Chapter 9

PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

PowerPoint Slides prepared by: Andreea CHIRITESCU

Eastern Illinois University

Perfect Competition

CHAPTER

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Market Structure• Market structure

– All the characteristics of a market that influence how trading takes place

• Four basic kinds of market structure– Perfect competition– Monopoly– Monopolistic competition– Oligopoly


What Is Perfect Competition?• Competition

– A situation of diffuse, impersonal competition in a highly populated environment

• Perfect competition1. Large numbers of buyers and sellers

2. Sellers offer a standardized product

3. Sellers can easily enter into or exit from the market

4. Buyers and sellers are well-informed


What Is Perfect Competition?• Large number of buyers and sellers

– No individual decision maker can significantly affect the price of the product by changing the quantity it buys or sells

• Standardized product offered by sellers– Buyers do not perceive differences

between the products of one seller and another


What Is Perfect Competition?• Easy entry into and exit from the market

– No significant barriers or special costs to discourage new entrants

– No barriers to exit• Well-informed buyers and sellers

– Buyers and sellers have all information relevant to their decision to buy or sell


What Is Perfect Competition?• Is perfect competition realistic?

– Yes: the market for wheat– Other markets, one or more of the

assumptions of perfect competition will not be met

– The model of perfect competition is powerful

– Many markets, while not strictly perfectly competitive, come reasonably close


The Perfectly Competitive Firm• A perfectly competitive firm

– Faces a demand curve that is horizontal (perfectly elastic) at the market price

– Price taker • Treats the price of its product as given and

beyond its control


FigureThe Competitive Industry and Firm


1

Price per

Ounce

Ounces of

Gold per Day

(a) Market Price per

Ounce

Ounces of

Gold per Day

(b) Firm

D

S

$800 $800 d

Demand Curve

Facing the Firm

1. The intersection of the market supply and the market demand curves . . .

2. determines the equilibrium

market price. 3. The typical firm can sell all

it wants at the market price . . .

4. so it faces a horizontal demand curve.

The Perfectly Competitive Firm• Total revenue (TR) curve

– Straight line that slopes upward – Slope of the TR curve = the price of output

• Marginal revenue (MR) curve– Horizontal line at the market price– MR = the market price– Same as the demand curve facing the firm


TableCost and Revenue Data for Small Time Gold Mines


1

Figure

Panel (a) shows a competitive firm’s total revenue (TR) and total cost (TC) curves. TR is a straight line with slope equal to the market price. Profit is maximized at 7 ounces per day, where the vertical distance between TR and TC is greatest. Panel (b) shows that profit is maximized where the marginal cost (MC) curve intersects the marginal revenue (MR) curve, which is also the firm’s demand curve.

Profit Maximization in Perfect Competition


2

Dollars

Output 21 43 5 6 7 98 10

Dollars

Output 21 43 5 6 7 98 10

MC

TR

$5,600

4,200

TC

1,100

d=MR$800

Slope = 800

Maximum Profit

per Day = $1,400

(a)

(b)

The Perfectly Competitive Firm• Marginal cost (MC)

– First falls and then rises• Total cost

– Rises first at a decreasing rate and then at an increasing rate

• Total profit = TR + TC• Profit-maximizing output

– Where the MC curve crosses the MR curve from below


The Perfectly Competitive Firm• Profit per unit = P – ATC• Firm earns profit: P > ATC• Firm suffers a loss: P < ATC• Total profit (or loss)

– At the best output level– Area of a rectangle

• Height = distance between P and ATC• Width = quantity of output


Figure

The competitive firm in panel (a) produces where marginal cost equals marginal revenue, or 7 units of output per day. Profit per unit at that output level is equal to revenue per unit ($800) minus cost per unit ($600), or $200 per unit. Total profit (indicated by the blue-shaded rectangle) is equal to profit per unit times the number of units sold, $200 × 7 = $1,400.

Measuring Profit or Loss (a) Economic Profit


3

Dollars

Ounces of

Gold per Day21 43 5 6 7 98 10

d=MR$800

ATC

Profit per

Ounce ($200)

MC

600

Figure

In panel (b), we assume that the market price is lower, at $400 per ounce. The best the firm can do is to produce 5 ounces per day and suffer a loss shown by the red area. It loses $200 per ounce on each of those 5 ounces produced, so the total loss is $1,000—the area of the red-shaded rectangle.

Measuring Profit or Loss (b) Economic Loss


3

Dollars

Ounces of

Gold per Day21 43 5 6 7 98 10

d=MR$400

ATC

Loss per

Ounce ($200)

MC

600

The Perfectly Competitive Firm• Shut down if

– TR < TVC– P < AVC

• Shutdown price – The price at which a firm is indifferent

between producing and shutting down


The Perfectly Competitive Firm• Firm’s short-run supply curve

– A curve that shows the quantity of output a competitive firm will produce at different prices

– Is its MC curve for all prices above minimum AVC• For all prices below minimum AVC, the firm

will shut down


Figure

Panel (a) shows a typical competitive firm facing various market prices. For prices between $2 and $7 per bushel, the profit-maximizing quantity is found by sliding along the MC curve. Below $2 per bushel, the firm is better off shutting down, because P < AVC. Panel (b) shows the firm’s supply curve, which is the same as its MC curve for all prices above the shutdown price of $2 per bushel.

Short-Run Supply under Perfect Competition


4

Dollars

Bushels per Year

(a) Price per

Bushel

Bushels per Year

(b)

$7 d1=MR1

MC

ATC

AVC

5 d2=MR2

2 d4=MR4

4 d3=MR3

1 d5=MR5

7,0005,000

4,0002,000

1,000

$7

5

2

4

1

7,0005,000

4,0002,000

Firm’s

Supply

Curve

Competitive Markets in the Short Run• In the short run

– The number of firms in the industry is fixed• Market supply curve

– A curve indicating the quantity of output• That all sellers in a market will produce• At different prices• In the short run

– Add up the quantities of output supplied by all firms in the market at each price


FigureDeriving the Market Supply Curve


5

Dollars

Bushels

per Year

(a) Firm Price per

Bushel

Bushels per Year

(b) Market

$7

AVC5

2

4

7,0005,000

4,0002,000

$7

5

2

4

1

700,000500,000

400,000200,000

Market

Supply

Curve

Firm’s

Supply

Curve

1

1. At each price . . .

2. the typical firm supplies the

profit-maximizing quantity. 3. The total supplied by all firms at different prices is the market supply curve

Competitive Markets in the Short Run• Short run equilibrium

– Economic profit • If P > ATC

– Economic loss • If AVC < P < ATC


FigurePerfect Competition


6

FigureShort-Run Equilibrium in Perfect Competition


7

Price per

Bushel

Bushels per Year

Dollars

Bushels per Year

$7

4

MCS

1. When the demand curve is D1 and market equilibrium is here . . .

3. If the demand curve shifts to D2 the market equilibrium moves here . . .

4. and the typical firm operates here, suffering a short-run loss.

D1

700,000

$7 d1=MR1

4 d2=MR2

ATC

7,0004,000

2. the typical firm operates here, earning economic profit in the short run.

D2

400,000

Profit per Bushel at p =$7

Loss per Bushel at p =$4

Competitive Markets in the Short Run• Perfect competition

– Market • Sums up the buying and selling preferences

of individual consumers and producers• Determines the market price

– Each buyer and seller• Takes the market price as given• Able to buy or sell the desired quantity


Competitive Markets in the Long Run• Long run

– New firms can enter a competitive market• Expectations of continued economic profit• Positive economic profit continues to attract

new entrants until economic profit is reduced to zero

– Existing firms can exit the market• Expectations of continued economic loss• Economic losses continue to cause exit until

the losses are reduced to zero


Competitive Markets in the Long Run• Entry into a market

– Entirely new firm enters a market– An existing firm adds a new product line– An existing firm creates a new branch

(local market)• Exit from a market

– Going out of business– A firm switches out of a particular product

line, even as it continues to produce other things


Competitive Markets in the Long Run• Short-run profit to long-run equilibrium

– Short-run equilibrium• Economic profit, P > ATC

– Long-run: attract new entrants• Market supply curve shifts rightward

– Market price falls– Horizontal demand curve facing each firm shifts

downward– Each firm will slide down its marginal cost curve,

decreasing output• Until each firm is earning zero economic profit


FigureFrom Short-Run Profit to Long-Run Equilibrium (a, b)


8

Price per

Bushel

Bushels

per Year

Dollars

Bushels

per Year

$9

S1

With initial supply curve

S1, market price is $9 . . .

so each firm earns an economic profit.

D

900,000

A

MCATC

5,000

$9 d1

9,000

A

FigureFrom Short-Run Profit to Long-Run Equilibrium (c, d)


8

Price per Bushel

Bushels

per Year

Dollars

Bushels

per Year

$9

S1

Profit attracts entry, shifting the

supply curve rightward . . .

until market price falls to $5 and

each firm earns zero economic profit.

D

900,000

A

MCATC

$9 d1

9,000

A

5 d25

S2

1,200,000

E

5,000

E

Competitive Markets in the Long Run• Short-run loss to long-run equilibrium

– Short-run equilibrium• Economic loss, P < ATC

– Long-run: firms exit the market• Until each firm is earning zero economic profit

• Zero economic profit (Normal profit)– Just enough accounting profit to cover

implicit costs– Not the same as zero accounting profit


Competitive Markets in the Long Run• Perfect competition and plant size

– Long-run equilibrium: plant and output level that bring it to the bottom of its LRATC curve

• In long-run equilibrium– The competitive firm operates where:

MC = minimum ATC = minimum LRATC = P


FigurePerfect Competition and Plant Size


9

Dollars

Output Per Period

Dollars

Output Per Period

1. With its current plant and ATC curve, this firm earns zero economic profit.

LRATC

P1

d1=MR1

ATC1MC1

q1

2. But the firm could earn positive profit with a larger plant, producing here.

P* d2=MR2

LRATC

ATC2MC2

q*

E

3. As all firms increase plant size and output, market price falls to its lowest possible level . . .

4. and each earns zero economic profit, producing at minimum LRATC.

What Happens When Things Change?• Initial long-run equilibrium and market

demand curve shifts rightward– Short-run

• A rise in market price• A rise in market quantity• A rise in economic profits

– Long-run: entry of new firms• Market supply shifts rightward• Drives down the price• Economic profit is eliminated


What Happens When Things Change?• Constant cost industry

– An industry in which the long-run supply curve is horizontal • Each firm’s cost curves are unaffected by

changes in industry output

• Long-run supply curve– A curve indicating price and quantity

combinations in an industry – After all long-run adjustments have taken

place


What Happens When Things Change?• In a constant cost industry

– In which industry output has no effect on individual firms’ cost curves

– The long-run supply curve is horizontal– In the long-run, the industry will supply any

amount of output demanded at an unchanged price


Figure

At point A in panel (a), the market is in long-run equilibrium. The typical firm in panel (b) operates at the minimum of its ATC and LRATC curves, and earns zero economic profit. The lower panels show what happens if demand increases.

A Constant Cost Industry (a, b)


10

Dollars

Output per period

(a)Dollars

Output per period

(b)

P1 d1=MR1

LRATC

ATC

MC

q1

A

P1

S1

D1

Q1

A

Figure

In the short run, the market reaches a new equilibrium at point B in panel (c), and the typical firm in panel (d) earns economic profit at the higher price PSR. In the long run, profit attracts entry, increasing market supply and lowering price. Entry continues until economic profit at the typical firm in panel (d) is reduced to zero, which requires the price to drop to P1, its original level. In panel (d), the typical firm returns to point A, and in panel (c), the new long-run market equilibrium is point C. The increase in demand raises output, but leaves price unchanged, as shown by the horizontal long-run supply curve connecting points A and C.

A Constant Cost Industry (c, d)


10

Dollars

Output per period

(c)Dollars

Output per period

(d)

P1 d1=MR1

LRATC

ATC

MC

q1

A

P1

S1

D1

D2

QSR

BPSR

S2

SLR

PSR

dSR=MRSR

qSR

B

Q2

C

Q1

A

What Happens When Things Change?• Increasing cost industry

– An industry in which the long-run supply curve slopes upward• Each firm’s LRATC curve shifts upward as

industry output increases

• In an increasing cost industry– A rise in industry output shifts up each

firm’s LRATC curve, so that zero economic profit occurs at a higher price

– The long-run supply curve slopes upward


Figure

Point A in both panels shows the initial long-run market equilibrium, with the typical firm earning zero economic profit. After demand increases, the market reaches a new short-run equilibrium at point B in panel (a). At the higher price, the typical firm earns economic profit (not shown). In the long run, profit attracts entry, supply increases and price begins to fall. But in an increasing cost industry, the rise in industry output also causes costs to rise, shifting up the LRATC curve. In the final, long-run market equilibrium (point C in both panels), price at P2 is higher than originally, and the typical firm once again earns zero economic profit. The increase in demand raises both output and price, as shown [in panel (a)] by the upward-sloping long-run supply curve.

An Increasing Cost Industry


11

Dollars

Output per period

(a) MarketDollars

Output per period

(b) Firm

P1 d1=MR1

LRATC1

q1

AP1

S1

D1

D2

PSR

S2

SLR

P2

d2=MR2

B

P2

LRATC2

C

Q2

C

Q1

A

What Happens When Things Change?• Decreasing cost industry

– An industry in which the long-run supply curve slopes downward• Each firm’s LRATC curve shifts downward as

industry output increases

• In a decreasing cost industry– A rise in industry output shifts down each

firm’s LRATC curve, so that zero economic profit occurs at a lower price

– Long-run supply curve slopes downward


Figure

Point A in both panels shows the initial long-run market equilibrium, with the typical firm earning zero economic profit. After demand increases, the market reaches a new short-run equilibrium at point B in panel (a). At the higher price, the typical firm earns economic profit (not shown). In the long run, profit attracts entry, supply increases, and price begins to fall. But in a decreasing cost industry, the rise in industry output causes costs to fall, shifting down the LRATC curve. In the final, long-run market equilibrium (point C in both panels), price at P2 is lower than originally, and the typical firm once again earns zero economic profit. The increase in demand raises output but lowers price, as shown [in panel (a)] by the downward-sloping long-run supply curve.

A Decreasing Cost Industry


12

Dollars

Output per period

(a) MarketDollars

Output per period

(b) Firm

P1 d1=MR1

LRATC1

q1

AP1

S1

D1

D2

PSR

S2

SLRP2

d2=MR2

B

P2

LRATC2

C

Q2

C

Q1

A

What Happens When Things Change?• As demand increases or decreases in a

market– Prices change: act as signals for firms to

enter or exit an industry• When demand increases

– Price tends to initially overshoot its long-run equilibrium value • Sizable temporary profits for existing firms• Pulls new firms into the market• Increase industry output


What Happens When Things Change?• When demand decreases

– Price falls below its long-run equilibrium value• Sizable losses for existing firms• Drive existing firms out of the market• Decrease industry output

• Market signals – Price changes that cause changes in

production to match changes in consumer demand


Figure

In the upper panel, an increased desire for bottled water shifts the market demand curve rightward, from D1 to D2. Price and quantity rise in the short run, and we move from A to B along short-run supply curve S1. The lower panel shows the corresponding short-run movement from A to B along the economy’s PPF: Greater production of bottled water, less production of other things. In the long run, the higher price creates economic profit, attracting new firms, and shifting the supply curve rightward (upper panel). Price falls and quantity rises further. In the figure, we assume bottled water is an increasing cost industry, so entry brings the price down to P3, at point C, which is higher than the original price. In the lower panel, the further long-run increase in bottled water production moves us along the PPF, from B to C.

How a Change in Demand Reallocates Resources


13

Price Per Bottle

Quantity of Bottled WaterQuantity Of Other Goods

Quantity of Bottled Water

S1 S2

D1

D2

P1

Q1

A

B

C

Q2 Q3

P2

Q1 Q2 Q3

Production

possibilities

frontier

AB

C

What Happens When Things Change?• Technological advance

– Rightward shift of the market supply curve– Decreasing market price– In the short run

• Early adopters may enjoy economic profit

– In the long run• All adopters will earn zero economic profit

– Firms that refuse to use the new technology will not survive


Figure

Technological change may reduce LRATC. In panel (b), the first solar panel firms to adopt new, cost-saving technologies earn economic profit in the short run, because they can initially sell at the old market price of $9.50 per installed watt. That profit leads its competitors to adopt the same technology and attracts new entrants. As market supply increases, price falls until it reaches $7 per installed watt, and each firm is once again earning zero economic profit.

Technological Change in Perfect Competition


14

Price per Installed Watt

Watts Installed per Month

(a) MarketDollars per Installed Watt

Watts Installed per Month

(b) Firm

$9.50 d1=MR1

LRATC1

q1

$9.50

D

Q1 Q2

7 d2=MR2

7

LRATC2

S1

A

S2

B

Real Estate Agents and theZero-Profit Result

• Markets in which entry and exit do not affect the market price– The zero-profit result still holds: with a

twist– In these markets, instead of prices, costs

adjust to eliminate economic profit and loss



• Real estate agent (seller)– Commission = 3% of the price

• Horizontal MR curve

– Costs• Office space, transportation, a computer• Agent’s time: showing homes to finicky

buyers, negotiating with buyers’ agents• MC curve slopes upward



• Profit-maximizing agent– Increase the number of homes sold until

MC = MR– Earns zero economic profit

• Long-run equilibrium



• An increase in the price of homes– Higher dollar commission– Economic profit in the short run– Long-run: more real-estate agents

• Higher MC cost curve• Zero economic profit


Figure

Commission per Sale

Number of Homes Sold per Year

(b)

After Commissions Rise, Long-Run Profit Returns to Zero


15

$6,000 d1=MR1

ATC1

$12,000 d2=MR2

MC1

15

B

10

A

ATC2

MC2

5

C

Commission per Sale

Number of Homes Sold per Year

(a)

$6,000 d1=MR1

ATC1

$12,000 d2=MR2

MC1

15

B

10

A

FigureMembership in National Association of Realtors


16

Chapter 9

Economy & Finance

Transcript of Chapter 9