Perfect Competition

1. Perfect Competition Sometimes referred to as Pure Competition or just The Competitive Firm

2. Market Structure • The specific market structure determines their pricing and output production.

3. Background on Markets When economists analyze the production decisions of a firm, they take into account the structure of the market in which the firm is operating. Four Different Market Structures: • Perfect Competition • Monopoly • Monopolistic Competition • Oligopoly

4. Market Model Price/Output Market economy has 4 models and they all vary from one seller to many sellers… None is “typical.” Each unique and attempting to operate with his “self-interest” in mind. Each will work towards MC=MR (Profit Maximizing point and loss minimizing point.)

5. Market structure characteristics All four market structures have four distinguishing characteristics: • The number and size of the firms in the market. • The ease with which firms may enter and exit the market. • The degree to which firms’ products are differentiated. • The amount of information available to both buyers and sellers regarding prices, product characteristics and production techniques.

6. Characteristics of Pure Competition • There are many sellers and many buyers, none of which is large in relation to total sales or purchases. • Each firm produces and sells a homogeneous product. • Buyers and sellers have all relevant information with respect to prices, product quality, sources of supply, and so on. • There is easy entry into and exit from the industry.

7. Perfect Competitive Market • There are very few if any competitive markets. • Why teach about a non-existent form of competition? • Many firms actually function as purely competitive.

8. Questions to answer: • When is a firm making a profit? • What are the unique characteristics of competitive firms? • How much output will a competitive firm produce? • When will competitive firm maximize profits? • When will the competitive firm shut down?

9. A Perfectly Competitive Firm is a Price Taker – Why? • A seller that does not have the ability to control the price of the product it sells; it takes the price determined in the market.

10. Competitive Markets • If an industry is profitable, it lures in new firms and existing firms expand. Supply shifts right. • This causes price to fall and profits to decline. • Some firms, both old and new, fail and close.

11. The Demand Curve of the Perfect Competitor Question If the perfectly competitive firm is a price taker, who or what sets the price? Answer - The Market

12. The Demand Curve - continued The perfectly competitive firm is a price taker, selling a homogenous commodity with perfect substitutes. 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

13. The Demand Curve for a Producer of Secure Digital Cards

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

15. Profit Maximization

16. Take a personal look? • How many of you owned a computer 15 years ago? • How many own a compact disc player today? • How many have discarded the VCR in favor of a another digital tool? • Do you own an Ipod? • Do you own an IPhone? • Do you own an Ipad? • Do you own a Blackberry? • Do you own a graphing calculator? • Did your parents have a graphing calculator? • How did your parents type project papers for economics class? Competition has brought the above changes about.

17. Price Taker Discussion When there are many firms, all producing and selling the same product using the same inputs and technology, competition forces each firm to charge the same market price for its good. • Because each firm sells the same homogeneous product, no single firm can increase the price that it charges above the price charged by other firms in the market (without losing business.) • No single firm can affect the market price by changing the quantity of output it supplies- because many firms- each firm is small in size.

18. Demand CurveIndividual firm/industry • The perfect competitor faces a horizontal or perfectly elastic demand curve. • The demand curve is identical to the MarginalRevenue Curve (because the firm can sell as much as it wants to sell at market price.) It is not necessary to lower the price to sell more. • The demand curve for the entire industry slopesdownward (this is a result of aggregate entries and exits into the market.)

19. Market Demand Curves vs. Firm Demand Curves While the actions of a single competitive firm are negligible, the unified actions of many such firms are not. The individual firm’s equilibrium quantity of output will be completely determined by the amount of output the individual firm chooses to supply Demand Curve

20. $18 Marginal cost 16 Profits decreasing 14 Price (= MR) 12 Profits increasing 10 Price or Cost (per bushel) 8 6 4 2 0 1 2 3 4 5 6 7 Quantity (bushels per day) Profit Maximization p = MC MRB Profit-maximizing rate of output MCB

21. Profit Maximization

22. SHORT RUN • In the short-run, individual firm may make profit or loss • In long run will break even • You can always tell if the firm is making a profit or loss by looking at the DEMAND CURVE AND THE ATC CURVE • If the demand curve is ABOVE the ATC curve at any point the firm will make a profit. • If the demand curve is always BELOW the ATC curve the firm will lose money.

23. MC p = MC Profit ATC P d(P = MR) C A P > MC P < MC decrease q Increase q Profit Maximization when the Firm is a Price Taker • In the short run, the price taker will expand output until marginal revenue (price) is just equal to marginal cost. Price B • This will maximize the firm’s profits (rectangle BACP). • When P > MC then the firm can make more on the next unit sold than it costs to increase output for that unit. In order for the firm to maximize its profits it increases output until MC = P. • When P < MC then the firm made less on the last unit sold than it cost for that unit. In order for the firm to maximize its profits it decreases output until MC = P. Output/ Time q 0

24. MC ATC Loss AVC A d(P = MR) C P2 P1 p = MC Operating • In the graph to the right, the firm operates at an output level where p = MC, but here ATC > MC resulting in a loss for the firm. Price • The magnitude of the firm’s short-run losses is equal to the size of the of the rectangle BACP1 • A firm experiencing losses but covering its average variable costs will operate in the short-run. B • A firm will shutdown in the short-run whenever price falls below average variable cost (P2). • A firm will shutdown in the long-run whenever price falls below average total cost. Output/ Time q 0

25. For the perfect competitor in the LR, the most profitable output is at the minimum point of its ATC curve. • The firm is forced to operate at peak efficiency and that is why it operates at the minimum of itsATC curve.. Not anything to do with virtue------- just competition.

26. $96 Total revenue 88 80 72 64 56 Total Revenue 48 40 32 24 16 pe= $8 8 0 1 2 3 4 5 6 7 8 9 10 11 12 Quantity Total Revenue

27. Most profitable point for any firm Profit maximization is where MC = MR Efficiency: A firm operates at peak efficiency when it produces its product at the lowest possible cost… That would be at the MINIMUM POINT OF ITS ATC CURVE – the break even point.

28. Profit-Maximization Rule • Profit is maximized by producing the quantity of output at which MR = MC. • For Perfect Competition, profit is maximized when P = MR = MC* • * This condition is unique for perfect competition and does not hold for other market structures.

29. Realization • Marginal Cost • A firm’s goal is not to maximize revenues, but to maximize profits. • Marginal revenue is compared to marginal costs to determine the best level of output. • What an additional unit of output brings in is its marginal revenue (MR).

30. Price Price MarketSupply Individual firms musttake the market price. P P Demand forSingle Firm MarketDemand Output / Time Output / Time Remember… Firm Demand Curve is Different from Industry’s Demand Curve

31. Entry and Exit • It is easy to enter or exit an industry in perfect competition. • If more firms enter (lured in by economic profits), the market supply curve shifts right and price falls. • As price falls, economic profits decrease and approach zero. • Entry will cease. • Some firms could be making losses by this time. • Many will cut back output or exit. • If so, the supply curve shifts back to the left and the price rises.

32. Long Run • In the long run there is time for firms to enter or leave the industry. This factor ensures that the firm will make ZERO profits in the long run.

33. Short- vs. Long-Run Equilibrium

34. Profit- what kind is it??? • Pure Profit -an amount above that necessary to keep the owner in the industry… is not considered part of total cost • Pure profit is the residual after all costs (including normal profit) have been met • Pure profit will attract other firms into the market • Normal Profit will not induce firms into the market- nor are they low enough to force others to leave.. Breaking even..

35. Long Run • In the LR, no firm will accept losses. • It will simply close up shop and go out of business. • But also remember – one firm leaving the industry WILL NOT affect market price.

36. Market Entry

37. Profit Squeeze

38. Factor Costs • Factor costs mean wages, rent and interest- are far the most important determinants of whether costs are falling, constant or increasing. • Usually factor costs will eventually rise which makes every industry an increasing costs industry. Example: as more and more land is used by an expanding industry, rent will be bid up… Time influences supply: Whether industry is in SR or LR …all can adjust in LR if desire to do so.

39. LR Continued • If one firm is losing money, presumably others are too. • When enough firms go out of business, industry supply declines which pushes price up… • This price rise is reflected in a new demand curve for the individual firm. P D1D2S1 S2 NPI OP I Q OPI = Original Price for individual ; NPI = new price for individual

40. Rules for Entry and Exit • If P > ATC, economic profits exist. • Enter the industry or expand capacity. • If P < ATC, economic losses exist. • Reduce capacity (or exit if P < AVC). • If P = ATC, economic profits are zero. • Maintain existing capacity (no entry or exit).

41. Lower Costs: Improve Profits and Stimulate Output • If a firm lowers its costs of production, it will encourage increases in output. • The cost curves fall, and MC appears to shift right. • Profit maximization occurs at point Jbefore and point N after the reduced costs take effect.

42. The Decision to Shut Down in the Short Run • Firms can’t always make a profit • Ski resort in summer • Surf shop in winter • Shutting down • Firm will shut down if it cannot cover variable costs • Shutting down is not the same as going out of business and exiting the industry

43. Shutdown point for a firm • A firm compares total revenue with total cost to see what its profit or loss is. • Remember there are fixed and variable costs. • Fixed costs have to be paid whether operating or not. • Suppose: a firm’s total cost is $300,000 at a certain level of output. $200,000 made up of variable costs,such as labor and raw materials and $100,000made up of fixed costs such as interest payments, taxes, and rent.

44. Shutdown Continued • If the firm’s total revenue is $240,000 it is clearly taking a loss. The difference between TR and TC in this case is $60,000. • Notice that the total revenue of $240,000 pays all of the firms variable costs ($200,000) and also pays $40,000 of its fixed cost. If the firm were to shut down on the other hand, its loss would total $100,000- the amount of the fixed cost.

45. Shutdown • If competition drives price below AVC for a firm, it will shut down and exit the industry. • If the exiting firm has inventory, it will dump that inventory on the market at a reduced price. • This will cause the industry price to drop further, possibly causing losses for other industry firms.

46. The Competitive Process(this is the market- not the individual) • Competitive forces drive the product’s price down, making it more affordable to more consumers. Thus the market expands. • Also, competitive forces spur firms to improve quality, add features, and look for lower costs. • This is the market mechanism at work. • Market mechanism: the use of market prices and sales to signal desired outputs (or resource allocations).

47. Shutdown Continued • As long as a firm can cover ALL of its variablecost by remaining in operation, it will do so. • ****It’s shutdown point will be where TR no longer covers TVC. Shutdown: when MR falls below the firm’sminimum AVC. When a firm shuts down, it does not necessarily leave the industry. Shutdown is a SR response…and is based on fixed costs of established plant and variable costs of operating it.

48. Profit Maximization and Loss Minimization for the Perfectly Competitive Firm: Three Cases I • In Case 1, TR TC and the firm earns profits. • It continues to produce in the short run.

49. Profit Maximization and Loss Minimization for the Perfectly Competitive Firm: Three Cases II • In Case 2, TR < TC and the firm takes a loss. • It shuts down in the short run because it minimizes its losses by doing so; it is better to lose $400 in fixed costs than to take a loss of $450.

50. Profit Maximization and Loss Minimization for the Perfectly Competitive Firm: Three Cases III • In Case 3, TR < TC and the firm takes a loss. • It continues to produce in the short run because it minimizes its losses by doing so; it is better to lose $80 by producing than to lose $400 in fixed costs by not producing.