UBEA 1013: ECONOMICS 1 CHAPTER 5: MARKET STRUCTURE: PERFECT COMPETITION 5.1 Characteristic 5.2 Short-run Decision: Profit Maximization 5.3 Short-run Decision: Minimizing Loss 5.4 Long-run Adjustment 5.5 External Changes: Consumer Preference & Technology 5.6 Efficiency of Perfect Competition

UBEA 1013: ECONOMICS Characteristic i. Many firms: A single firm’s production is relatively very small compare to the market demand. ii. Homogenous product: product/service has no unique characteristic, so consumers don’t care which firm they buy from. iii. Perfect information: Firms are price taker because of (i), (ii) and buyers & sellers are well informs about price. No transaction cost assumed. Firm only decide how much to produce >> results in perfectly elastic demand. iv. Free entry / exit: No legal, technology, capital, incumbent advantage or others constraint to entry/exit. No transaction cost assumed. New firms enter (existing firms exit) if industry earning above (negative) normal profit. (>> economic profit = 0 >> normal profit = normal rate of return)

UBEA 1013: ECONOMICS 3 Figure 5.1: Market and Firm’s Demand Curve 5.1 Characteristic

UBEA 1013: ECONOMICS Short-run Decision: Profit Maximization Profit, π (q) = TR (q) – TC (q) Differentiating against quantity on the above equation gives the rate of change of each variable. (Δ π / Δq) = (ΔTR / Δq) – (ΔTC / Δq) = MR – MC Profit maximization is when (Δ π / Δq) = 0. Why? (Δ π / Δq) > 0; MR > MC; should increase q (Δ π / Δq) < 0; MR < MC; should decrease q (Δ π / Δq) = MR – MC = 0 »» MR = MC (is the profit maximization condition) »» MR = p = MC (one price for every level of output & the whole market/industry )

UBEA 1013: ECONOMICS 5 Figure 5.2: Profit Maximization Condition In a perfect competition market structure, ATR is equal to MR equal to price. Therefore, graphically, firm earns profit if its price is above its ATC curve. 5.2 Profit maximization

UBEA 1013: ECONOMICS 6 Figure 5.3: Firm Earning Positive Profit in Short-run Total revenue = ($5.00 X 300 = $1,500) Total cost = ($4.20 X 300 = $1,260) >> Total profit = [($ $4.20)*300 = $240] or [$1,500 - $1,260 = $240] 5.2 Profit maximization

UBEA 1013: ECONOMICS 7 If average revenue less than average total cost, a firm suffer losses. However, it is whether average (total) revenue less than average (total) variable cost or not is the critical factor for the firm to either continue operation or shut down. TR – TVC = Operating profit. Positive operating profit (TR – TVC > 0) can be used to offset fixed costs and reduce total losses. So, it is better for the firm to keep operating. 5.3 Short-run Decision: Minimizing Loss

UBEA 1013: ECONOMICS 8 If the operating profit is negative (TR < TVC), the firm suffers operating losses that push total losses above fixed costs. So, it is better to shut down. Summary: TR > TVC: Decision = Keep operating (in short term) TR < TVC: Decision = Shut down Those decisions is known as minimizing losses. 5.3 Minimizing loss

UBEA 1013: ECONOMICS 9 Figure 5.4: Minimizing Losses with Positive Operating Profit 5.3 Minimizing loss

UBEA 1013: ECONOMICS 10 Case 1: Shut-down $ Case 2: Operate at price = $3.50 $ Total Revenue (q=0) 0.00Total revenue ($3.50*225) Minus: Variable cost0.00Variable cost ($3.10*225)(697.50) Operating profit/loss (TR –TVC) 0.00Operating profit/loss (TR –TVC) Minus: Fixed cost(225.00)Fixed cost(225.00) Total profit/loss(225.00)Total profit/loss(135.00) Table 5.1: Comparison of Losses 5.3 Minimizing loss

UBEA 1013: ECONOMICS 11 Figure 5.5: Shut Down Point & Short-run Supply Cost Minimum market price for the firm to make a shut down decision >>> MR = MC = AVC Firm supply curve >>> P = MR = MC (but above AVC) 5.3 Minimizing loss

UBEA 1013: ECONOMICS 12 Figure 5.6: Industry Short-run Supply Curve To be continue next week … Minimizing loss

UBEA 1013: ECONOMICS Long-run Adjustment In long run, firm only earn zero economic profit Total accounting cost Normal profit Total Revenue Total economic cost Zero econ profit

UBEA 1013: ECONOMICS 14 WHY zero economic profit ??? A) FREE ENTRY & EXIT When economic profit > 0: >> Encourage NEW firms to come in >> Market supply increase (SS curve shift rightward) >> Price drop >> TR drop >> profit drop >> When economic profit = 0, no incentive to come in When economic profit < 0: >> Incentive for existing (losing) firms to exit >> Market supply drop (SS curve shift leftward) >> Price increase >> TR increase >> loss reduced >> When economic profit = 0, no incentive to exit 5.4 Long run adjustment

UBEA 1013: ECONOMICS 15 Entry & Exit Figure 5.7: Exit in Short-run Losses Situation Only normal profit in the long run that did not encourage entry or exit from the industry 5.4 Long run adjustment

UBEA 1013: ECONOMICS External Changes: Consumer Preference & Technology A1) Changing preference: Increase in demand When preference increase: >> DD curve shift rightward, qty & price increase >> Existing firm gain positive economic profit >> Incentive for expansion or new firms entry >> Market SS increase: SS curve shift rightward, qty increase but price drop until each firm earn zero economic profit >> With the increase of new firms, the market share for each firm in the industry decrease, thus a firm might end up producing q X0 units of output

UBEA 1013: ECONOMICS 17 A2) Changing preference: Decrease in demand When preference drop: >> DD curve shift leftward, qty & price decrease >> Existing firm suffer economic losses >> Incentive for contraction or exit >> Market SS decrease: SS curve shift leftward, qty drop but price increase until each firm earn zero economic profit >> With the exit of firms, the market share for each firm in the industry increase, thus a firm might end up producing q Y0 units of output 5.5 External Changes

UBEA 1013: ECONOMICS 18 B) Advancing technology: Technology improvements (a) Adopt new technology (b) Old technology firm Economic loss Positive economic profit New firms entry SS up, P down Profit reducing Produce at lower cost ExitAdopt new technology SS down, P up Zero economic profit 5.5 External Changes

UBEA 1013: ECONOMICS Efficiency of Perfect Competition (a) What will be produced? (b) How will it be produced? (c) Who will get what is produced? (i) Produce what people want (i) Incentive to use best technology to lower cost. (ii) SS – DD free interaction (iii) Produce at P = MC (ii) MP L = P L (i) Purchasing power (income) (ii) Free to choose, subject to purchasing power constraint End