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Part Two: Microeconomics of Product Markets. CHAPTER 7 PERFECT COMPETITION. In this chapter you will learn:. 7.1 The four basic market structures 7.2 The conditions required for perfectly competitive markets 7.3 How firms in perfect competition maximize profits or minimize losses

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CHAPTER 7 PERFECT COMPETITION

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Part two microeconomics of product markets

Part Two: Microeconomics

of Product Markets

CHAPTER 7PERFECT COMPETITION


In this chapter you will learn

In this chapter you will learn:

7.1 The four basic market structures

7.2 The conditions required for perfectly competitive markets

7.3 How firms in perfect competition maximize profits or minimize losses

7.4 Why the marginal cost curve and supply curve of competitive firms are the same

7.5 About the firm’s profit maximization in the long run

7.6 About the efficiency of competitive markets

Chapter 7


Four market structures

Four Market Structures

  • Perfect Competition

  • Monopoly

  • Monopolistic Competition

  • Oligopoly

Pure

Monopoly

Pure

Competition

Monopolistic

Competition

Oligopoly

Market Structure Continuum

Chapter 7.1


Characteristics of perfect competition

Characteristics of Perfect Competition

  • Very Large Numbers

  • Standardized Product

  • Price-Takers

  • Easy Entry and Exit

Pure

Monopoly

Pure

Competition

Monopolistic

Competition

Oligopoly

Market Structure Continuum

Chapter 7.2


Demand for a firm in perfect competition

Demand for a Firm in Perfect Competition

  • Perfectly Elastic Demand

  • Average, Total, and Marginal Revenue

    • average revenue = price

    • marginal revenue = price

    • total revenue = price x quantity

      Illustrated…

Chapter 7.2


Chapter 7 perfect competition

]

]

]

]

]

]

]

]

]

]

131

131

131

131

131

131

131

131

131

131

x

Chapter 7.2


Figure 7 1 the demand and revenue curves for a firm in perfect competition

Figure 7-1 The Demand and Revenue Curves for a Firm in Perfect Competition

1179

1048

917

786

655

524

393

262

131

0

TR

Demand is perfectly elastic since the firm can sell as much output as it wants at the market price

Price and revenue

D = MR = AR

2 4 6 8 10 12

Quantity Demanded

Chapter 7.2


Profit maximization in the short run

Profit Maximization in the Short Run

  • Purely competitive firm can maximize its profit (minimize its loss) only by adjusting output

    Two Approaches:

  • total revenue-total cost approach

  • marginal revenue-marginal cost approach

Chapter 7.3


Chapter 7 perfect competition

p=$131

Chapter 7.3


Chapter 7 perfect competition

Break-even point

Break-even point (normal profit)

Figure 7-2

Maximum economic profit $299

TR

TR

TC

Chapter 7.3


Total revenue total cost approach

Total Revenue-Total Cost Approach

  • Profit = TR - TC

  • Profit is maximized where the vertical distance between TR and TC is maximized

  • Break-even points are where TR=TC

  • Now, the marginal revenue-marginal cost approach…

Chapter 7.3


Chapter 7 perfect competition

Should the firm produce the 1st unit?

What about the 2nd unit?

What about the 9th unit?

]

]

]

]

9 units will maximize profits

the same profit-maximizing result

as with the TR-TC approach!

]

]

]

]

]

Figure 7-3

Chapter 7.3


Marginal revenue marginal cost approach

Marginal Revenue-Marginal Cost Approach

Short run profit maximization occurs where MR=MC:

  • Rule applies only if producing is preferable to shutting down

  • Rule is an accurate guide to profit maximization for ALL firms

  • Rule can be restated as P=MC for purely competitive firms, since MR=P

Chapter 7.3


Chapter 7 perfect competition

131

97.78

9

MC

Profit = 9 X (131 - 97.78) = 299

ATC

Find ATC

AVC

Find the quantity

where MR=MC

AFC

Chapter 7.3


Loss minimizing case

Loss-Minimizing Case

  • Suppose price falls from $131 to $81…

Chapter 7.3


Chapter 7 perfect competition

Firm should produce the first 6 units

]

]

]

]

]

]

]

]

]

Figure 7-4

Chapter 7.3


Chapter 7 perfect competition

Loss = 6 X (81 - 91.67) = -64.02 < TFC

91.67

81

MC

ATC

AVC

AFC

Chapter 7


Shutdown case

Shutdown Case

  • Suppose the price falls even further, to $71…

Chapter 7.3


Chapter 7 perfect competition

94

71

MC

ATC

Loss = 5 X (71 - 94) = -115>TFC

AVC

AFC

When price is below

minimum AVC, the firm

should shut down

5

Chapter 7.3


Figure 7 6 marginal cost and short run supply

Figure 7-6 Marginal Cost and Short-Run Supply

ATC

P

MC

Costs and revenues (dollars)

AVC

At every price, the

MR = MC point

indicates the quantity

being produced...

Q

Chapter 7.4


Chapter 7 perfect competition

P3

MR3

Q3

Marginal Cost and Short-Run Supply

ATC

P

MC

Costs and revenues (dollars)

AVC

Record the

quantity being

supplied for

each price

Q

Chapter 7.4


Chapter 7 perfect competition

Marginal Cost and Short-Run Supply

ATC

P

MC

Costs and revenues (dollars)

AVC

P3

MR3

P2

MR2

At a lower price

a lower quantity

will be supplied

Q

Q2

Q3

Chapter 7.4


Chapter 7 perfect competition

Marginal Cost and Short-Run Supply

ATC

P

MC

Costs and revenues (dollars)

P4

AVC

MR4

P3

MR3

P2

MR2

At a higher price

a higher quantity

will be supplied

Q

Q2

Q3

Q4

Chapter 7.4


Chapter 7 perfect competition

Marginal Cost and Short-Run Supply

ATC

MC

P

MR5

P5

Costs and revenues (dollars)

P4

AVC

MR4

P3

MR3

P2

MR2

MR1

P1

Firm should not

produce

below P2

Q

Q2

Q3

Q4

Q5

Chapter 7.4


Chapter 7 perfect competition

Marginal Cost and Short-Run Supply

ATC

P

Short-run

supply curve

(Above AVC)

MC

MR5

P5

Costs and revenues (dollars)

P4

AVC

MR4

P3

MR3

P2

MR2

MR1

P1

Q

Q2

Q3

Q4

Q5

Chapter 7.4


Marginal cost and short run supply

Marginal Cost and Short-run Supply

  • Firm’s short-run supply curve is the portion of its MC curve above minimum AVC

  • Diminishing Returns, Production Costs, and Product Supply

  • Supply curve shifts:

    • A wage increase shifts the supply curve upward and to the left (decreasing in supply)

    • Technological progress would shift the supply curve downward to the right (increasing in supply)

Chapter 7.4


Figure 7 7 competitive equilibrium for a firm and the industry

Economic

Profit

P

P

Q

Q

Figure 7-7Competitive Equilibrium for a Firm and the Industry

S=MCs

ATC

MC

D

$111

$111

AVC

D

8

8000

Firm

(price taker)

Industry

1000 firms

Chapter 7.4


Table 7 4 output determination in perfect competition in the short run

Table 7-4 Output Determination in Perfect Competition in the Short Run

Chapter 7.4


Profit maximization in the long run

Profit Maximization in the Long Run

  • Assumptions:

    • Entry and Exit Only

    • Identical Costs

    • Constant-Cost Industry

Chapter 7.5


The goal of our analysis

The Goal of Our Analysis

  • In the long run, p = minimum ATC

  • Because:

    • Firms seek profit and avoid losses

    • Firms are free to enter and exit the industry

Chapter 7.5


Figure 7 8 entry eliminates economic profits

D2

Figure 7-8 Entry Eliminates Economic Profits

If product demand increases...

S1

P

MC

P

ATC

$60

$50

$40

$60

$50

$40

Economic Profits

MR

D1

Q

Q

100

100,000

Firm

(price taker)

Industry

1000 firms

Chapter 7.5


Chapter 7 perfect competition

S2

Entry Eliminates Economic Profits

S1

...new firms enter, S increases, P falls

MC

P

P

ATC

$60

$50

$40

$60

$50

$40

MR

D2

New Equilibrium with more firms

D1

Q

Q

100

100,000

110,000

Firm

(price taker)

Industry

110,000 firms

Chapter 7.5


Chapter 7 perfect competition

D2

Figure 7-9 Exit Eliminates Losses

If product demand decreases...

S1

MC

P

P

ATC

$60

$50

$40

$60

$50

$40

MR

Economic Loss

D1

Q

Q

100

100,000

Firm

(price taker)

Industry

1000 firms

Chapter 7.5


Chapter 7 perfect competition

S3

90,000

Exit Eliminates Losses

...firms exit, S decreases, P increases

S1

MC

P

P

ATC

$60

$50

$40

$60

$50

$40

MR

D1

New equilibrium with fewer firms

D2

Q

Q

100

100,000

Firm

(price taker)

Industry

90,000 firms

Chapter 7.5


Long run equilibrium

Long-Run Equilibrium

  • If price > min ATC

    • profits attract new firms

    • as S increases, price drops to min ATC

  • If price < min ATC

    • losses cause firms to exit

    • as S decreases, price rises to min ATC

  • So, in the long run, p = min ATC

Chapter 7.5


Long run supply

Long-run Supply

  • Crucial factor is whether the number of firms in the industry affects the costs of individual firms

Chapter 7.5


Figure 7 10 long run supply for a constant cost industry is horizontal

Figure 7-10 Long-run Supply for a Constant-Cost Industry Is Horizontal

Demand increases

P

Profits attract new firms

S1

P>$50

P=$50

D2

D2

D1

Price remains the same in the long run

Q

Q1

Q2

Q2

Chapter 7.5


Figure 7 11 long run supply for an increasing cost industry is upsloping

Figure 7-11 Long-run Supply for an Increasing-Cost Industry Is Upsloping

Demand increases

Profits attract new firms

S1

P

P>>$50

P=$50

D2

D1

In the long run, greater supply is offered at a higher price

Q

Q2

Q1

Chapter 7.5


Long run supply for a decreasing cost industry is downsloping

long-run S

Long-run Supply for a Decreasing-Cost Industry Is Downsloping

Demand increases

S1

Profits attract new firms

P

P>$50

P=$50

P<$50

D1

D2

In the long run, greater supply is offered at a lower price

Q

Q2

Q1

Chapter 7.5


Figure 7 12 pure competition and efficiency

Price = MC = Minimum ATC

(normal profit)

Figure 7-12 Pure Competition and Efficiency

P

MC

ATC

MR

P

Q

Q

Chapter 7.6


Pure competition and efficiency

Pure Competition and Efficiency

  • Productive Efficiency

    • P = Minimum ATC

  • Allocative Efficiency

    • P = MC

Chapter 7.6


Allocative efficiency and consumer and producer surplus

Allocative Efficiency andConsumer and Producer Surplus

  • Consumer Surplus is the difference between what the consumer is willing to pay and the market price

  • Producer Surplus is the difference between the marginal cost of production and the market price

  • At equilibrium, consumer and producer surplus is maximized

Chapter 7.6


Figure 7 12 long run equilibrium a competitive firm and market

Figure 7-12 Long-Run Equilibrium:A Competitive Firm and Market

P

Consumer

Surplus

The sum of consumer and producer surplus is maximized

Pe

Producer Surplus

Q

Qe

Chapter 7.6


Pure competition and efficiency1

Pure Competition and Efficiency

  • Productive Efficiency

    • P = Minimum ATC

  • Allocative Efficiency

    • P = MC

  • Dynamic Adjustments

    • purely competitive markets adjust to restore efficiency when disrupted by changes in the economy

Chapter 7.6


The invisible hand revisited

The “Invisible Hand” Revisited

  • The efficient allocation of resources in perfect competition comes about because businesses and resource suppliers seek to further their self-interest

  • Both business profits and consumer satisfaction are maximized

Chapter 7.6


Chapter summary

Chapter Summary

  • 7.1 Four Market Structures

  • 7.2 Characteristics of Pure Competition and the Firm’s Demand Curve

  • 7.3 Profit Maximization in the Short Run

    • MR ( = P) = MC ; TR – TC is the highest

  • 7.4 Marginal Cost and Short-Run Supply

    • Firm’s short-run MC that Lies above its AVC

  • 7.5 Profit Maximization in the Long Run

  • 7.6 Pure Competition and Efficiency

    • P = ATC = MC

Chapter 7


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