Competitive firms and Markets

1. Competitive firms and Markets Perloff chapter 8

2. Competition • Firms are price takers. • Firm’s demand curve is horizontal. • Reasons for a horizontal demand curve: • Identical products from different firms; • Freedom of entry and exit; • Perfect knowledge of prices; • Low transaction costs. • Where all conditions are satisfied: Perfect Competition.

3. Profit • p = R – C • Definition of R straightforward. • Costs: • Business profit includes only explicit costs, e.g. workers wages and materials. • Owner doesn’t take a salary, what remains is profit. • Economic profit uses opportunity cost. • Suppose profit was £20000 but you could earn a salary of £25000, what should you do?

4. Profit maximisation p , Profit p * Profit p D < 0 p > 0 D 1 1 0 q * Quantity, q , Units per day Source: Perloff

5. Output decision • Produce where profit is maximised.

6. Profit maximisation p , Profit p * Profit p D < 0 p > 0 D 1 1 0 q * Quantity, q , Units per day Source: Perloff

7. Output decision • Produce where profit is maximised. • Produce where marginal profit is zero. • Marginal cost equals marginal revenue. • p(q) = R(q) – C(q) • Marginal Profit(q) = MR(q) – MC(q) = 0 • MR(q) = MC(q)

8. Shutdown rule • Shutdown if it reduces its loss. • In the short-run, shutting down means revenue and variable costs are zero. • It must continue to cover fixed costs. • p=R-VC-F=2000-1000-3000=-2000 • p=R-VC-F=500-1000-3000=-3500 • Shutdown if revenue is less than avoidable cost. • This rule is applicable in the long and short run.

9. Cost, revenue, Thousand $ Cost, C Revenue 4,800 Short-run output decision MR = 8 1 2,272 • MC=MR • R=pq • MC=p p * 1,846 426 p ( q ) p * = $426,000 100 0 – 100 140 284 q , Thousand metric tons of li me per year p , $ per ton 10 MC AC e 8 p = MR * = $426,000 p 6.50 6 0 140 284 , Thousand metric tons of li me per year q

10. Short run shutdown decision • Shutdown if revenue less than avoidable cost. • In short run avoidable costs are variable costs.

11. Short run shutdown decision p , $ per ton MC AC b 6.12 AVC 6.00 A = $62,000 p 5.50 e B = $36,000 5.14 5.00 a q , Thousand metric tons of lime per year 0 50 100 140

12. Short run supply curve of the firm p , $ per ton S e 4 8 p 4 e 3 AC 7 p 3 AVC e 2 6 p 2 e 1 p 5 1 MC 0 q = 50 q = 140 q = 215 q = 285 1 2 3 4 q , Thousand metric tons of lime per year

13. Industry SR supply curve with 5 identical firms (a) Firm (b) Market p , $ per ton p , $ per ton 3 2 7 7 S 1 1 S S S 4 S 6.47 6.47 AVC 5 S 6 6 5 5 MC 0 50 140 175 0 50 150 250 700 100 200 q , Thousand metric tons Q , Thousand metric tons of lime per year of lime per year

14. Industry SR supply curve with 2 different firms p , $ per ton 2 1 S S S 8 7 6 5 0 25 50 100 140 165 215 315 450 q , Q , Thousand metric tons of lime per year

15. SR equilibrium in the market (a) Firm (b) Market p , $ per ton p , $ per ton 8 8 S 1 S 1 D e 1 7 7 E 6.97 1 AC A B 2 D 6.20 6 6 AVC C 5 5 E e 2 2 0 q = 50 q = 215 0 Q = 250 Q = 1,075 2 1 2 1 q , Thousand metric tons Q , Thousand metric tons of lime per year of lime per year

16. Supply curve of the firm in the long-run p , $ per unit SR S LR S LRAC SRAC SRAVC p 35 B A 28 25 24 20 LRMC SRMC 0 50 110 q , Units per year

17. Long run adjustment of the industry • All factors are variable. • Entry and exit are possible. • Entry occurs with positive long-run profits • Exit occurs with long-run losses • Identical firms: • All firms make a loss when P<min(LAC), industry supply is zero. • All firms make a profit if P>min(LAC), number of firms is indeterminate. Note that elasticity of the industry supply curve increases with the number of firms.

18. Long run industry supply curve (a) Firm (b) Market p , $ per unit p , $ per unit S 1 LRAC Long-run market supply 10 10 LRMC 0 0 150 Q , Hundred metric tons of oil per year q , Hundred metric tons of oil per year

19. Upward sloping long run industry supply curve • Limited entry • New firms cannot enter because of legislative control. • New firms only enter when profits exceed the costs of entry. • Firms differ • Minimum LAC is lower for some firms than others. • Number of low LAC firms is limited. • Input prices vary with output • Increasing cost (firms in one industry account for much of the supply of a particular input). • Decreasing cost (economies of scale in the input supplier)

20. Differing firms: the LR supply curve for cotton Price, $ per kg Iran S 1.71 United States 1.56 Nicaragua, Turkey 1.43 Brazil 1.27 Australia 1.15 Argentina 1.08 Pakistan 0.71 0 1 2 3 4 5 6 6.8 Cotton, billion kg per year

21. Increasing cost industry (a) Firm (b) Market p , $ per unit p , $ per unit 2 MC 1 MC 2 AC S 1 AC e E 2 2 p 2 e E 1 1 p 1 q q q , Units per year Q = n q Q = n q Q , Units per year 1 2 1 1 1 2 2 2

22. Decreasing cost industry (b) Market (a) Firm p , $ per unit p , $ per unit 1 MC 2 MC 1 AC 2 AC e E 1 1 p 1 e E 2 2 p 2 S q q q , Units per year Q = n q Q = n q Q , Units per year 1 2 1 1 1 2 2 2

23. Long run competitive equilibrium (a) Firm (b) Market , $ per ton p , $ per ton 1 2 D D MC AC SR S F f AVC 2 2 11 11 E LR S 2 10 10 e E F f 1 1 1 7 7 0 100 150 165 0 1,500 2,000 3,300 3,600 q , Hundred metric tons Q , Hundred metric tons of oil per year of oil per year

24. Profit in the long run • Free entry • Entry occurs to the point where profits are zero • No profit in long-run equilibrium • Economic profit is revenue minus opportunity cost. • Restricted entry • Entry is often limited because of a limited quantity of an input eg. land. • Profits become rent.

25. Economic Rent p , $ per bushel MC AC (including rent) AC (excluding rent) p * p * = Rent q , Bushels of tomatoes per year q *