chapter 5&6 main lecture on revenue and perfect competition chapter 5&6 main lecture on...
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Chapter 5&6Main Lecture on Revenue and Perfect Competition
Chapter 5&6Main Lecture on Revenue and Perfect Competition
RevenueRevenue
• We have looked at Production and then We have looked at Production and then Cost so we have analysed a firm’s Cost so we have analysed a firm’s technical capabilities and the costs of technical capabilities and the costs of producing output, producing output,
• on average on average
• and at the margin (one more unit)and at the margin (one more unit)
• Now we have to examine what the firm Now we have to examine what the firm earns from producing an additional unitearns from producing an additional unit
REVENUEREVENUE
• …thus we need to define total, average and marginal revenue
• We start by examining revenue curves when firms are price takers
• By this we mean that firms are small relative to the total market and that they do not have much influence over the price charged.
• In such a market if they raise price people will go elsewhere…
• … and if they reduce price (even if it were profitable) they would not be able to cope with the resultant demand.
• …thus we need to define total, average and marginal revenue
• We start by examining revenue curves when firms are price takers
• By this we mean that firms are small relative to the total market and that they do not have much influence over the price charged.
• In such a market if they raise price people will go elsewhere…
• … and if they reduce price (even if it were profitable) they would not be able to cope with the resultant demand.
RevenueRevenue
• That is, they perceive the price they can That is, they perceive the price they can receive as constant.receive as constant.
• So as far as they are concerned the So as far as they are concerned the demand curve is demand curve is horizontal.
• That means they believe:
• They can sell as much as they want at the going price.
Deriving a firm’s Deriving a firm’s ARAR and and MRMR: price-taking firm: price-taking firm
O O
Pri
ce (
£)
AR
, MR
(£
)
Q (millions) Q (hundreds)
Pe
S
D
(a) The market (b) The firm
O O
Pri
ce (
£)
AR
, MR
(£
)
Pe
S
D
Q (millions) Q (hundreds)
(a) The market (b) The firm
Deriving a firm’s Deriving a firm’s ARAR and and MRMR: price-taking firm: price-taking firm
Total revenue for a price-taking firmTotal revenue for a price-taking firm
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
(£
)
Quantity
Quantity(units)
0200400600800
10001200
Price
5555555
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
(£
)
Quantity
Quantity(units)
0200400600800
10001200
Price
5555555
TR(£)
0100020003000400050006000
Total revenue for a price-taking firmTotal revenue for a price-taking firm
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
(£
)
Quantity
Quantity(units)
0200400600800
10001200
Price
5555555
TR(£)
0100020003000400050006000
Total revenue for a price-taking firmTotal revenue for a price-taking firm
TR
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
(£
)
Quantity
Total revenue for a price-taking firmTotal revenue for a price-taking firm
TR
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
(£
)
Quantity
Quantity(units)
0200400600800
10001200
Price = AR= MR (£)
5555555
TR(£)
0100020003000400050006000
Total revenue for a price-taking firmTotal revenue for a price-taking firm
AR=TR/Q
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
(£
)
Quantity
Quantity(units)
0200400600800
10001200
Price = AR= MR (£)
5555555
TR(£)
0100020003000400050006000
Total revenue for a price-taking firmTotal revenue for a price-taking firm
AR=TR/Q
5555555
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
(£
)
Quantity
Quantity(units)
0200400600800
10001200
Price = AR= MR (£)
5555555
TR(£)
0100020003000400050006000
Total revenue for a price-taking firmTotal revenue for a price-taking firm
AR=TR/Q
5555555
MR
0
1000
2000
3000
4000
5000
6000
0 200 400 600 800 1000 1200
TR
(£
)
Quantity
Quantity(units)
0200400600800
10001200
Price = AR= MR (£)
5555555
TR(£)
0100020003000400050006000
Total revenue for a price-taking firmTotal revenue for a price-taking firm
AR=TR/Q
5555555
MR
5555555
£5
Mathematics of Revenue:Mathematics of Revenue:
QPTR .
Average Revenue PQ
QP
Q
TR
.
Total Revenue
Marginal Revenue
When P is constant P
Q
QPd
dQ
TRd).()(
Price Taking FirmsPrice Taking Firms
• So in conclusion: When a firm is a price So in conclusion: When a firm is a price taker, MR and AR are constant and equal to taker, MR and AR are constant and equal to the price of the output.the price of the output.
VERY Short-run equilibrium of industry and firm VERY Short-run equilibrium of industry and firm under perfect competitionunder perfect competition
O O
S
D
(a) (a) Industry Industry
P £
Q (millions)
VERY Short-run equilibrium of industry and firm VERY Short-run equilibrium of industry and firm under perfect competitionunder perfect competition
O O
S
D
(a) (a) Industry Industry
P £
Pe
Q (millions)
VERY Short-run equilibrium of industry and firm VERY Short-run equilibrium of industry and firm under perfect competitionunder perfect competition
O O
S
D
(a) (a) Industry Industry
P £
Pe
(b) (b) Firm Firm
ARD = AR= MR
Q (millions) q (thousands)
VERY Short-run equilibrium of industry and firm VERY Short-run equilibrium of industry and firm under perfect competitionunder perfect competition
O O
S
D
(a) (a) Industry Industry
P £
Q (millions)
Pe
(b) (b) Firm Firm
ARD = AR= MR
MC
qe
q (thousands)
Very Short-run equilibrium of industry and firm Very Short-run equilibrium of industry and firm under perfect competitionunder perfect competition
O O
S
D
(a) (a) Industry Industry
P £
Q (millions)
Pe
(b) (b) Firm Firm
ARD = AR= MR
MC
qe
AC
AC
q (thousands)At what level of output should
the firm Produce?
O O
S
D
(a) (a) Industry Industry
P £
Q (millions)
Pe
(b) (b) Firm Firm
ARD = AR= MR
MC
qe
AC
AC
q (thousands)
Produce where MR = MCProduce where MR = MC
RULE ALWAYS HOLDSRULE ALWAYS HOLDS
At Qe how much profit does the firm make?
O O
S
D
(a) (a) Industry Industry
P £
Q (millions)
Pe
(b) (b) Firm Firm
ARD = AR= MR
MC
qe
AC
AC
q (thousands)
O O
S
D
(a) (a) Industry Industry
P £
Q (millions)
Pe
(b) (b) Firm Firm
ARD = AR= MR
MC
qe
AC
AC
q (thousands)
At Qe how much profit does the firm make?
O O
S
D
(a) (a) Industry Industry
P £
Q (millions)
Pe
(b) (b) Firm Firm
ARD = AR= MR
MC
Qe
AC
AC
Q (thousands)Area =
(AR-AC)*Qe
At Qe how much profit does the firm make?
Supernormal ProfitsSupernormal Profits
• What was included in total costs when we What was included in total costs when we drew the TC and AC curves?drew the TC and AC curves?
• We included the cost of capital, labour, and We included the cost of capital, labour, and raw materials and also:raw materials and also:
• ……an appropriate return for the an appropriate return for the entrepreneur for his or her labour, capital entrepreneur for his or her labour, capital invested, and riskinvested, and risk
• So what does the yellow area represent?So what does the yellow area represent?
• (AR – AC)*Q(AR – AC)*Qee = =
Supernormal profitSupernormal profit
O O
S
D
(a) (a) Industry Industry
P £
Q (millions)
Pe
(b) (b) Firm Firm
ARD = AR= MR
MC
Qe
AC
AC
Q (thousands)
Supernormal Profit
Supernormal profitSupernormal profit
PERFECT COMPETITIONPERFECT COMPETITION
– Produce where MR = MC
– Under perfect Competition P = MR
– So MR= P = MC
– possible supernormal profits = (AR-AC)*Q
– Produce where MR = MC
– Under perfect Competition P = MR
– So MR= P = MC
– possible supernormal profits = (AR-AC)*Q
Very Short-run equilibrium of industry and firm Very Short-run equilibrium of industry and firm under perfect competitionunder perfect competition
O O
S
D
(a) (a) Industry Industry
P £
Q (millions)
P
(b) (b) Firm Firm
ARD = AR= MR
MC
Qe
AC
AC
Q (thousands)
Supernormal Profit
Supernormal profits will attract Supernormal profits will attract aa more firms to the more firms to the industry. industry.
O O
S
D
(a) (a) Industry Industry
P
£
Q (millions)
P
(b) (b) Firm Firm
ARD = AR= MR
MC
Qe
AC
AC
Q (thousands)
Before S = n* QBefore S = n* Qee
now Snow S = (n+a) * Q= (n+a) * Qee
So Supply curve moves out!So Supply curve moves out!
O O
S
D
(a) (a) Industry Industry
P
£
Q (millions)
P
(b) (b) Firm Firm
ARD = AR= MR
MC
Q
AC
AC
Q (thousands)
S1
Qe Q1
Price fallsPrice falls
O O
S
D
(a) (a) Industry Industry
P
£
Q (millions)
Pe
(b) (b) Firm Firm
ARD = AR= MR
MC
Qe
AC
AC
Q (thousands)
S1
O O
S
D
(a) (a) Industry Industry
P
£
Q (millions)
Pe
(b) (b) Firm Firm
ARD = AR= MR
MC AC
AC
Q (thousands)
S1
.. And a new LONG RUN equilibrium is established at .. And a new LONG RUN equilibrium is established at PPee,Q,Qee
O O
S
D
(a) (a) Industry Industry
P
£
Q (millions)
P
(b) (b) Firm Firm
ARD = AR= MR
MC
Qe
AC
AC
Q (thousands)
S1
Pe
PERFECT COMPETITIONPERFECT COMPETITION
• Short-run supply curve of industry
• Long-run equilibrium of the firm
– all supernormal profits competed away because new firm enter
– Since AR=AC in long-run equilibrium:
(AR-AC)*Q=0
So there is NO supernormal profits.
• Short-run supply curve of industry
• Long-run equilibrium of the firm
– all supernormal profits competed away because new firm enter
– Since AR=AC in long-run equilibrium:
(AR-AC)*Q=0
So there is NO supernormal profits.
LONG RUN Equilibrium under Perfect Competition LONG RUN Equilibrium under Perfect Competition requires that AR=P=MR=MC=ACrequires that AR=P=MR=MC=AC
O O
D
(a) (a) Industry Industry
P
£
Q (millions)
(b) (b) Firm Firm
D = AR= MR
MC
Qe
AC
Q (thousands)
S1
Pe Pe
Suppose now demand falls. Suppose now demand falls.
O O
D1
(a) (a) Industry Industry
P
£
Q (millions)
P0
(b) (b) Firm Firm
MC
Qe
AC
Q (thousands)
S1
P1
Pe
D0
What happens to supply now?What happens to supply now?
Suppose now demand falls. Suppose now demand falls.
O O
D1
(a) (a) Industry Industry
P
£
Q (millions)
P0
(b) (b) Firm Firm
MC
Qe
AC
Q (thousands)
S1
P1
Pe
D0
Our same MR = MC rule applies, but there is Our same MR = MC rule applies, but there is one more considerationone more consideration
RecallRecall
• In the short run, capital is fixed while labor In the short run, capital is fixed while labor may vary. So TC=FC+VC (Fixed Costs and may vary. So TC=FC+VC (Fixed Costs and Variable Costs). Variable costs=labour Variable Costs). Variable costs=labour costs.costs.
• AVC (average variable), is equal to:AVC (average variable), is equal to:
labour costs/Qlabour costs/Q
The rest of the firms costs are The rest of the firms costs are fixed costsfixed costs (costs to capital equipment). Those are the (costs to capital equipment). Those are the ones which, in the short run, the firm ones which, in the short run, the firm cannot escape.cannot escape.
O O
D1
P
£
P0
MC
Q1
ACS1
P1
Pe
D0
Our same MR = MC rule applies, but there is Our same MR = MC rule applies, but there is one more considerationone more consideration
We need to check where the AVC curve lies. Why?
AVC
In this case P > AVC so will continue to produce.
By doing so, cover AVC and make some contribution to covering Fixed Costs
Q0
O O
D1
P
£
P0
MC
Q1
ACS1
P1
Pe
D0
Our same MR = MC rule applies, but there is Our same MR = MC rule applies, but there is one more considerationone more consideration
We need to check where the AVC curve lies. Why?
AVC
But overall making a (supernormal) loss
= (AC-P)Q < 0
Q0
O O
D1
P
£
P0
MC
Qe
ACS1
P1
Pe
D0
What if P is below AVC?What if P is below AVC?
AVC
In this case the firm can’t cover variable costs, so better to close down (lay of all workers) and
only lose FC
To sum up: Let’s derive the short-run supply curveTo sum up: Let’s derive the short-run supply curve
O O
(a) (a) Industry Industry
P £
P1
Q (millions)
(b) (b) Firm Firm
D1 = MR1
Q (thousands)
MC
Q1
a
D1
S
O O
(a) (a) Industry Industry
P £
P1
Q (millions)
D1
(b) (b) Firm Firm
D1 = MR1
MC
Q2
a
P2
D2 = MR2b
S
D2
Q (thousands)
Deriving the short-run supply curveDeriving the short-run supply curve
O O
(a) (a) Industry Industry
P £
P1
Q (millions)
S
D1
(b) (b) Firm Firm
D1 = MR1
MC
Q3
a
P2
D2 = MR2
D2
b
P3
D3 = MR3
D3
c
Q (thousands)
Deriving the short-run supply curveDeriving the short-run supply curve
AVC
O O
(a) (a) Industry Industry
P £
P1
Q (millions)
S
D1
(b) (b) Firm Firm
D1 = MR1
S
a
P2
D2 = MR2
D2
b
P3
D3 = MR3
D3
c
Q (thousands)
Deriving the short-run supply curveDeriving the short-run supply curve“equals” the MC curve until p=AVC“equals” the MC curve until p=AVC
AVC
PERFECT COMPETITIONPERFECT COMPETITION
• Short-run supply curve of industry is equal to MC curve (as long as the price is above AVC)
• Long-run equilibrium of the firm
– all supernormal profits competed away
– long-run industry supply curve
• Short-run supply curve of industry is equal to MC curve (as long as the price is above AVC)
• Long-run equilibrium of the firm
– all supernormal profits competed away
– long-run industry supply curve
O O
D
(a) (a) Industry Industry
P
£
Q (millions)
(b) (b) Firm Firm
D = AR= MR
MC
Qe
AC
Q (thousands)
S
Pe Pe
D1
What happened to Supply here in the Long Run What happened to Supply here in the Long Run ??
MC=P=AC (so AC at minimum)MC=P=AC (so AC at minimum)
S1
LRS
PERFECT COMPETITIONPERFECT COMPETITION
• Short-run supply curve of industry
• Long-run equilibrium of the firm
– all supernormal profits competed away
– long-run industry supply curve (horizontal at minimum AC)
• Short-run supply curve of industry
• Long-run equilibrium of the firm
– all supernormal profits competed away
– long-run industry supply curve (horizontal at minimum AC)
PERFECT COMPETITIONPERFECT COMPETITION
• Advantages of perfect competition
– production at minimum AC (which is efficient)
– only normal profits in long run (no supernormal profits)
– responsive to consumer wishes: consumer sovereignty (demand influences price and so firms’ actions)
– competition efficiency
• Advantages of perfect competition
– production at minimum AC (which is efficient)
– only normal profits in long run (no supernormal profits)
– responsive to consumer wishes: consumer sovereignty (demand influences price and so firms’ actions)
– competition efficiency
PERFECT COMPETITIONPERFECT COMPETITION
• Disadvantages of perfect competition
– There really are none
• Except perhaps….
– Disadvantage is that it may not be a valid version of reality
– Perfect competition rests on the following assumptions
firms are price takers ? (small r.t. market)freedom of entry and exit ? (depends on product)identical products OK approximation
(typically)
• Disadvantages of perfect competition
– There really are none
• Except perhaps….
– Disadvantage is that it may not be a valid version of reality
– Perfect competition rests on the following assumptions
firms are price takers ? (small r.t. market)freedom of entry and exit ? (depends on product)identical products OK approximation
(typically)