1

Industrial Organization & Perfect Competition

2

Perfectly Competitive Markets Structure Assumptions

Many buyers and sellers Homogeneous product or output

– Note: these first two assumptions imply that the perfectly competitive firm is a price taker.

– P(x) = P* = where is the demand for the individual firm’s output.

– Also note that if P(x) is just P*, then mr=P*, too.

“Free” entry and exit Full and symmetric information

3

Perfectly Competitive Markets

Every demander is a price-taker (no buyer can influence the price).

Every supplier is a price-taker (no seller can influence the price).

The market price is known to all potential buyers and sellers and anyone who wishes to trade at that price can do so.

4

An Example

Jonathan’s farm is perfectly competitive and uses the inputs shown to produce the quantities of apples indicated on the table.

Jonathan's Apple Farm Production Function

Apples (tons/year)

Land (acres)

Labor (hired)

Proprietor's time (hours)

0 100 0 1,10050 100 2,500 1,100

100 100 3,700 1,100150 100 5,000 1,100200 100 6,800 1,100250 100 10,000 1,100300 100 15,000 1,100350 100 27,000 1,100

5

Production Detail

Apple Farm Production Function (detail)

Apples (tons/year)

Land (acres)

Labor (hired)

Proprietor's time (hours)

200 100 6,800 1,100210 100 7,320 1,100220 100 7,900 1,100230 100 8,530 1,100240 100 9,220 1,100250 100 10,000 1,100260 100 10,800 1,100

Here is some finer detail regarding the apple farm.

6

Factor Prices

Jonathan is a factor price taker.

Use these factor prices to build the cost tables.

Prices

Labor's time $8.00 per hourOwner's time $12.00 per hourRent $124.00 per acre

7

CostsJonathan's Apple Farm Costs

Apples (tons/year) Land

Hired Labor

Proprietor's time Total Cost

Average Cost

Marginal Cost

(midpoint formula)

0 12,400 0 13,200 25,60050 12,400 20,000 13,200 45,600 912 296

100 12,400 29,600 13,200 55,200 552 200150 12,400 40,000 13,200 65,600 437 248200 12,400 54,400 13,200 80,000 400 400250 12,400 80,000 13,200 105,600 422 656300 12,400 120,000 13,200 145,600 485 1,360350 12,400 216,000 13,200 241,600 690

8

Finer Cost DetailsJonathan's Apple Farm Costs (detail)

Apples (tons/year) Land

Hired Labor

Proprietor's time Total Cost

Average Cost

Marginal Cost

(midpoint formula)

200 12,400 54,400 13,200 80,000 400210 12,400 58,560 13,200 84,160 401 440220 12,400 63,200 13,200 88,800 404 484230 12,400 68,240 13,200 93,840 408 528240 12,400 73,760 13,200 99,360 414 588250 12,400 80,000 13,200 105,600 422 632260 12,400 86,400 13,200 112,000 431

9

Graph of Jonathan’s Cost Curves

The marginal cost of each ton of apples is shown as the red line.

The average cost is shown as the blue line.

Notice that the marginal cost = average cost at average cost’s minimum.

Jonathan's Cost Functions

0

100

200

300

400500

600

700

800

900

1,000

0 100 200 300 400

Apples (tons/year)

$/t

on

Average Cost Marginal Cost (midpoint formula)

10

Profit Maximization Profit () = total revenue(tr) - total cost(tc). Profit depends on the firm’s output level (x). So… (x) = tr(x) - tc(x) Define

– marginal revenue (mr) = tr/x– marginal cost (mc) = tc/x

NOTE: Since we have a perfectly competitive firm P=mr for all levels of production.

11

Profit Maximization General rules for profit maximization: If x* maximizes , then

– mr = mc at x*– x* is a profit max and not a profit min – at x* it’s worth operating

Reminder: since the firm is perfectly competitive, P=mr for all values of x.

12

Jonathan’s Profit and Loss Suppose the market

price is $600/ton. The vertical

difference between Jonathan’s total revenue and total cost curve is his profit.

The profit maximum occurs at 240 tons/year.

Total Cost and Revenue

0

50,000

100,000

150,000

200,000

250,000

300,000

0 50 100 150 200 250 300 350 400

Apples (tons/year)

$

Total Cost

Total Revenue

Maximum Profit, market price= marginal cost

Total Cost, slope=marginal cost

Total Revenue, slope=market price

13

Finding Profit Maximizing Points Using The Marginal Cost Curve

Jonathan will supply apples to the market in increasing quantities as the price rises.

The points on the marginal cost curve correspond to profit maximizing quantities at two different market prices.

The quantity supplied at a market price of $600/ton is (about) 240 (black dot).

Consider another market price, P=1,200 and note that x* increases.

Marginal Cost of Apples

0

200

400

600

800

1,000

1,200

1,400

1,600

0 100 200 300 400

Apples (tons/year)

Pri

ce (

$/to

n)

mc

mr when P=600

mr when P=1,200

14

Finding the Value of Profit - Case A

If market price is P*, then the firm supplies x* where mr=mc.

Total Revenue=OACQ*

Total Cost=OBDQ*Note: use the atc curve to get the value of total costs by multiplying atc by x*

Profit = tr-tc=BACD

P* = mr

mcatc

A

B

C

D

OQuantityx*

P

15

Finding the Value of Profit - Case B

If market price is P*, then the firm supplies x* where mr=mc.

Total Revenue=OBDQ*

Total Cost=OBDQ*

Profit = tr-tc=0

Note: economic profit = 0

P* = mr

mc atc

B D

OQuantityx*

P

16

Finding the Value of Profit - Case C If market price is P*, then the firm

supplies x* where mr=mc. Total Revenue=OACQ* Total Cost=OBDQ*

Profit = tr-tc = -ABDCNote: Profits are negative. They are loses.

Should firm continue to operate? Good question. Now need to look at where the average variable cost curve is. Recall: produce at a loss provided tr vc orp avc

Since P>avc at x*, firm should produce x*.

P* = mr

mc atc

BD

OQuantityx*

A C

P

avc

17

The Firm’s Supply Curve

An individual perfectly competitive firm’s supply curve (the srsfirm) is its marginal cost curve above its average variable cost curve.

For a perfectly competitive firm, choosing the output at which market price equals marginal cost maximizes profits.– Remember, it’s really mr=mc at x*, but since the

firm is a price taker, P=mr all the time, so P=mc at x*.

18

Jonathan’s Supply Curve At the market price

indicated on the vertical axis, profit maximizing apple production is given by the marginal cost curve, which is Jonathan’s supply of apples curve.

The supply curve is the the marginal cost curve above average variable cost because profit maximizing behavior means increasing production until marginal cost = market price.

Single Farm Supply of Apples

0

200

400

600

800

1,000

1,200

1,400

1,600

0 100 200 300 400

Apples (tons/year)

Pri

ce

($

/to

n)

19

Total Costs and Economic Profits

Total costs include fixed costs, variable costs (at market prices) and the opportunity cost of owned factors (such as the owner’s time, land, and equipment owned by the business).

Economic profits are the difference between total revenue from sales and total costs, as defined above.

20

Back to Jonathan’s Farm...

The apple market is competitive. Jonathan cannot control the price of

apples. Consider, for the moment, a price of

say $528/ton now To profit maximize Jonathan produces

until P (=mr) = mc

21

Jonathan’s Economic Profit and Loss

At the market price of $528, the profit maximizing apple production is the highlighted line.

Apple Farm Profits (detail)

Apples (tons/year) Total Cost

Total Revenue

Marginal Cost

Marginal Revenue = Market

PriceEconomic

Profits200 80,000 105,600 25,600210 84,160 110,880 440 528 26,720220 88,800 116,160 484 528 27,360230 93,840 121,440 528 528 27,600240 99,360 126,720 588 528 27,360250 105,600 132,000 632 528 26,400260 112,000 137,280 25,280

22

Graph of Jonathan’s Revenue and Cost

The vertical difference between Jonathan’s total revenue and total cost curves is his economic profits.

The slope of the total cost line (marginal cost) is equal to the slope of the total revenue line (marginal revenue = market price)

Total Cost and Revenue

0

50,000

100,000

150,000

200,000

250,000

0 50 100 150 200 250 300 350 400

Apples (tons/year)

$

Total Cost Total Revenue

Maximum Profit, market price= marginal cost

Total Cost, slope=marginal cost

Total Revenue, slope=market price

23

Graph of Jonathan’s Economic Profits

The chart at the right shows that Jonathan’s economic profits are maximized at apple production where the market price is equal to the marginal cost (230 tons/year).

Profits are maximized when marginal cost is as close as possible to market price, without exceeding it.

The slope of economic profits = zero at the profit maximum.

Economic Profits (detail)

25,000

25,500

26,000

26,500

27,000

27,500

28,000

200 210 220 230 240 250 260

Apples (tons/year)

$

24

Accounting Profits

Accounting profits are defined as total sales revenue (the same as total revenue in the economic profits definition) minus operating costs (costs of goods sold + administrative and sales costs for those who know some accounting).

Accounting Profits = Sales Revenue - Accounting Costs

25

Did Jonathan Make Accounting Profits?

The blue line in the table illustrates that Jonathan makes an accounting profit of $40,800 when the apple price is $528/ton.

Accounting Profits vs. Economic Profits (detail)

Apples (tons/year)

Total Revenue

Accounting Costs

Accounting Profits Total Costs

Economic Profits

200 105,600 66,800 38,800 80,000 25,600210 110,880 70,960 39,920 84,160 26,720220 116,160 75,600 40,560 88,800 27,360230 121,440 80,640 40,800 93,840 27,600240 126,720 86,160 40,560 99,360 27,360250 132,000 92,400 39,600 105,600 26,400260 137,280 98,800 38,480 112,000 25,280

26

Economic Profits

Economic profits are the difference between total revenue and total costs.

Economic total costs include the opportunity costs of all inputs to the production process–in particular, the opportunity costs of the owner’s time and physical capital (equipment and space).

27

Reconciling Economic and Accounting Profits

The table to the right shows that Jonathan’s economic profits equal his accounting profits minus the opportunity cost of his time.

Thus, when the price of apples is $528/ton and 230 tons/year are sold, economic profits = $27,600

Reconciling Accounting and Economic Profits (detail)

Apples (tons/year)

Accounting Profits

- Opportunity Cost of

Jonathan's Time

= Economic Profits

200 38,800 13,200 25,600210 39,920 13,200 26,720220 40,560 13,200 27,360230 40,800 13,200 27,600240 40,560 13,200 27,360250 39,600 13,200 26,400260 38,480 13,200 25,280

28

Question 1

At a market price of $440/ton for apples, what is the optimal annual production of apples?

Use the data on your handout to answer this question.

29

Answer 1

Marginal cost = market price = $440/ton at a production level of 210 tons/year.

This is the profit maximizing level of output when the market price is $440/ton.

30

Question 2

At a market price of $440/ton for apples, what are Jonathan’s accounting and economic profits?

31

Answer 2

Total revenue = $440 x 210 = $92,400. Total costs = $124 x 100 (land) + $8.00

x 7,320 (labor) + $12.00 x 1,100 (proprietor’s time) = $84,160 .

Economic profits = total revenue - total costs = $92,400 - $84,160 = $8,240.

32

Answer 2 (continued)

Total revenue = $440 x 210 = $92,400. Accounting costs = $124 x 100 (land) + $8.00

x 7,320 (labor) = $70,960. Accounting profits = total revenue -

accounting costs = $92,400 - $70,960 = $21,440.

Economic profits = accounting profits - opportunity cost of owner’s time = $21,440 - $13,200 = $8,240.

33

Question 3

At a market price of $400/ton for apples, what are Jonathan’s accounting and economic profits?

34

Answer 3

Optimal production = 200 tons/year. Total revenue = $400 x 200 = $80,000. Economic profits = total revenue - total

costs = $80,000 - $80,000 = 0. Accounting profits = total revenue -

accounting costs = $80,000 - 66,800 = 13,200.

35

Question 4

Should Jonathan continue to operate the apple farm if the market price of apples is $400/ton?

36

Answer 4

Jonathan’s economic profits are zero when the market price of apples is $400/ton ($0.20/pound, about the current price wholesale price for first quality fresh apples).

Jonathan just recovers the opportunity cost of his time ($13,200), so he is indifferent between producing apples and taking a job at $12/hour.

37

Producers Surplus Revisited Producers surplus measures the gain to the firm from

selling all units at the market price. Producers surplus is the supply-side equivalent of

consumers surplus. Total producers surplus = the area above the marginal

cost curve and below the market price = economic profits + fixed costs.

Incremental producers surplus = the difference between the market price and the marginal cost of the given unit of production.

38

Jonathan’s Producers Surplus Jonathan’s total

producers surplus, when the market price is $528, is the sum of his economic profits ($27,600) and his fixed costs ($25,600) = $53,200.

Jonathan's Producers Surplus

0

200

400

600

800

1,000

1,200

1,400

1,600

0 100 200 300 400

Apples (tons/year)

Pri

ce

($

/to

n)

Market Price = $528

Producers surplus = area above the marginal cost curve, below the market price = $53,200

39

Producers Surplus and Economic Profits

Producers surplus is not equal to economic profits.

Producers surplus includes fixed costs. Economic profits = producers surplus -

fixed costs. Producers surplus = economic profits +

fixed costs.

40

The Market Supply Curve

The market supply curve is the sum of the quantities supplied by each seller at each market price.

Market supply, thus reflects the marginal costs of each of the producers in the market.

This is Short Run Market Supply (SRS)

41

Supply Curve for a New York Apple Farm

The data used to construct Jonathan’s supply curve were representative of the typical New York State apple farm.

The supply curve for a single apple farm is shown to the right.

Single Farm Supply of Apples

0

200

400

600

800

1,000

1,200

1,400

1,600

0 100 200 300 400

Apples (tons/year)

Pri

ce

($

/to

n)

It is the same as the supply curve we have been using, based on the marginal cost curve of a single farm.

42

Market Supply Curve: Horizontal Summation

Farm A’s Supply of Apples

0

200

400

600

800

1,000

1,200

1,400

1,600

0 100 200 300 400

Apples (tons/year)

Pri

ce (

$/to

n)

Farm B’s Supply of Apples

0

200

400

600

800

1,000

1,200

1,400

1,600

0 100 200 300 400

Apples (tons/year)

Pri

ce (

$/to

n)

At a price of $1000/ton, add Farm A’s supply to Farm B’s supply to get market supply (about 560 tons/year). Add over all farms.

The market supply curve is the horizontal summation of the firms’ supply curves.

43

Short Run Equilibrium - Summary The firm is profit maximizing - no desire at

current market price to change the quantity supplied.– Firm is on its short run supply curve

Market Demand = Short run Market Supply– No tendency for market price to change

Note: number of firms fixed, technology given and firm’s capital fixed.

Get: (P*, X*, x*) Firms can have +/0/- profit.

44

Profit Signal

When profit in the short run is positive there are firms at the margin that want to enter the market and it is assumed that they can.

When profit in the short run is negative there are firms at the margin that want to exit the market and it is assumed that they will.

45

Long Run Equilibrium

All the short run equilibrium properties. But also…no firms wish to exit the market

nor do firms want to enter. Get: (P*, X*, x*, N*) Note: For there to be neither entry or exit,

need economic profit to be zero. This is a long run equilibrium requirement. Otherwise the number of firms in the market will still be in flux.

46

Long Run Equilibrium Position Profit max implies that mr=lrmc at x*. Zero profit implies P=lratc at x*. Since the firm is perfectly competitive, P=mr at all values

of x. By substitution, P=lratc at x* and P=lratc at x*. Therefore lrmc=lratc at x*. This implies that x* is at the minimum of the typical firm’s

lratc. x* is at MES. P* must be the price consistent with the minimum value on

the lratc curve. N* and X* determined by position of market demand.

47

Long Run Equilibrium Picture

lratc

xx*X*

P* P* mr

SRS w/N*

D

X

A a

typical firmmarket

48

Steps to Draw The Picture?

Doesn’t matter how you draw it, as long as you draw it correctly in the end.

Draw-a-person test.

49

What’s not ok...

50

Increases in Demand

When demand increases and is expected to remain at the increased level, the short run response is to move along the short run supply curve--higher price and greater quantity supplied.

The long run response is to have entry in the market, movement along the long run supply curve--price returns to the minimum average total cost and quantity supplied increases.

51

Long Run Adjustment Picture

lratc

xx*X*

P* P* mr

SRS w/N*

D

X

A a

typical firmmarket

D new

P’ P’ mr’B

srmc

sratc

b

X’ x’

52

Long Run Equilibrium Picture

lratc

xx*X*

P* P* mr

SRS w/N*

D

Q

A a

typical firmmarket

D new

P’ P’ mr’B

srmc

sratc

b

X’ x’

SRS w/N**

C

X**

LRS

53

Long Run Supply in the Market

Both points A and C in the previous picture are long run equilibrium points.

Point B is a temporary short run equilibrium point.

If you connect all points like A and C you get the market long run supply curve in a perfectly competitive market.

X*

P*

SRS w/N*

D

X

A

D new

P’B

X’

SRS w/N**

C

X**

LRS

54

Long Run Supply in the Market The long run supply curve in

the market is horizontal at the long run equilibrium price P*.

P* is sometimes called the “normal price.”

P* is the price consistent with the typical firm’s minimum long run average total cost.

Note: important assumption is that the position of the firm’s cost curve is unaffected by entry (or exit) of firms in the market.

X*

P*

SRS w/N*

D

X

A

D new

P’B

X’

SRS w/N**

C

X**

LRS

55

Example: Long Run Supply in the System-fixer Market

The market demand for system installations is shown by the blue line in the graph.

The market is very much larger than firm’s at the efficient scale, so we expect competitive conditions to prevail.

The long run supply (in red) reflects the technological and competitive conditions in the market: surviving firms must operate at the scale of firm B at a minimum average total cost of $26/installation.

Short run supply is shown in brown.

Market for System Installations

0

5

10

15

20

25

30

35

40

45

50

0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000

Quantity (Installations/week)

Pri

ce (

$/in

stal

lati

on

)Demand

Long Run Supply

Short Run Supply

56

Question

How many firms are there in the long run in the system-fixer market?

57

Answer

Firms with the efficient scale do 8 installations per week at an average total cost of $26/installation.

At $26/installation the market demand is 8,000 installations per week.

Therefore, there are 1,000 firms in the market.

58

Increase in Demand in the System-fixer Market

Demand increases in the market as indicated by the new (black) demand curve.

The short run response is an increase in price with not much additional quantity supplied (point A), movement along the short run supply curve.

The long run response is a return to the original price of $26/installation and an expansion of quantity supplied along the long run supply curve (point B).

Increase in Demand

0

5

10

15

20

25

30

35

40

45

50

0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000

Quantity (Installations/week)

Pri

ce (

$/in

stal

lati

on

)Demand

Long Run Supply

Short Run Supply

New Demand

A

B

59

Question

What would be the long run result of a fall in demand for system installations when the quantity demanded at $26/installation is 4,000.

60

Answer

Now, only 500 firms operating at the minimum efficient scale will survive.

The industry will shrink by exit of some system fixer firms. Of the original 1,000 firms, only 500 survive.

61

External Economies and Diseconomies of Scale

If the industry exhibits no external economies or diseconomies of scale, then the industry long run supply curve is perfectly elastic (horizontal). The industry grows by replicating firms at the efficient scale. Entry and exit leaves the position of cost curves intact. This is called a constant cost industry.

If the industry exhibits external diseconomies of scale, then the industry long run supply curve is upward sloping. The minimum average total cost of all firms in the industry rises as the size of the market grows. This is called an increasing cost industry.

If the industry exhibits external economies of scale, then the industry long run supply curve is downward sloping. The minimum average total cost falls as the size of the industry grows. This is called a decreasing cost industry.

62

Constant Cost Industry

When we draw the long run supply curve as a horizontal line, we are asserting that there are no external economies or diseconomies of scale.

Lack of economies or diseconomies of scale means that growth of the industry doesn’t foster technological improvements and doesn’t change the prices of inputs.

63

External Diseconomies of Scale

When an industry long run supply curve slopes upward, the industry exhibits external diseconomies of scale.

This can occur because the prices of the inputs rise as the industry expands.

This can also occur because the industry becomes “congested” and the minimum average total cost at the efficient scale rises.

Quantity

Pric

e

Long run supply with external diseconomies of scale in the industry

64

Examples of Long Run Supply Curves that Slope Up As a competitive industry grows its demand for certain

specialized factors increases (information systems specialists in the accounting service industry, fabrication equipment in the microprocessor industry).

Increased demand for specialized factors means that the equilibrium price of these factors will increase (movement along a factor supply curve--increased quantity and increased price of the factor).

So as the industry (not the firm) grows, the price of these specialized factors increases and the minimum average total cost rises.

Thus, the long run supply curve slopes upward.

65

Long Run Competitive Equilibrium - Reviewed

The firms in a perfectly competitive market are in long run equilibrium when– Quantity supplied = Quantity demanded at the current

market price.– Firm’s are profit maximizing so that marginal revenue

(= Price) = marginal cost for all firms in the market.– Price = minimum average total cost for all firms in the

market, implying zero economic profit.– No firm wants to enter the market.– No firm currently in the market wants to exit.

66

Why are there zero economic profits in the long run? Zero economic profits means that all factors used in

production make exactly their opportunity cost. Purchased factors receive their market price, which is

equal to their opportunity cost. Owned factors receive the same compensation that they

would receive in their next best use, which is also equal to their opportunity cost.

Thus, no firm wants to enter the market because it cannot make any more money than it is currently making.

Similarly, no firm wants to leave the market because it cannot make any more money in any other business.

67

Performance Efficiency:

– Allocative efficiency: (look at market) The level of output traded is allocatively efficient if it maximizes net social surplus.

– Productive efficiency: (look at the firm) The firm’s output level is productively efficient if it is at the minimum of the firm’s long run average total cost curve, that is, if it is at least as large as minimum efficient scale of production.

Equity: – Is the outcome of the allocatoin process fair?

Equitable? Just?

68

Long Run Competitive Equilibrium - Performance

Efficiency:– The market equilibrium is allocatively efficient. That is, at

X*, net social surplus is maximized.– Each firm is productively efficient. That is each firm

operates at, at least, minimum efficient scale. Each firm operates at the minimum of its long run average total cost curve.

Equity: Is the outcome of the competitive process fair? Equitable? Just? – Good questions that we do not answer here and now.

69

Allocative Efficiency - Proof

If X* is allocatively efficient, then net social surplus should be as high as it can feasibly be.

Net Social Surplus = $TBsociety - $TCsociety

When net social surplus is as high as it can be, $MBsociety = $MCsociety

Question: Is the outcome of the competitive process allocatively efficient?

70

Answer Demand=Supply at X*. Demand represents $marginal benefit. Supply represents $marginal cost. So…marginal benefit equals marginal cost at

X*.

So…net social surplus is maximized at X*. There is no transaction among the buyers

and sellers that improves the welfare of at least one person without reducing the welfare of at least one person.

71

Productive Efficiency - Proof Profit max implies that mr=lrmc at x*. Zero profit implies P=lratc at x*. Since the firm is perfectly competitive, P=mr at all

values of x. By substitution, P=lratc at x* and P=lratc at x*. Therefore lrmc=lratc at x*. This implies that x* is at the minimum of the typical

firm’s lratc. x* is at MES. P* must be the price consistent with the minimum

value on the lratc curve.