ECON649/ECON991

1. ECON649/ECON991 Lecture 6

2. Perfect Competition

3. Short Run Equilibrium • Firm & industry are in SR equilibrium when: • market demand = market supply& • Each firm producing its π-max or loss-min output level P* will be maintained unless D or S change and firm’s output maintained unless its revenue or costs change.

4. Remember that: Note the absence of TFC as they do not vary with output. So MC is independent of fixed costs. At profit max MR = MC  so optimum output level in the SR is unaffected by fixed costs. Irrelevance of Fixed Costs for Optimising Behaviour

5. Irrelevance of Fixed Costs for Optimising Behaviour • Any TFC shifts the TC curve upwards but does not alter the slope of TC (so MC unchanged)  profit max position is unchanged. • TFC  profitat every level of output by the same amount. We can therefore regard TFC as a sunk cost • i.e. at the time the firm commits itself to the fixed cost (e.g. leasing a factory) the opportunity to spend the money on something else is gone

6. TC2 TR TR TC Slope = MR TC1 Slope = MC TFC2 TC due to TFC TFC1 Profit max output unchanged after TFC, but absolute size of profit at every level of output. Q Q* MRMC MC MR Q* Q

7. SR Supply Curve of Perfectly Competitive Firm • Seen that π-max/loss-min firm accepts market P & sets output via MC = MR : P > AVC • If P* changes  shift  or  of firm’s MR curve  New π-max/loss min output MKT FIRM P S MC P2* MR2 P1* MR1 D2 D1 Q Q

8. SR Supply Curve of Perfectly Competitive Firm • Consider series of diff P* series of diff MR curves for firm • Applying π-max/loss-min rule series of output levels (Q’s) & their matching prices (Sounds like a supply curve to me) MC AVC S firm D P6 MR6 P6 d C P5 MR5 P5 c B P4 MR4 P4 b A P3 MR3 P3 a P2 MR2 P2 MR1 P1 P1 Q1

9. P MC AVC P4 MR4 P3 MR3 P2 MR2 P1 MR1 P0 MR0 P MR Q Q1 Q3 Q0 Q2 Q Do not satisfy P > AVC SR Supply Curve of Perfectly Competitive Firm Supply curve of firm • For all P* < AVC, Q = 0 is loss min output level • So long as P* > AVC, firm will supply Q assoc. with MC = MR • The section of MC which lies above AVC represents firm’s S curve S curve shows various Qs π-max/loss-min firm willing and able to supply at each possible price, ceteris paribus.

10. Market or Industry S Curve • Market S curve is derived via horizontal summation of individual firm’s S curves • Take given P (say $1) & add Q’s (4+5=9) & transfer result to Market graph P P P MC2 = S2 Market supply MC1 = S1 $3 $3 $3 $2 $2 $2 $1 $1 $1 Q 9 14 19 Q Q 4 6 8 5 8 11 Firm 1 Market Firm 2

11. Long Run Adjustment • In the LR: • Firms able to vary all inputs • Firms able to enter & leave the industry • If economic π (above normal π) is being made  new firms entering market • Increase in market supply • Decrease in P* • Erosion of economic π

12. Long Run Adjustment • With S1=D  P1  economic or above normal π • Eventually entry of new firms  S2=D  P2  normal π only • No further entry of new firms once NORMAL π ONLY being made

13. Long Run Adjustment Economic or above normal profit S1 FIRM P MKT P ATC MC S2 P1 P1 MR1 P2 P2 MR2 D Q Q2 Q1 Q

14. Long Run Adjustment • Recall definition of normal π= min acceptable return in the LR losses not acceptable in LR • Losses  some existing firms leaving market market S curve to left P* erosion of losses • No further exit once normal π being made.

15. Long Run Adjustment Loss FIRM MKT MC ATC S2 P P S1 P2 P2 MR2 P1 P1 MR1 D Q Q1 Q2 Q

16. Long Run Equilibrium Long run equilibrium occurs where:- • Market D = Market S AND • Each firm* Produces Q* where MC = MR and * Makes normal π only Freedom of entry & exit of firms in response to π/loss signal ensures this result FIRM P MKT P MC ATC S P* P* MR1 D Q Q Q*

17. Efficiency and Perfect Competition in LR • There are 2 notions of efficiency which we want to distinguish between: • Productive or economic efficiency – occurs when a particular level of output is being produced at the lowest possible cost (i.e. the level of output could not be produced with fewer resources  this occurs at every point on the LRAC curve).

18. Efficiency and Perfect Competition in LR • Allocative efficiency – occurs when production is organised so that the goods or services produced are what consumers want.i.e. P = MC P reflects preferences of consumers (i.e. demand) and allocates resources to the goods and services they want most. MC reflects the supply by producers of the desired quantity of the good or service to consumers. So DEMAND = SUPPLY

19. Efficiency and Perfect Competition in LR IN SUMMARY: • In equilibrium MR = MC, but remember that MR = P, so we can rewrite equilibrium condition as P = MC • In the LR, only a normal profit can be earned so that firm is operating at the minimum point of its LR ATC curve and consumers are paying the lowest possible price.

20. Efficiency and Perfect Competition in LR • Our equilibrium condition in the LR can then be restated asMR = MC = P = ATC • So at this point S = D and product is being produced at the lowest possible cost and P is the lowest possible price. • This result means that Perfect Competition in the LR is both productively and allocatively efficient.

21. Monopoly

22. Monopoly The word MONOPOLY is derived from the Greek words MONOS = alone POLEIN = to sell one seller

23. Characteristics • Single seller of product with no close substitutes • High barriers to entry firm has entire market to itself  firm and market are same thing Examples: • Australia Post as stamp seller • The only casino in a capital city (Star City in Sydney)

24. Barriers to Entry = factors that restrict/discourage entry of firms to a market and prevent new firms competing on an equal basis with the existing firm

25. Barriers to Entry • Barriers include: • Legal barriers = laws, licenses, patents • Technological barriers = sole access to best production techniques • Control of essential raw materials • Network externalities • Natural barriers via • economies of scale  cost advantage over potential entrants • prohibitive set-up costs for potential entrants

26. Revenue Conditions • Since monopoly firm is the only producer of the product  firm’s D curve is the market D Curve  negatively sloped D curve via Law of Demand • Suppose the data in the table applies to a monopoly firm…..

27. Marginal Revenue • Need to consider marginal revenue when the firm faces the market demand curve. • Start with prices and quantities that relate to the demand schedule shown here. D

28. Marginal Revenue • Price = average revenue (AR) since AR = TR/Q = (P x Q)/Q = P • Marginal revenue (MR) = change in TR resulting from a 1-unit change in quantity sold, so MR = TR/Q

29. Relationship between TR and MR

30. Marginal Revenue • Plotting the MR and AR curves on same graph  MR & AR both downward sloping with MR twice as steep as AR • AR = red line • MR = blue line D = AR MR

31. Marginal Revenue • From calculus, if AR = P = 11 – 1Q  TR = P x Q = (11 – 1Q)Q = 11Q – 1Q2 MR = ∂TR/∂Q = 1st derivative of TR  MR = 11 – 2Q

32. Price Elasticity Along Negatively - Sloped Linear D Curve P MR = 0 E = 1 E > 1 E = 1 P1 E < 1 MR < 0 E < 1 MR > 0 E >1 D Q1 Q MR

33. Output and Pricing Decisions • π max/loss min output level is determined by same rule as firm in perfect competition  set MC = MR  Q* > 0 provided P > AVC (otherwise set Q = 0) What about price? • Unlike Perfect Competition firm, monopoly is able to set/choose the price that it will charge.

34. Output and Pricing Decisions • Price (P*) is the price that allows firm to sell its π max/loss min output (Q*) P With Q = Q* consumers would be willing and able to pay P* MC P* D MR 0 Q Q*

35. Profitability in the SR • SR profitability is not specified in the Monopoly model 3 possibilities (as in Perfect Comp.) • TR > TC  economic (above normal) profit • TR = TC  normal profit • TR < TC  loss

36. Above Normal Profit (TR > TC) P = TR (0P*AQ*) = TC (0CBQ*) MC ATC A P* = economic or above normal profit (P*ABC) B C D MR 0 Q Q*

37. Normal Profit (TR = TC) P ATC MC A P* = TR (0P*AQ*) = TC (0P*AQ*) D MR 0 Q Q*

38. Loss (TR < TC) P ATC MC B C A P* = TR (0P*AQ*) = TC (0CBQ*) = loss (P*ABC) D MR 0 Q Q*

39. Profitability in the SR • Whether firm makes profit or loss at Q* output level depends on firm’s ATC and AR (=P*). • If making a loss in SR decision about whether to remain in production is the same as for Perfect Competition: • if P < AVC, then SHUTDOWN, Q = 0, and loss is restricted to just TFC. • If P > AVC, stay in production, Q > 0, and loss = <TFC

40. SR Loss Minimisation (P > AVC) P ATC AVC MC B C TR = 0P*AQ* A P* TFC(CBDV) TC = 0CBQ* Loss if stay in production = P*ABC D V Stay in production as loss < TFC TVC(VDQ*0) D MR 0 Q Q*

41. SR Loss Minimisation (P < AVC) ATC P AVC B C MC TFC(CBDV) TR = 0P*AQ* V D TC = 0CBQ* Loss if stay in production = P*ABC P* A Shutdown as loss will then be smaller = TFC only TVC(VDQ*0) D MR 0 Q Q*

42. SR Loss Minimisation (P = AVC) P ATC AVC MC B C TFC(P*ABC) TR = 0P*AQ* A P* TC = 0CBQ* loss if stay in production = P*ABC Loss = TFC either way TVC(P*AQ*0) D MR 0 Q Q*

43. Profitability in the LR • Due to existence of barriers to entry a monopoly can continue to earn economic profit in the LR. • Potential competitors unable to enter market and compete away excess returns. • So in the LR can be making either economic (above normal) profit or normal profit. • Losses are unacceptable in the LR. • If making a loss will shutdown in LR.

44. REQUIRED READING This week’s lecture: Perfect Competition (cont.) • Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics Chapter 7 Monopoly • Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics Chapter 8

45. REQUIRED READING Next week’s lecture: Monopoly • Hubbard, Garnett, Lewis & O’Brien, Essentials of Economics Chapter 8