1. Market Structure and Perfect Competitive Firm Hall and Lieberman, 3 rd edition, Thomson South-Western, Chapter 8

2. 2 Overview What you will learn from this lecture – Market structure – 3 Requirements for perfect competition –Demand curve for a competitive firm –Supply curve for a competitive firm –How is the profit is maximized? At which output level? –How is profit or loss is measured using graphs? –Short Run Equilibrium –Long Run Equilibrium –Perfect Competition and Plant Size in the long run –What happens when things change?

3. 3 Part I Market Structure Sellers want to sell at the highest possible price –Buyers seek lowest possible price –All trade is voluntary –different goods and services are sold in vastly different ways Economists think about market structure –Characteristics of a market that influence behavior of buyers and sellers when they come together to trade

4. 4 Types of Market For any particular market, we ask –How many buyers and sellers are there in the market? –Is each seller offering a standardized product, more or less indistinguishable from that offered by other sellers? –Are there any barriers to entry or exit, or can outsiders easily enter and leave this market? Four basic types of market –Perfect competition –Monopoly –Monopolistic competition –Oligopoly

5. 5 Part II. The Three Requirements of Perfect Competition Large numbers of buyers and sellers –Each buys or sells only a tiny fraction of the total quantity in the market Sellers offer a standardized product Sellers can easily enter into or exit from market –Significant barriers to entry and exit can completely change the environment in which trading takes place Examples?

6. 6 i. A Large Number of Buyers and Sellers In perfect competition, there must be many buyers and sellers –How many? Number must be so large that no individual decision maker can significantly affect price of the product by changing quantity it buys or sells

7. 7 ii. Selling Standardized Products Buyers do not perceive significant differences between products of one seller and another –For instance, buyers of wheat do not prefer one farmer ’ s wheat over another

8. 8 iii. Easy Entry into and Exit from the Market Easy Entry –no significant barriers to discourage new entrants –any firm wishing to enter can do business on the same terms as firms that are already there Easy exit –A firm suffering a long-run loss must be able to sell off its plant and equipment and leave the industry for good, without obstacles

9. 9 iii. Easy Entry into and Exit from the Market In many markets there are significant barriers to entry –Legal barriers –Existing sellers have an important advantage that new entrants can not duplicate Brand loyalty –Cost advantage of existing firms from significant economies of scale

10. 10 Is Perfect Competition Realistic? Assumptions are rather restrictive In reality, one or more of assumptions will be violated in vast majority of markets –Yet economists use perfect competition more often than any other market structure Why? –Model of perfect competition is powerful –Many markets come reasonably close to be perfect competitive Perfect competition can approximate conditions and yield accurate-enough predictions in a wide variety of markets

11. 11 Even if conditions for perfectly competitive markets are not satisfied … Assumptions are close enough for predictions of –Firm entry or exit –Price increase or decrease –Increase or decrease in industry quantity –Increase or decrease in firm quantity

12. 12 Part III. The Perfectly Competitive Firm What is occurring in a competitive market is quite different from the view we get when looking at a perfect competitive firm. –entirely different picture In learning about competitive firm, must also discuss competitive market in which it operates

13. 13 Figure 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

14. 14 Goals and Constraints Perfectly competitive firm faces a cost constraint when producing any given level of output –Firm ’ s production technology –Prices it must pay for its inputs Cost function for a perfectly competitive firm is standard

15. 15 The Demand Curve Facing a Perfectly Competitive Firm Demand curve is horizontal, or infinitely price elastic Why? –Output is standardized –No matter how much a firm decides to produce, it cannot make a noticeable difference in market quantity supplied So cannot affect market price –Firm is a price taker Treats the price of its output as given and beyond its control Its only decision is how much output to produce and sell

16. 16 Cost and Revenue MR at each quantity is the same as the market price – MR = Price –marginal revenue curve and demand curve facing firm are the same –A horizontal line at the market price

17. 17 Profit Maximization: The Total Revenue and Total Cost Approach Firm ’ s profit per unit –( Revenue per unit ) – ( cost per unit )  profit per unit = P – ATC Total Profit = TR – TC=Q(P-ATC) TR and TC approach –Pick out the output level where there is biggest difference between TR and TC –Most direct way of viewing firm ’ s search for the profit-maximizing output level

18. 18 Figure 2a: Profit Maximization: find greatest TR - TC TR 550 $2,800 2,100 TC Slope = 400 Ounces of Gold per Day Dollars 12345678910 Maximum Profit per Day = $700

19. 19 Profit Maximization: The Marginal Revenue and Marginal Cost Approach Profit-maximizing output is found where MC curve crosses MR curve from below –Or where P =MC Firm should continue to increase output as long as p=MR>MC

20. 20 Figure 2b: Profit Maximization Find MR =MC from below MC $400 D = MR Ounces of Gold per Day Dollars 12345678910

21. 21 Measuring Total Profit Graphically How to measure profit or loss? 1.Find the optimal output level Q* from profit maximization –MR =MC or using TR & TC method 2.At Q*, find the ATC, unit cost for producing that amount of outputs 3.Pointing out the difference between P and ATC along the vertical axis 4.The area (P-ATC) X Q* is –Profit if P>ATC –Loss if P<ATC

22. 22 Figure 3a: Measuring Profit if P > ATC $400 300 Profit per Ounce ($100) d = MR MC ATC Economic Profit Ounces of Gold per Day Dollars 12345678

23. 23 Figure 3b: Measuring Loss if P < ATC MC ATC d = MR $300 200 Loss per Ounce ($100) Economic Loss Ounces of Gold per Day Dollars 12345678

24. 24 The Firm’s Short-Run Supply Curve A competitive firm is a price taker –Then decides how much output it will produce at that price –Whenever the market price is set at a new level, the best output level will be determined by firms, using the MR and MC approach –Exception If the firm is suffering a loss large enough to justify shutting down, it will not produce along its MC curve –Zero output produced instead

25. 25 Figure 4: Short-Run Supply Under Perfect Competition 0.50 1,000 2,000 4,000 5,000 7,000 1.00 2.00 $3.50 2.50 MC ATC d 1 =MR 1 AVC (a) Firm's Supply Curve 0.50 2,0004,000 5,000 7,000 1.00 2.00 $3.50 2.50 (b) d 2 =MR 2 d 3 =MR 3 d 4 =MR 4 d 5 =MR 5 Bushels per Year Dollars Price per Bushel Bushels per Year

26. 26 The Shutdown Price and Supply Curve Shutdown price is the price at which a firm is indifferent between producing and shutting down Supply curve has two parts –Whenever P>AVC, supply curve coincides with MC curve –Whenever P<AVC, firm will shut down A vertical line segment at zero units of output Figure 4: For all prices below $1 — the shutdown price — output is zero and the supply curve coincides with vertical axis

27. 27 The (Short-Run) Market Supply Curve The shut run market supply curve is obtained from the aggregation of individual firm ’ s supply curve –summing quantities of output supplied by all firms in market at each price As we move along the market supply curve, we are assuming that two things are constant –Fixed inputs of each firm –Number of firms in market

28. 28 Figure 5: Deriving The Market Supply Curve 0.50 1.00 2.00 $3.50 2.50 Market Supply Curve 200,000 400,000 500,000 700,000 Firm's Supply Curve 0.50 2,0004,000 5,000 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 Bushels per Year 2.the typical firm supplies the profit-maximizing quantity.

29. 29 Figure 6: Perfect Competition Quantity Demanded at Different Prices Quantity Supplied at Different Prices Quantity Supplied by Each Firm Quantity Demanded by Each Consumer Individual Demand Curve Individual Supply Curve Quantity Demanded by All Consumers at Different Prices Quantity Supplied by All Firms at Different Prices Market Demand Curve Market Supply Curve P S D Q Market Equilibrium Added together

30. 30 Part IV. Short-Run Equilibrium In perfect competition, market sums buying and selling preferences of individual consumers and producers, and determines market price –Each buyer and seller then takes market price as given –Each is able to buy or sell desired quantity Competitive firms can earn an economic profit or suffer an economic loss –Example: Figure 2

31. Figure 7 Short-run Profit Maximization 10 firms each producing 100 units Short-run equilibrium conditions met (K fixed) FirmIndustry PP q Q D S MC ATC P0P0 P0P0 1000100

32. But firm is making positive economic profit : Long Run equilibrium? Incentive for entry or exit? FirmIndustry PP q Q D S MC ATC P0P0 P0P0 1000100 Profit>0

33. Part V. Long-run equilibrium conditions Short-run Firm: Price = Marginal Cost: Firms maximize profits Industry: supply = demand Long-run Firm: Price = ATC: Zero economic profit No incentive to enter or exit

34. 34 Profit and Loss in the Long Run Economic profit and loss are the forces driving long-run change –Entry of outsiders if expecting continued economic profit –Exit of insiders if expecting losses In real world entry and exit occur literally every day In some cases, we see entry occur through formation of an entirely new firm or occur when an existing firm adds a new product to its line Exit can occur in different ways –Selling off its assets and freeing itself once and for all from all costs –Switches out of a particular product line, even as it continues to produce other things

35. Figure 8 Positive Economic Profit Invites Entry in the Long-run and Causes Industry Supply to Rise FirmIndustry PP q Q D S MC ATC P0P0 P0P0 1000100 P1P1 P1P1 S’ 901080

36. Long-run equilibrium Number of firms rises to12 firms = 1080/90 P = ATC FirmIndustry PP q Q D S MC ATC P0P0 P0P0 1000100 P1P1 P1P1 S’ 901080

37. 37 From Short-Run Profit to Long-Run Equilibrium -- start with profit in the short run Positive economic profit will attract new entrants  Increasing number of firms in market  As number of firms increases, market supply curve will shift rightward causing several things to happen 1.Market price falls 2.Then demand curve facing each firm shifts downward 3.Each then slide down its marginal cost curve, decreasing output

38. 38 From Short-Run Profit to Long-Run Equilibrium -- start with profit in the short run This process of adjustment continues, requiring market supply curve to shift rightward enough, and the price to fall enough Until when the reason for entry — positive profit — no longer exits –So that each existing firm is earning zero economic profit In sum, in a competitive market, positive economic profit continues to attract new entrants until economic profit is reduced to zero

39. Figure 9 : Short-run Profit Maximization 15 firms each producing 80 units Short-run equilibrium conditions met (K fixed) FirmIndustry PP q Q D S MC ATC P0P0 P0P0 120080 AVC

40. Short-run Profit Maximization 15 firms each producing 80 units Short-run equilibrium conditions met (K fixed) FirmIndustry PP q Q D S MC ATC P0P0 P0P0 120080 AVC LOSS

41. FirmIndustry PP q Q D S MC ATC P0P0 P0P0 120080 AVC Negative Economic Profit Induces Exit in the Long-run, Industry Supply Falls Number of firms falls to 12 firms = 1080/90 P1P1 P1P1 S’ 901080

42. 42 From Short-Run Profit to Long-Run Equilibrium -- start with loss in the short run In a competitive market, economic losses continue to cause exit until losses are reduced to zero –Raising market price until typical firm breaks even again

43. 43 Distinguishing Short-Run from Long-Run Outcomes In short-run equilibrium, competitive firms can earn profits or suffer losses In long-run equilibrium, after entry or exit has occurred, economic profit is always zero When economists look at a market, they choose the period more appropriate for question at hand

44. 44 Figure 10a/b: From Short-Run Profit To Long-Run Equilibrium S1S1 d1d1 ATC MC $4.50 With initial supply curve S 1, market price is $4.50… $4.50 900,0009,000 So each firm earns an economic profit. A A Price per Bushel Market Bushels per Year Dollars Firm Bushels per Year D

45. 45 Figure 10c/d: From Short-Run Profit To Long-Run Equilibrium S1S1 d1d1 ATC MC $4.50 Profit attracts entry, shifting the supply curve rightward… $4.50 900,0009,0005,000 until market price falls to $2.50 and each firm earns zero economic profit. S2S2 d1d1 A A 2.50 E E MarketFirm Price per Bushel Bushels per Year Dollars Bushels per Year D 1,200,000

46. 46 Part VI. The Notion of Zero Profit in Perfect Competition The same forces — entry and exit — that cause all firms to earn zero economic profit also ensure –in long-run equilibrium, every competitive firm will select its plant size and output level so that it operates at minimum point of its LRATC curve

47. 47 Perfect Competition and Plant Size Figure 6 illustrates a firm in a perfectly competitive market –Left panel does not show a true long-run equilibrium In long-run typical firm will want to expand by sliding down its LRATC curve and produce more output at a lower cost per unit –potentially earn an economic profit Same opportunity to earn positive economic profit will attract new entrants that will establish larger plants from the outset Entry and expansion must continue in this market until the price falls to P* where each firm earn zero economic profit

48. 48 Figure 11: Perfect Competition and Plant Size P1P1 q1q1 d 1 = MR 1 LRATC MC 1 ATC 1 E d 2 = MR 2 LRATC MC 2 ATC 2 P* q* 4.and all firms earn zero economic profit and produce at minimum LRATC.. Dollars Output per Period 3.As all firms increase plant size and output, market price falls to its lowest possible level... 1.With its current plant and ATC curve, this firm earns zero economic profit. 2.The firm could earn positive profit with a larger plant, producing here.

49. 49 A Summary of the Competitive Firm in the Long-Run At each competitive firm in long-run equilibrium P = MC = minimum ATC = minimum LRATC This equality is satisfied when the typical firm produces at point E in figure 6 –Where its demand, marginal cost, ATC, and LRATC curves all intersect In perfect competition, consumers are getting the best deal they could possibly get

50. 50 Part IV. What Happens When Things Change? -- 1. A Change in Demand Short-run impact of an increase in demand is –Rise in market price –Rise in market quantity –Economic profits This will cause: –More entrants and higher market supply –Market equilibrium will move from point A to point C Long-run supply curve –indicating quantity of output that all sellers in a market will produce at different prices after all long-run adjustments have taken place

51. 51 Figure 12a/b: An Increasing-Cost Industry INITIAL EQUILIBRIUM D1D1 S1S1 A P1P1 Q1Q1 P1P1 q1q1 MC A ATC 1 d 1 = MR 1 Output per Period Market Dollars Firm Output per Period Price per Unit

52. 52 Figure 12c/d: An Increasing-Cost Industry NEW EQUILIBRIUM MC ATC 1 Dollars Firm P1P1 q1q1 A d 1 = MR 1 Output per Period Market S1S1 Output per Period Price per Unit D1D1 A P1P1 Q1Q1 d SR = MR SR d 2 = MR 2 P2P2 P SR P2P2 ATC 2 C B B C Q SR Q2Q2 q1q1 q SR S2S2 S LR D2D2

53. 53 Increasing Cost Industry This type of industry (which is the most common) is called an increasing cost industry Entry  Increase in demand for inputs  price of those inputs increases –Shifts up typical firm ’ s ATC curve Raises market price at which firms earn zero economic profit As a result, long-run supply curve slopes upward

54. 54 Decreasing and Constant Cost Industries A constant cost industry -- entry has no effect on input prices –Industry might use such a small percentage of total inputs that there is no noticeable effect on input prices –Typical firm ’ s ATC curve stays put Market price at which firms earn zero economic profit does not change Long-run supply curve is horizontal Decreasing cost industry -- entry by new firms actually decreases input prices –Causes typical firm ’ s ATC curve to shift downward –Lowers market price at which firms earn zero economic profit –Long-run supply curve slopes downward

55. 55 Small Summary Increasing Cost Industry Constant Cost Industry Decreasin g Cost Industry Entry effect on input prices Up No effect Down ATC curve Shifts up Stays Shifts down Zero profit market Price Up Not change Down Long-run supply curve Slope upward Horizontal Slope downward

56. 56 Part V. Using the Theory: Changes in Technology Technological advance that results in increasing returns to scale will –Induce some firms to change technologies and produce more –lead to a rightward shift of market supply curve, decreasing market price –In short-run, early adopters may enjoy economic profit –in long-run, more will adopt, economic profit falls to zero –Firms that refuse to use the new technology will not survive –Some technologies are biased toward large firms, others toward smaller firms. If technologies lower minimum efficient scale, more firms will enter as industry price falls

57. 57 Summary –3 Requirements for perfect competition many sellers and buyers many sellers and buyers standardized products standardized products free entry and exit free entry and exit –Demand curve for a competitive firm is perfect elastic (horizontal line) MR = P –Supply curve for a competitive firm is discrete is MC when P> AVC is MC when P> AVC is zero when P<AVC is zero when P<AVC –2 approaches to maximize profit by choosing output level Maximized difference between TR and TC MR = MC –Profit can be measured using graphs –Short run equilibrium: profits or loss –Long run equilibrium: zero economic profits P=marginal cost=minimum ATC=minimum LRATC P=marginal cost=minimum ATC=minimum LRATC