1. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. A Lecture Presentation in PowerPoint to accompany Exploring Economics by Robert L. Sexton and Peter Fortura

2. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Chapter 8 Competition

3. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures Economists have identified four different market structures in which firms operate: perfect competition, monopoly, monopolistic competition, and oligopoly. Each structure has key characteristics, but it is sometimes difficult to decide which structure a given firm or industry most appropriately fits.

4. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures At one end of the continuum of market environments is pure monopoly. There is a single seller. The seller sets the price that will maximize its profits.

5. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures Monopolistic competition falls between perfect competition and monopoly; firms have elements of both competition and monopoly power. Each firm's product is differentiated from competitors’, so each has some monopoly power. However, because there are so many competitors, it also has an element of competitive markets.

6. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures Oligopoly also falls between perfect competition and monopoly, where a few firms produce similar or identical goods, as opposed to one firm or many. Unlike monopoly, oligopoly allows for some competition between firms. Unlike competition, individual firms have a significant share of the total market for the good being produced.

7. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures An oligopolist is very conscious of the actions of competing firms, and its behaviour is closely related to that of its competitors. An oligopolist does have some control over price and thus is a price searcher.

8. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures At the other end of the spectrum, perfect competition involves a large number of buyers and sellers, a homogeneous (standardized) product, and easy market entry and exit.

9. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures In perfect competition, no single firm produces more than an extremely small proportion of output, so no firm can influence the market price or quantity. Firms are price takers, who must accept the market price as determined by the forces of demand and supply.

10. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures In perfectly competitive market, consumers believe that all firms sell identical (homogeneous) products, so the products are perfect substitutes.

11. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures Product markets characterized by perfect competition have no significant barriers to entry or exit. This means that it is fairly easy for entrepreneurs to become suppliers of the product or, if they are already producers, to stop supplying the product.

12. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures Barriers to entry are modest, so large numbers of firms can enter the business if they so desire. Because of easy market entry and exit, perfectly competitive markets generally consist of a large number of small suppliers.

13. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures Highly organized markets for securities and agricultural commodities are the best example of a perfectly competitive market.

14. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.1 The Four Different Market Structures While the assumptions for perfect competition may seem a bit unrealistic, the model is useful. Many markets resemble perfect competition: Firms face very elastic demand curves and relatively easy entry and exit. It gives us a standard of comparison.

15. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.2 The Price Taker’s Demand Curve Perfectly competitive firms are price takers, selling at the market-determined price. An individual seller cannot sell at any price higher than the current market price because buyers could purchase the same good from someone else at the market price. A seller would not charge a lower price when he could sell all he wants at the market price.

16. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.2 The Price Taker’s Demand Curve In a perfectly competitive market, an individual seller can change his output and it will not alter the market price. Each producer provides such a small fraction of the total supply that a change in the amount he or she offers does not have a noticeable effect on market price.

17. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.2 The Price Taker’s Demand Curve In a perfectly competitive market an individual firm can sell as much as it wishes to place on the market at the prevailing price. In other words, the demand, as seen by the seller, is perfectly elastic at the market price.

18. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.2 The Price Taker’s Demand Curve Since a perfectly competitive seller won't charge more than the market price because no one will buy at higher prices, nor charge less because the seller can sell all she wants at the market price, the demand curve is horizontal at the market price over the entire range of outputs that could possibly be produced.

19. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price 150 D Quantity of Wheat (thousands of bushels) 0 $5 100200 Quantity of Wheat (bushels) 0 $5 d S Firm's Demand Curve Market price and output determined here Firm is a price taker—must take market price Market and Individual Demand Curves in Perfect Competition

20. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.2 The Price Taker’s Demand Curve The position or height of each firm’s demand curve varies with every change in the market price. Sellers are provided with current information about market demand and supply conditions as a result of price changes.

21. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.2 The Price Taker's Demand Curve The perfectly competitive model does not assume any knowledge on the part of individual buyers and sellers about market demand and supply  they only have to know the price of the good they sell.

22. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. $6 Price Quantity (market) 0 5 $6 Q0Q0 Q1Q1 D0D0 d0d0 d1d1 D1D1 Quantity (firm) 0 5 S Market Prices and the Position of a Firm’s Demand Curve

23. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.3 Profit Maximization The firm’s objective is to maximize profits. It wants to produce the amount that maximizes the difference between its total revenues and total costs.

24. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.3 Profit Maximization Total revenue (TR) is the revenue that the firm receives from the sale of its products. Total revenue for a perfectly competitive firm equals the market price of the good (P) times the quantity (q) of units sold: (TR = P x q).

25. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.3 Profit Maximization Average revenue (AR) equals total revenue divided by the number of units sold of the product (TR/q).

26. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.3 Profit Maximization Marginal revenue (MR) is the additional revenue derived from the sale of one more unit of the good. In a perfectly competitive market, additional units of output can be sold without reducing the market price, therefore marginal revenue is constant and equal to the market price, which is also the average revenue.

27. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.3 Profit Maximization In perfect competition, marginal revenue, average revenue, and price are all equal: P = MR = AR. There are two methods for identifying a firm's profit maximizing output. the marginal approach the total cost-total revenue approach

28. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Revenues for a Perfectly Competitive Firm

29. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.3 Profit Maximization In all types of market environments, firms will maximize profits at that output where one maximizes the difference between total revenue and total costs, which is the same output level where marginal revenue equals marginal costs.

30. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.3 Profit Maximization The importance of equating marginal revenue and marginal costs for maximizing profits is straightforward.

31. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.3 Profit Maximization As long as the marginal revenue derived from expanded output exceeds the marginal cost of that output, the expansion of output creates additional profits. However, expansion of output when the marginal cost of production exceeds marginal revenue will lead to losses on the additional output, decreasing profits.

32. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.3 Profit Maximization The profit-maximizing output rule says a firm should always produce where its MR = MC.

33. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price MC q TOO LITTLE q*q*q TOO MUCH Quantity of Wheat (bushels per year) 0 $5 Profit increasing up to q* Profit decreasing beyond q* P = MR = AR A firm maximizes profits by producing the quantity where MR = MC, at q* MR MC Finding the Profit Maximizing Level of Output MR

34. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.3 Profit Maximization Total revenues and total costs and the profit-maximizing output rule give the same result.

35. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Cost and Revenue Calculations For A Perfectly Competitive Firm

36. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses Producing at the profit-maximizing output level does not mean that a firm is actually generating profits. It merely means that a firm is maximizing its profit opportunity at a given price level. A firm could be: earning profits, generating losses, or breaking even.

37. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses Three easy steps to determine economic profits, economic losses, or zero economic profits: Where MR equals MC proceed down to horizontal axis to find q*, the profit- maximizing output level. At q*, go straight up to demand curve, then to price axis to find the market price, P*. Now you can find TR at the profit-maximizing output level because TR = P x q.

38. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses The last step is to find total costs. Go straight up from q* to the short-run average total cost (SRATC) curve; this will give you the average cost per unit. If we multiply average total costs by the output level, we can find the total costs (TC = ATC x q).

39. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses If TR > TC at the profit-maximizing output level, the firm is generating economic profits. If TR < TC, the firm is generating economic losses. If TR - TC, the firm is earning zero economic profits, Covering both implicit and explicit costs, economists sometimes call zero economic profit a normal rate of return.

40. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 0 ATC 0 0 q* = 120 P > ATC at q* Economic Profit Price MC P < ATC at q* Economic Loss P = ATC at q* Economic Profit P = MR = AR ATC = $5 P* = $4 $4.90 ATC = $5 P* = $6 q* = 80q* = 100 P = MR = AR (Profit-maximizing quantity)(Loss-minimizing quantity)(Profit-maximizing quantity) Quantity (firm) Quantity (firm) Quantity (firm) Total Profit Total Loss Short-Run Profits, Losses and Zero Economic Profits MC ATC MC P = MR = AR

41. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses A firm generating an economic loss faces a tough choice: Should it continue to produce or shut-down its operation in the short run? To make this decision, we need to consider average variable costs.

42. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses If a firm cannot generate enough revenues to cover its variable costs, then it will have larger losses if it operates than if it shuts down (losses in that case = fixed costs). Thus, a firm will not produce at all unless the price is greater than its average variable costs.

43. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses At price levels greater than or equal to average variable costs, a firm may continue to operate in the short run even if average total costs  variable and fixed costs  are not completely covered. Because fixed costs continue whether the firm produces or not, it is better to earn enough to cover a portion of these costs rather than earn nothing at all.

44. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses When price is less than average total costs but more than average variable costs, the firm produces in the short run, but at a loss. To shut down would make this firm worse off because it can cover at least some of its fixed costs with the excess of revenue over its variable costs.

45. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price Quantity (firm) 0 q P P > AVC Do not shut down P = MR = AR ATC AVC MC Shutdown Point Short-Run Losses

46. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses When the price a firm is able to obtain for its product is below its average variable costs at all ranges of output, it is unable to cover even its variable costs in the short run. Since it is losing even more than the fixed costs it would lose if it shut down, it is most logical for the firm to cease operations.

47. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price Quantity 0 q P P < AVC Shutdown P = MR = AR ATC AVC MC Shutdown Point Short-Run Losses: Price Below AVC

48. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses At all prices above minimum AVC, the firm produces in the short run, even if ATC is not completely covered. At all prices below the minimum AVC the firm shuts down. Therefore the short-run supply curve of an individual competitive seller is identical with that portion of the MC curve that lies above the minimum of the AVC curve.

49. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses As a cost relation, the MC curve above minimum AVC shows the marginal cost of producing any given output. As a supply curve, the MC curve above minimum AVC shows the equilibrium output that the firm will supply at various prices in the short run.

50. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses Beyond the point of lowest AVC, the MC of successively larger outputs are progressively greater, so the firm will supply larger amounts only at higher prices.

51. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price Quantity 0 ATC AVC MC Short-Run Supply The Firm’s Short-Run Supply Curve

52. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.4 Short-Run Profits and Losses The short-run market supply curve is the horizontal summation of the individual firms' supply curves, providing that input prices are not affected by increased production of existing firms. Because the short run is too brief for new firms to enter the market, the market supply curve is the horizontal summation of existing firms.

53. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Quantity of Wheat (bushels per day) 0 5080 B A P1P1 P0P0 Individual Firm Supply (MC) Quantity of Wheat (Thousands of bushels per day) 0 5080 P = AVC Market Supply Price per Bushel Price per Bushel P1P1 P0P0 P = AVC b a B A Deriving the Short-Run Supply Curve

54. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 0 P1P1 q2q2 P2P2 P3P3 P4P4 d 4, mr 4 d 3, mr 3 d 2, mr 2 d 1, mr 1 The Short-Run Output Decision q3q3 q4q4 ATC AVC MC Shutdown point

55. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.5 Long-Run Equilibrium If perfectly competitive producers make economic profits, resources devoted to that lucrative business increase. More firms enter the industry and existing firms expand, shifting the market supply curve to the right over time. The impact of increasing supply, other things equal, is to reduce the equilibrium price.

56. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.5 Long-Run Equilibrium As entry into the profitable industry pushes down the market price, producers will move from making a profit (P > ATC) to zero economic profits (P = ATC). In long ‑ run equilibrium, perfectly competitive firms make zero economic profits, earning a normal return on the use of their capital.

57. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.5 Long-Run Equilibrium Zero economic profits is an equilibrium or stable situation because any positive economic (above ‑ normal) profits signal resources into the industry, beating down prices and thus revenues to the firm.

58. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.5 Long-Run Equilibrium Economic losses signal resources to leave the activity, reducing supply which leads to increased prices and higher firm revenues to the remaining firms. Only at zero economic profits is there no tendency for firms to either enter or leave the business.

59. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price Quantity 0 Q0Q0 Q1Q1 S0S0 S1S1 D 0 q1q1 q0q0 P0P0 P1P1 MC ATC P0P0 P1P1 Price d 0, mr 0 d 1, mr 1 Profits Disappear With Entry

60. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.5 Long-Run Equilibrium The long ‑ run competitive equilibrium for a perfectly competitive firm can be graphically illustrated. Where MC = MR, short-run and long- run average total costs are also equal. The ATC curves touch the MC and MR (demand) curves at the equilibrium output point.

61. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.5 Long-Run Equilibrium Because the MR curve is also the AR curve, average revenues and average total costs are equal at the equilibrium point.

62. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.5 Long-Run Equilibrium The long-run equilibrium output in perfect competition occurs at the lowest point on the ATC curve, so the equilibrium condition in the long run in perfect competition is for firms to produce at that output that minimizes per-unit total costs.

63. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price Quantity of Wheat (bushels per year) 0 q*q* P ATC MC P = MR = AR The Long-Run Competitive Equilibrium

64. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.6 Long-Run Supply When the output of an entire industry changes, we consider two possible industry cost conditions. constant costs increasing costs The shape of the long-run supply curve depends on the extent to which input costs change when there is entry or exit of firms in the industry.

65. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.6 Long-Run Supply In a constant-cost industry, the prices of inputs do not change as output is expanded. The industry does not use inputs in sufficient quantities to affect input prices.

66. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.6 Long-Run Supply Because the industry is one of constant costs, industry expansion does not alter firm's cost curves, and the industry long-run supply curve is horizontal.

67. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.6 Long-Run Supply The short-run higher profits from an increase in demand attracts entry until long-run equilibrium is again reached. The long ‑ run equilibrium price is at the same level that prevailed before demand increased. The only long ‑ run effect of the increase in demand is an increase in industry output.

68. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 0 P0P0 S D 0 a. Initial Equilibrium ATC MC q0q0 Q0Q0 Quantity of Blueberries (firm) 0 S D1D1 D0D0 0 q0q0 Profits b. Short-Run Profits MC q1q1 Q0Q0 Q1Q1 Quantity of Blueberries (firm) Quantity of Blueberries (market) ATC P0P0 Quantity of Blueberries (market) Demand Increase in a Constant-Cost Industry Continued... a A A B P0P0 P1P1 P1P1 P0P0 d 1, mr 1 d 0, mr 0 b a

69. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 0 LRS S0S0 S1S1 0 c. Long-Run Entry and No Economic Profits MC Q0Q0 Q1Q1 Q2Q2 Quantity of Blueberries (firm) Demand Increase in a Constant-Cost Industry D1D1 D0D0 Quantity of Blueberries (market) P1P1 P0P0 P0P0 P1P1 q0q0 q1q1 d 1, mr 1 d 0, mr 0 ATC B CA

70. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.6 Long-Run Supply In an increasing-cost industry, the cost curves of the individual firms rise as the total output of the industry increases.

71. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.6 Long-Run Supply When an industry utilizes a large portion of an input, input prices will rise when the industry uses more of that input as it expands output, which will shift firms' cost curves upward. Examples include “extractive” industries, which utilize large portions of the total supply of specialized natural resources such as land or mineral deposits.

72. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.6 Long-Run Supply The short-run higher profits from an increase in demand attracts entry until long-run equilibrium is again reached; producers' MC and AC curves will be higher, so that the new long-run equilibrium is at a higher price. The long-run industry supply curve in this case has a positive slope.

73. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Increasing-Cost Industry

74. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.6 Long-Run Supply Even in this case, the long-run supply is usually more elastic than the short-run supply because in the long run, firms can enter and exit the industry.

75. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.6 Long-Run Supply The output that results from equilibrium conditions of market demand and supply in perfectly competitive markets is economically efficient. Only at this outcome can maximum output be obtained from our scarce resources.

76. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. 8.6 Long-Run Supply Once the competitive equilibrium is reached, the buyers' marginal benefit equal the sellers' marginal cost (both equal to the price) and the sum of consumer and producer surplus is maximized. If there are no externalities, then total welfare is maximized and resources are allocated efficiently.

77. Copyright © 2007, Nelson, a division of Thomson Canada Ltd.. Price B A Quantity 0 0 Allocative Efficiency and Perfect Competition S = MC D = MB S = MC D = MC Q0Q0 Q0Q0 Q*Q* Q*Q* MC MB Q*Q* MC MB Q*Q*