Perfect Competition Industrial Organization: Part 2

1. Perfect CompetitionIndustrial Organization: Part 2 MicroMod5 Miller

2. Objectives • By the end of this module, SWBAT • Understand how the world price dominates firms in the perfect competition model and serves as their perfectly elastic demand curve • Graph the conditions of a PC market and locate profit and loss margins • Locate shut down and exit prices • Explain how large numbers of entering and exiting firms affect long run economic profits

3. SLOs • Agricultural markets operate in a PC structure • You will see how difficult it is to maintain a profit in this industry  cost cutting measures employed more and more often to reduce AVC • Labor costs, fertilizers, and pesticides are all parts of AVC for a farm • Grocers pressure farms to produce cheaply by lowering world price of agricultural goods  wage slavery for farm workers, cheaper and more synthetic fertilizers, and more pesticides to maximize output • Remember – YOU ARE WHAT YOU EAT

4. Premises • For a market to be perfectly competitive there must be: • a vast number of buyers and sellers in the market • very little product differentiation • free entrance and exit into and out of the market • As a result, competitive firms are price takers • Has interesting effects on firm behavior

5. Competitive Revenue • As we already know, TR = P x Q • Since competitive firms must sell at a preordained market price, marginal revenue is equal to average revenue • that is to say that the revenue produced by the sale of the next item is equal to the revenue of all sales divided by all the items sold (REFER TO PG. 281) • creates a very slim profit margin

6. Maximizing Profits • delicate balancing act • produce too little, not generate enough revenue - missing out on more profits • produce too much, marginal costs too high, cut into profits • REMEMBER - these firms can’t just increase P, customers will then flock to their competition with lower P and then first firm makes nothing

7. Maximizing Profits • end result are the following principles (REFER TO PGS 283, 284) • MR > MC → increase Q • MR < MC → decrease Q • MR = MC → profits maxed out • When MR = MC, a positive sloping straight curve is created → supply curve of a firm in a perfectly competitive market • to determine profit from a graph, use the formula Profit = (P-ATC) x Q

8. Maximizing Profits • Note that P = MR • Remember from last module that firms should always produce at the point where MR crosses MC • If this point is also where ATC crosses MC this is the “break even point”

9. Maximizing Profits • If P (MR) crosses MC ABOVE where MC crosses ATC, then there is an economic profit • If P (MR) crosses MC BELOW where MC crosses ATC, there there is an economic loss • Therefore, firms in these markets are very vulnerable to changes in price • A good example in agriculture

10. Visualizing Profits • draw the marginal cost and average total cost curves • then choose a P and draw it as a horizontal line and mark the point where P intersects MC • draw a rectangle by drawing a vertical line that either rises from or drops from where P and MC meet towards the ATC (REFER TO 290)

11. Long Term Weirdness • When most of firms in industry operate at P below ATC, suffer losses - incentive for firms to exit • When firms exit, supply decreases - increasing profits - incentive for firms to enter • eventually this oscillation will settle into a strange long term condition where P=ATC=MC (Perfectly elastic supply curve) • seems like no profit here but there is ACCOUNTING profit here  so remain in business

12. Even Weirder • an increase in demand for goods in these types of markets will only result in short term profits • remember profits create incentive for more entry → more supply → shift to the right in short run supply curve → restabilizing price on old long run supply curve (PG. 294)

13. Weirder Still • Long run supply technically slopes upward even though you just learned its perfectly elastic • costs tend to vary by individual producer and increase gradually over time (inflation effects) • the following maxim is still true however - easier for firms to enter and exit in long run than short run, long term supply curve more elastic than short run

14. Shutting it Down • in economics, shutdown is a temporary situation (short term) • the term “exit” refers to closing down the business entirely • fixed costs previously invested in business that can’t be recovered in short term = sunk costs

15. Shutting it Down • shutdowns have no impact on sunk costs - businesses just have to “eat it” • exits however allow owners to sell investments, recoup sunk costs • when to shut down in competitive markets? • when P < AVC • P = MR = AR so marginal revenue MUST be greater than average variable cost • when to exit competitive markets? • P < ATC

16. Example – Miller Orchard • Let’s say Miller Orchard grows Pink Lady Apples and sells that at the world price • There will be good years (P>MC) and the orchard will make economic profit • There will be ok years (P=MC) and the orchard will make just accounting profit and break even economically

17. Example – Miller Orchard • There will be bad years where P<MC but not lower than AVC and Miller will still sell all his apples and just eat the loss • There will be years so bad that P<AVC and Miller won’t even pick the apples because the price is too low to cover his operating costs • Miller will only sell the orchard if P<AFC , which means that Miller’s sunk costs (the orchard) is now worth more on the market than his potential crop

18. Example – Miller Orchard • What should Miller do to maximize profits on his orchard?

19. Example – Miller Orchard • What should Miller do to maximize profits on his orchard? • Diversify his apple crops and non-apple crops

20. Example – Miller Orchard • Sell some other types of apples like Granny Smith • If the world price for one variety is unfavorable, perhaps it is because another is favorable due to a shift in consumer demand

21. Example – Miller Orchard • Economic losses from one variety of apple could be offset by profits from another

22. Example – Miller Orchard • Grow a pear • This would insulate Miller Orchard from losses in the entire apple industry • Even better strategy if apples and pears had different harvesting seasons

23. Summary • Perfectly competitive firm structures are rare • Special condition in which world price = demand = marginal revenue = average revenue • Only way to increase revenue is to increase output because these firms are “price takers” • When world prices are favorable, more firms enter the market, increase supply and drive down economic profits to zero • When economic profits are zero, firms leave the market, supply decreases and economic profits rise

24. Summary • Firms in the PC market structure should temporarily shut down operations if P falls below AVC and should sell all assets if P falls below AFC • The market conditions exist in such a peculiar way because • Products are essentially identical and not branded • There are almost no barriers to entry and new firms come and go easily • Even if firms operate at zero economic profit, there is still enough accounting profit ($) to subsist