Econ 1000 Lecture 6: Perfect Competition

Econ 1000 Lecture 6:Perfect Competition C.L. Mattoli (C) Red Hill Capital Corp., Delaware, USA 2008

Prologue • Businesses are stuck in the short run, although the length of the short run can vary depending on the business. • The point is that, in most businesses it is not possible to change everything quickly. • For example, if you own a store, it will not be easy to move the location. To move will require fitting out the new place, changing business cards, advertising the new location, etc. (C) Red Hill Capital Corp., Delaware, USA 2008

Prologue • Other changes for other businesses might be even longer. • Thus, businesses will have some inputs that are fixed and others that can be more easily varied, like man (woman) hours. • When we begin production and go from 0 units to the first, that will require adding some variable input, for example, labor, to the fixed. • Given that, we can calculate the output per unit of the variable input, e.g., labor. (C) Red Hill Capital Corp., Delaware, USA 2008

Prologue • There is efficiency gained when you add, for example, a second unit of labor. • Suppose that the company consists of 2 machines, fixed inputs. The first machine does the roughing out of the products and the second machine is a finishing machine. • With one laborer she has to do the roughing out, then, move over to the other machine to finish the product. It is very inefficient. (C) Red Hill Capital Corp., Delaware, USA 2008

Prologue • There is an efficiency gain, and the two can produce more than 2 times the output of one laborer. • The marginal product is the change in output that occurs by adding one more unit of variable input. So it is a unit cost, specifically, for the next unit. • As more units of input are added, there will continue to be efficiency gains, up to a point, then, efficiency begins to be lost. (C) Red Hill Capital Corp., Delaware, USA 2008

Prologue • As a result, the extra (marginal) output (product) increases, peaks, then, decreases. • There is also an average output per unit of input. • Using the average-marginal rule, the average output per unit of input will increase, as marginal product increases. • Average variable cost per unit of output is inversely related to average output per unit variable input, i.e., 1/[output/variable input] = variable input/output. (C) Red Hill Capital Corp., Delaware, USA 2008

Prologue • For example, 2 employees/2.2 tons of grapes = 0.91 employees/ton of grapes. So, it costs 0.91 employees per unit of grapes. • Thus, as MP increases, average cost decreases, and vice versa. • As output increases, the fixed input is also spread over more units, so total cost per unit decreases, then increases. (C) Red Hill Capital Corp., Delaware, USA 2008

Prologue • MC will be inverse to MP, as the change in output per input increasing means the cost per new unit is decreasing. • Then, we can use the average-marginal rule to look at cost curves. • We give a diagrammatic summary of the basic concepts in the next few slides. (C) Red Hill Capital Corp., Delaware, USA 2008

Marginal Product (C) Red Hill Capital Corp., Delaware, USA 2008

MP vs. MC (C) Red Hill Capital Corp., Delaware, USA 2008

AC & MC MC ATC AVC AFC (C) Red Hill Capital Corp., Delaware, USA 2008

This week • Chapter 7 • Perfect Competition (C) Red Hill Capital Corp., Delaware, USA 2008

Objectives • We will describe market structure. • We will finally get to a bottom line: profits. • We will look at what it means for a market to be perfectly competitive. • We will see why governments around the world promote market competition. • We will examine how the internet is changing the structure of world markets (C) Red Hill Capital Corp., Delaware, USA 2008

Where we are coming from • We have studied the ideas of supply and demand, on their own, and examined the underlying motivations that lead to the general shapes of supply and demand curves. • Then, we looked at general interactions between supply and demand to get market equilibrium, and think about how changes in equilibrium might occur. (C) Red Hill Capital Corp., Delaware, USA 2008

Where we are coming from • People are motivated by self-interest, but that self-interest leads to competition on both sides, supply and demand, and, in the end, self-interest serves society and results in positive benefits. • On the demand side, self-interest is manifest in wants, desires, and needs, but it also tempers the price that they will pay for things. • That puts limits on the supply side: they cannot simply charge whatever they want. (C) Red Hill Capital Corp., Delaware, USA 2008

Where we are coming from • What suppliers charge will affect not only how much they sell but also the total revenue that they will be able to take in. • Last week we examined output, its motivations, and its limitations. • Suppliers want to make profits but they have to face certain constraints. • We saw that there is a short-run, in which only certain changes can be made to change the ability to supply, and a longer-run, in which more can be done to change supply. (C) Red Hill Capital Corp., Delaware, USA 2008

Where we are coming from • We examined the cost side and found that suppliers face diminishing returns to inputs. • Diminishing returns means that suppliers will face changing unit costs, which will affect their eventual profitability. • We also saw that they might face changing costs structures depending on their size, which are manifest in concepts of economies of scale: bigger, itself, might result in a longer-run way to reduce unit cost. (C) Red Hill Capital Corp., Delaware, USA 2008

Where we are coming from • Suppliers, eventually, might also face diseconomies of scale because of the organizational structure of business, in general. • In the end, that means that suppliers will, in most cases, always face a cost structure that will limit their ability to make profits. • This week, we examine profitability in the case of perfectly competitive markets. (C) Red Hill Capital Corp., Delaware, USA 2008

Market Structures (C) Red Hill Capital Corp., Delaware, USA 2008

Market Structure • Firms sell things under a number of different sets of market conditions, which economists refer to as market structures. • Economists then go on to identify several basic forms of market structure characterized by certain key features. • The basic characteristics that shape market structure, include the number of firms in the industry, the differentiability of products, ease of entry and exit in the market, and availability and dissemination of information. (C) Red Hill Capital Corp., Delaware, USA 2008

Market Structure • Those characteristics are indicative of the degree of competition firms face in a market. • If there are more firms, there are more places to buy something. • If the products of those firms are more or less interchangeable, there is no reason to go to one firm than to another, except, perhaps for other reasons of convenience. • If entry into the industry is easy, firms already in the industry will face the threat of more competition. If it is difficult, they will face less of a threat. (C) Red Hill Capital Corp., Delaware, USA 2008

The Basic Market Structures • Based on these simple parameters, there will be a range of competitiveness by firms in markets, ranging from none to a lot. • In a monopoly, there is one seller who dominates the market. • Then, there might be only a few large firms that dominate a market in an oligopoly. (C) Red Hill Capital Corp., Delaware, USA 2008

The Basic Market Structures • After that, there might be monopolistic competition, in which products are differentiable, and there are many sellers, but monopolists compete to get people to like their product instead of the others. • Finally, there is perfect competition, which is the focus of this lecture. • We summarize features of the various market structures, in the next slide. (C) Red Hill Capital Corp., Delaware, USA 2008

Comparative Market Structures (C) Red Hill Capital Corp., Delaware, USA 2008

The Elements of Perfect Competition (C) Red Hill Capital Corp., Delaware, USA 2008

Perfect Competition • Perfect competition means, basically, that no single firm can gain a competitive advantage over the others. That will be the case under a few rudimentary conditions. • If there are many small firms, none of which has a large enough share of total output (total supply) that it can affect market price. (C) Red Hill Capital Corp., Delaware, USA 2008

Perfect Competition • In addition, it must be assumed that the suppliers do not collude but act independently. • Example would be egg farmers. There are thousands of egg farmers. If one decides to raise his price, it will have no affect on the going market price for eggs. (C) Red Hill Capital Corp., Delaware, USA 2008

Perfect Competition • Next, we assume the product is fungible (homogeneous, indistinguishable, standardized, all the same). • That way, no single supplier is able to gain a competitive advantage through advertising, quality distinction, or even convenience of location. (C) Red Hill Capital Corp., Delaware, USA 2008

Perfect Competition • Buyers are indifferent about which supplier they go to. There are no famous brand names. No one knows Coke and Pepsi. They just know cola. • For example, fishmonger Ho’s lobster (long xia) is no better than fishmonger Chen’s lobster. They all come from the same sea. (C) Red Hill Capital Corp., Delaware, USA 2008

Perfect Competition • Ease of both entry and exit are part of the basis for perfect competition. • That means, first, that there are no barriers to entry, like, startup cost (financial), technical, licensing, patent, permit, or government-imposed barriers. • In that regard, anyone will be able to enter the market, on the one hand, and will not be discouraged by penalties, like investment, contractual, or legal reasons, to exit the business, on the other hand. (C) Red Hill Capital Corp., Delaware, USA 2008

Perfect Competition • Resources are completely mobile to freely enter and exit the market. • That is especially important in an industry in decline, in order for prices to adjust quickly. • Easy entry assures that excess profits will not persist. Others seeing juicy profits will quickly enter the industry, and prices will be competitive. (C) Red Hill Capital Corp., Delaware, USA 2008

Perfect Competition • For example, you go into the bicycle rental business. You buy a bicycle and a cell phone to start your business, and you can easily close the business any time. • A further assumption is that market participants are well-informed and well-educated about the product, including knowledge of the product, its production costs, and prices. (C) Red Hill Capital Corp., Delaware, USA 2008

Perfect World (No one’s Perfect) • The idea of perfect competition is a perfect world ideal. Models are not reality but only try to approximate it under simplified ideal conditions. • The world is not perfect and rational. There is no perfect information. There is convenience of going to a store one block from you instead of one mile. Self-interest can lead to bad behavior. (C) Red Hill Capital Corp., Delaware, USA 2008

Perfect World (No one’s Perfect) • However, we expect markets, like farm products, inter-city trucking, or housecleaning services, to be close to the competitive model. There are many sellers, and products are very similar. • Moreover, the model can provide a benchmark against which real-world market structure and performance can be judged. (C) Red Hill Capital Corp., Delaware, USA 2008

Competition and Policy • In chapter 4, we saw that lack of competition can lead to market failures that result in inefficient outcomes. • On the other hand, perfectly competitive markets will lead to maximum efficiency. • In that regard, governments around the world have devoted much regulation and legislation to promote efficiency by encouraging competition and to discourage anti-competitive behavior through legal and financial penalties. (C) Red Hill Capital Corp., Delaware, USA 2008

ACCC: Australia’s Competition Watchdog • In Australia, for example, The Australian Competition and Consumer Commission (ACCC) is the statutory authority charged with oversight and enforcement of the relevant Trade Practices Act that deal with competition. • The objective of The Act is to enhance the welfare of Australians by promoting competition and fair trading and providing for consumer protection. • The ACCC also administers the Price Surveillance Act. (C) Red Hill Capital Corp., Delaware, USA 2008

ACCC Objectives • Improve competition and efficiency in markets • Foster fair trade practices in well-informed markets. • Promote competitive pricing when possible and restrain prices in markets where competition is less than effective • Inform and educate the community about the Trade Practices Act • Use resources efficiently and effectively (C) Red Hill Capital Corp., Delaware, USA 2008

New Zealand Commerce Commission (NZCC) Goals • Dynamic markets and all goods and services produced at competitive prices • Consumers confident of information they receive when making choices • Regulated industries constrained from making excess profits, face incentives to invest, and share efficiency gains with consumers. (C) Red Hill Capital Corp., Delaware, USA 2008

Policy Goals, Summarized • Even if not all industries are naturally competitive, government policies encourage efficiency by encouraging them to act as if they are competitive. • Even though not all people practice enlightened self-interest, policy seeks to ban unethical behavior. • Bad behaviors that governments seek to eliminate are: colluding to raise price/ profitability, exercising monopoly power at the expense of consumers, and misleading advertising. (C) Red Hill Capital Corp., Delaware, USA 2008

Policy Goals, Summarized • The authorities can order breakups of companies that have gained too much market power. • They can disallow mergers that would result in too much market power residing in one company. • They can disallow false advertising. • They can impose price controls, like many countries do with public utility companies. • They can impose fines and compensatory damages for bad behaviors, (C) Red Hill Capital Corp., Delaware, USA 2008

Information • Information is one of the most important things in business. • Businesses need to keep some information secret, otherwise their competitors will gain advantage. • The importance of information is highlighted by the large role that disclosure of information and its accuracy play in competition and securities laws around the world. (C) Red Hill Capital Corp., Delaware, USA 2008

Consequences of Perfect Competition for Suppliers (C) Red Hill Capital Corp., Delaware, USA 2008

Price Taker, not Price Maker • In a perfectly competitive market, market price is determined by aggregate supply and demand. • Moreover, consumers have perfect information about the actual market price. • The product is fungible, and the firm faces competition from inside the industry and the threat of others entering the industry. (C) Red Hill Capital Corp., Delaware, USA 2008

Price Taker, not Price Maker • An individual firm is small and has no control to affect price (no market power), and if it tried to charge a higher-than-market price, informed consumers would not purchase from that firm because they can switch to another supplier with no effort, at all (he is right next door with the proper price). • Thus, a firm is a price taker: it will necessarily have to sell at the going market price or sell nothing, at all. (C) Red Hill Capital Corp., Delaware, USA 2008

Price Taker, not Price Maker • In that regard, we can think of the individual firm as facing a completely horizontal, perfectly elastic demand curve. • The firm must supply any amount that it can and wants to supply at the going market price or consumers will simply turn to another of the many other suppliers. The International Market for Electronic Components Market Aggregates Individual Firms 120 100 80 70 60 40 20 Price per unit (dollars) 0 20 40 60 80 100 0 5 10 Quantity of output (1000’s units/hour) Quantity of output (units/hour) (C) Red Hill Capital Corp., Delaware, USA 2008

Each Firm Faces Perfect Elastic Demand • In the above, graphical example, the individual firm’s output is several units per hour, while the industry output is an aggregate of 60,000 units/hr. at equilibrium with total demand. • Equilibrium occurs at a price of $70/unit. • Therefore, a firm must take that price, no matter what it’s output. (C) Red Hill Capital Corp., Delaware, USA 2008

Each Firm Faces Perfect Elastic Demand • It, effectively, faces horizontal demand, on its part, because no matter how much output it supplies, that is the price that people will be willing to pay for its product. • As we learned, when demand is horizontal, perfect elastic, a firm charging a higher price than that where supply intersects the demand curve will sell nothing. (C) Red Hill Capital Corp., Delaware, USA 2008

Each Firm Faces Perfect Elastic Demand • On the other hand, selling at a price, below the one price in demand, would be stupid because he can sell the same amount at a higher price. • Moreover, a downward change in price would, in that case, also lead to a decrease in revenues because the firm will not be able to increase sales by decreasing price ([ΔQ/Q]/[ΔP/P] = ED = 0). (C) Red Hill Capital Corp., Delaware, USA 2008

Short-run Profit Maximization: Perfect Competition (C) Red Hill Capital Corp., Delaware, USA 2008

The Framework • At the beginning of module 3, we discussed how elasticity of demand puts a constraint on the supplier because changing price can have different affects on total revenues. • In perfect competition, the constraint becomes one fixed price against which the supplier must judge his costs and ability to make a profit. (C) Red Hill Capital Corp., Delaware, USA 2008

Econ 1000 Lecture 6: Perfect Competition