Level 5 Economics: Theory of the Firm [2] Economic Principles Economic Principles Economic Environment Economic Environment

Level 5 Economics: Theory of the Firm [2] Learning Outcome Three Theory of the Firm: 2.Profit Maximisation under Perfect Competition

Perfect Competition Perfect Competition S & R, S fig 6.1fig 6.1 markets in which there are so many buyers and so many sellers that no individual buyer or seller can affect the market price markets in which there are so many buyers and so many sellers that no individual buyer or seller can affect the market price – individual sellers are price-takers; they decide on quantity only firms produce a homogeneous product firms produce a homogeneous product – each firm produces identical products eg the product is unbranded no entry-barriers for new firms no entry-barriers for new firms close examples of perfectly competitive industries? market gardeners, taxi drivers, home handymen

Revenue curve for a competitive firm with many (eg 1,000) similar small firms in the market, each firm (with 0.1% of market) is too small to shift the market supply curve with many (eg 1,000) similar small firms in the market, each firm (with 0.1% of market) is too small to shift the market supply curve if just one fig supplier produces (say 20%) more than before, the market price does not change eg if each firm initially supplies 160 packs of figs, (0.02%) market output increases from 160,000 to 160,032 (0.02%) marginal revenue is always the price – contrast with all firms raising output by 20% in this case, the market supply curve shifts 20% to right eg market output increases from 160,000 to 192,000 exampleexample in which all firms increase output from 160 to 192

back only 20% increase in output by only 1 firm means 0.02% increase in market output Fig Market

back Consider market with 1,000 identical firms

under perfect competition, marginal revenue equals price an individual firm under perfect competition can sell as much as it supplies at the current market price, so long as an individual firm under perfect competition can sell as much as it supplies at the current market price, so long as – each firm's output remains small relative to the industry's output – competitor firms do not change their output quantities also, by definition, also, by definition, – average revenueprice – average revenue always equals price – total revenue (TR) = price (P) x quantity (Q) = AR x Q S & R, S fig 6.2fig 6.2

Key Assumption: Firms maximise Profits Profit equals Profit ( ) equals S & R, S fig 7.1fig 7.1 – total revenue (TR) minus total cost (TC) Profit-maximising Quantity Profit-maximising Quantity – firms maximise profit at quantity (Q) when marginal cost (MC) = (MR) marginal revenue perfect competition – with perfect competition, MR = price so, in a perfectly competitive market, a profit- maximising firm supplies the quantity for which: marginal cost = marginal revenue = price S & R, S fig 7.2 also 7.11fig fig 7.2fig 7.2 again

Types of Profit in Short-run Equilibrium applying the MC=MR rule to establish Q e : applying the MC=MR rule to establish Q e : S & R, S fig 7.3fig 7.3 maximising profitminimising loss maximising profit or minimising loss – economic profit > 0[economic profit]profit above-normal (supernormal) profit – economic profit < 0[ economic loss ]loss below-normal (subnormal) profit is typically an accounting profit above zero – economic profit = 0;[ break-even point ] normal profit; accounting profit always above-zero normal profit what happens if the market price falls? what happens if the market price falls?

Varying Profits and Losses supply curve for individual firm (see fig 7.5) can shut-down (Q=0) in the short run if stopping production gives a smaller loss

Long-run Equilibrium of the Firm long-run allows for entryexit of firms long-run allows for entry & exit of firms economic profits eliminated economic profits eliminated S & R, S fig 7.6 (eg arising from an increased demand, high P)fig 7.6 – some firms enter the industry – increase in market supply – result: long-run decrease in market price economic losses resolved economic losses resolved (eg arising from decreased demand, low P)losses – some firms exit the industry – decrease in market supply – result: long-run increase in market price

Under Perfect Competition, in long-run equilibrium, Profits are Maximised at Zero at normal profits, firms produce at their technical optimum, at the appropriate scale at normal profits, firms produce at their technical optimum, at the appropriate scale – price equals minimum long-run average cost – price stabilises at the low point of the LAC curveLAC curve firms that do not maximise profits end up with economic losses in the long run, firms that do not maximise profits end up with economic losses – competition is more about market discipline than market freedom real-world competition is imperfect to some degree real-world competition is imperfect to some degree

Price equals Marginal Benefit Price also equals Marginal Benefit The price paid for a product represents the happiness from marginal use of that product The price paid for a product represents the happiness from marginal use of that product remember Henry and his chocolate bars In an efficient market: In an efficient market: – price = marginal benefit = marginal cost eg price is a measure of the last bit of happiness and unhappiness "price = marginal cost" is a condition for efficiency "price = marginal cost" is a condition for efficiency – otherwise, efficiency gains can be realised: price > marginal cost if price > marginal cost, there will be increased net benefits if more resources are allocated to that good net benefits price < marginal cost if price < marginal cost, there will be increased net benefits if fewer resources are allocated to that good and more resources are allocated to other goods

textbook (4e) ch.7 p146/7, Q2 textbook (5e) ch.7 p150/1, Q2 solution ex sheet 3baex sheet 3ba (mainly on costs) Homework

7 Which one of the following does not occur in perfect competition? a No single firm can exert a significantinfluence on the market price ofthe good. b There are many buyers. c There are significant restrictions on entry into the industry. d Firms and buyers are completely informed about the output and input prices of the industry. 8 A firm has total revenue of $100m, explicit costs of $90m and implicit costs of $20million. Its pure economic profit is a $80million b $70million c $10million d - 9 All firms maximise their profits at the output level where a price equals marginal cost b marginal revenue equals marginal cost c marginal revenue equals price d price is greater than average cost

Net Benefits Consumer (household) point of view Consumer (household) point of view happiness – unhappiness = welfare Producer (firm) point of view Producer (firm) point of view total revenue – total cost = profit back