Lecture notes Prepared by Anton Ljutic

© 2004 McGraw–Hill Ryerson Limited Perfect Competition CHAPTER EIGHT

© 2004 McGraw–Hill Ryerson Limited This Chapter Will Enable You to: Distinguish between a firm, an industry and a market Explain the conditions necessary for a perfectly competitive market to exist Use two approaches to explain how a firm might maximize its profits Explain what is meant by break-even price and shut down price Explain how a firm’s supply curve is derived Explain the effect of a change in market demand or market supply on both the industry and the firm

© 2004 McGraw–Hill Ryerson Limited Industry vs. Market Industry –A name for a group of producers Market –Refers to the interaction of both producers and consumers

© 2004 McGraw–Hill Ryerson Limited Characteristics of Different Markets Perfect competition –Many sellers, identical product, easy entry, no seller’s control over price: commodities such as wheat market in which all buyers and sellers are price takers –There are many firms, selling an identical product Monopoly –There is a single firm, selling a unique product Monopolistic competition –There are many firms, selling a differentiated product Differentiated oligopoly –There are few firms, selling an identical product

© 2004 McGraw–Hill Ryerson Limited Characteristics of Different Markets Perfect competition –Numerous sellers, identical product, easy entry, no control over price –Example: commodities such as wheat Monopolistic competition –Many sellers, differentiated product, easy entry, low control over price –Example: restaurants Undifferentiated vs. Differentiated oligopoly –Few sellers, identical vs. differentiated product, difficult entry, moderate vs. substantial control over price –Example: oil refining vs. automotive and tobacco Monopoly –One firm, unique product, very difficult entry, substantial control over price –Example: local telephone providers, cable

© 2004 McGraw–Hill Ryerson Limited Conditions for Perfect Competition to Exist Large number of small buyers and sellers, all of whom are price takers No preferences shown (undifferentiated product) Easy entry and exit by both buyers and sellers The same market information available to all to make rational production and purchasing decisions

© 2004 McGraw–Hill Ryerson Limited Examples of Perfectly Competitive Markets World markets for commodities like aluminum, zinc, cotton, rubber, oil,wheat Agricultural products (though Canada has marketing boards) True competition exists between a wheat farmer in Alberta and another in Manitoba, not between Coca-Cola and Pepsi or between Reebok and Nike

© 2004 McGraw–Hill Ryerson Limited $10 The Competitive Industry and the Firm D*=AR=MR P Q Q D1D1 S1S1 P of wheat Market S and DSingle firm’s D Figure 8.1

© 2004 McGraw–Hill Ryerson Limited Total, Average and Marginal Revenue Total revenue (TR) –Price times output (P x Q) Average revenue (AR) –The amount of revenue received per unit sold –To calculate it, you divide total revenue (TR) by output (Q) Marginal revenue –The extra revenue derived from the sale of one more unit AR = TR / Q ; MR =  TR /  Q

© 2004 McGraw–Hill Ryerson Limited Price, Profit and Output Under Perfect Competition (I) Total profits –the difference between total revenue and total cost (TR – TC) Break-even output –The level of output at which the sales revenue of the firm just covers fixed and variable costs, including normal profit (i.e., where TR = TC)

© 2004 McGraw–Hill Ryerson Limited A higher price opens a wider range of profitable outputs, increased production and greater profits A lower price reduces the range of profitable outputs and results in lower production and smaller profit for producers Price, Profit and Output Under Perfect Competition (II)

© 2004 McGraw–Hill Ryerson Limited Total Revenue, Costs and Profits Break-even TT TR TC Q TR TC T  Figure 8.3

© 2004 McGraw–Hill Ryerson Limited The Marginal Approach to Profitability Marginal profit –The additional economic profit from the production and sale of of an extra unit of output –To calculate it, divide  total profit by  output To maximize its total profit, the firm should increase production to the point at which the marginal profit is zero, that is, where marginal revenue is equal to marginal cost

© 2004 McGraw–Hill Ryerson Limited Average and Total Profits AR, AC P= AR= MR MC AC Q Profit-max. Q MR=MC Break-even points P1P1 Figure 8.5

© 2004 McGraw–Hill Ryerson Limited Break-Even and Shutdown Price Break-even price –The price at which the firm makes only normal profits, that is, makes zero economic profits Shutdown price –The price that is just sufficient to cover a firm’s variable costs

© 2004 McGraw–Hill Ryerson Limited Break-Even and Shutdown Price for Competitive Firm MC ATC AVC Pbe Psd AR, cost The break- even price is Pbe. The shut- down price is Psd The break- even price is Pbe. The shut- down price is Psd Pbe=Break-even P Psd=Shut-down P Q Figure 8.7

© 2004 McGraw–Hill Ryerson Limited Should the Firm Produce? At any output – is the price higher than AC? YES NO YES NO Firm makes economic profit Is price higher than AVC? Shut-down Firm produces at a loss

© 2004 McGraw–Hill Ryerson Limited The Firm’s Supply Curve MC=supply ATC AVC AR, cost The firm’s supply curve is the marginal cost curve MC above minimum AVC The firm’s supply curve is the marginal cost curve MC above minimum AVC Q Figure 8.8

© 2004 McGraw–Hill Ryerson Limited The Industry Demand and Supply Curves P Q D S = MC $35 60 The industry’s supply curve is the total of all the firms’ MC curves. The equilibrium price is $35 and the equilibrium quantity is 60. The industry’s supply curve is the total of all the firms’ MC curves. The equilibrium price is $35 and the equilibrium quantity is 60.

© 2004 McGraw–Hill Ryerson Limited Short vs. Long Run PeriodFirmIndustryOverall Effect Short-runFirm size is fixed No. of firms is fixed Fixed Capacity Long-runSize of firm can vary No. of firms can vary Variable Capacity

© 2004 McGraw–Hill Ryerson Limited The Long-Run Effects of an Increase in Demand S1S1 S2S2 D1D1 D2D2 P Q a b c P2P2 P1P1 The increase in demand (D 1 to D 2 ) causes P to rise to P 2 and Q to rise from a to b In the long run new firms enter the industry and the supply shifts to S 2 and Q rise to c the market price falls back to P 1 P 1 is the long-run equilibrium price

© 2004 McGraw–Hill Ryerson Limited The Long-Run Effects of a Decrease in Demand S2S2 S1S1 D2D2 D1D1 P Q a b c P2P2 P1P1 The decrease in demand (D 1 to D 2 ) causes P to fall to P 2 and Q to fall from a to b In the long run Some firms exit the industry and the supply shifts left to S 2 and Q falls to c the market price rises back to P 1 P 1 is the long-run equilibrium price

© 2004 McGraw–Hill Ryerson Limited Constant-Cost Industry Increases in demand are met by exact increases in supply. Price is unaffected. The LRS curve is horizontal D1D1 D2D2 D3D3 S1S1 S2S2 S3S3 LRS P Q

© 2004 McGraw–Hill Ryerson Limited Decreasing-Cost Industry Industry expansion leads to lower costs. Price falls. The LRS curve is downward- sloping D1D1 D2D2 D3D3 S1S1 S2S2 S3S3 LRS P Q

© 2004 McGraw–Hill Ryerson Limited Increasing-Cost Industry Industry expansion leads to increasing costs. Price rises. The LRS curve is upward- sloping D1D1 D2D2 D3D3 S1S1 S2S2 S3S3 LRS P Q

© 2004 McGraw–Hill Ryerson Limited Chapter Summary: What to Study and Remember distinction between a firm, an industry and a market conditions necessary for a perfectly competitive market to exist two approaches to explain how a firm might maximize its profits what is meant by break-even price and shut down price the derivation of a firm’s supply curve the effect of a change in market demand or market supply on both the industry and the firm