1 Perfect Competition APEC 3001 Summer 2007 Readings: Chapter 11.
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Transcript of 1 Perfect Competition APEC 3001 Summer 2007 Readings: Chapter 11.
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1
Perfect Competition
APEC 3001
Summer 2007Readings: Chapter 11
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Objectives
• Accounting versus Economic Profit
• Profit Maximization Assumption
• Characteristics of Perfect Competition
• Perfect Competition in the Short Run
• Short Run Industry Supply
• Perfect Competition in the Long Run
• Perfect Factor Mobility in the Long Run
• Industry Supply in the Long Run
• Price Elasticity of Supply
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Accounting versus Economic Profit
• Accounting Profit– Explicit Costs
– Explicit Benefits
– Does Not Incorporate Opportunity Costs
• Economic Profit– Explicit & Implicit Costs
– Explicit & Implicit Benefits
– Incorporates Opportunity Costs
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Example of Accounting Versus Economic Profit
• Suppose a corn farmer– spends $300 an acre on seed, fertilizer, & pesticides,
– spends $50 an acre on equipment to plant, cultivate, & apply chemicals,
– produces 150 bushels per acre, &
– sells the crop for $3.00 a bushel.
• Question: What is the farmer’s accounting profit?– $3150 - $300 - $50 = $100/acre
• Question: What is missing for economic profit?– Opportunity cost of land.
– Opportunity cost of labor.
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The Profit Maximization Assumption
• What is a firm’s objective?– Fundamental Assumption: Firms seek to maximize economic profit.
• Is this a good assumption?– It depends on the extent to which our socio-economic institutions reward
firms that generate more profit.
• How do firm’s maximize profit?– Trial & Error
– Cold & Calculating
– Imitation
• Does it really matter how they get there?– No!
– It only matters that they tend to get there.
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Characteristics of Perfect Competition
• Sale of a Standardized Product
• Firms are Price Takers (Perfectly Elastic Demand)
• Factors of Production Are Perfectly Mobile in the Long Run
• Firms and Consumers Have Perfect Information
Sufficient, but not necessary!
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Perfect Competition in the Short RunDefinitions
• Profit: = TR – TC where TR is total revenue & TC is total costs.
• Total Revenue: – Price Quantity (TR = P0Q where P0 is the market price).
• Marginal Revenue (MR): – The change in total revenue that results from a one unit change in sales:
MR = TR/Q = TR’.
• Average Revenue (AR): – Total revenue divided by output: AR = TR/Q.
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Total Revenue for a Competitive Firm
Output (Q)
$
TR=P0Q
Slope = P0 = MR = AR
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Total Revenue and Cost for a Competitive Firm
Output (Q)
$
TR
TC
FC
Q1 Q2 Q3Q0
Slope = P0 Slope = P0
a
a: MR = MC & < 0
b
b: MR > MC & TR = TC
c
c: MR = MC & > 0
d: MR < MC & TR = TCd
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Profit Curve for a Competitive Firm
Profit: =TR-TC
$
-FC
Q1 Q2 Q3
Q0
Output (Q)
0
a
b
c
d
a: Minimum
b: = 0 & Increasing
c: Maximum
d: = 0 & Decreasing
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Finding the Profit Maximizing Output
• How do we maximize a function, say = TR - TC?– We can take the derivative & set it equal to 0: ’ = TR’ – TC’ = 0.
• Recall that TR’ = MR = P0 & TC’ = MC.
• Profit is maximized where P0 = MC!
– But this happens at two points: a & c!
– But we know c is better than a!
• How can we tell these two points apart?– For a maximum, the second derivative must be negative: ’’ = TR’’ –
TC’’ < 0.• TR’’ = 0 & TC’’ = MC’
• Profit is maximized where P0 = MC & MC’ > 0 (increasing marginal costs)!
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Marginal Revenue and Cost Curves
Output (Q)
$
MR
MC
Q2Q0
P0
a c
a: ’ = 0 & ’’ > 0 Minimum
c: ’ = 0 & ’’ < 0 Maximum
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So, is that all there is to it?
• Well, no!– P0 = MC & MC increasing tells us how to maximize profit when we
choose to produce.
– It does not tell us whether or not we should produce.
• Question: When will we be better off producing something instead of nothing?
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Different Profit Curves for a Competitive Firm
1
$
-FC
Q2Q0
Output (Q)
0
2
= -FC
a1
a2
c1
c2
’ = 0 tells us to look at a1, a2, c1, & c2
’’ < 0 tells us to throw out a1 & a2
For c1, should we produce Q2 or 0?
Notice that for c1 1 > -FC, so we should produce Q2.
For c2, should we produce Q2 or 0?
Notice that for c2 2 < -FC, so we should produce 0.
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In the short run, we should produce only if profit exceeds fixed costs ( > –FC)!
> –FC TR – VC – FC > –FC or TR > VC
• Dividing by Q: AR = P0 > AVC
• Three Profit Maximizing Conditions:– P0 = MC
– MC’ > 0 (Marginal Costs are increasing)
– P0 > AVC
• These conditions imply a firm’s supply curve equals marginal costs above minimum average variable costs & 0 below minimum average variable costs!
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Perfectly Competitive Supply in the Short Run
Output (Q)
$/Q
MC
AVC
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Short Run Industry Supply
• To find the market demand for a product, we horizontally summed individual demand curves.
• To find industry supply in the short run, we also need to horizontally sum individual firm supply in the short run.
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Example Short Run Industry Supply
• Suppose– Firm A’s supply is
• QA = 0 for P < 10 &
• QA = 5 + 0.5P for P 10
– Firm B’s supply is• QB = 0 for P < 20 &
• QB = 5 + P for P 20
• Industry Supply:– For P < 10, QS = 0
– For 20 > P 10, QS = QA = 5 + 0.5P
– For P 20, QS = QA + QB = 5 + 0.5P + 5 + P = 10 + 1.5P
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Firm A’s Supply
0
10
20
30
40
50
0 5 10 15 20 25 30
Output (Q)
Pri
ce (
P)
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Firm B’s Supply
0
10
20
30
40
50
0 10 20 30 40 50 60
Output (Q)
Pri
ce (
P)
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Figure 9: Industry Supply for Firm A and B
05
101520253035404550
0 10 20 30 40 50 60 70 80
Output (Q)
Pri
ce (
P)
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Perfect Competition in the Long Run
• Three Profit Maximizing Conditions:– Marginal Revenue Equals Marginal Costs: MR = P0 = LMC
– Marginal Costs Must Be Increasing: LMC’ > 0
– Average Revenue Must Exceed Average Costs: AR = P0 > LAC
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Long Run Production For Perfect Competition:An Example With Economic Profits
Output (Q)
$/Q
MC
Q0*
c
MR0 =AR0P0
LAC
a
b
d
Profit = area abcdThis firm will wantto produce in the
long run!
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Long Run Production For Perfect Competition:An Example With Economic Losses
Output (Q)
$/Q
MC
LAC
P0 b
a
Q0*
MR0 =AR0
Loss = area abcd
c
d
This firm will not want to producein the long run!
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Perfectly Competitive Supply in the Long Run
Output (Q)
$/Q
LMC
LAC
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Perfect Factor Mobility in the Long Run
• Can economic profit persist in the long run?
• Not with perfect factor mobility!– Firms will see economic profits & choose to enter the industry.
– Firm entry will increase supply and drive down the equilibrium price.
– As the equilibrium price falls, so will economic profit.
– As long as there are economic profits to be had, there will be new firms entering the industry.
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Market Equilibrium
Price
Quantity
S0 = MC
D
P0
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Long Run Profit Maximization for a Perfectly Competitive Firm
Output (Q)
$/Q
MC
Q0*
MR0 =AR0P0
LAC
Profit
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New Market Equilibrium With Entry
Price
Quantity
S0 = MC
D1
P0
S1 = MC+MCE
P1
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Long Run Profit Maximization With New Equilibrium Prices
Output (Q)
$/Q
MC
Q0*
MR0 =AR0P0
LAC
P1
Q1*
MR1 =AR1
Perfect factor mobilitymeans there will be
entry as long as thereis economic profit.
Entry stops when theprice is driven downminimum long run
average costs.
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Long Run Supply with Constant Input Prices
Price
Quantity
S = Minimum LAC
Long run supply is perfectly elastic!
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Question: Are there any instance where the long run supply curve will be something other than a
horizontal line?
• Pecuniary Diseconomy: – A rise in production cost that occurs when an expansion of industry output
causes a rise in the prices of inputs.
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Example of Increasing Long Run Average Cost
P
Q
QD
QS
P
Q
LMC
LAC
w
L
LD
LS
r
K
KD
KS
P*
w* r*
QS’
P**
LD’
w**
KD’
r**
LMC’
LAC’
Panel IIPanel I
Panel IVPanel III
Q*Q**
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Shape of Long Run Supply
• Horizontal Line (Perfectly Elastic): – Factor supplies must be perfectly elastic.
• Upward Sloping: – Pecuniary diseconomies imply factor supplies are positively sloped.
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Price Elasticity of SupplyDefinition
• The percentage change in the quantity supplied divided by the percentage change in price:
S
SS
S
S Q
P
P
Q
P
PQ
Q
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Price Elasticity of SupplyAn Example
• Suppose QS = 10P – 5 & P = 2
– QS = 102 – 5 = 15
QS/P = 10
3
11
15
210
S
SS Q
P
P
Q
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Price Elasticity of SupplyA Few Facts
S = 1 whenever a linear supply curve goes through the origin.
• Long run supply curves are more elastic than short run supply curves.
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What You Need to Know
• Difference in Accounting & Economic Profit
• The Profit Maximization Assumption
• The Characteristics of Perfect Competition
• Implications of Perfect Competition for Short Run Production
• Short Run Industry Supply with Perfect Competition
• Implications of Perfect Competition for Long Run Production
• Implications of Perfect Factor Mobility for Long Run Supply
• Determinants of the Shape of Long Run Industry Supply
• How to Calculate the Price Elasticity of Supply