1. Chapter 5&6 Main Lecture on Revenue and Perfect Competition Chapter 5&6 Main Lecture on Revenue and Perfect Competition

2. Revenue We have looked at Production and then Cost so we have analysed a firm’s technical capabilities and the costs of producing output,We have looked at Production and then Cost so we have analysed a firm’s technical capabilities and the costs of producing output, on averageon average and at the margin (one more unit)and at the margin (one more unit) Now we have to examine what the firm earns from producing an additional unitNow we have to examine what the firm earns from producing an additional unit

3. REVENUE …thus we need to define total, average and marginal revenue We start by examining revenue curves when firms are price takers By this we mean that firms are small relative to the total market and that they do not have much influence over the price charged. In such a market if they raise price people will go elsewhere… … and if they reduce price (even if it were profitable) they would not be able to cope with the resultant demand. …thus we need to define total, average and marginal revenue We start by examining revenue curves when firms are price takers By this we mean that firms are small relative to the total market and that they do not have much influence over the price charged. In such a market if they raise price people will go elsewhere… … and if they reduce price (even if it were profitable) they would not be able to cope with the resultant demand.

4. Revenue That is, they perceive the price they can receive as constant.That is, they perceive the price they can receive as constant. So as far as they are concerned the demand curve isSo as far as they are concerned the demand curve is horizontal. That means they believe: They can sell as much as they want at the going price.

5. Deriving a firm’s AR and MR: price-taking firm O O Price (£) AR, MR (£) Q (millions)Q (hundreds) PePe S D (a) The market(b) The firm

6. O O Price (£) AR, MR (£) PePe S D Q (millions)Q (hundreds) (a) The market(b) The firm Deriving a firm’s AR and MR: price-taking firm

7. Total revenue for a price-taking firm TR (£) Quantity (units) 0 200 400 600 800 1000 1200 Price 55555555555555

8. TR (£) Quantity (units) 0 200 400 600 800 1000 1200 Price 55555555555555 TR (£) 0 1000 2000 3000 4000 5000 6000 Total revenue for a price-taking firm

9. TR (£) Quantity (units) 0 200 400 600 800 1000 1200 Price 55555555555555 TR (£) 0 1000 2000 3000 4000 5000 6000 Total revenue for a price-taking firm TR

10. TR (£) Quantity Total revenue for a price-taking firm TR

11. TR (£) Quantity (units) 0 200 400 600 800 1000 1200 Price = AR = MR (£) 55555555555555 TR (£) 0 1000 2000 3000 4000 5000 6000 Total revenue for a price-taking firm AR= TR/Q

12. TR (£) Quantity (units) 0 200 400 600 800 1000 1200 Price = AR = MR (£) 55555555555555 TR (£) 0 1000 2000 3000 4000 5000 6000 Total revenue for a price-taking firm AR= TR/Q 55555555555555

13. TR (£) Quantity (units) 0 200 400 600 800 1000 1200 Price = AR = MR (£) 55555555555555 TR (£) 0 1000 2000 3000 4000 5000 6000 Total revenue for a price-taking firm AR= TR/Q 55555555555555 MR

14. TR (£) Quantity (units) 0 200 400 600 800 1000 1200 Price = AR = MR (£) 55555555555555 TR (£) 0 1000 2000 3000 4000 5000 6000 Total revenue for a price-taking firm AR= TR/Q 55555555555555 MR 55555555555555 £5

15. Mathematics of Revenue: Average Revenue Total Revenue Marginal Revenue When P is constant

16. Price Taking Firms So in conclusion: When a firm is a price taker, MR and AR are constant and equal to the price of the output.So in conclusion: When a firm is a price taker, MR and AR are constant and equal to the price of the output.

17. VERY Short-run equilibrium of industry and firm under perfect competition OO S D (a) Industry P£ Q (millions)

18. VERY Short-run equilibrium of industry and firm under perfect competition OO S D (a) Industry P£ PePe Q (millions)

19. VERY Short-run equilibrium of industry and firm under perfect competition OO S D (a) Industry P£ PePe (b) Firm AR D = AR = MR Q (millions) q (thousands)

20. VERY Short-run equilibrium of industry and firm under perfect competition OO S D (a) Industry P£ Q (millions) PePe (b) Firm AR D = AR = MR MC qeqe q (thousands)

21. Very Short-run equilibrium of industry and firm under perfect competition OO S D (a) Industry P£ Q (millions) PePe (b) Firm AR D = AR = MR MC qeqe AC q (thousands) At what level of output should the firm Produce?

22. OO S D (a) Industry P£ Q (millions) PePe (b) Firm AR D = AR = MR MC qeqe AC q (thousands) Produce where MR = MC RULE ALWAYS HOLDS

23. At Q e how much profit does the firm make? OO S D (a) Industry P£ Q (millions) PePe (b) Firm AR D = AR = MR MC qeqe AC q (thousands)

24. OO S D (a) Industry P£ Q (millions) PePe (b) Firm AR D = AR = MR MC qeqe AC q (thousands) At Q e how much profit does the firm make?

25. OO S D (a) Industry P£ Q (millions) PePe (b) Firm AR D = AR = MR MC QeQe AC Q (thousands) Area = (AR-AC)*Q e At Q e how much profit does the firm make?

26. Supernormal Profits What was included in total costs when we drew the TC and AC curves?What was included in total costs when we drew the TC and AC curves? We included the cost of capital, labour, and raw materials and also:We included the cost of capital, labour, and raw materials and also: …an appropriate return for the entrepreneur for his or her labour, capital invested, and risk…an appropriate return for the entrepreneur for his or her labour, capital invested, and risk So what does the yellow area represent?So what does the yellow area represent? (AR – AC)*Q e =(AR – AC)*Q e = Supernormal profit

27. OO S D (a) Industry P£ Q (millions) PePe (b) Firm AR D = AR = MR MC QeQe AC Q (thousands) Supernormal Profit Supernormal profit

28. PERFECT COMPETITION – –Produce where MR = MC – –Under perfect Competition P = MR – –So MR= P = MC – –possible supernormal profits = (AR-AC)*Q – –Produce where MR = MC – –Under perfect Competition P = MR – –So MR= P = MC – –possible supernormal profits = (AR-AC)*Q

29. Very Short-run equilibrium of industry and firm under perfect competition OO S D (a) Industry P£ Q (millions) P (b) Firm AR D = AR = MR MC QeQe AC Q (thousands) Supernormal Profit

30. Supernormal profits will attract a more firms to the industry. OO S D (a) Industry P £ Q (millions) P (b) Firm AR D = AR = MR MC QeQe AC Q (thousands) Before S = n* Q e now S = (n+a) * Q e

31. So Supply curve moves out! OO S D (a) Industry P £ Q (millions) P (b) Firm AR D = AR = MR MC Q AC Q (thousands) S1S1 QeQe Q1Q1

32. Price falls OO S D (a) Industry P £ Q (millions) PePe (b) Firm AR D = AR = MR MC QeQe AC Q (thousands) S1S1

33. OO S D (a) Industry P £ Q (millions) PePe (b) Firm AR D = AR = MR MC AC Q (thousands) S1S1

34. .. And a new LONG RUN equilibrium is established at P e,Q e OO S D (a) Industry P £ Q (millions) P (b) Firm AR D = AR = MR MC QeQe AC Q (thousands) S1S1 PePe

35. PERFECT COMPETITION Short-run supply curve of industry Long-run equilibrium of the firm – –all supernormal profits competed away because new firm enter – –Since AR=AC in long-run equilibrium: (AR-AC)*Q=0 So there is NO supernormal profits. Short-run supply curve of industry Long-run equilibrium of the firm – –all supernormal profits competed away because new firm enter – –Since AR=AC in long-run equilibrium: (AR-AC)*Q=0 So there is NO supernormal profits.

36. LONG RUN Equilibrium under Perfect Competition requires that AR=P=MR=MC=AC OO D (a) Industry P £ Q (millions) (b) Firm D = AR = MR MC QeQe AC Q (thousands) S1S1 PePe PePe

37. Suppose now demand falls. OO D1D1 (a) Industry P £ Q (millions) P0P0 (b) Firm MC QeQe AC Q (thousands) S1S1 P1P1 PePe D0D0 What happens to supply now?

38. Suppose now demand falls. OO D1D1 (a) Industry P £ Q (millions) P0P0 (b) Firm MC QeQe AC Q (thousands) S1S1 P1P1 PePe D0D0 Our same MR = MC rule applies, but there is one more consideration

39. Recall In the short run, capital is fixed while labor may vary. So TC=FC+VC (Fixed Costs and Variable Costs). Variable costs=labour costs.In the short run, capital is fixed while labor may vary. So TC=FC+VC (Fixed Costs and Variable Costs). Variable costs=labour costs. AVC (average variable), is equal to:AVC (average variable), is equal to: labour costs/Q The rest of the firms costs are fixed costs (costs to capital equipment). Those are the ones which, in the short run, the firm cannot escape.

40. OO D1D1 P £ P0P0 MC Q1Q1 AC S1S1 P1P1 PePe D0D0 Our same MR = MC rule applies, but there is one more consideration We need to check where the AVC curve lies. Why? AVC In this case P > AVC so will continue to produce. By doing so, cover AVC and make some contribution to covering Fixed Costs Q0Q0

41. OO D1D1 P £ P0P0 MC Q1Q1 AC S1S1 P1P1 PePe D0D0 Our same MR = MC rule applies, but there is one more consideration We need to check where the AVC curve lies. Why? AVC But overall making a (supernormal) loss = (AC-P)Q < 0 Q0Q0

42. OO D1D1 P £ P0P0 MC QeQe AC S1S1 P1P1 PePe D0D0 What if P is below AVC? AVC In this case the firm can’t cover variable costs, so better to close down (lay of all workers) and only lose FC

43. To sum up: Let’s derive the short-run supply curve OO (a) Industry P£ P1P1 Q (millions) (b) Firm D 1 = MR 1 Q (thousands) MC Q1Q1 a D1D1 S

44. OO (a) Industry P£ P1P1 Q (millions) D1D1 (b) Firm D 1 = MR 1 MC Q2Q2 a P2P2 D 2 = MR 2 b S D2D2 Q (thousands) Deriving the short-run supply curve

45. OO (a) Industry P£ P1P1 Q (millions) S D1D1 (b) Firm D 1 = MR 1 MC Q3Q3 a P2P2 D 2 = MR 2 D2D2 b P3P3 D 3 = MR 3 D3D3 c Q (thousands) Deriving the short-run supply curve AVC

46. OO (a) Industry P£ P1P1 Q (millions) S D1D1 (b) Firm D 1 = MR 1 S a P2P2 D 2 = MR 2 D2D2 b P3P3 D 3 = MR 3 D3D3 c Q (thousands) Deriving the short-run supply curve “equals” the MC curve until p=AVC AVC

47. PERFECT COMPETITION Short-run supply curve of industry is equal to MC curve (as long as the price is above AVC) Long-run equilibrium of the firm – –all supernormal profits competed away – –long-run industry supply curve Short-run supply curve of industry is equal to MC curve (as long as the price is above AVC) Long-run equilibrium of the firm – –all supernormal profits competed away – –long-run industry supply curve

48. OO D (a) Industry P £ Q (millions) (b) Firm D = AR = MR MC QeQe AC Q (thousands) S PePe PePe D1D1 What happened to Supply here in the Long Run ? MC=P=AC (so AC at minimum) S1S1 LRS

49. PERFECT COMPETITION Short-run supply curve of industry Long-run equilibrium of the firm – –all supernormal profits competed away – –long-run industry supply curve (horizontal at minimum AC) Short-run supply curve of industry Long-run equilibrium of the firm – –all supernormal profits competed away – –long-run industry supply curve (horizontal at minimum AC)

50. PERFECT COMPETITION Advantages of perfect competition – –production at minimum AC (which is efficient) – –only normal profits in long run (no supernormal profits) – –responsive to consumer wishes: consumer sovereignty (demand influences price and so firms’ actions) – –competition  efficiency Advantages of perfect competition – –production at minimum AC (which is efficient) – –only normal profits in long run (no supernormal profits) – –responsive to consumer wishes: consumer sovereignty (demand influences price and so firms’ actions) – –competition  efficiency

51. PERFECT COMPETITION Disadvantages of perfect competition – –There really are none Except perhaps…. – –Disadvantage is that it may not be a valid version of reality – –Perfect competition rests on the following assumptions   firms are price takers? (small r.t. market)   freedom of entry and exit? (depends on product)   identical productsOK approximation (typically) Disadvantages of perfect competition – –There really are none Except perhaps…. – –Disadvantage is that it may not be a valid version of reality – –Perfect competition rests on the following assumptions   firms are price takers? (small r.t. market)   freedom of entry and exit? (depends on product)   identical productsOK approximation (typically)