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Econ 10 - 951

Econ 10 - 951. UNC-Chapel Hill Spring 2001. Lecture 9 Perfect Competition 02/08/2000. 1. Price Takers and Price Searchers. Price Takers. Price Takers produce identical products and each seller is small relative to the market. Each seller has little or no effect on the market price.

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Econ 10 - 951

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  1. Econ 10 - 951 UNC-Chapel Hill Spring 2001 Lecture 9 Perfect Competition 02/08/2000

  2. 1. Price Takers and Price Searchers

  3. Price Takers • Price Takers produce identical products and each seller is small relative to the market. • Each seller has little or no effect on the market price. • Each firm can sell as much as it wantsat the market price • It is unable to sell any output at a price greater than the market price • Example: agriculture (wheat, corn, soybeans) • Also called purely competitive market.

  4. Price Searchers • Price Searchers face a downward sloping demand curve for their product. • The amount that the firm is able to sell is inversely related to the price it charges. • Examples: • Nike, • General Motors, • Exxon, • most retail stores

  5. Why Study Price Takers? • Model applies to some markets such as agriculture. • Model helps us understand the relationship between individual firms and market supply. • Increases our knowledge of competition as a dynamic process

  6. 2. Markets When Firms are Price Takers

  7. Conditions for a Market of Price Takers • All firms produce an identical product. • A large number of firms are in the market. • Each firm supplies only a small portion of the total supplied to the market. • No barriers to entry or exit exist.

  8. Price is determinedin the market. Price Price MarketSupply Individual firms musttake the market price. P P Demand forSingle Firm MarketDemand Output / Time Output / Time • The market forces of supply and demand determine price. Price Taker’s Demand Curve • Price takers have no control over the price that they may charge in the market. If such a firm was to offer their good/service at a price above that established by the market, then consumers would simply buy elsewhere. • Thus, the demand for the product of the firm is perfectly elastic. Only at the market price will there be any demand.

  9. 3. Output in the Short Run

  10. MarginalRevenue (MR) = the change in total revenue the change in output Marginal Revenue • Marginal Revenue is the change in total revenue divided by the change in output. • In a price taker market, Marginal Revenue = market price.

  11. 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 • This will maximize the firm’s profits (rectangle BACP). B • When P > MCthen 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 < MCthen 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

  12. TotalRevenue(TR) Profit(TR - TC) TotalCost(TC) Output 0 1 2 . . . . . . . 8 9 Profits occurwhereTR > TC 10 TC 11 Profits Maximizedwhere difference is largest TR 12 13 14 15 16 17 Losses occurwhereTC > TR 18 19 20 21 • An alternative way of viewing profit maximization within the firm focuses on the relationship between total revenue (TR) and total cost (TC). Total Revenue / Total Cost Approach 0 25.00 - 25.00 • At low levels of output profits are negative as total costs exceed total revenue. 5 29.80 - 24.80 10 33.75 - 23.75 • After some point, total revenues may exceed total costs. Profit is maximized where this difference is maximized. . . . . . 48.00 - 8.00 40 - 4.25 45 49.25 Average and/or Marginal Product - .25 50 50.25 125 55 3.50 51.50 6.75 60 53.25 100 9.25 65 55.75 10.75 70 59.25 75 11.00 75 64.00 10.00 80 70.00 50 85 77.25 7.75 4.50 90 85.50 0.00 25 95 95.00 - 8.00 100 108.00 Output Level - 20.00 125.00 105 2 4 8 10 6 16 12 14 20 18 22

  13. MarginalRevenue(MR) Profit(TR - TC) MarginalCost(MC) Output 0 1 2 . . . . . . . 8 MC 9 10 11 Profit MaximumP = MR = MC 12 13 14 15 16 17 18 19 20 21 • We can show the relationship between theTR/TC and the MR/MC approach. Marginal Revenue / Marginal Cost Approach • Below, low levels of output delivermarginal revenue to the firm greater than the marginal cost of increased output. ---- ---- - 25.00 5 $ 4.80 - 24.80 • After some point, though, additional units cost more than their marginal revenue. 5 $ 3.95 - 23.75 . • Profit is maximized where P= MR = MC. . . . . • Both the TR/TC and the MR/MC method yield the same profit maximizing output, q=15 $ 1.50 - 8.00 5 - 4.25 5 $ 1.25 Price and CostPer Unit - .25 5 $ 1.00 9 5 3.50 $ 1.25 6.75 5 $ 1.75 7 9.25 5 $ 2.50 MR 10.75 5 $ 3.50 5 11.00 5 $ 4.75 10.00 5 $ 6.00 3 5 $ 7.25 7.75 4.50 5 $ 8.25 0.00 1 5 $ 9.50 - 8.00 5 $ 13.00 Output Level - 20.00 $ 17.00 5 2 4 8 10 6 16 12 14 20 18 22

  14. MC ATC Loss AVC A d(P = MR) C P2 P1 p = MC Operating with Short-Run Losses • 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

  15. Firm’s Short-Run Supply Curve • A firm maximizes profits when it produces at P=MC and variable costs are covered. • A firm’s short-run supply curve is its marginal cost curve above average variable cost.

  16. Short-Run Market Supply • The short-run market supply is the horizontal sum of the all firms’ short-run marginal cost curves

  17. Price Price MC is thefirm’ssupply curve MC Ssr(MC) ATC AVC Output Output Representative Firm Market • Given resource prices, the marginal cost curve (MC) is the representative firm’s supply curve for a specific good. Supply Curve for the Firm and the Market • As price rises above the short-run shutdown price of P1,, the firm will supply additional units of the good. • The short-run market supply curve (Ssr) is merely the sum of the MCs of all the firms. • Note that below P1 no quantity is supplied because P < AVC. P3 P3 P2 P2 P1 P1 q1 q2 q3 Q1 Q2 Q3

  18. 1. How do firms that are price takers differ from those that are price searchers? What are the distinguishing characteristics of a price taker market? Questions for Thought: 2.Why is competition in a market important? Is there a positive or negative impact on the economy when strong competitive pressures drive various firms out of business? Why or why not?

  19. 4. Output Adjustments in the Long Run

  20. Economic Profits and Entry • If price exceeds average total cost, firms will earn an economic profit. • Economic profit induces both • entry of new firms • expansion in the scale of operation of existing firms. • Capital moves into the industry, shifting the market supply to the right. This will continue until price falls to ATC • In the long-run, competition drives economic profit to zero.

  21. Economic Losses and Exit • If average total cost exceeds price, firms will suffer an economic loss. • Economic losses induce • exit of firms from the market • a reduction in the scale of operation of remaining firms. • As market supply decreases, price will rise to average total cost. • Thus, profits and losses move price toward the zero-profit long-run equilibrium.

  22. Ssr Price Price MC ATC P1 d D Output Output Firm Market Long-run Equilibrium • The two conditions necessary for long-run equilibrium in a price-taker market are depicted here. • First, the quantity supplied and the quantity demanded must be equal in the market, as shown below at P1 with output Q1. • Second, the firms in the industry must earn zero economic profit (that is, the “normal market rate of return”) at the established market price (P1 below). P1 q1 Q1

  23. S1 S2 Price Price MC ATC P2 P1 d2 d1 D2 D1 Output Output Firm Market • Consider the market for toothpicks. If the introduction of a new candy product that sticks to one’s teeth causes the market demand for toothpicks to increase from D1 to D2 . . . Adjusting to Expansion in Demand • . . . the market price for toothpicks rises to P2 . . . • . . . shifting the firm’s demand curve upward. At the higher price, firms will expand output to q2 and earn short-run profits. • The economic profits will draw competitors into the industry, shifting the market supply curve from S1 to S2. P2 P1 q1 q2 Q1 Q2

  24. S2 Price Price MC ATC Slr P1 P2 P1 d1 d2 d1 D1 D2 Output Output Firm Market • After the increase in market supply, a new equilibrium is established at the original market price (P1) and a larger rate of output (Q3). Adjusting to Expansion in Demand • As the market price returns to P1, the demand curve facing the firm returns to its original level. • In the long-run, economic profits are driven down to zero. • Note the long-run market supply curve is flat (Slr). S1 P2 P1 P1 q1 q1 q2 Q1 Q2 Q3

  25. S1 S2 Price Price MC ATC P2 P1 d2 d1 D2 D1 Output Output Firm Market • If, instead, something occurs that causes market demand for toothpicks to decrease from D1 to D2 . . . Adjusting to a Decline in Demand • . . . the market price for toothpicks falls to P2 . . . • . . . shifting the firm’s demand curve downward, inducing a reduction in output to q2. The firm is now making losses. • Short-run losses cause some competitors to go out of business, and others to reduce the scale of their operation, shifting the market supply curve from S1 to S2. P1 P2 q2 q1 Q2 Q1

  26. S2 Price Price MC ATC Slr P1 P2 P1 d2 d1 d1 D2 D1 Output Output Firm Market • After the decrease in market supply, a new equilibrium is established at the original market price (P1) and a smaller rate of output (Q3). Adjusting to Decline in Demand • As the market price returns to P1, the demand curve facing the firm returns to its original level. • In the long-run, economic profit returns to zero. • Note the long-run market supply curve is flat (Slr). S1 P1 P1 P2 q2 q1 q1 Q3 Q2 Q1

  27. Long Run Supply • Constant-Cost Industry: Industry where per-unit costs remain unchanged as marketoutput is expanded. • Occurs when the industry’s demand for resource inputs is small relative to the total demand for the resources. • The long-run market supply curve in a constant-cost industry is horizontal.

  28. Long Run Supply • Increasing-Cost Industry: Industry where per-unit cost rises as market output is expanded. • Results because an increase in industry output generally leads to stronger demand and higher prices for the inputs. • The long-run market supply curve in a increasing-cost industry is upward-sloping. • Most common type of industry

  29. Long Run Supply • Decreasing-Cost Industry: Industry were per-unit costs decline as market output expands. • Implies either economies of scale exist in the industry or that an increase in demand for inputs leads to lower input prices. • The long-run market supply curve in a decreasing-cost industry is downward-sloping. • Decreasing-cost industries are uncommon.

  30. Price Price S2 S1 MC2 MC1 ATC2 ATC1 P1 d1 P1 D2 D1 q1 Q1 Output Output Firm Market • Consider the market below, where an increase in the market demand pushes up the market price, leading to short-run profits for the individual firms. Increasing Costs and Long-Run Supply • Economic profit entices some new firms to enter the market and others to increase the scale of their operation. . . • . . . shifting out the market supply curve and lowering the market price. The firm’s costs are now higher (ATC2 & MC2) because the stronger demand for inputs pushes their price up. P2 Q2

  31. Price Price Slr MC2 ATC2 P3 P1 d2 d1 D1 D2 Output Output Firm Market Increasing Costs and Long-Run Supply • This process continues until economic profits are eliminated. • At the new equilibrium price (P3), a larger quantity is supplied to the market (Q3). • Because this is an increasing-cost industry, expansion in market output leads to a higher equilibrium price. • Thus, the long-run supply curve (Slr) is upward sloping. S2 S1 MC1 ATC1 P2 P3 P1 q1 Q1 Q3 Q2

  32. Supply Elasticity and Role of Time • In the short run, fixed factors of production such plant size limit the ability of firms to expand output quickly. • In the long run, firms can alter plant size and other fixed factors of production. • Therefore, the market supply curve will be more elastic in the long-run than in the short run.

  33. St2 St3 Slr P2 P1 t1 = 1 week • The elasticity of the market supply curve usually increases as more time is allowed for adjustment to a change in price. Time and the Elasticity of Supply Price St1 • Consider the market supply curve to the right. At time 1, with price P1, Q1 is supplied. • If the market price increases to P2, initially Q2 is supplied, but as the time horizon increases the composition of firms and their scale changes. • With time, larger quantities of the good are brought to market (Q3, Q4, Q5 ). • The slope of the market supply curve becomes flatter and flatter (more and more elastic) as the time horizon expands Q1 Q2 Q3 Q4 Q5 0 t3 = 3 months Output / Time t2 = 1 month tlr = 6 months

  34. 5. Role of Profits and Losses

  35. Profits and Losses • Firms earn an economic profit by producing goods that can be sold for more than the cost of the resources required for their production. • Profit is a reward for actions that increase the value of resources. • Losses are a penalty imposed on firms that reduce the value of resources.

  36. 6. Price Takers, Competition, and Prosperity

  37. Competitive Process • The competitive process provides a strong incentive for producers to operate efficiently and heed the views of consumers. • Competition and the market process harness self-interest and use it to direct producers to wealth-creating activities.

  38. 1. How does competition among firms affect the incentive of each firm to (a) operate efficiently (produce at a low per unit cost) (b) produce goods that consumers value? What happens to firms that fail to do these 2 things? Questions for Thought: 2. Will firms in a price-taker market be able to earn profits in the long run? Why or why not? What are the major determinants of profitability for a firm? 3.Within the framework of the price-taker model, how will an unanticipated increase in demand for a product affect each of the following in a market that was initially in long-run equilibrium?a. the short-run market price, output, and profitability of the product b. the long-run market price, output, and profitability of the product

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