Market Structures and Marginal Analysis Perfect Competition

A perfectly competitive market must meet the following assumptions: a large number of small-scale producers. No one firm is large enough to influence the market Each firm is a price taker, selling its output at a price determined in the market The product is homogeneous, identical to that produced by other firms. Consumers are indifferent as to whose product they buy. Perfect Competition The resources used are perfectly mobile, meaning that their use can be easily changed in response to market changes Consumers have perfect knowledge of the market in terms of price and availability. No individual consumer can influence price There are no economic or legal barriers to the free entry of exit of firms

Perfect Competition What happens in the market: All producers turn up with their goods for sale (on any one day the supply curve will be perfectly inelastic) Buyers turn up (with a certain demand for what’s on sale) Bidding sets the price, and the market is cleared Price Quantity MARKET If demand is greater than expected, then the market price rises. If demand is greater than expected, then the market price rises. And when demand falls, price will fall. S D’ D p p Shifts in supply will also impact on the price.

Perfect Competition The price that is set in the market determines the price (and therefore the demand curve) for each of the firms in this industry. These firms can sell as much as they wish at that market price, so each individual firm faces a perfectly elastic demand curve for their product. S D p Price Quantity MARKET Price Quantity INDIVIDUAL PRODUCER D

Perfect Competition Again, if demand is greater than expected, then the market price rises and this will impact on the demand curve faced by individual firm. Price Quantity MARKET Price Quantity INDIVIDUAL PRODUCER S D p D

Perfect Competition Again, if demand is greater than expected, then the market price rises, and this will impact on the demand curve faced by individual firm. Or, if new firms should join the industry and increase supply, then price will fall along with the demand curve faced by individual firm. Price Quantity MARKET Price Quantity INDIVIDUAL PRODUCER S D p D

Perfect Competition We assume that individual firms want to make the greatest profit possible. So, how does a firm know which level of output will generate the greatest profit? Marginal Analysis will provide the answer. Our tools are: Marginal Cost Marginal Revenue, and Marginal Profit

Marginal Analysis Definitions: Marginal Cost (MC) is the extra cost of an increase in output. Marginal Revenue (MR) is the extra revenue gained from selling that output. Marginal Profit will be the difference between the two, the extra profit generated from producing and selling more output.

Marginal Analysis This example looks at a firm operating in a perfectly competitive market. Quantity $ so, Marginal Revenue is a constant MR

Marginal Analysis Raising output too high can reduce the profit. + By increasing output, extra profits can be earned. + MC Loss MC Loss MC Loss MR Profit MR Profit MR P MR MC MR MR MR MR MC MC MC and more and more and more and more and more and more Output

Marginal Analysis Raising output here reduces the profit By increasing output, extra profits can be earned. Marginal profits are negative Marginal (extra) profits are positive MC Loss MC Loss MC Loss MC MR Profit MR Profit MR P MR MC MR MR MR MR MC MC MC Output

Marginal Analysis Raising output here reduces the profit By increasing output, extra profits can be earned. So this is the output that maximises profit for the firm MC where MR=MC (the marginal profit = O) and from here on marginal profits are negative MR Marginal (extra) profits are positive up to this point MC MR and more and more and more and more and more and more Output

P r o f i t M a x i m i s i n g B e h a v i o u r The Rules: Marginal Analysis P r o f i t M a x i m i s i n g B e h a v i o u r The Rules: At an output where: MR > MC, marginal profit is positive, so increase output to raise profits MC > MR, marginal profit is negative, so reduce output to raise profits MC = MR, marginal profit is zero, so profits are maximised. This is called equilibrium output, Q* This rule applies to ALL firms in ALL market situations