11 Perfect Competition

Market Structure and Market Structure and Perfect Competitive FirmPerfect Competitive Firm

Hall and Lieberman, 3Hall and Lieberman, 3rdrd edition, edition, Thomson South-Western, Chapter 8Thomson South-Western, Chapter 8

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OverviewOverviewWhat you will learn from this lectureWhat you will learn from this lecture

– Market structureMarket structure– 3 Requirements for perfect competition3 Requirements for perfect competition– Demand curve for a competitive firmDemand curve for a competitive firm– Supply curve for a competitive firmSupply curve for a competitive firm– How is the profit is maximized? At which How is the profit is maximized? At which

output level?output level?– How is profit or loss is measured using How is profit or loss is measured using

graphs?graphs?

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Part I Market StructurePart I Market StructureSellers want to sell at the highest Sellers want to sell at the highest possible price possible price – Buyers seek lowest possible priceBuyers seek lowest possible price– All trade is voluntaryAll trade is voluntary– different goods and services are sold in different goods and services are sold in

vastly different waysvastly different ways

Economists think about market Economists think about market structurestructure– Characteristics of a market that influence Characteristics of a market that influence

behavior of buyers and sellers when they behavior of buyers and sellers when they come together to tradecome together to trade

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Types of MarketTypes of MarketFor any particular market, we ask For any particular market, we ask – How manyHow many buyers and sellers are there in the buyers and sellers are there in the

market?market?– Is each seller offering a Is each seller offering a standardized productstandardized product, ,

more or less indistinguishable from that more or less indistinguishable from that offered by other sellers?offered by other sellers?

– Are there any Are there any barriers to entry or exitbarriers to entry or exit, or can , or can outsiders easily enter and leave this market?outsiders easily enter and leave this market?

Four basic types of marketFour basic types of market– Perfect competitionPerfect competition– MonopolyMonopoly– Monopolistic competitionMonopolistic competition– OligopolyOligopoly

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Part II. The Three Requirements of Perfect Part II. The Three Requirements of Perfect CompetitionCompetition

Large numbers of buyers and sellersLarge numbers of buyers and sellers– Each buys or sells only a tiny fraction of the Each buys or sells only a tiny fraction of the

total quantity in the markettotal quantity in the market

Sellers offer a standardized productSellers offer a standardized product

Sellers can easily enter into or exit Sellers can easily enter into or exit from marketfrom market– Significant barriers to entry and exit can Significant barriers to entry and exit can

completely change the environment in completely change the environment in which trading takes place which trading takes place

Examples?Examples?

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i. A Large Number of Buyers and Sellersi. A Large Number of Buyers and Sellers

In perfect competition, there In perfect competition, there must be many buyers and must be many buyers and sellerssellers– How many?How many?

Number must be so large that no Number must be so large that no individual decision maker can individual decision maker can significantly affect price of the significantly affect price of the product by changing quantity it product by changing quantity it buys or sellsbuys or sells

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ii. Selling Standardized Productsii. Selling Standardized Products

Buyers do not perceive Buyers do not perceive significant differences between significant differences between products of one seller and products of one seller and anotheranother– For instance, buyers of wheat do For instance, buyers of wheat do

not prefer one farmer’s wheat over not prefer one farmer’s wheat over anotheranother

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iii. Easy Entry into and Exit from the Marketiii. Easy Entry into and Exit from the Market

Easy EntryEasy Entry – no significant barriers to discourage no significant barriers to discourage

new entrants new entrants – any firm wishing to enter can do any firm wishing to enter can do

business on the same terms as firms business on the same terms as firms that are already therethat are already there

Easy exitEasy exit– A firm suffering a long-run loss must A firm suffering a long-run loss must

be able to sell off its plant and be able to sell off its plant and equipment and leave the industry for equipment and leave the industry for good, without obstaclesgood, without obstacles

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iii. Easy Entry into and Exit from the Marketiii. Easy Entry into and Exit from the Market

In many markets there are In many markets there are significant barriers to entrysignificant barriers to entry– Legal barriersLegal barriers– Existing sellers have an important Existing sellers have an important

advantage that new entrants can not advantage that new entrants can not duplicateduplicate

Brand loyaltyBrand loyalty– Cost advantage of existing firms from Cost advantage of existing firms from

significant economies of scalesignificant economies of scale

The U.S. Market is characterized by entry and exitThe U.S. Market is characterized by entry and exitExample: Job creation and destruction in manufacturingExample: Job creation and destruction in manufacturing

Annual averagesAnnual averages– 10% of jobs disappear forever10% of jobs disappear forever– 9% of jobs appear for the first time9% of jobs appear for the first time– Shutdowns responsible for 23% of Shutdowns responsible for 23% of

job destructionjob destruction– Start-ups responsible for 16% of Start-ups responsible for 16% of

job creationjob creation

Haltiwanger, Davis and Schuh, Haltiwanger, Davis and Schuh, Job Creation and Job Creation and Job Destruction.Job Destruction. MIT Press. 1996. MIT Press. 1996.

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Is Perfect Competition Realistic?Is Perfect Competition Realistic?Assumptions are rather restrictive Assumptions are rather restrictive

In reality, one or more of assumptions will In reality, one or more of assumptions will be violated in vast majority of marketsbe violated in vast majority of markets– Yet economists use perfect competition Yet economists use perfect competition

more often than any other market more often than any other market structurestructure

Why?Why?– Model of perfect competition is powerfulModel of perfect competition is powerful– Many markets come reasonably close to Many markets come reasonably close to

be perfect competitivebe perfect competitive

Perfect competition can Perfect competition can approximateapproximate conditions and yield accurate-enough conditions and yield accurate-enough predictions in a wide variety of marketspredictions in a wide variety of markets

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Even if conditions for perfectly competitive Even if conditions for perfectly competitive markets are not satisfied…markets are not satisfied…

Assumptions are close Assumptions are close enough for predictions ofenough for predictions of– Firm entry or exitFirm entry or exit– Price increase or decreasePrice increase or decrease– Increase or decrease in Increase or decrease in

industry quantityindustry quantity– Increase or decrease in firm Increase or decrease in firm

quantityquantity

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Part III. The Perfectly Competitive FirmPart III. The Perfectly Competitive Firm

What is occurring in a What is occurring in a competitive market is quite competitive market is quite different from the view we get different from the view we get when looking at a perfect when looking at a perfect competitive firm. competitive firm. – entirely different pictureentirely different picture

In learning about competitive In learning about competitive firm, must also discuss firm, must also discuss competitive market in which it competitive market in which it operatesoperates

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Figure 1: The Competitive Industry and FirmFigure 1: The Competitive Industry and Firm

Ounces of Gold per Day

Price per Ounce

D

$400

S

Market

Demand Curve Facing

the Firm

$400

Firm

1. The intersection of the market supply and the market demand curve…

3. The typical firm can sell all it wants at the market price…

Ounces of Gold per Day

Price per Ounce

2. determine the equilibrium market price

4. so it faces a horizontal demand curve

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Goals and ConstraintsGoals and Constraints

Perfectly competitive firm faces a Perfectly competitive firm faces a cost constraint when producing cost constraint when producing any given level of output any given level of output – Firm’s production technology Firm’s production technology – Prices it must pay for its inputsPrices it must pay for its inputs

Cost function for a perfectly Cost function for a perfectly competitive firm is standardcompetitive firm is standard

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The Demand Curve Facing a The Demand Curve Facing a Perfectly Competitive FirmPerfectly Competitive Firm

Demand curve isDemand curve is horizontal, or infinitely horizontal, or infinitely price elasticprice elasticWhy?Why?– Output is standardizedOutput is standardized– No matter how much a firm decides to No matter how much a firm decides to

produce, it cannot make a noticeable produce, it cannot make a noticeable difference in market quantity supplied difference in market quantity supplied

So cannot affect market priceSo cannot affect market price– Firm is a price takerFirm is a price taker

Treats the price of its output as given and Treats the price of its output as given and beyond its controlbeyond its controlIts only decision is how much output to Its only decision is how much output to produce and sellproduce and sell

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Cost and RevenueCost and Revenue

MR at each quantity is the MR at each quantity is the same as the market pricesame as the market price– MR = PriceMR = Price– marginal revenue curve and marginal revenue curve and

demand curve facing firm are demand curve facing firm are the samethe same

– A horizontal line at the market A horizontal line at the market priceprice

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Profit Maximization: The Total Revenue Profit Maximization: The Total Revenue and Total Cost Approachand Total Cost Approach

Firm’s profit per unitFirm’s profit per unit– ( Revenue per unit ) – ( cost per unit )( Revenue per unit ) – ( cost per unit )

profit per unit = P – ATCprofit per unit = P – ATC

Total Profit = TR – TC=Q(P-ATC)Total Profit = TR – TC=Q(P-ATC)TR and TC approachTR and TC approach– Pick out the output level where there Pick out the output level where there

is biggest difference between TR and is biggest difference between TR and TCTC

– Most direct way of viewing firm’s Most direct way of viewing firm’s search for the profit-maximizing search for the profit-maximizing output leveloutput level

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Figure 2a: Profit Maximization: find Figure 2a: Profit Maximization: find greatest TR - TCgreatest TR - TC

TR

550

$2,800

2,100

TC

Slope = 400

Ounces of Gold per Day

Dollars

1 2 3 4 5 6 7 8 9 10

Maximum Profit per Day = $700

2020

Profit Maximization: The Marginal Revenue Profit Maximization: The Marginal Revenue and Marginal Cost Approachand Marginal Cost Approach

Profit-maximizing output is Profit-maximizing output is found where MC curve crosses found where MC curve crosses MR curve from belowMR curve from below– Or where P =MCOr where P =MC

Firm should continue to increase Firm should continue to increase output as long as p=MR>MCoutput as long as p=MR>MC

Requires no new concepts or Requires no new concepts or techniquestechniques

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Figure 2b: Profit Maximization Figure 2b: Profit Maximization Find MR =MC from belowFind MR =MC from below

MC

$400 D = MR

Ounces of Gold per Day

Dollars

1 2 3 4 5 6 7 8 9 10

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Measuring Total Profit GraphicallyMeasuring Total Profit Graphically

How to measure profit or loss?How to measure profit or loss?1.1. Find the optimal output level Q* Find the optimal output level Q*

from profit maximizationfrom profit maximization– P =MC or using TR & TC methodP =MC or using TR & TC method

2.2. At Q* , find the ATC, unit cost for At Q* , find the ATC, unit cost for producing that amount of outputsproducing that amount of outputs

3.3. Pointing out the difference Pointing out the difference between P and ATC along the between P and ATC along the vertical axisvertical axis

4.4. The area (P-ATC) X Q* is The area (P-ATC) X Q* is – Profit if P>ATCProfit if P>ATC– Loss if P<ATCLoss if P<ATC

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Figure 3a: Measuring Profit if P Figure 3a: Measuring Profit if P > ATC> ATC

$400300

Profit per Ounce ($100)

d = MR

MC

ATC

Economic Profit

Ounces of Gold per Day

Dollars

1 2 3 4 5 6 7 8

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Figure 3b: Measuring Loss if P < ATCFigure 3b: Measuring Loss if P < ATC

MC

ATC

d = MR$300

200

Loss per Ounce ($100)

Economic Loss

Ounces of Gold per Day

Dollars

1 2 3 4 5 6 7 8

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The Firm’s Short-Run Supply CurveThe Firm’s Short-Run Supply Curve

A competitive firm is a price takerA competitive firm is a price taker– Then decides how much output it will Then decides how much output it will

produce at that priceproduce at that price– Whenever the market price is set at a Whenever the market price is set at a

new level, the best output level will be new level, the best output level will be determined by firms, using the MR and determined by firms, using the MR and MC approachMC approach

– ExceptionExceptionIf the firm is suffering a loss large enough to If the firm is suffering a loss large enough to justify shutting down, it will not produce justify shutting down, it will not produce along its MC curvealong its MC curve

– Zero output produced insteadZero output produced instead

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Figure 4: Short-Run Supply Under Perfect Figure 4: Short-Run Supply Under Perfect CompetitionCompetition

0.50

1,0002,000

4,0005,000

7,000

1.00

2.00

$3.50

2.50

MCATC

d1=MR1

AVC

(a)

Firm's Supply Curve

0.50

2,0004,000

5,000

7,000

1.00

2.00

$3.50

2.50

(b)

d2=MR2

d3=MR3

d4=MR4

d5=MR5

Bushels per Year

Dollars Price per Bushel

Bushels per Year

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The Shutdown Price and Supply CurveThe Shutdown Price and Supply Curve

Shutdown price is the price at which a Shutdown price is the price at which a firm is indifferent between producing firm is indifferent between producing and shutting downand shutting down

Supply curve has two partsSupply curve has two parts– Whenever P>AVC, supply curve coincides Whenever P>AVC, supply curve coincides

with MC curvewith MC curve– Whenever P<AVC, firm will shut downWhenever P<AVC, firm will shut down

A vertical line segment at zero units of outputA vertical line segment at zero units of output

Figure 4: For all prices below $1—the Figure 4: For all prices below $1—the shutdown price—output is zero and the shutdown price—output is zero and the supply curve coincides with vertical axissupply curve coincides with vertical axis

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The (Short-Run) Market Supply CurveThe (Short-Run) Market Supply Curve

The shut run market supply curve is The shut run market supply curve is obtained from the aggregation of obtained from the aggregation of individual firm’s supply curveindividual firm’s supply curve– summing quantities of output supplied summing quantities of output supplied

by all firms in market at each priceby all firms in market at each price

As we move along the market supply As we move along the market supply curve, we are assuming that two curve, we are assuming that two things are constantthings are constant– Fixed inputs of each firmFixed inputs of each firm– Number of firms in marketNumber of firms in market

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Figure 5: Deriving The Market Supply CurveFigure 5: Deriving The Market Supply Curve

0.501.00

2.00

$3.50

2.50

Market Supply Curve

200,000400,000

500,000700,000

Firm's Supply Curve

0.50

2,000 4,0005,000

7,000

1.00

2.00

$3.50

2.50

1. At each price . . .3.The total supplied by all firms at different

prices is the market supply curve.

Firm Market

Bushels per Year

Price per Bushel

Price per Bushel

Bushels per Year

2. the typical firm supplies the profit-maximizing quantity.

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SummarySummary– 3 Requirements for perfect competition3 Requirements for perfect competition

many sellers and buyersmany sellers and buyers standardized productsstandardized products free entry and exitfree entry and exit

– Demand curve for a competitive firm is Demand curve for a competitive firm is perfect elastic (horizontal line)perfect elastic (horizontal line)

MR = PMR = P– Supply curve for a competitive firm is discreteSupply curve for a competitive firm is discrete

is MC when P> AVCis MC when P> AVC is zero when P<AVCis zero when P<AVC

– 2 approaches to maximize profit by choosing 2 approaches to maximize profit by choosing output leveloutput level

Maximized difference between TR and TC Maximized difference between TR and TC MR = MCMR = MC

– Profit can be measured using graphsProfit can be measured using graphs