Ch06 - Perfectly Competitive Markets

8/3/2019 Ch06 - Perfectly Competitive Markets

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The Perfectly Competitive

MarketEconomics 11

UPLB



Market Economy

the market is a system where buyers and sellersexchange goods or services

market is actually a very logical mechanism that

helps answer the basic economic questions of what, how much and for whom to producedifferent commodities.

system continually allocates goods and servicesto various units with the help of a pricing mechanism



The Market System

a market for commodities - rice, milk, water,coffee, clothes and many others.

a market for the inputs used in the production

of these commodities like steel, minerals andlabor.

Each market may have a different structure:

the number of sellers or buyers demand for the commodity

control in the market.



Two General Types of Markets

I. the Perfectly Competitive Market [5 main

features]

II. the imperfect market

Monopoly – one firm

Oligopoly – two or more, but few firms

Monopolistic competition – many firms selling

differentiated products.



5 Features of Perfectly Competitive Market

1. Smallness of buyers and sellers relative to the

market

2. Homogeneous product

3. Absence of artificial restraints or controls

4. Perfect mobility of goods and resources

5. Perfect information



The Demand Curve Faced by the Firm

since the firm cannot control the market price,owing to its smallness relative to the market, thefirm can actually sell as much output as it wants

without influencing the price. the firm in perfect competition faces a perfectly

elastic demand curve

the equilibrium price is still determined in themarket by the forces of demand and supply

P

Q

d



Revenues of the Firm

Total revenue (TR) is the firm's gross income from the sale of itsproduct

TR=P.Q

Marginal revenue (MR) is the additional revenue earned fromeach additional unit of output sold.

MR=∆TR/∆Q

Average revenue (AR) is total revenue divided by output.

AR=TR/Q



Market Firm

Q

D

P* P* d

0 0Q

Price

Equilibrium price is determined

in the market

Once determined, a firm can sell as

much as it wants at that price

S

Market



Market Firm

Q

D

P* P* d

0 0Q

Price

Equilibrium price is determined

in the market

Once determined, a firm can sell as

much as it wants at that price

S

D2

Market

P2

d2

P2

D2



FIGURE 6.1. The market and firm demand curves for a perfectly competitive good.In the left panel of this diagram, we find a downward sloping market demand curve forthe good. Its intersection with the market supply curve determines the equilibrium price(P* ) that will prevail in the market. Since a perfectly competitive firm can sell all that itwants at P* , the firm’s demand curve is the horizontal line shown at the right panel of thisdiagram.

P

Q

0 Output

P r i c e

Demand

Supply

P

Q

0 Output

P r i c e

(A) Market (B) Firm

P* P*



Price, MR and AR

Q P TR MR AR

0 200 0 - -

1 200 200 200 200

2 200 400 200 200

3 200 600 200 200

4 200 800 200 200

5 200 1000 200 200

Under pure competition, P = MR = AR



0 1 2 3

P= 200

400

600

Revenue

Q

TR

MR = AR

Output



Output Price Total Revenue

Marginal

Revenue Total Cost Marginal Cost Profit

(Q) (P) (TR) (MR) (TC) (MC) (Π)

0 200 0 ~ 500 ~ -500

1 200 200 200 591 91 -391

2 200 400 200 668 77 -268

3 200 600 200 737 69 -137

4 200 800 200 804 67 -4

5 200 1000 200 875 71 125

6 200 1,200 200 956 81 244

7 200 1,400 200 1,053 97 347

8 200 1,600 200 1,172 119 428

9 200 1,800 200 1,319 147 481

10 200 2,000 200 1,519 200 481 11 200 2,200 200 1,784 265 416

12 200 2,400 200 2,119 335 281

13 200 2,600 200 2,529 410 71

14 200 2,800 200 3,019 490 -291

15 200 3,000 200 3,599 580 -599

Total Cost, Total Revenue, and Profit at Different Levels of Output



TR,TC

π

TC

TR

Q

Q0

0

P r o f i t

T o t

a l R e v e n u e ,

T o t a l C o

s t

Q0 Q* Q1

Output



Deriving profits from the TR and TC curves

Top panel Profits or losses are measured by the vertical distance between the TR

and TC curves. For quantities between Q0 and Q1, the TR curve is abovethe TC curve. For these levels of output, the firm’s profits are positive.

The TR and TC curves intersect at output levels Q0 and Q1. This meansthat the firm’s profits at these levels of output are zero since TR=TC.

For output levels to the left of Q0 and to the right of Q1, the TR curve isbelow the TC curve, which implies that the profits are negative.

Bottom Panel - a “bell-shaped” profit curve.

firm’s profits are highest at Q* where the slope of the TR curve (MR) andthe slope of the TC curve (TC) are equal. Hence, Q* is the firm’s profit-maximizing level of output.



P r

i c e ,

R e v e n u e a n d

C o s t

Output

MC

AC

AVC

Q

200

Q*

0

profit

A

C B

E

D

150

100

MR = ARP*

Total Revenue TR = 0P*AQ*,

Total Cost TC = 0CBQ*,

Profit π= CP*AB



Profit maximization for a perfectly

competitive firm The firm maximizes its profit at the intersection of the MR and

MC curves (point A) This means that the firm’s profit-maximizing level of output is equal to Q*.

How large is the firm’s profit? The firm’s total revenue is equal to the product of the price (line segment

0P*) and its output (line segment 0Q*). This suggests that its totalrevenue is equal to the area 0P*AQ*.

On the other hand, the firm’s total cost is equal to the product of itsaverage cost at Q* (line segment 0C) and its output (line segment 0Q*). This means that total cost is equal to the area 0CBQ*.

Since profit is equal to TR less TC, it is therefore equal to the differencebetween areas 0P*AQ* and 0CBQ*. In other words, the firm’s profit isequal to CP*AB



P r i c e ,

R e v e n

u e a n d C o s t

Output

MC

AC

AVC

Q

P2

Q2

*

P2= MR2= AR2

0

profit

P1

Q2

*

EFFECT OF A FALL IN PRICE FROM P1 TO P2



The effects of a fall in the output price

Since profit maximization requires the equality

between MR and MC, the fall in the price leads

to a fall in the firm’s output from Q1 to Q2 .

Profit also decreases



P r i c e ,

R e v e n u e a n d C o s t

Output

MC

AC

AVC

Q

P3

Q3

* 0

P3= MR3= AR3

IF PRICE FALLS TO P3 WHERE P=AC

At P3, P=AC, so TR=TC,profit is zero



Break even point

When price falls down to P 3 , price equals the

lowest point of the firm’s average cost curve.

This means that the firm’s total cost and total

revenue are equal

Thus, the firm’s profit at P 3 is equal to zero. We

refer to this as the break-even point.



P r i c e ,


Output

MC

AC

AVC

Q

P4

Q4

* 0

loss

P4= MR4= AR4

PRICE falls below AC at P4

If price falls below AC at P4. The firm incurs a loss but mustcontinue to produce to minimize losses.

A

BC

DE



Loss Minimization at a price between the minimum

AC and AVC curves

If the output price (such as P4) is between theminimum points of the AC and AVC curves, MR =MC at point A, and the best output level is equal toQ4.

The firm is experiencing losses at P4. TR<TCimplying a loss of P4 CBA.

To minimize its losses, the firm will continue to produce. If the firm decides to stop production, it

will still continue to pay for its fixed costs ECBD Since area ECBD is larger than P2CBA, its losses

from closing down are larger than its losses fromcontinued production.



P r i c e ,


Output

MC

AC

AVC

Q

P5

Q5*0

loss

P5= MR5= AR5

At P5 = min AVC, the loss is equal to the Total Fixed

Cost (TFC), which is the also the loss if the firm did

not produce. Therefore the firm should shut down.



P r i c e ,

R e v e n u

e a n d C o s t

Output

MC

AC

AVC

Q

P5

Q5

0

P1

P2

P3

P4

Q4 Q3 Q2 Q1

Note that Q changes as P changes. Given the P, Q is

determined at P=MC. There for the MC curve traces the

firm’s supply curve, but only above the minimum AVC



P r i c e ,


Output

MC

AC

AVC

Q

P5

Q5

P= MR= AR

0

loss

P1

P2

P3

P4

Q4 Q3 Q2 Q1

Firm’s Supply Curve:

Portion of MC curve above

the AVC curve



Long Run Equilibrium

Suppose that the price level (determined by D-S)

is such that it is profitable for firms to operate.

Positive profits will attract new firms into the

industry.

Supply curve will shift to the right

Price will decline until profit is driven down to zero.



Long Run Equilibrium

Suppose that the price level (as determined by

D-S conditions) is such that it not profitable for

firms to operate.

Negative profits will make some firms leave the

industry.

Supply curve will shift to the left

Price will increase until profit is no longer negative.



SACMC

LAC

MR, AR

S0

Q0

P

At Po, firms are reaping profits. Newfirms are attracted as long as profitsare positive. Supply curve shifts tothe right, so price falls.

D

S1

P0

P1

P0

P1

The entry or exit of firms will stoponly when profit is reduced tozero. This is at the lowest point ofthe LAC curve.

Q1



LAC

SAC1

Q0

COST

SMC1

LMC

Long Run Equilibrium of the Industry: P = LMC = SMC, P = LAC = SAC

P MR, AR



Constant cost industry

Suppose that the industry’s initial long -run equilibriumcorresponds to price and output levels P0 and Q0,respectively.

With an increase demand from D0 to D1 “short-run”

equilibrium price and quantity increase The higher price makes the industry profitable. Firms

will be encouraged to enter the industry. This causes arightward shift in the market supply curve.

We have a constant cost industry if the shift in thesupply curve leads to a long-run equilibrium whereinthe market price goes back to P0.



D0 D1

P

Q

Quantity

P r i c

e

S0S1

P0

P1

Q0 Q1

Long Run Supply Curve



LAC

SAC1

Q0

COST

SMC1

LMC

The increase in price will make the industry profitable. This will result

in entry of new firms. The increased supply will drive the price down

until profits are back to zero at P0.

P0 MR 0

P1 MR 1



Increasing cost industry

Suppose that the industry’s initial long -run equilibriumcorresponds to price and output levels P0 and Q0,respectively.

With an increase demand from D0 to D1 “short-run”

equilibrium price and quantity increase. The higher price makes the industry profitable. Firms

will be encouraged to enter the industry. The entry of firms causes LAC to shift upwards.

We have a increasing cost industry if the shift in thesupply curve leads to a long-run equilibrium whereinthe market price P1 is greater than P0.



LAC0

SAC1

Q0

COST

SMC1

LMC

The increase in price will make the industry profitable. The entry of

new firms causes the LAC to increase (move up). Equilibrium will be

established at P1,Q

1

P0 MR 0

P1 MR 1

P’1

LAC1

Q0 Q1



D0 D1

P

Q

Quantity

P r i c

e

S0

S1

P0

P’1

Q0 Q1

P’1 P1


INCREASING COST INDUSTRY



Decreasing cost industry

Industry’s initial long -run equilibrium corresponds toprice and output levels P0 and Q0, respectively.

An increase demand from D0 to D1 results in higher

equilibrium price and quantity.

The higher price makes the industry profitable. Firms

will be encouraged to enter the industry. However, the

entry of firms causes LAC to shift downwards.

We have a decreasing cost industry if the shift in thesupply curve leads to a long-run equilibrium wherein

the market price P1 is less than P0.



LAC0

SAC1

Q0

COST

SMC1

The initial increase in price will make the industry profitable.

However, the entry of new firms will cause the LAC to decrease (shift

downward). Equilibrium will be established at P1

,Q1

P0

MR 0P1

MR 1

P’1

LAC1

Q0Q1



D0 D1

P

Q

Quantity

P r i c e

S0 S1

P0

P’1

Q0

Q1

P1


DECREASING COST INDUSTRY



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Ch06 - Perfectly Competitive Markets

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Transcript of Ch06 - Perfectly Competitive Markets