Perfect Competition

Study Session 5

Exam

You should be able to explain what a price-taker market is and how price and output are determined in the short run and the long run. Pay special attention to the relationship between marginal cost, marginal revenue, price, and output for a perfectly competitive firm. Know how the concept of economic profir applies to perfect competition. Finallv. von should be

Focus able to explain the adjustments that take place in response to changes in industry demand. A good understanding of the case of perfect competition is important because this is the model of economically efficient markets to which we will compare other market structures in the reviews that follow.

t.OS 18.a: Describe the characteristic.1, oi perfect competition, expia:n why firm;, in a perfectly competitive market are price takers, and differentiate between market and firm demand curves.

Price takers are firms that face horizontal (perfectly elastic) demand curves. They can sell all of their output at the prevailing market price, but if they set their output price higher than the market price, they would sell nothing. They are price takers because they take the market price as given and do not have to devote any resources to discovering the best price at which to sell their product. A "price-taker market" is equivalent to a perfectly competitive market.

Perfect competition assumes the following:

• All the firms in the market produce identical products.

• There is a large number of independent firms.

• Each seller is small relative to the size of the total market.

• There are no barriers to entry or exit.

Producer firms in perfect competition have no influence over market price. Market supply and demand determine price. As illustrated in Figure 1, the individual firm's demand schedule is perfectly elastic (horizontal).

Figure 1: Price-Taker Demand

Price

Quantity

In a perfectly competitive market a firm will continue to expand production until marginal revenue, MR, equals marginal cost. MC. Marginal revenue is the increase in total revenue Irom selling one more unit of a good or service. For a price taker, marginal revenue is simply price because all additional units are assumed to be sold at the same (market) price. In pure competition, a firm's marginal revenue is equal to the market price and a firms MR curve, presented in Figure 2. is identical to its demand curve. A prohi-maximizing firm will produce the quantity, Q", when Ml. = MR.

Figure 2: Profit-Maximizing Output For A Price-Taker

Quantity

1.0S I8.h: Determine the profit maximizing (loss minimizing) output for a perfectly competitive firm, and explain marginal cost, marginal revenue, and economic profit and loss.

All firms maximize (economic) profit by producing and selling the quantity for which marginal revenue equals marginal cost. For a price taker in a perfectly competitive market, this is the same as producing and selling the output for which marginal revenue equals (market) price. Economic profit equals total revenues less the opportunity cost of production, which includes the cost of a normal return to all factors of production, including invested capital.

Figure 3(a) illustrates that in the short run, economic profit is maximized when marginal revenue = marginal cost = price, or MR = MC = P. As shown in Figure 3(b), profit maximization also occurs when total revenue exceeds total cost by the maximum amount.

An economic loss occurs on any units for which marginal revenue is less than marginal cost. At any output above the quantity where MR = MC, the firm will be generating losses on its marginal production and will maximize profits by reducing output to where

Figure 3: Short-Run Profit Maximization

(a) Marginal Approach

(b) Total Approach

Price

profit maximizing output

profit maximizing output

Revenue (Costs)

TR - TC is maximum profit maximizing output

Qu.nni

In a perfectly competitive market, a firm will not earn economic profits for any significant period of time. The assumption is that new firms (with average and marg .nal cost curves identical to those of existing firms) will enter the industry to earn profits, increasing market supply and eventually reducing market price so that it just equals a firms average total cost (ATC). In equilibrium, each firm is producing the quantity f which P = MR = MC = ATC, so that no firm earns economic profits and each firm i: producing the quantity for which ATC is a minimum (the quantity for which ATC -MC). This is illustrated in Figure 4.

Figure 4: Equilibrium in a Perfectly Competitive Market

Figure 4: Equilibrium in a Perfectly Competitive Market

Figure 5 illustrates that firms will experience economic losses when price is below average total cost (P < ATC). In this case, the firm must decide whether to continue operating. A firm will minimize its losses in the short run by continuing to operate when P < ATC but P > AVC. As long as the firm is covering its variable costs and some of its fixed costs, its loss will be less than its fixed (in the short run) costs. If the firm is only just covering its variable costs (P = AVC), the firm is operating at its shutdown point. If the firm is not covering its variable costs (P < AVC) by continuing to operate, its losses will be greater than its fixed costs. In this case, the firm will shut down (zero output) and lay off its workers. This will limit its losses to its fixed costs (e.g., its building lease and debt payments). If the firm does not believe price will ever exceed ATC in the future, going out of business is the only way to eliminate fixed costs.

Figure 5: Short-Run Loss

Price economic loss

The long-run equilibrium output level for perfectly competitive firms is where MR = MC = ATC, which is where ATC is at a minimum. At this output, economic profit is zero and only a normal return is realized.

LOS 18.c: Describe a perfectly competitive firms short-run supply curve and explain the impact of changes in demand, entry and exit of firms, and changes in plant size on the long-run equilibrium.

Recall that price takers should produce where P = MC. Referring to Figure 6(a), a firm will shut down at a price below Pr Between P, and P2 a firm will continue to operate in the short run. At P2 the firm is earning a normal profit—economic profit equals zero. At prices above P2, a firm is making economic profits and will expand its production along the MC line. Thus, the short-run supply curve for a firm is its MC line above the average variable cost curve, AVC. The supply curve shown in Figure 6(b) is the short-run market supply curve, which is the horizontal sum (add up the quantities from all firms at each price) of the MC curves for all firms in a given industry. Since firms will supply more units at higher prices, the short-run market supply curve slopes upward to the right.

Figure 5: Short-Run Loss

Price economic loss

Figure 6: Short-Run Supply Curves

(a) Firm Supply (b) Market Supply

(a) Firm Supply (b) Market Supply

Changes in Demand, Entry and Exit, and Changes in Plant Size

In the short run, an increase in market demand (a shih ol the market demand curve to the right) will increase both equilibrium price and quantity, while a decrease in market demand will reduce both equilibrium price and quantity. The change in equilibrium price will change the (horizontal) demand curve faced by each individual firm and the profit-maximizing output of a firm. These cffects for an increase in demand are illustrated in Figure 7. An increase in market demand from D, to D, increases tl e

short-run equilibrium price from P, to 1\ and equilibrium output from Qj to Q,. In Figure 7(b), we see the short-run cffect of the increased market price on the outp.u of an individual firm. The higher price leads to a greater profit-maximizing output, O, At the higher output level, a firm will earn an economic profit in the short run. li: response to the increase in demand in the long run, some firms will increase their scale of operations, and new firms will likely enter the industry. In response to a decrease in demand, the short-run equilibrium price and quantity will fall, and firms will decrease their scale of operations or exit the market in the long run.

Figure 7: Short-Run Adjustment to an Increase in Demand Under Perfect Competition

Price Price

Supply

Quantity

A firm's long-run adjustment to a shift in industry demand and the resulting change in price may be either to alter the size of its plant or leave the market entirely. The marketplace abounds with examples of firms that have increased their plant sizes (or added additional production facilities) to increase output in response to increasing market demand. Other firms, such as Ford and GM, have decreased plant size to reduce economic losses. This strategy is commonly referred to as downsizing.

If an industry is characterized by firms earning economic profits, new firms will enter the market. This will cause industry supply to increase (the industry supply curve shifts downward and to the right), increasing equilibrium output and decreasing equilibrium price. Even though industry output increases, however, individual firms will produce less because as price falls, each individual firm will move down its own supply curve. The end result is that a firm's total revenue and economic profit will decrease.

If firms in an industry are experiencing economic losses, some of these firms will exit the market. This will decrease industry supply and increase equilibrium price. Each remaining firm in the industry will move up its individual supply curve and increase production at the higher market price. This will cause total revenues to increase, reducing any economic losses the remaining firms had been experiencing.

LOS 18,d: Discuss how a permanent change in demand or changes in technology affect price, output, and economic profit.

A permanent change in demand leads to the entry of firms to or exit of firms from an industry. Let's consider the permanent increase in demand illustrated in Figure 8. The initial long-run industry equilibrium condition shown in Figure 8(a) is at the intersection of demand curve DQ and supply curve SQ, at price P0 and quantity Qq. As indicated in Figure 8(b), at the market price of PQ each firm will produce q0. At this price and output, each firm earns a normal profit, and economic profit is zero. That is, MC = MR = P and ATC is at its minimum. Now, suppose industry demand permanently increases such that the industry demand curve in Figure 8(a) shifts to Dr The new market price will be Pj and industry output will increase to Q,. At the new price P,, existing firms will produce qj and realize an economic profit since Pj > ATC. Positive economic profits will cause new firms to enter the market. As these new firms increase total industry supply, the industry supply curve will gradually shift to S,, and the market price will decline back to PQ. At the market price of P0, the industry will now produce Q,, with an increased number of firms in the industry, each producing at the original quantity, q0 The individual firms will no longer enjoy an economic profit since ATC =

Figure 8: Effects of a Permanent Increase in Demand

(a) Industry

Price

Price and Cost

Price

Price and Cost

The long-run equilibrium price after a permanent increase in demand may be higher or lower than before, depending on the effect of greater input purchases on input prices. In a situation referred to as external economies of scale, input prices fall because of the greater demand. As computer demand increased, economies of scale in producing the central processing units allowed computer makers to decrease prices, even as output increased. This effect was compounded by technological improvements in manufacturing technology. The long-run supply curve for the industry is downward sloping when external economies of scale reduce production costs for larger quantities.

External diseconomies of scale refer to a situation when the increased demand for productive inputs results in an increase in their prices. In this case, a permanent increase in market demand for the finished product will result in an increase in both equilibrium price and output. A permanent increase in the market demand for aluminum will increase the long-run equilibrium price and output of aluminum since the supply curve for bauxite (aluminum ore) is upward sloping. The long-run supply curve for the industry is upward sloping when external diseconomies of scale increase production costs as industry output expands.

In sum, the slope of the long-run industry supply curve depends on the effect of increased industry output on the prices of the important inputs in the production process. The two cases are illustrated in Figure 9. The initial price change in response to an increase in industry demand, from D0 to Dj, is movement along the short-run supply curve (SRS0) to a higher price in the short run (PSR). In the long run as producers enter the industry, short-run industry supply increases to SRSj and the shape of the long-run industry supply curve (LRS) depends on whether productive inputs are subject to economies or diseconomies of scale. With external economies (diseconomies) of scale, the long-run effect of a permanent increase in demand is an increase in output and a decrease (increase) in the equilibrium market price to PLR.

Figure 9: Long-Run Industry Supply in a Competitive Market

(a) External Economies of Scale (b) External Diseconomies of Scale

Price Price

(a) External Economies of Scale (b) External Diseconomies of Scale

Price Price

Figure 9: Long-Run Industry Supply in a Competitive Market

Technological changes, such as a lower-cost production process, usually require firms to invest in additional fixed assets (e.g., plant and equipment). Consequently, technological advances take some time to become common practice throughout an industry. Once individual firms have implemented technological changes, their costs decline and their supply (cost) curve shifts to the right. At the lower costs, firms are willing to supply a given quantity at a reduced price, or provide more of a product at a higher price. In either case, the lower cost structure for the individual firms shifts the industry supply curve to the right. With a given demand, and this repositioned industry supply curve, the industry supplies more of a given product at a lower price.

Firms that are the first to adopt the new cost-reducing technology will earn economic profits. New firms that use the new technology will be attracted to the industry by profits. Existing firms using the older (higher-cost) technology will experience economic losses and be forced to either adopt the new technology or exit the industry. Long-run equilibrium with price equal to minimum average total cost for the new technology will be established after all firms in the industrv have adopted the new technology. In long-run equilibrium, firms again will earn zero economic profits as the number of firms in the industrv will be the number for which total industrv supply makes equilibrium price-equal to minimum average total cost (and marginal cost) for each firm.

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