Market Structure and Perfect Competitive Firm

Hall and Lieberman, 3rd edition, Thomson South-Western, Chapter 8 South-

Overview
What you will learn from this lecture

Market structure 3 Requirements for perfect competition Demand curve for a competitive firm Supply curve for a competitive firm How is the profit is maximized? At which output level? How is profit or loss is measured using graphs? Short Run Equilibrium Long Run Equilibrium Perfect Competition and Plant Size in the long run What happens when things change?
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Part I Market Structure

Sellers want to sell at the highest possible price
Buyers seek lowest possible price All trade is voluntary different goods and services are sold in vastly different ways

Economists think about market structure

Characteristics of a market that influence behavior of buyers and sellers when they come together to trade
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Types of Market
For any particular market, we ask
How many buyers and sellers are there in the market? Is each seller offering a standardized product, product, more or less indistinguishable from that offered by other sellers? Are there any barriers to entry or exit, or can exit, outsiders easily enter and leave this market?

Four basic types of market

Perfect competition Monopoly Monopolistic competition Oligopoly
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Part II. The Three Requirements of Perfect Competition

Large numbers of buyers and sellers
Each buys or sells only a tiny fraction of the total quantity in the market

Sellers offer a standardized product Sellers can easily enter into or exit from market
Significant barriers to entry and exit can completely change the environment in which trading takes place

Examples?
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i. A Large Number of Buyers and Sellers

In perfect competition, there must be many buyers and sellers How many?
Number must be so large that no individual decision maker can significantly affect price of the product by changing quantity it buys or sells

ii. Selling Standardized Products

Buyers do not perceive significant differences between products of one seller and another
For instance, buyers of wheat do not prefer one farmers wheat over farmer another

iii. Easy Entry into and Exit from the Market

Easy Entry
no significant barriers to discourage new entrants any firm wishing to enter can do business on the same terms as firms that are already there

Easy exit
A firm suffering a long-run loss must longbe able to sell off its plant and equipment and leave the industry for good, without obstacles
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iii. Easy Entry into and Exit from the Market

In many markets there are significant barriers to entry
Legal barriers Existing sellers have an important advantage that new entrants can not duplicate Brand loyalty Cost advantage of existing firms from significant economies of scale

Is Perfect Competition Realistic?

Assumptions are rather restrictive In reality, one or more of assumptions will be violated in vast majority of markets Yet economists use perfect competition more often than any other market structure Why? Model of perfect competition is powerful Many markets come reasonably close to be perfect competitive Perfect competition can approximate conditions and yield accurate-enough accuratepredictions in a wide variety of markets
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Even if conditions for perfectly competitive markets are not satisfied satisfied
Assumptions are close enough for predictions of
Firm entry or exit Price increase or decrease Increase or decrease in industry quantity Increase or decrease in firm quantity
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Part III. The Perfectly Competitive Firm

What is occurring in a competitive market is quite different from the view we get when looking at a perfect competitive firm.
entirely different picture

In learning about competitive firm, must also discuss competitive market in which it operates
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Figure 1: The Competitive Industry and Firm

1. The intersection of the market supply and the market demand curve Price per Ounce Market S 3. The typical firm can sell all it wants at the market price Firm

Price per Ounce

$400 D

$400

Demand Curve Facing the Firm

Ounces of Gold per Day 2. determine the equilibrium market price

Ounces of Gold per Day 4. so it faces a horizontal demand curve

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Goals and Constraints

Perfectly competitive firm faces a cost constraint when producing any given level of output Firms production technology Firm Prices it must pay for its inputs Cost function for a perfectly competitive firm is standard

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The Demand Curve Facing a Perfectly Competitive Firm

Demand curve is

horizontal, or infinitely

price elastic
Why? Output is standardized No matter how much a firm decides to produce, it cannot make a noticeable difference in market quantity supplied So cannot affect market price Firm is a price taker Treats the price of its output as given and beyond its control Its only decision is how much output to produce and sell
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Cost and Revenue

MR at each quantity is the same as the market price
MR = Price marginal revenue curve and demand curve facing firm are the same A horizontal line at the market price
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Profit Maximization: The Total Revenue and Total Cost Approach

Firm Firms profit per unit
( Revenue per unit ) ( cost per unit )
profit per unit = P ATC

Total Profit = TR TC=Q(P-ATC) TC=Q(PTR and TC approach

Pick out the output level where there is biggest difference between TR and TC Most direct way of viewing firms firm search for the profit-maximizing profitoutput level
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Figure 2a: Profit Maximization: find greatest TR - TC

Dollars $2,800 2,100 TR TC Maximum Profit per Day = $700

550

Slope = 400

8 9 10 Ounces of Gold per Day

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Profit Maximization: The Marginal Revenue and Marginal Cost Approach ProfitProfit-maximizing output is found where MC curve crosses MR curve from below
Or where P =MC

Firm should continue to increase output as long as p=MR>MC

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Figure 2b: Profit Maximization Find MR =MC from below

Dollars

MC

$400

D = MR

8 9 10 Ounces of Gold per Day

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Measuring Total Profit Graphically

How to measure profit or loss?
1. Find the optimal output level Q* from profit maximization
MR =MC or using TR & TC method

2. At Q* , find the ATC, unit cost for producing that amount of outputs 3. Pointing out the difference between P and ATC along the vertical axis 4. The area (P-ATC) X Q* is (P Profit if P>ATC Loss if P<ATC
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Figure 3a: Measuring Profit if P > ATC

Economic Profit
Dollars ATC

Profit per Ounce ($100) $400 300

MC d = MR

Ounces of Gold per Day

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Figure 3b: Measuring Loss if P < ATC

Economic Loss
Dollars

MC Loss per Ounce ($100) ATC $300 200 4 d = MR Ounces of Gold per Day

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The Firms Short-Run Supply Curve ShortA competitive firm is a price taker
Then decides how much output it will produce at that price Whenever the market price is set at a new level, the best output level will be determined by firms, using the MR and MC approach Exception
If the firm is suffering a loss large enough to justify shutting down, it will not produce along its MC curve
Zero output produced instead
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Figure 4: Short-Run Supply Under Perfect ShortCompetition

(a) Dollars ATC $3.50 2.50 2.00 AVC 1.00 0.50 MC d1=MR1 d2=MR2 d3=MR3 d4=MR4 d5=MR5 Bushels 1,000 4,000 7,000 per Year 2,000 5,000

(b) Price per Bushel $3.50 2.50 2.00 1.00 0.50 2,0004,000 5,000
Bushels 7,000 per Year
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Firm's Supply Curve

The Shutdown Price and Supply Curve

Shutdown price is the price at which a firm is indifferent between producing and shutting down Supply curve has two parts
Whenever P>AVC, supply curve coincides with MC curve Whenever P<AVC, firm will shut down
A vertical line segment at zero units of output

Figure 4: For all prices below $1the $1 shutdown priceoutput is zero and the price supply curve coincides with vertical axis
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The (Short-Run) Market Supply Curve (ShortThe shut run market supply curve is obtained from the aggregation of individual firms supply curve firm
summing quantities of output supplied by all firms in market at each price

As we move along the market supply curve, we are assuming that two things are constant
Fixed inputs of each firm Number of firms in market
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Figure 5: Deriving The Market Supply Curve

1. At each price . . . Firm Price per Bushel $3.50 2.50 2.00 1.00 0.50 2,000 4,000 7,000 Bushels per Year 5,000 2. the typical firm supplies the profit-maximizing quantity. Firm's Supply Curve Price per Bushel $3.50 2.50 2.00 1.00 0.50 400,000 700,000 Bushels per Year 200,000 500,000 3.The total supplied by all firms at different prices is the market supply curve. Market Market Supply Curve

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Figure 6: Perfect Competition

Individual Demand Curve Quantity Demanded at Different Prices Quantity Supplied at Different Prices Individual Supply Curve

Added together Market Demand Curve Quantity Demanded by All Consumers at Different Prices

Added together Quantity Supplied by All Firms at Different Prices Market Supply Curve

Market Equilibrium
P S D

Quantity Demanded by Each Consumer

Quantity Supplied by Each Firm

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Part IV. Short-Run Equilibrium ShortIn perfect competition, market

sums buying and selling preferences of individual consumers and producers, and determines market price Each buyer and seller then takes market price as given
Each is able to buy or sell desired quantity Competitive firms can earn an economic profit or suffer an economic loss
Example: Figure 2
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Figure 7 Short-run Profit Maximization Short10 firms each producing 100 units ShortShort-run equilibrium conditions met (K fixed) Firm
P MC P0 P ATC P0

Industry
S

D 100 q 1000 Q

But firm is making positive economic profit : Long Run equilibrium? Incentive for entry or exit? Firm
P MC P0 P ATC P0

Industry
S

Profit>0

D 100 q 1000 Q

Part V. Long-run equilibrium conditions LongShortShort-run

Firm: Price = Marginal Cost: Firms maximize profits Industry: supply = demand

LongLong-run
Firm: Price = ATC: Zero economic profit No incentive to enter or exit

Profit and Loss in the Long Run

Economic profit and loss are the forces driving long-run change long Entry of outsiders if expecting continued economic profit Exit of insiders if expecting losses

In real world entry and exit occur literally every day In some cases, we see entry occur through formation of an entirely new firm or occur when an existing firm adds a new product to its line Exit can occur in different ways
Selling off its assets and freeing itself once and for all from all costs Switches out of a particular product line, even as it continues to produce other things

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Figure 8 Positive Economic Profit Invites Entry in the Long-run and Causes Industry Supply to Rise LongFirm
P MC P0 P1 P ATC P0 P1 D 90 100 q 1000 1080 Q

Industry
S S

LongLong-run equilibrium Number of firms rises to12 firms = 1080/90 P = ATC Firm
P MC P0 P1 P ATC P0 P1 D 90 100 q 1000 1080 Q

Industry
S S

From Short-Run Profit to Long-Run Equilibrium ShortLong-

-- start with profit in the short run

Positive economic profit will attract new entrants
Increasing number of firms in market As number of firms increases, market supply curve will shift rightward causing several things to happen

1. Market price falls 2. Then demand curve facing each firm shifts downward 3. Each then slide down its marginal cost curve, decreasing output

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From Short-Run Profit to Long-Run Equilibrium ShortLong-- start with profit in the short run
This process of adjustment continues, requiring market supply curve to shift rightward enough, and the price to fall enough Until when the reason for entry entry positive profitno longer exits profit So that each existing firm is earning zero economic profit In sum, in a competitive market, positive economic profit continues to attract new entrants until economic profit is reduced to zero
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Figure 9 : Short-run Profit Maximization Short15 firms each producing 80 units ShortShort-run equilibrium conditions met (K fixed) Firm
P MC ATC AVC P0 q P0 D 80 1200 Q S P

Industry

ShortShort-run Profit Maximization 15 firms each producing 80 units ShortShort-run equilibrium conditions met (K fixed) Firm
P MC ATC AVC P0
LOSS

Industry
P

P0 D 80 q 1200 Q

Negative Economic Profit Induces Exit in the Long-run, Industry Supply Falls LongNumber of firms falls to 12 firms = 1080/90
Firm Industry
P MC ATC AVC P1 P0 D 80 90 q 1080 1200 Q P S S

P1 P0

From Short-Run Profit to Long-Run Equilibrium ShortLong-- start with loss in the short run In a competitive market, economic losses continue to cause exit until losses are reduced to zero Raising market price until typical firm breaks even again

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Distinguishing Short-Run from Long-Run ShortLongOutcomes

In short-run equilibrium, competitive shortfirms can earn profits or suffer losses In long-run equilibrium, after entry longor exit has occurred, economic profit is always zero When economists look at a market, they choose the period more appropriate for question at hand

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Figure 10a/b: From Short-Run Profit To ShortLongLong-Run Equilibrium

Market Price per Bushel A $4.50 S1 With initial supply curve S1, market price is $4.50 Dollars Firm So each firm earns an economic profit.

MC A d ATC 1

$4.50

D 900,000
Bushels per Year

9,000

Bushels per Year

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Figure 10c/d: From Short-Run Profit To ShortLongLong-Run Equilibrium

Market Price per Bushel A $4.50 $4.50 S1 S2 Dollars MC A d ATC 1 E 2.50 D
Bushels 900,000 1,200,000 per Year

Firm

2.50

d1
Bushels per Year

5,000

9,000

Profit attracts entry, shifting the supply curve rightward

until market price falls to $2.50 and each firm earns zero economic profit.

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Part VI. The Notion of Zero Profit in Perfect Competition

The same forcesentry and forces exit exitthat cause all firms to earn zero economic profit also ensure in long-run equilibrium, every longcompetitive firm will select its plant size and output level so that it operates at minimum point of its LRATC curve
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Perfect Competition and Plant Size

Figure 6 illustrates a firm in a perfectly competitive market Left panel does not show a true long-run longequilibrium
In long-run typical firm will want to expand longby sliding down its LRATC curve and produce more output at a lower cost per unit potentially earn an economic profit

Same opportunity to earn positive economic profit will attract new entrants that will establish larger plants from the outset Entry and expansion must continue in this market until the price falls to P* where each P* firm earn zero economic profit
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Figure 11: Perfect Competition and Plant Size

1. With its current plant and ATC curve, this firm earns zero economic profit. Dollars MC1 P1 LRATC ATC1 d1 = MR1 MC2 ATC E P* 2. The firm could earn positive profit with a Output per 4. and all firms earn q1 larger plant, q* Period producing here. zero .economic profit and produce at minimum LRATC. d2 = MR2 Output per Period
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3. As all firms increase plant size and output, market price falls to its lowest possible level . . . Dollars LRATC

A Summary of the Competitive Firm in the Long-Run LongAt each competitive firm in long-run longequilibrium P = MC = minimum ATC = minimum LRATC This equality is satisfied when the typical firm produces at point E in figure 6 Where its demand, marginal cost, ATC, and LRATC curves all intersect In perfect competition, consumers are getting the best deal they could possibly get

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Part IV. What Happens When Things Change? -- 1. A Change in Demand

ShortShort-run impact of an increase in demand is Rise in market price Rise in market quantity Economic profits This will cause: More entrants and higher market supply Market equilibrium will move from point A to point C LongLong-run supply curve indicating quantity of output that all sellers in a market will produce at different prices after all longlong-run adjustments have taken place

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Figure 12a/b: An Increasing-Cost Industry IncreasingINITIAL EQUILIBRIUM

Price per Unit

Market
S1

Dollars

Firm
MC ATC1

P1

P1

d1 = MR1

D1 Q1 Output per Period q1 Output per Period

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Figure 12c/d: An Increasing-Cost Industry IncreasingNEW EQUILIBRIUM

Price per Unit PSR P2 P1 A D2 D1 Q1 QSR Q2 Output per Period q1 q1 qSR Output per Period
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Market
S1 B C S2 SLR

Dollars PSR

Firm
B C MC ATC2 ATC1d = MR 2 2 d1 = MR1
dSR = MRSR

P2 P1 A

Increasing Cost Industry

This type of industry (which is the most common) is called an increasing cost industry Entry Increase in demand for inputs price price of those inputs increases Shifts up typical firms ATC curve firm
Raises market price at which firms earn zero economic profit
As a result, long-run supply curve slopes longupward
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Decreasing and Constant Cost Industries

A constant cost industry -- entry has no effect on input prices
Industry might use such a small percentage of total inputs that there is no noticeable effect on input prices Typical firms ATC curve stays put firm
Market price at which firms earn zero economic profit does not change LongLong-run supply curve is horizontal

Decreasing cost industry -- entry by new firms actually decreases input prices
Causes typical firms ATC curve to shift downward firm Lowers market price at which firms earn zero economic profit Long-run supply curve slopes downward Long-

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Small Summary
Increasing Cost Industry Up Entry effect on input prices ATC curve Zero profit market Price LongLong-run supply curve Shifts up Up Constant Cost Industry No effect Decreasin g Cost Industry Down

Stays Not change

Shifts down Down

Slope upward

Horizontal

Slope downward
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Part V. Using the Theory: Changes in Technology

Technological advance that results in increasing returns to scale will Induce some firms to change technologies and produce more lead to a rightward shift of market supply curve, decreasing market price In short-run, early adopters may enjoy shorteconomic profit in long-run, more will adopt, economic profit longfalls to zero Firms that refuse to use the new technology will not survive Some technologies are biased toward large firms, others toward smaller firms. If 56 technologies lower minimum efficient scale, more firms will enter as industry price falls

Summary
3 Requirements for perfect competition
many sellers and buyers standardized products free entry and exit

Demand curve for a competitive firm is perfect elastic (horizontal line)

MR = P

Supply curve for a competitive firm is discrete

is MC when P> AVC is zero when P<AVC

2 approaches to maximize profit by choosing output level

Maximized difference between TR and TC MR = MC

Profit can be measured using graphs Short run equilibrium: profits or loss Long run equilibrium: zero economic profits P=marginal cost=minimum ATC=minimum LRATC
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