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Competitive Markets
Lesson 9

 

Pure Competitive

  1. Purely Competitive Firms - accepts the market price in order to sell their products. They are also called price takers.
    • Characteristics:
      • All firms produce an identical product (homogeneous).
        • Consumers do not care where they buy the product
      • Many sellers and buyers are in the market
        • Each firm supplies only a small portion to the market
        • One firm or buyer cannot influence the price of the market
      • No barriers to entry or exit exist
        • Example: If one firm earns economic profit, then rival firms can easily enter the market and try to earn profits
        • If firms are earning a loss, then some firms will leave the market
        • Economic profits are driven to zero as firms enter / leave a market
      • The firms maximize profit by adjusting production level, but cannot influence market price.
  2. Why study price takers?
    • Understand why competition is important
    • Clarifies differences between price-takers and other firm types
    • Agricultural markets, retail, some service markets, and stock markets tend to be price takers

Output in the Short Run

1. Marginal Revenue (MR) - is the change in total revenue when output increases by one unit.

  • Refer to graph
  • The farmer only sees the market price.
    • If the farmer sells 1 bushel, he receives $2 (MR). The farmer sells another bushel, he receives another $2 (MR)
    • If the farmer raises his price of corn above the market price, then nobody buys it.
      • Consumers buy the bushel from competitors for $2
    • If the farmer sells his corn below the market price, then he lowers his revenue (loses money)
    • Thus, he can sell all his corn at the market price, so MR = P* = $2.
Price Taker's Demand Curve
A Farmer The Market
Price Price
Demand for a farmer's product A market
Quantity Quantity

2. Profit maximization - the price taker will expand output in the short run until:

P* = MR = MC

Note: The market price is P* and marginal cost is MC. Further, the MR = MC maximizes profits for monopolies, oligopolies, and monopolistically competitive firms, while MR = P* is only valid for price takers.

Blue arrow This rule maximize the firm's profits (or minimize its losses)

Example: If MR = $3 and MC = $2. MR > MC, the firm will collect $3 for selling that last "additional" unit that only costs $2 to produce. Profit increases by $1.

If MR = $3 and MC = $5. MR < MC, the firm will collect $3 for selling that last unit that costs $5 to produce. The firm should reduce production by 1 unit to increase profits.

  • Price takers earn profits by maximizing total revenue (TR) and minimizing total costs(TC)
    • Total Revenue (TR) = P * q
    • Profits = TR - TC
    • Taking vertical slices (adjusting output q) until TR -TC is maximized, which is shown below:
Firm
Price / Per-unit costs
A firm is maximizing profits
The point where profit is maximized is at the production level q when MC = MR = P*
A firm is maximizing profits
Quantity
  • Using the marginal cost, market price, and average total cost, we can show a competitive firm earning a profit.
    • Firm earns a profit when Market Price > ATC
    • The "green" rectangle is firm's profit
  • The derivation is:

Profit = Total Revenue - Total Cost

Profit = P q - ATC q = (P - ATC) q

Firm
Price / Per-unit costs
A firm is maximizing profits
Quantity

3. Losses and going out of business.

  • Short-run.
    • A firm experiencing losses, but covering its average variable costs, will operate in the short run
    • Example: AVC = $10 per product, AFC = $10, and the firm produces where MR = MC.
      • Competitive market: P* = MR
        • If P* = $5; firm cannot cover its variable costs, so it shuts down; it still pays its fixed costs
        • If P* = $10; firm covers its variable costs, but earns a loss
        • If P* = $15; firm still earns a loss, but also covers some of its fixed costs
        • If P* = $20; firm breaks even
        • If P* > $20; firm earns an economic profit
    • Shutdown - temporary halt in the production or operation of a business.
      • A firm shuts down when P* < AVC
      • The firm still pays fixed costs during the shutdown.
      • Motels, restaurants, and theme parks shutdown during off seasons
  • Long-run.
    • A firm will "go out of business" in the long run whenever P < ATC.
    • Going out of business - firm permanently exits the market and avoids paying fixed costs.
      • If P = $0.25 for a generic soda and the ATC = $0.50
      • This firm cannot continue to operate for a long time with losses.
  A Firm
  Price / Per-unit costs
Firm produces quantity q where
MC = MR = P

ATC > Market Price, the firm is earning a loss or profit is negative.

Profit = Total Revenue - Total Cost

Profit = P q - ATC q

The loss = "The red area"

A firm is earning a loss
  Quantity

4. A firm maximizes profits when it produces at P* = MC. A firm's short-run supply curve is its marginal cost curve above average variable cost. Firm produces if the market price exceeds its average variable costs.

Law of Supply - as the price of a product increases, firms will increase quantity supplied.

A Firm's Cost Curves A Firm's Supply Curves
Price / Per-unit costs Price / Per-unit costs
A firm's average cost curves A firm's supply function
Quantity Quantity

 

Output Adjustments in the Long Run

  • In the long-run, firms earn zero economic profit
    • A normal rate of return, i.e. accounting profit
  • If P* > ATC, firms earn an economic profit
    • New firms enter the market
    • SR Supply increases while the price decreases until it equals P = ATC
    • Economic profit = 0
  • If P* < ATC, firms earn a loss
    • Some firms leave the market
    • SR supply decreases, while the price increases until it equals P = ATC
    • Economic profit = 0
  • Long-run equilibrium
    • The market determines the price and quantity of milk
      • P* = $2 and market quantity = 10 (thousand)
    • Each firm supplies q quantity of milk
      • Earn zero economic profit
      • P* = ATC = $2
A Milk Firm's Long-Run Cost Curve The Milk Market
Price / Per-unit costs Price / Per-unit costs
A firm is earning zero economic profits A market for milk
Quantity Quantity (in thousands)
  • Example: The U.S. Gov. says drinking milk does the body good
    • Consumers start buying more milk (tastes and preferences)
      • The demand curve shifts right.
        • New market price is P2
        • Quantity supplied and sold is Q2
    • Firms expand output to q2
      • Earn economic profits (P2 > ATC)
    • Long-run equilibrium
      • New firms enter the milk market
      • Short-run supply increases
      • Price decreases, until P1 = ATC again
    • Result:
      • Same market price, P1
      • More milk produced and sold, Q3
      • More firms are in the market and all earn zero economic profit
A Milk Firm's Long Run Cost Curve The Milk Market
Price / Per-unit costs Price / Per-unit costs
A firm's average cost functions A firm's long-run supply curve
Quantity Quantity
  • Economic losses and exit
  • Example: Consumers' income increases and rice is an inferior product
    • The original demand & supply curves are D1 & S1
    • Demand curve shifts left.
      • New market price is P2
      • Quantity supplied and sold is Q2
    • Firms contract output to q2
      • Earn economic losses (P2 < ATC)
    • Long-run equilibrium
      • Some firms leave the rice market
      • Short-run supply decreases
      • Price increases, until P1 = ATC again
    • Result:
      • Same market price, P1
      • Less rice produced and sold, Q3
      • Less firms are in the market and all earn zero economic profit
A Firm Producing Rice The Rice Market
Price / Per-unit costs Price / Per-unit costs
A firm's average cost functions A firm's long-run supply curve
Quantity Quantity

Long run supply - the minimum price which firms will supply various production levels when all factors of production can be adjusted. The long-run supply is the black lines in the milk and rice markets

  1. Constant-cost industry - industry were resource prices remain unchanged as market output is expanded
    • Long-run market supply curve is horizontal (perfectly elastic)
    • Illustrated above in milk and rice markets
    • An expanding/contracting industry has no impact on the resource markets, because it is a small industry
  2. Increasing-cost industry - industry were factor prices rise as market output is expanded
    • Long-run market supply curve is upward-sloping
    • Most common type of industry
    • Example: If automobile factory expands production, then resource prices will increase: skilled labor, steel, plastics, etc.
  3. Decreasing-cost industry - industry were factor prices decline as market output is expanded
    • Long-run market supply curve is downward-sloping
    • Rare type of industry
    • Example: Electronic industry. As more and more transistors are etched onto chips, then cost of chips, computers, etc. keep decreasing
Automobile Firm - Increasing Costs Computer Chip Firm - Decreasing Costs
Price Price
An increasing long-run supply curve A decreasing long-run supply curve
Quantity Quantity

P1 and Q1 are the original demand and supply curves for both markets. Consumer demand more cars and electronics, because of higher incomes. The new market price is P2. Both industries earn economic profits, which cause them to expand.

Blue arrow As car industry expands, the resource prices increase (skilled labor, steel, etc.), causing the long-run price and quantity to be P3 and Q3.

As the electronic industry expands, the resources prices decrease (computer chips), causing long-run price and quantity to be P3 and Q3.

Competitive Process and Role of Profits

  • Profit is a reward for increasing the value of resources.
    • total revenue (consumers' valuation) > total costs (firm's costs of resources).
      • Minimize costs
      • Operate efficiently
      • Innovate
      • Weeds out inefficient firms
      • Satisfy consumers
  • Losses are a penalty imposed on firms that reduce the value of resources.
    • Firm will either leave the market, restructure, or bankrupt.
  • Competitive market is efficient
    • Allocative efficiency - businesses transfer resources to profitable industries that consumers want
      • P* = MC
    • Productive efficiency - businesses produce products for the lowest price
      • P* = min ATC
    • Social welfare is maximized
      • Consumer plus producer welfares are maximized
  • New products
    • Microwave ovens
    • Personal computers
    • DVDs / Blue Ray
Blue arrow Competitive markets and profits create wealth and direct resources to produce highly-valued goods.

Terminology

  • purely competitive firms
  • price taker
  • total revenue
  • marginal revenue
  • break-even point
  • P* = MR=MC
  • shutdown
  • going out of business
  • Law of Supply
  • short-run supply curve
  • long-run supply curve
  • constant-cost industry
  • increasing-cost industry
  • decreasing-cost industry
  • productive efficiency
  • allocative efficiency
 

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