Q = n Qi = n.a + n.b.P
The short-run competitive industry supply (ctd) • For an industry composed of 2 firms:
Efficiency of the short-run competitive equilibrium • Competitive markets result in allocative efficiency, i.e. they fully exploit the possibilities for mutual gains through exchange
The producer surplus • The firm's gain compared with the alternative of producing nothing (DP) is: DP = (P – ATC).Q* - (-FC) • Producer surplus: [P – (ATC – FC/Q*)].Q* = [P – AVC].Q* • because AVC = ATC – FC/Q • It is the difference between what the firm actually gets (P.Q*) and the minimum it was requiring to supply a positive output (AVC.Q*)
Outline. • Adjustments in the long run • Applying the Perfect Competitive Model
The long-run market equilibrium • In the long run, all inputs are variable so that a firm will choose to go out of business if it cannot earn a "normal" profit in its current industry • In the long run • If firms in an industry make positive economic profits, other firms are going to enter this industry. This will drive the market price down because supply is going to increase. • If firms make negative profits, the opposite movement will take place.
Allocative Efficiency • This long-run market equilibrium has a number of nice efficiency properties: • The equilibrium price is equal to the long-run and short-run marginal cost so that all possibilities for mutually beneficial trade are exhausted. • All producers earn only a normal rate of profit. All these properties define what is called allocative efficiency.
The long-run competitive industry supply curve • With U-shaped LAC curves
Changing input prices and long-run supply • So far, we have assumed that input prices did not vary with the amount of output produced • However, for a number of very large industries, the amount of inputs purchased constitutes a substantial share of the market • When this happens, the price of inputs increases as output rises. This generates a pecuniary diseconomy. • In this case, the long-run curve is upward sloping even if individual LAC curves are U-shaped • These are called increasing cost industries
Decreasing cost industries • In some cases, an increase in the volume of output may reduce the price of inputs. • This is the case if the increase in the demand for the input creates an incentive for innovation resulting in lower production costs for those inputs (e.g. computers). • In this case there is a pecuniary economy and the long-run industry supply curve is downward sloping. • These are called decreasing cost industries.
The elasticity of supply • The price elasticity of supply is the percentage change in supply in response to a given change in prices
The elasticity of supply (ctd) • So, it can be re-written as: • In the short-run the supply curve is upward sloping so that the elasticity of supply will be positive. • For industries with a long-run horizontal supply curve, the elasticity is infinite.
Outline. • Applying the Perfect Competitive Model
The perfect competitive model: to what extent is it useful (useless)? • No industries strictly satisfy the 4 conditions of perfect competition • Still, it may be a useful tool, in particular because its long-run properties apply in a large number of industries • Example:decrease in the number of small family farms which are increasingly replaced by large corporate ones.
Price support policies • In this particular case, resource mobility is far from being perfect. • Many farmers are strongly attached to their land • Programs supporting the price of agricultural products • These programs have failed miserably
Changes in the EC policy • As a way of protecting the long-term viability of family farms the agricultural price support could not have been more ill-conceived. • More efficient ways to aid family farmers would have been a reduction in income taxes or even, more directly, cash grants. • This is actually what the European Commission has realised recently. "Severing the link between subsidies and production (usually termed decoupling’) will enable EU farmers to be more market-orientated. They will be free to produce according to what is most profitable for them while still enjoying a required stability of income".
