Perfect Competition

Market Structure/Market Power The way a firm behaves (how much output it decides to produce and the price it sells its products at) depend on the STRUCTURE of the market –mainly regarding the degree of competition

What Is Perfect Competition? When a market structure has perfect, total, equal, absolute competition between firms only a model! extreme does not exist in the real world; however, it can be used as a starting point to base other models off of

Assumptions The only necessary condition is that each firm has no control AT ALL over the price of the product (price taker) Other very common conditions: –Many sellers –Many buyers –Homogenous products –No barriers to entry/exit –Perfect knowledge –Completely mobile factors of production

The Market Price determined totally in market place by demand and supply – no one would sell any higher, because no consumers would buy, and no one would sell lower, because that would be…stupid. And non-profit- maximizing. S D P Q E Quantity Price

The Firm Faces a perfectly elastic demand curve (and therefore also average revenue curve and marginal revenue curve) –Why? Because they have no control over price – they must sell at price P and nothing more, nothing less – everyone has complete knowledge, and it is easy for firms to enter/exit d, AR, MR Price Output 0

TR = p*q (where p=price, q=output) AR = TR/q = p*q/q = p(this is why the demand curve=the AR curve on the previous diagram) Each marginal unit is sold at the constant price, therefore MR = p (this is why the demand curve=the MR curve on the previous diagram)

Short Run Equilibrium Profit is maximized at MR=MC (short run equ’m), so output is = to q –One unit less? Lose profit to be made on that unit. MR>MC –One unit more? Loss made on that unit, reducing total profit. MC<MR ATC MC d, AR, MR q Output p Price

Short Run Equilibrium (what you just saw)… NOT TO BE CONFUSED WITH LONG RUN EQUILIBRIUM!!! (what you are about to see)

(well not yet) Why is the short run equ’m diagram shown before not applicable for long run? Because SNP are made in short run (when MR=MC; see below): MC d, AR, MR q Output p b a c Price Firm produces 0-q of output; this output, multiplied by average total costs, equals all costs: this is where q hits the ATC curve, or at “b”. “c” represents cost, and “c-b-q- 0” (blue block) is total costs. Total revenues = p*q, or “p- a-q-0”. So, as normal profit has been made (break even, or “c-b-q-0”), SNP has been made as extra: “p-a-b-c”. 0

SO this is why short run equ’m (previous slide) does not equal long run equ’m! Because… Long Run Equilibrium: Industry is in equ’m when normal profit is made and no SNP is made

So how is long run equ’m achieved? Remember, there is perfect knowledge. So new firms move in to industry to make SNP. As they do, supply expands and price falls. The supply curve shifts rightwards; price falls; thus, in the diagram for the single firm (the black slide), the perfectly elastic demand curve (also showing price) slides downwards. Firms always produce at MC=MR. Because the demand curve = the price curve = the MR curve, when the price falls, the MR curve slides down to a new position and hits a new point on the MC curve. This continues until it reaches the point where MR=MC=ATC=d=AR. Only normal profit is made – no more SNP. Total costs now is equal to total revenue. Since no more SNP is being made, no new firms are attracted into the industry and the process stops. Let’s see a picture….

D S1 S2 S3 p1 p2 p3 p1 p2 p3 0 Q1 Q2 Q3 MC ATC d1, AR1, MR1 d2, AR2, MR2 d3, AR3, MR3 Q3 Q2 Q1 0 Quantity Output Price

Shutdown Point In LR Equ’m, a firm cannot produce where less than normal profits are being made – they will lose. But in SR Equ’m this can be justified. Keep this in mind: –When a firm shuts down, the must pay fixed costs still. When they are in operation, the must pay fixed and variable costs

ATC MC d, AR, MR q Output p Price AVC d c b a 0 Currently the firm is making a loss: total revenue = 0-q-a-p, and total costs = 0- q-b-c. Loss is p-a-b-c. If they shut down, they will produce nothing (therefore no revenue), but will have to pay the fixed costs (ATC-AVC, or the space between the two curves). These are equal to d-e-b-c. If the firm doesn’t close down, though, they will have fixed costs and variable costs. They will also have revenue. So, revenue covers all variable costs (0-q-e-d), and the surplus (d-e- a-p) goes towards covering the fixed costs (d-e-b-c). Now, only a loss of p-a- b-c is made instead of d-e-b-c. This is the obvious choice for a profit maximiser. e