perfect competition
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© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Perfect Competition: Short Run and Long Run
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Features of a Perfectly Competitive Market
1. There are many firms.
2. The product is standardized, or homogeneous.
3. Firms can freely enter or leave the market in the long run.
4. Each firm takes the market price as given.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Short-run Output Decision
The firm’s objective is to produce the level of output that will maximize profit.
Economic profit = total revenue minus total economic cost. Total revenue = price x quantity sold.
The cost structure of the business firm is the same as the one we studied earlier.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Firm’s Total Cost Structure (Reviewed)
The shape of the total cost curve comes from diminishing returns in the short run.
ST C T FC ST VC Short-run Total Cost =
Total Fixed Cost +
Short-run Total Variable Cost
Total CostShort-run
CostVariable
Total
CostFixed
MinuteRakes perOutput:
STCTVCFCQ
360360
448361
4812362
5115363
5620364
6327365
7236366
8448367
10165368
12690369
1661303610
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Revenue Structure of the Competitive Business Firm
The perfectly competitive firm is a price-taking firm. This means that the firm takes the price from the market.
As long as the market remains in equilibrium, the firm faces only one price—the equilibrium market price.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Computing the Total Revenue of a Price-taker
Since the perfectly competitive firm faces a constant price, the shape of its total revenue is an upward-sloping line. Total revenue changes only with changes in the quantity sold.
($)Revenue
Total
Price ($)MinuteRakes perOutput:
TRPQ
0.00250
25.00251
50.00252
75.00253
100.00254
125.00255
150.00256
175.00257
200.00258
225.00259
250.002510
0
50
100
150
200
250
Co
st
in $
0 1 2 3 4 5 6 7 8 9 10 Output: Rakes per minute
Total Revenue
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Totals Approach to Profit Maximization
To maximize profit, a producer finds the largest gap between total revenue and total cost.
ProfitTotal CostShort-run
($)Revenue
Total
MinuteRakes per
Output:
STCTRQ
-36360.000
-194425.001
24850.002
245175.003
4456100.004
6263125.005
7872150.006
9184175.007
99101200.008
99126225.009
84166250.0010
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Marginal Approach
The other way to decide how much output to produce involves the marginal principle.
Marginal PRINCIPLEIncrease the level of an activity if its marginal benefit exceeds its marginal cost, but reduce the level if the marginal cost exceeds the marginal benefit. If possible, pick the level at which the marginal benefit equals the marginal cost.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Marginal Revenue
The benefit of producing and selling rakes is the revenue the firm collects. If the firm sells one more rake, total revenue increases by $25.
Marginal benefit = marginal revenue = market price
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Marginal Rule for Profit Maximization
A firm maximizes profit in accordance with the marginal principle—by setting marginal revenue (or market price) equal to marginal cost.
ProfitCostMarginalShort-run
Price ($)Revenue =Marginal
MinuteRakes perOutput:
SMCPQ
-36-250
-198251
24252
243253
445254
627255
789256
9112257
9917258
9925259
84402510
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Profit Maximization Using the Marginal Approach
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Economic Profit
Profit per unit equals revenue per unit (or price) minus cost per unit (or average total cost).
($25 - $14) = 11
Total economic profit equals:(price – average cost) x quantity produced
($25 - $14) x 9 = $99
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Shut-down Decision
The firm should continue to operate if the benefit of operating (total revenue) exceeds the cost of operating, or total variable cost.
TR = (P x Q) must be greater than STVC = SAVC x Q, therefore,
• If P > SAVC, the firm should continue to operate
• If P < SAVC, the firm should shut down
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Shut-down Decision
When price drops to $9, the firm adjusts output down to 6 rakes per minute to maintain P=SMC.
The firm suffers a loss, but since price is greater than average variable cost, the firm continues to operate.
The average variable cost of producing 6 rakes per minute is $6.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Shut-down Decision
The firm’s shut- down price is the price at which the firm is indifferent between operating and shutting down.
At $5, P = SAVC. Above this price, the firm is better off continuing to produce at a loss. Below this price, the firm is better off shutting down because it could not recover its operating cost.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Short-run Supply Curve
The firm’s short-run supply curve shows the relationship between the market price and the quantity supplied by the firm over a period of time during which one input—the production facility—cannot be changed.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Short-run Supply Curve
For any price above the shut-down price, the firm adjusts output along its marginal cost curve as the price level changes.
The short-run supply curve is the firm’s SMC curve rising above the minimum point on the SAVC curve.
Below the shut-down price, quantity supplied equals zero.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Market Supply Curve
The short-run market supply curve shows the relationship between the market price and the quantity supplied by all firms in the short run.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
A Market in Long-run Equilibrium
1. The quantity of the product supplied equals the quantity demanded
2. Each firm in the market maximizes its profit, given the market price
3. Each firm in the market earns zero economic profit, so there is no incentive for other firms to enter the market
A market reaches a long-run equilibrium when three conditions hold:
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
A Market in Long-run Equilibrium
In short-run equilibrium, quantity supplied equals quantity demanded and each firm in the market maximizes profit.
In addition to the conditions above, in long-run equilibrium the typical firm earns zero economic profit so there is no further incentive for firms to enter the market.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
A Market in Long-run Equilibrium
In long-run equilibrium, price equals marginal cost (the profit-maximizing rule), and price equals short-run average total cost (zero economic profit).
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Long-run Supply Curve for an Increasing-cost Industry
An increasing-cost industry is an industry in which the average cost of production increases as the total output of the industry increases.
The average cost increases as the industry grows for two reasons:
Increasing input prices Less productive inputs
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Industry Output and Average Production Cost
Number of Firms
Industry Output
Rakes per Firm
Typical Cost for Typical
Firm
Average Cost per
Rake
50 350 7 $70 $10
100 700 7 84 12
150 1,050 7 96 14
The rake industry is an increasing-cost industry because the average cost of production increases as the total output of the industry increases.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Drawing the Long-run Market Supply Curve
Each point on the long-run supply curve shows the quantity of rakes supplied at a particular price (i.e., at a price of $12, 100 firms produce 700 rakes).
The long-run industry supply curve is positively-sloped for an increasing cost industry.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
An Increase in Demand and the Incentive to Enter
An increase in market demand puts upward pressure on price. As price increases, there is an opportunity to earn profit in the short run, and the industry attracts new firms.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Long-run Effects of an Increase in Demand
In the short-run, firms respond to the increase in demand by adjusting output in their existing production facilities, and the price adjusts from $12 to $17.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
The Long-run Effects of an Increase in Demand
In the long run, after new firms enter, equilibrium settles at $14.
The new price is a higher price than the price before the increase in demand (increasing cost industry).
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Long-run Supply Curve for an Constant-cost Industry
In a constant-cost industry, firms continue to buy inputs at the same prices.
The long-run supply curve is horizontal at the constant average cost of production.
After the industry expands, the industry settles at the same long-run equilibrium price as before.
© 2001 Prentice Hall Business Publishing© 2001 Prentice Hall Business Publishing Economics: Principles and Tools, 2/eEconomics: Principles and Tools, 2/e O’Sullivan & SheffrinO’Sullivan & Sheffrin
Long-run Supply Curve for the Ice Industry
In the long-run, the price of ice returns to its original level.
An increase in the demand for ice increases the price of ice to $5 per bag.