Lecture 11 market structure- perfect competition

Chapter 8

Profit Maximization and Competitive Supply

©2005 Pearson Education, Inc.

Staples and Office Depot Merger

1997, Staples and Office Depot wanted to merge

FTC analyzed the effect of proposed merger on consumers.

What would the decision be based on?


Coca Cola Inc.


Coca Cola Inc.

Coca Cola is reviewing price of Coke.

What should it expect revenue to be if it increased its price?


MARKET STRUCTURE

Chapter 8 5


MARKET STRUCTURE

What determines concentration in a market?

Number of firms?

Number of firms is a good indicator if firms are homogeneous

Chapter 8 6


SEARCH ENGINES:

: 64.1%

: 18.0%

: 13.6%

Chapter 8 7


SODA COMPANIES

: 41.2% : 15.4%

: 33.6%

Chapter 8 8


Satellite TV Providers

Chapter 8 9


MEASURING MARKET CONCENTRATION

Chapter 8 10


CONCENTRATION INDEX

Measure ability of firms to raise price above competitive level.

Higher concentration index, greater likely hood to collude

Chapter 8 11


CONCENTRATION RATIO

m- Firm Concentration Ratio

Sum total of share of total industry sales accounted by m largest firms

Chapter 8 12


m-Firm Concentration RatioFirm Industry X Industry Y1 20 60

2 20 10

3 20 5

4 20 5

5 20 5

Total 100 85

Chapter 8 13


m-Firm Concentration Ratio% of total industry o/p

Chapter 8 14

Number of Firms

60

80

1 4

Y

X


INDUSTRY CLASSIFICATION

US Bureau of Census has a classification of industries : Standard Industrial Classification

Number classification where each succeeding number represents a finer classification

Chapter 8 15


INDIAN INDUSTRY CLASSIFICATION

National Sample Survey Organization classifies industries in India in a similar fashion.

National Industrial Classification

5 Digit Index

Chapter 8 16


National Industry ClassificationSection: e.g. Section C: ManufacturingDivision: e.g. 13, Manufacturing textilesGroup: e.g. 131, Spinning, weaving and

finishing of textilesClass: e.g. 1311, Preparation and Spinning

of textilesSub-Class: e.g. 13111 Preparation and

spinning of cotton fibre including blended cotton

Chapter 8 17



2 20 10

3 20 5

4 20 5

5 20 5

Total 100 85

Chapter 8 18


Herfindahl and Hirschman Index

Weighted average of market shares of firms

An industry with only one firm will have HHI index of 10,000

As number of firms increases HHI decreases

Chapter 8 19

21 iN

i SHHI



2 20 10

3 20 5

4 20 5

5 20 5

Total 100 85

Chapter 8 20


Herfindahl and Hirschman Index

HHI for Industry X= 2,000

HHI for Industry Y = 3,850

Chapter 8 21


TYPES OF MARKET STRUCTURE

Chapter 8 22


TYPES OF MARKET STRUCTURE

PERFECT COMPETITION

MONOPOLYOLIGOPOLY

Chapter 8 23


PERFECT COMPETITION

Chapter 8 24

©2005 Pearson Education, Inc. Chapter 8 25

ASSUMPTIONS OF PERFECT COMPETITION

1. Price taking

2. Product homogeneity

3. Free entry and exit


Perfectly Competitive Markets

1. Price Taking The individual firm sells a very small share

of the total market output and, therefore, cannot influence market price

Each firm takes market price as given – price taker

The individual consumer buys too small a share of industry output to have any impact on market price



2. Product Homogeneity The products of all firms are perfect

substitutes Product quality is relatively similar as well

as other product characteristics Agricultural products, oil, copper, iron,

lumber Heterogeneous products, such as brand

names, can charge higher prices because they are perceived as better



3. Free Entry and Exit When there are no special costs that make

it difficult for a firm to enter (or exit) an industry

Buyers can easily switch from one supplier to another

Suppliers can easily enter or exit a market Pharmaceutical companies are not perfectly

competitive because of the large costs of R&D required


When are Markets Competitive?

Few real products are perfectly competitive

Many markets are, however, highly competitiveThey face relatively low entry and exit costsHighly elastic demand curves

No rule of thumb to determine whether a market is close to perfectly competitiveDepends on how they behave in situations


Do firms maximize profits?

Managers in firms may be concerned with other objectives

Revenue maximizationRevenue growthDividend maximizationShort-run profit maximization (due to bonus or

promotion incentive) Could be at expense of long run profits


Profit Maximization

Implications of non-profit objectiveOver the long run, investors would not

support the companyWithout profits, survival is unlikely in

competitive industriesManagers have constrained freedom to

pursue goals other than long-run profit maximization


OPTIMAL OUTPUT

Chapter 8 32


Marginal Revenue, Marginal Cost, and Profit Maximization

We can study profit maximizing output for any firm, whether perfectly competitive or notProfit () = Total Revenue - Total CostIf q is output of the firm, then total revenue is

price of the good times quantityTotal Revenue (R) = Pq



Costs of production depends on outputTotal Cost (C) = C(q)

Profit for the firm, , is difference between revenue and costs

)()()( qCqRq



Firm selects output to maximize the difference between revenue and cost

We can graph the total revenue and total cost curves to show maximizing profits for the firm

Distance between revenues and costs show profits


Profit Maximization – Short Run

0

Cost,Revenue,

Profit($s per

year)

Output

C(q)

R(q)A

B

(q)q0 q*

Profits are maximized where MR (slope at A) and MC (slope at B) are equal

Profits are maximized where R(q) – C(q) is maximized



Slope of the revenue curve is the marginal revenueChange in revenue resulting from a one-unit increase

in output

Slope of the total cost curve is marginal costAdditional cost of producing an additional unit of

output


Marginal Revenue, Marginal Cost, and Profit MaximizationProfit is negative to begin with, since revenue is

not large enough to cover fixed and variable costs

As output rises, revenue rises faster than costs increasing profit

Profit increases until it is maxed at q*

Profit is maximized where MR = MC or where slopes of the R(q) and C(q) curves are equal



Profit is maximized at the point at which an additional increment to output leaves profit unchanged

MCMRMCMR

qC

qR

q

CR

0

0


The Competitive Firm

d$4

Output (bushels)

Price$ per bushel

100 200

Firm Industry

D

$4

S

Price$ per bushel

Output (millions of bushels)

100



Demand curve faced by an individual firm is a horizontal lineFirm’s sales have no effect on market price

Demand curve faced by whole market is downward slopingShows amount of goods all consumers will

purchase at different prices



The competitive firm’s demandIndividual producer sells all units for $4

regardless of that producer’s level of outputMR = P with the horizontal demand curveFor a perfectly competitive firm, profit

maximizing output occurs when

ARPMRqMC )(


SHORT RUN OPTIMAL OUTPUT

Chapter 8 43


Choosing Output: Short Run

In the short run, capital is fixed and firm must choose levels of variable inputs to maximize profits

We can look at the graph of MR, MC, ATC and AVC to determine profits


q2

A Competitive Firm

10

20

30

40

Price50

MC

AVC

ATC

0 1 2 3 4 5 6 7 8 9 10 11Outputq*

AR=MR=PA

q1 : MR > MCq2: MC > MRq*: MC = MR

q1

Lost Profit for q2>q*Lost Profit

for q2>q*


Choosing Output: Short Run

The point where MR = MC, the profit maximizing output is chosen

MR = MC at quantity, q*, of 8At a quantity less than 8, MR > MC, so more

profit can be gained by increasing outputAt a quantity greater than 8, MC > MR,

increasing output will decrease profits


A Competitive Firm – Positive Profits

10

20

30

40

Price50

0 1 2 3 4 5 6 7 8 9 10 11Outputq2

MC

AVC

ATC

q*

AR=MR=PA

q1

D

C B Profits are determined

by output per unit times quantity

Profit per unit = P-AC(q) = A to B

Total Profit = ABCD


PROFITS AND LOSSES

Chapter 8 48



A firm does not have to make profitsIt is possible a firm will incur losses if the

P < AC for the profit maximizing quantity

Still measured by profit per unit times quantity

Profit per unit is negative (P – AC < 0)


A Competitive Firm – Losses

Price

Output

MC

AVC

ATC

P = MRD

At q*: MR = MC and P < ATCLosses = (P- AC) x q* or ABCD

q*

A

BC


Choosing Output in the Short Run

Summary of Production Decisions

Profit is maximized when MC = MRIf P > ATC the firm is making profitsIf P < ATC the firm is making losses


SHUTDOWN OUTPUT

Chapter 8 52


Short Run Production

Why would a firm produce at a loss?Might think price will increase in near futureShutting down and starting up could be

costlyFirm has two choices in short run

Continue producingShut down temporarilyWill compare profitability of both choices


Short Run Production

When should the firm shut down?

If AVC < P < ATC, the firm should continue producing in the short run

Can cover all of its variable costs and some of its fixed costs

If AVC > P < ATC, the firm should shut downCannot cover its variable costs or any of its

fixed costs


A Competitive Firm – LossesPrice

Output

P < ATC but AVC so

firm will continue to produce in short run

MC

AVC

ATC

P = MRD

q*

A

BC

Losses

EF


SHORT RUN SUPPLY CURVE

Chapter 8 56


Competitive Firm – Short Run Supply

Supply curve tells how much output will be produced at different prices

Competitive firms determine quantity to produce where P = MCFirm shuts down when P < AVC

Competitive firms’ supply curve is portion of the marginal cost curve above the AVC curve


A Competitive Firm’sShort-Run Supply Curve

Price($ per

unit)

Output

MC

AVC

ATC

P = AVC

P2

q2

The firm chooses theoutput level where P = MR = MC,

as long as P > AVC.

P1

q1

S

Supply is MC above AVC



Supply is upward sloping due to diminishing returns


CHANGE IN COSTS AND SUPPLY CURVE

Chapter 8 60



Over time, prices of product and inputs can change

How does the firm’s output change in response to a change in the price of an input?We can show an increase in marginal costs

and the change in the firm’s output decisions


MC2

q2

Input cost increases and MC shifts to MC2

and q falls to q2.

MC1

q1

The Response of a Firm toa Change in Input Price

Price($ per

unit)

Output

$5

Savings to the firmfrom reducing output


MARKET SUPPLY CURVE

Chapter 8 63


Short-Run Market Supply Curve

Shows the amount of product the whole market will produce at given prices

Is the sum of all the individual producers in the market

We can show graphically how we can sum the supply curves of individual producers


MC3

Industry Supply in the Short Run$ perunit

MC1

SThe short-runindustry supply curve

is the horizontalsummation of the supply

curves of the firms.

Q

MC2

15 21

P1

P3

P2

1082 4 75


ELASTICITY OF SUPPLY

Chapter 8 66


Elasticity of Market Supply

Elasticity of Market SupplyMeasures the sensitivity of industry output to

market priceThe percentage change in quantity supplied,

Q, in response to 1-percent change in price

)//()/( PPQQEs


Elasticity of Market SupplyWhen MC increases rapidly in response to

increases in output, elasticity is lowWhen MC increases slowly, supply is relatively

elasticPerfectly inelastic short-run supply arises

when the industry’s plant and equipment are so fully utilized that new plants must be built to achieve greater output

Perfectly elastic short-run supply arises when marginal costs are constant


PRODUCER SURPLUS

Chapter 8 69


Producer Surplus in the Short Run

Price is greater than MC on all but the last unit of output

Therefore, surplus is earned on all but the last unit

The producer surplus is the sum over all units produced of the difference between the market price of the good and the marginal cost of production

Area above supply curve to the market price


ProducerSurplus

Producer surplus is area above MC

to the price

Producer Surplus for a FirmPrice($ per

unit ofoutput)

Output

AVCMC

AB

P

q*

At q* MC = MR.Between 0 and q,

MR > MC for all units.


The Short-Run Market Supply Curve

Sum of MC from 0 to q*, it is the sum of the total variable cost of producing q*

Producer Surplus can be defined as the difference between the firm’s revenue and its total variable cost

We can show this graphically by the rectangle ABCDRevenue (0ABq*) minus variable cost

(0DCq*)


Producer surplus is also ABCD = Revenue minus variable costs

Producer Surplus for a FirmPrice($ per

unit ofoutput)

Output

ProducerSurplus

AVCMC

AB

P

q*

CD


Producer Surplus Versus Profit

Profit is revenue minus total cost (not just variable cost)

When fixed cost is positive, producer surplus is greater than profit

VC- R PS Surplus Producer

FC - VC- R Profit


Producer Surplus Versus Profit

Costs of production determine magnitude of producer surplusHigher cost firms have less producer surplusLower cost firms have more producer surplusAdding up surplus for all producers in the

market given total market producer surplusArea below market price and above supply

curve


D

P*

Q*

ProducerSurplus

Market producer surplus isthe difference between P*

and S from 0 to Q*.

Producer Surplus for a MarketPrice

($ perunit of

output)

Output

S


LONG RUN OUTPUT DECISIONS

Chapter 8 77


Choosing Output in the Long Run

In short run, one or more inputs are fixedDepending on the time, it may limit the

flexibility of the firmIn the long run, a firm can alter all its

inputs, including the size of the plantWe assume free entry and free exit

No legal restrictions or extra costs


q1

BC

AD

In the short run, thefirm is faced with fixedinputs. P = $40 > ATC.

Profit is equal to ABCD.

Output Choice in the Long RunPrice

Output

P = MR$40

SACSMC

q3q2

$30

LAC

LMC



In the short run, a firm faces a horizontal demand curveTake market price as given

The short-run average cost curve (SAC) and short-run marginal cost curve (SMC) are low enough for firm to make positive profits (ABCD)

The long-run average cost curve (LRAC)Economies of scale to q2

Diseconomies of scale after q2


Output Choice in the Long RunPrice

Outputq1

BC

ADP = MR$40

SACSMC

q3q2

$30

LAC

LMCIn the long run, the plant size will be increased and output increased to q3.

Long-run profit, EFGD > short runprofit ABCD.

FG


Long-Run Competitive Equilibrium

For long run equilibrium, firms must have no desire to enter or leave the industry

We can relate economic profit to the incentive to enter and exit the market



Zero-ProfitA firm is earning a normal return on its

investmentDoing as well as it could by investing its

money elsewhereNormal return is firm’s opportunity cost of

using money to buy capital instead of investing elsewhere

Competitive market long run equilibrium



Entry and ExitThe long-run response to short-run profits is

to increase output and profitsProfits will attract other producersMore producers increase industry supply,

which lowers the market priceThis continues until there are no more profits

to be gained in the market – zero economic profits


Long-Run Competitive Equilibrium – Profits

S1

Output Output

$ per unit ofoutput

$ per unit ofoutput

LAC

LMC

D

S2

$40 P1

Q1

Firm Industry

Q2

P2

q2

$30

• Profit attracts firms• Supply increases until profit = 0


Long-Run Competitive Equilibrium – Losses

S2

Output Output

$ per unit ofoutput

$ per unit ofoutput

LAC

LMC

D

S1

P2

Q2

Firm Industry

Q1

P1

q2

$20

$30

• Losses cause firms to leave• Supply decreases until profit = 0



1. All firms in industry are maximizing profits MR = MC

2. No firm has incentive to enter or exit industry Earning zero economic profits

3. Market is in equilibrium QD = QS



Economic RentThe difference between what firms are willing

to pay for an input less the minimum amount necessary to obtain it

When some have accounting profits that are larger than others, they still earn zero economic profits because of the willingness of other firms to use the factors of production that are in limited supply



An ExampleTwo firms A & B that both own their landA is located on a river which lowers A’s

shipping cost by $10,000 compared to BThe demand for A’s river location will

increase the price of A’s land to $10,000 = economic rent

Although economic rent has increased, economic profit has become zero


Firms Earn Zero Profit inLong-Run EquilibriumTicketPrice

Season TicketsSales (millions)

$7

1.0

A baseball teamin a moderate-sized city

sells enough tickets so that price is equal to marginal

and average cost(profit = 0).

LACLMC


1.3

$10

Economic Rent

TicketPrice

$7.20 A team with the samecost in a larger citysells tickets for $10.

Firms Earn Zero Profit inLong-Run Equilibrium

Season TicketsSales (millions)

LACLMC



With a fixed input such as a unique location, the difference between the cost of production (LAC = 7) and price ($10) is the value or opportunity cost of the input (location) and represents the economic rent from the input



If the opportunity cost of the input (rent) is not taken into consideration, it may appear that economic profits exist in the long run

Lecture 11 market structure- perfect competition

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