Competitive firms and Markets Perloff chapter 8

Competition Firms are price takers. Firm’s demand curve is horizontal. Reasons for a horizontal demand curve: Identical products from different firms; Freedom of entry and exit; Perfect knowledge of prices; Low transaction costs. Where all conditions are satisfied: Perfect Competition.

Profit p = R – C Definition of R straightforward. Costs: Business profit includes only explicit costs, e.g. workers wages and materials. Owner doesn’t take a salary, what remains is profit. Economic profit uses opportunity cost. Suppose profit was £20000 but you could earn a salary of £25000, what should you do?

Profit maximisation p , Profit p * Profit D p < 0 D p > 0 1 1 q q * Quantity, q , Units per day Source: Perloff

Output decision Produce where profit is maximised.

Profit maximisation p , Profit p * Profit D p < 0 D p > 0 1 1 q q * Quantity, q , Units per day Source: Perloff

Output decision Produce where profit is maximised. Produce where marginal profit is zero. Marginal cost equals marginal revenue. p(q) = R(q) – C(q) Marginal Profit(q) = MR(q) – MC(q) = 0 MR(q) = MC(q)

Shutdown rule Shutdown if it reduces its loss. In the short-run, shutting down means revenue and variable costs are zero. It must continue to cover fixed costs. p=R-VC-F=2000-1000-3000=-2000 p=R-VC-F=500-1000-3000=-3500 Shutdown if revenue is less than avoidable cost. This rule is applicable in the long and short run.

Short-run output decision Cost, revenue, Thousand $ Short-run output decision Cost, C Revenue 4,800 MR = 8 2,272 1 p * 1,846 MC=MR R=pq MC=p 426 p ( q ) 100 p * = $426,000 – 100 140 284 q , Thousand metric tons of li me per year p , $ per ton 10 MC AC e 8 p = MR p * = $426,000 6.50 6 140 284 q , Thousand metric tons of li me per year

Short run shutdown decision Shutdown if revenue less than avoidable cost. In short run avoidable costs are variable costs.

Short run shutdown decision p , $ per ton MC AC b 6.12 AVC 6.00 A = $62,000 5.50 p e B = $36,000 5.14 5.00 a 5.50-5.14=36 6.12-5.50=62 TC=6.12*100000=612000 VC=514000 TR=550000 TR-TC=-62000 FC=(6.12-5.14)*100000=98000 50 100 140 q , Thousand metric tons of lime per year

Short run supply curve of the firm , $ per ton S e 4 8 p 4 e 3 AC 7 p 3 AVC e 2 6 p 2 e 1 5 p 1 MC q = 50 q = 140 q = 215 q = 285 1 2 3 4 q , Thousand metric tons of lime per year

Industry SR supply curve with 5 identical firms (a) Firm (b) Market p , $ per ton p , $ per ton 7 7 1 2 S 3 S 1 S S S 4 6.47 6.47 AVC S 5 6 6 5 5 MC 50 140 175 50 150 250 700 100 200 q , Thousand metric tons Q , Thousand metric tons of lime per year of lime per year

Industry SR supply curve with 2 different firms , $ per ton S 2 S 1 S 8 7 6 5 25 50 100 140 165 215 315 450 q , Q , Thousand metric tons of lime per year

SR equilibrium in the market (a) Firm (b) Market p , $ per ton p , $ per ton 8 1 8 S S D 1 e 1 7 7 E 6.97 1 AC A B D 2 6.20 6 AVC 6 C 5 5 E e 2 2 q = 50 q = 215 Q = 250 Q = 1,075 2 1 2 1 q , Thousand metric tons Q , Thousand metric tons of lime per year of lime per year

Supply curve of the firm in the long-run , $ per unit S SR S LR LRAC SRAC SRAVC 35 p A B 28 25 24 20 LRMC SRMC 50 110 q , Units per year

Long run adjustment of the industry All factors are variable. Entry and exit are possible. Entry occurs with positive long-run profits Exit occurs with long-run losses Identical firms: All firms make a loss when P<min(LAC), industry supply is zero. All firms make a profit if P>min(LAC), number of firms is indeterminate. Note that elasticity of the industry supply curve increases with the number of firms.

Long run industry supply curve (a) Firm (b) Market p , $ per unit p , $ per unit S 1 LRAC Long-run market supply 10 10 LRMC 150 Q , Hundred metric tons of oil per year q , Hundred metric tons of oil per year

Upward sloping long run industry supply curve Limited entry New firms cannot enter because of legislative control. New firms only enter when profits exceed the costs of entry. Firms differ Minimum LAC is lower for some firms than others. Number of low LAC firms is limited. Input prices vary with output Increasing cost (firms in one industry account for much of the supply of a particular input). Decreasing cost (economies of scale in the input supplier)

Differing firms: the LR supply curve for cotton Price, $ per kg Iran 1.71 S United States 1.56 Nicaragua, Turkey 1.43 Brazil 1.27 Australia 1.15 Argentina 1.08 Pakistan 0.71 1 2 3 4 5 6 6.8 Cotton, billion kg per year

Increasing cost industry (a) Firm (b) Market p , $ per unit p , $ per unit MC 2 MC 1 AC 2 S AC 1 e E 2 2 p 2 e E 1 1 p 1 q q q , Units per year Q = n q Q = n q Q , Units per year 1 2 1 1 1 2 2 2

Decreasing cost industry (a) Firm (b) Market p , $ per unit 1 p , $ per unit MC MC 2 AC 1 AC 2 e 1 E p 1 1 e 2 E 2 p 2 S q q q , Units per year Q = n q Q = n q Q , Units per year 1 2 1 1 1 2 2 2

Long run competitive equilibrium (a) Firm (b) Market , $ per ton p , $ per ton D 1 2 MC D AC S SR f AVC F 2 2 11 11 E 2 S LR 10 e 10 E f 1 F 1 1 7 7 100 150 165 1,500 2,000 3,300 3,600 q , Hundred metric tons Q , Hundred metric tons of oil per year of oil per year

Profit in the long run Free entry Restricted entry Entry occurs to the point where profits are zero No profit in long-run equilibrium Economic profit is revenue minus opportunity cost. Restricted entry Entry is often limited because of a limited quantity of an input eg. land. Profits become rent.

Economic Rent p , $ per bushel MC AC (including rent) AC (excluding rent) p * p * = Rent begin by assuming that the land is not paid for. AC includes opportunity cost, owners of land could rent land to other potential farmers who want to produce tomatoes. q * q , Bushels of tomatoes per year