Chapter 8 Perfect Competition ECONOMICS: Principles and Applications, 4e HALL & LIEBERMAN, © 2008 Thomson South-Western

2 Market structure The characteristics of a market that influence how trading takes place 1.How many buyers and sellers? 2.Products: standardized or significantly different? 3.Barriers to entry/exit ?

3 Market structure Types of markets –Perfect competition –Monopoly –Monopolistic competition –Oligopoly

4 Perfect Competition Many buyers and sellers –no individual decision maker can significantly affect the price of the product Standardized product –buyers do not perceive differences between the products Sellers can easily enter/exit the market –no significant barriers to discourage new entrants

5 Is Perfect Competition Realistic? Many markets - while not strictly perfectly competitive - come reasonably close Perfect competition can approximate conditions and yield accurate-enough predictions in a wide variety of markets

6 The Competitive Firm’s Demand Curve Horizontal demand curve – perfectly elastic - at the market price Output is standardized Price taker –The price of its output is given Decision –How much output to produce and sell

7 The Competitive Firm’s Demand Curve D S Ounces of Gold per Day Price per Ounce MarketFirm Ounces of Gold per Day Price per Ounce $400 1.The intersection of the market supply and the market demand curve… $400 3.The typical firm can sell all it wants at the market price… 2.determines the equilibrium market price Demand Curve Facing the Firm 4.so it faces a horizontal demand curve. Figure 1 The Competitive Industry and Firm

8 Cost and Revenue Data Marginal revenue –Is the market price Marginal revenue curve –The demand curve facing the firm –A horizontal line at the market price

9 Profit Maximization TR 550 $2,800 2,100 TC Slope = 400 Ounces of Gold per Day Dollars Profit = TR-TC Maximum Profit per Day = $700 Figure 2 Profit Maximization in Perfect Competition (a) TR-TC

10 Profit Maximization MC $400 d = MR Ounces of Gold per Day Dollars Figure 2 Profit Maximization in Perfect Competition (b) MR=MC Profit maximization MR=MC

11 Profit Maximization Total Profit = TR – TC MR>MC – increase output Maximize profit: MR=MC Measuring Total Profit –Profit per unit = P – ATC If P > ATC – the firm earns profit If P < ATC – the firm suffers a loss

12 Measuring Profit or Loss Ounces of Gold per Day Dollars MC ATC $400 d = MR Figure 3 Measuring Profit or Loss a) Economic Profit Total profit = profit per unit *Q 300 Profit per unit=revenue per unit - cost per unit Profit per Ounce ($100) MR=MC Q=7

13 Measuring Profit or Loss MC ATC d = MR $ Loss per unit= cost per unit - revenue per unit Loss per Ounce ($100) Ounces of Gold per Day Dollars Figure 3 Measuring Profit or Loss b) Economic Loss MR=MC Q=5 Total loss = loss per unit *Q

14 The Firm’s Short-Run Supply Curve The firm –takes the market price as given –decides how much output to produce at that price Profit-maximizing output level: P=MC –As price of output changes, firm will slide along its MC curve in deciding how much to produce –Exception – If the firm is suffering a loss large enough to justify shutting down

15 The Firm’s Short-Run Supply Curve ,000 2,000 4,000 5,000 7, $ MC ATC d 1 =MR 1 AVC (a) Firm's Supply Curve ,0004,000 5,000 7, $ (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 Figure 4 Short-Run Supply Under Perfect Competition

16 The Shutdown Price Price at which a firm is indifferent between producing and shutting down If P>AVC – produce If P<AVC – shut down Firm’s supply curve –Is its MC curve for all prices above AVC, and a vertical line at zero units for all prices below AVC.

17 Competitive Markets in the Short- Run Fixed number of firms in industry Market supply curve –Quantity of output - all sellers in a market will produce at different prices –Add up the quantities of output supplied by all firms in the market at each price

18 Competitive Markets in the Short- Run $ Market Supply Curve 200, , , ,000 Firm's Supply Curve ,0004,000 5,000 7, $ 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. Figure 5 Deriving The Market Supply Curve

19 Short-Run Equilibrium Competitive firms can e arn economic profit, or suffer an economic loss The market –sums buying and selling preferences of individual consumers and producers, and determines market price Each buyer and seller –Takes market price as given –Is able to buy or sell the desired quantity

20 Perfect Competition Quantity Demanded at Different Prices Quantity Supplied at Different Prices 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 Quantity Supplied by Each Firm Quantity Demanded by Each Consumer P S D Q Market Equilibrium Added together Figure 6 Perfect Competition

21 Perfect Competition 400,000700, $3.50 S D1D1 D2D2 MC d1d1 d2d2 ATC 7,0004, $ If the demand curve shifts to D 2 and the market equilibrium moves here the typical firm operates here, earning economic profit in the short run. 1.When the demand curve is D 1 and market equilibrium is here... Profit per Bushel at p = $3.50 Price per Bushel Market Bushels per Year Dollars Firm Bushels per Year Loss per Bushel at p = $2 4.the typical firm operates here and suffers a short-run loss. Figure 7 Short-Run Equilibrium in Perfect Competition

22 Competitive Markets in the Long Run New firms can enter the market Existing firms can exit the market Profit and loss in the long run –Economic profit - outsiders enter the market –Economic losses - firms exit the market

23 From SR Profit to LR Equilibrium –Economic profit attracts new entrants –Market supply curve - shift rightward –Market price - falls –Demand curve facing each firm - shifts downward –Each firm - decrease output Positive economic profit - attracts new entrants until economic profit = 0

24 Long-Run Equilibrium S1S1 d1d1 ATC MC $4.50 With initial supply curve S 1, market price is $4.50… $ ,0009,000 so each firm earns an economic profit. A A Price per Bushel Market Bushels per Year Dollars Firm Bushels per Year D Figure 8 From Short-Run Profit to Long-Run Equilibrium

25 Long-Run Equilibrium S1S1 d1d1 ATC MC $4.50 Profit attracts entry, shifting the supply curve rightward… $ ,0009,0005,000 until market price falls to $2.50 and each firm earns zero economic profit. S2S2 d2d2 A A 2.50 E E MarketFirm Price per Bushel Bushels per Year Dollars Bushels per Year D 1,200,000 Figure 8 From Short-Run Profit to Long-Run Equilibrium

26 From SR Loss to LR Equilibrium –Economic losses - firms exit the market –Market supply curve - shift leftward –Market price - rises –Demand curve facing each firm - shifts upward Economic loses – firms exit until economic loss = 0 In the LR, firms earn “normal profit” - zero economic profit

27 Perfect Competition and Plant Size In LR equilibrium, every firm will select –Plant size –Output level And –Operate at minimum point of LRATC curve

28 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 the firm earns zero economic profit. 2.The firm could earn positive profit with a larger plant, producing here Figure 9 Perfect Competition and Plant Size

29 A Summary of the Competitive Firm in the LR In long-run equilibrium, the competitive firm produces Q where: MC=minimum ATC=minimum LRATC=P Consumers are getting the best deal they could possibly get

30 An Increase in Demand Short-run –Rise in market price –Rise in market quantity –Economic profits Long-run –Market equilibrium changes The long-run supply curve –Relationship between market price and market quantity - after all long-run adjustments have taken place

31 Constant Cost Industry Entry has no effect on input prices Industry output has no effect on individual firms’ cost curves Horizontal long-run supply curve The industry –supplies any amount of output demanded –at an unchanged price

32 LRATC Constant-Cost Industry D1D1 S1S1 A P1P1 Q1Q1 P1P1 q1q1 MC A ATC d 1 = MR 1 Output per Period Market Dollars Firm Output per Period Price per Unit Figure 10 A Constant-Cost Industry INITIAL EQUILIBRIUM

33 Constant Cost Industry MC ATC Dollars Firm P1P1 q1q1 A d 1 = MR 1 Output per Period Market S1S1 Output per Period Price per Unit D 1 A P1P1 Q1Q1 d SR = MR SR P SR B B C Q SR Q2Q2 q SR S2S2 S LR D2D2 Figure 10 A Constant Cost Industry NEW EQUILIBRIUM LRATC

34 Increasing Cost Industry Entry causes input prices to rise Each firm’s LRATC curve shifts upward as industry output increases Zero economic profit occurs at a higher price The long-run supply curve slopes upward

35 Increasing Cost Industry LRATC 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 2 = MR 2 P2P2 P SR P2P2 LRATC 2 C B C Q2Q2 S2S2 S LR D2D2 Figure 11 An Increasing Cost Industry

36 Decreasing Cost Industry Entry by new firms decreases input prices Each firm’s LRATC curve shifts downward as industry output increases Zero economic profit occurs at a lower price The long-run supply curve slopes downward

37 Decreasing Cost Industry LRATC 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 2 = MR 2 P2P2 P SR P2P2 LRATC 2 C B C Q2Q2 S2S2 S LR D2D2 Figure 12 A Decreasing Cost Industry

38 Market Signals and the Economy Market signals –Price changes - cause changes in production to match changes in consumer demand Demand increases - price rises –signals firms to enter the market –industry output increases Demand decreases –price falls –signals firms to exit the market –industry output decreases

39 A Change in Technology A technological advance –rightward shift of the market supply curve –market price decreases –Short run - economic profit –Long run - zero economic profit Firms that refuse to use the new technology will not survive.

40 A Change in Technology $3 Q1Q1 S1S1 2 Q2Q2 A B D S2S LRATC 1 LRATC 2 d 1 = MR 1 d 2 = MR $3 2 Bushels per Day Price per Bushel Market Dollars per Bushel Firm Bushels per Day Figure 13 Technological Change in Perfect Competition

41 Solar Power: Increasing Cost Industry Generating electricity from solar panels –costs more than twice as much as generating the same energy from fossil fuels With government help –by 2006, Germany became the world’s largest producer of solar energy The growth slowed dramatically in early 2006 –even though the subsidies and incentives remained The solar panel industry - increasing cost industry

42 Solar Power Firm 3.50 q1q1 d 1 = MR 1 LRATC 2003 A Market D 2003 Quantity of Solar Panels (Megawatts) Price (Dollars per peak watt) A $5.00 C 1,750 S 2005 Figure 14 The Global Market For Solar Panels Price (Dollars per peak watt) Quantity of Solar Panels (Megawatts) S 2003 B D 2005 d 2 = MR 2 $5.00 LRATC 2005 C

43 Solar Power D 2003 Quantity of Polysilicon (Millions of Kilograms per Year) Price per kilogram E Figure 15 The Global Market For Polysilicon S 2003 $70F D 2005