Chapter 23 Perfect Competition

1. Chapter 23Perfect Competition

2. Introduction Lithium has become an increasingly important input in the production of batteries for consumer electronics. Consequently, the demand for this element has increased. Yet, the inflation-adjusted price of lithium has been declining. What accounts for a falling price in the face of rising demand? In this chapter, as you learn about the characteristics of perfectly competitive markets, you will understand how the entry of new firms into the industry has caused this downward trend in prices.

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 (cont'd) • 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? • Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production • Short-Run Profits

6. Chapter Outline (cont'd) • The Short-Run Breakeven Price and the Short-Run Shutdown Price • The Supply Curve for a Perfectly Competitive Industry • Price Determination Under Perfect Competition • The Long-Run Industry Situation: Exit and Entry • Long-Run Equilibrium • Competitive Pricing: Marginal Cost Pricing

7. Did You Know That ... • The world’s oldest company that makes wooden pencils recently celebrated its 350th year of operations? • Throughout this time, however, many other pencil manufacturers have come and gone. • Low costs of entering and exiting the market account for this pattern. • This is one of the characteristics of a perfectly competitive market, the topic of this chapter.

8. 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

9. Characteristics of a Perfectly Competitive Market Structure (cont'd) • 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

10. Characteristics of a Perfectly Competitive Market Structure (cont'd) • Price Taker • A competitive firm that must take the price of its product as given because the firm cannot influence its price

11. Characteristics of a Perfectly Competitive Market Structure (cont'd) • Why a perfect competitor is a price taker • Large number of buyers and sellers • Homogenous products are perfect substitutes and indistinguishable across firms • Both buyers and sellers have equal access to information • No barriers to entry or exit (any firm can enter or leave the industry without serious impediments)

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

13. The Demand Curve of the Perfect Competitor (cont'd) • The perfectly competitive firm is a price taker, selling a homogenous commodity that is indistinguishable across all firms in the industry • Will sell all units for $5 • Will not be able to sell at a higher price • Will face a perfectly elastic demand curve at the going market price

14. Figure 23-1 The Demand Curve for Magneto Optical Disks

15. How Much Should the Perfect Competitor Produce? • Perfect competitor accepts price as given • Firm raises price, it sells nothing • Firm lowers its price, it earns less revenues than it otherwise would • Perfect competitor has to decide how much to produce • Firm uses profit-maximization model

16. How Much Should the Perfect Competitor Produce? (cont'd) • The model assumes that firms attempt to maximize their total profits. • The positive difference between total revenues and total costs • The model also assumes firms seek to minimize losses • When total revenues may be less than total costs

17. How Much Should the Perfect Competitor Produce? (cont'd) • Total Revenues • The price per unit times the total quantity sold • The same as total receipts from the sale of output

18. How Much Should the Perfect Competitor Produce? (cont'd) P is determined by the market in perfect competition Q is determined by the producer to maximize profit Profitp= Total revenue (TR) – Total cost (TC) TR = P x Q TC = TFC + TVC

19. How Much Should the Perfect Competitor Produce? (cont'd) • For the perfect competitor, price is also equal to average revenue (AR) because • The demand curve is the average revenue curve AR = = = P TR Q PQ Q

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

21. Figure 23-2 Profit Maximization, Panel (b)

22. Figure 23-2 Profit Maximization, Panel (c)

23. How Much Should the Perfect Competitor Produce? (cont'd) • 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

24. Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production • Marginal Revenue • The change in total revenues divided by the change in output MR = change in TR change in Q

25. Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production (cont’d) • Marginal Cost • The change in total cost divided by the change in output MR = change in TC change in Q

26. Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production (cont'd) • Profit maximization occurs at the rate of output at which • marginal revenue equals marginal cost MR = MC

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

28. Short-Run Profits (cont'd) • From Figure 23-2 previously, if we have production and sales of seven Titanium batteries, TR = $35, TC = $30, and profit = $5 per hour. • Now we take info from column 6 in panel (a) and add it to panel (c) to get Figure 23-3.

29. Figure 23-3 Measuring Total Profits

30. Short-Run Profits (cont'd) • Graphical depiction of maximum profits and graphical depiction of minimum losses • The height of the rectangular box in the previous figure represents profits per unit • The length represents the amount of units produced • When we multiply these two quantities, we get total economic profits

31. Short-Run Profits (cont'd) • Short-run average profits are determined by comparing ATC with P = MR = AR at the profit-maximizing Q • In the short run, the perfectly competitive firm can make either economic profits or economic losses

32. Figure 23-4 Minimization of Short-Run Losses

33. Short-Run Profits (cont’d) • We see in the previous Figure 23-4 that the marginal revenue (d2) curve is intersected (from below) by the marginal cost curve at an output rate of 5 batteries per hour • The firm is clearly not making profits because average total costs at that output rate are greater than the price of $3 per battery • The losses are shown in the shaded area

34. The Short-Run Break-Even Price and 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. The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd) • As long as total revenues from continuing to produce output exceed the associated variable costs, the firm will continue to produce • A firm goes out of business when the owners sell its assets; a firm temporarily shuts down when it stops producing, but is still in business

36. The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd) • As long as the price per unit sold exceeds the average variable cost per unit produced, the earnings of the firm’s owners will be higher if it continues to produce in the short run than if it shuts down.

37. The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd) • Short-Run Break-Even Price • The price at which a firm’s total revenues equal its total costs • At the break-even price, the firm is just making a normal rate of return on its capital investment (it’s covering its explicit and implicit costs). • 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.

38. Figure 23-5 Short-Run Break-Even and Shutdown Prices

39. The Short-Run Break-Even Price and the Short-Run Shutdown Price (cont'd) • The meaning of zero economic profits • Question • Why produce if you are not making a profit? • Answer • Distinguish between economic profits and accounting profits • Remember when economic profits are zero a firm can still have positive accounting profits

40. The Supply Curve for a Perfectly Competitive Industry • Question • What does the short-run supply curve for the individual firm look like? • Answer • The firm’s short-run supply curve in a competitive industry is its marginal cost curve at and above the point of intersection with the average variable cost curve

41. Figure 23-6 The Individual Firm’s Short-Run Supply Curve

42. The Supply Curve for a Perfectly Competitive Industry (cont'd) • The Industry Supply Curve • The locus of points showing the minimum prices at which given quantities will be forthcoming • Also called the market supply curve

43. Figure 23-7Deriving the Industry Supply Curve

44. Example: Vets Respond to Higher Market Prices of Treatments for Fido • Despite slight differences between veterinary clinics, the 16,000 veterinary practices in the U.S. approximate a perfectly competitive industry. • The demand for veterinary services has increased over the past decade, causing average fees to rise by 50 percent. • Clinics have responded by providing more pet care services, thereby moving up along their individual supply curves.

45. The Supply Curve for a Perfectly Competitive Industry (cont'd) • Factors that influence the industry supply curve (determinants of supply) • Firm’s productivity • Factor costs (wages, prices of raw materials) • Taxes and subsidies • Number of sellers

46. Price Determination Under Perfect Competition • 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 (consumers)

47. Price Determination Under Perfect Competition (cont'd) • 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

48. Figure 23-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve, Panel (a)

49. Figure 23-8 Industry Demand and Supply Curves and the Individual Firm Demand Curve, Panel (b)

50. What If . . . The government mandated that prices stay at long-run equilibrium levels? • If the government were to restrict price variations by keeping prices at long-run equilibrium levels, they would be unable to adjust to short-run changes in demand or supply. • The result would be shortages or surpluses of certain products.