perfect competition tutorial 8. page 2 firm’s output choice economists assume all firms maximize...

Perfect Competition

Tutorial 8

Firm’s Output Choice

Economists assume ALL firms maximize economic profits,

As shown by the cost functions developed in the last chapter, total costs depends on quantity of output of the firm.

To see how a firm’s revenue depends on its output level, we must look at the demand for the firm’s product, which is highly related to the market structure in which the firm is operating.

- Perfect Competition

- Monopoly

- Monopolistic Competition

- Oligopoly

CR

Perfect Competition

Characteristics of perfectly competitive markets:

- Large numbers of small buyers and sellers: price takers

- Homogeneous products

- Perfect information

- Free entry and exit

Demand Curve facing a Competitive Firm

Q q

p p

D

S

pe

d = p = MR

Market Individual Firm

Qe

Marginal revenue: additional revenue obtained by producing one more unit of output.

Short-run Output Decision

Q q

p p

D

S

pe

d = p = MR


Qe

SMC

MC = MR

q1 q2q*

At q1 , p > MC At q2 ,p < MC

Short-run Output Decision

To find the profit of the firm:

To show the profit in a per-unit diagram, it is often convenient to represent the profit as

P

q

p = MR

AC*

q*

p*

SAC

SMC

π

TCTR

qACpqq

Cpq )(

Short-run Shutdown Decision

What if the firm is making economic loss? - Keep on Production- Shut down

Which one to choose? Depending on market price

Shutdown: Do not produce temporarily. - Loss = TFC

Case 1: When SAC > P > AVCSAC x q > P x q > AVC x qTC > TR > TVCEconomic Loss = TC – TR < TC – TVC (= TFC)

Case 2: When SAC > AVC > PSAC x q > AVC x q > P x qTC > TVC > TREconomic Loss = TC – TR > TC – TVC (= TFC)

The firm will shut down only if its revenues cannot cover its variable cost

Short-run Shutdown Decision

p($)

q

p = MR

AC

q*

p*

SAC

AVC

SMC

AVC

TR – VC

AFC

Loss FC

Firm’s Short-run Supply Curve

The firm’s supply curve shows how much it will produce at various output prices.

The positively-sloped segment of the firm’s SMC curve above the point of minimum AVC, therefore, is the firm’s short-run supply curve.

o For prices below this level, the firm will choose to shut down, so this price level is called the shut-down price.

p($)

qq1

p1

A

BAVC

SMC

C

p0

p2

q2q0

Short-run Market Supply Curve

The short-run market supply curve is derived by horizontal summing all the individual firms’ supply curves:

q1

Q

p p

S1

p1

MarketFirm 1

p

S2

qq

SS

q2 q3

p2

q4 q1 + q2 q3 + q4

Firm 2

Short-run Competitive Market Equilibrium

The market equilibrium occurs when the quantity demanded by all consumers equals the total quantity supplied by all the firms in the market. That is,

sd QQ

Q q

p p

D

SS

p*

Q*

p = MR


SAC

SMC

q*

Long-run Output Choice and Firm’s Supply Curve

In the long run, a firm may adapt all of its inputs, such as adjusting plant size (capital employed), to fit market condition. Therefore, we should use the firm’s long-run cost functions for long-run analysis.

As firm will exit the market if it makes an economic loss in the long run. Therefore, the firm’s long-run supply curve is its long-run marginal cost curve above the minimum of its long-run average cost curve

p($)

q

SAC2

q2

SAC1

LAC

LMCSMC1 SMC2

q1

p1E MR

Free Entry and Long-run Competitive Market Equilibrium

In the long run, new firms can enter the industry.- New firms enter when π > 0.- Existing firms exit when π < 0.

Q q

p pSS0

p2


ACSAC

q2 q1

SS1

Q1

p1

D1

Q2

SMC MC

Comparative statics analysis

Increase in Demand:

Q q

p p

D1

SS1

p1

Q1


ACSAC

q1q2

SS2

Q2

p2

D2

Q3

SMC

Comparative statics analysis: Long run

The long-run market supply curve can be derived indirectly by connecting the long-run equilibrium before and after the increase in market demand.- Why not derive it by horizontal summation of all firms’ long-run supply curve?

p

Q

D1

D2

E2

E1

S


Long-run Market Supply Curve

Q q

p p

D1

SS1

p1

Q1


ACSAC

q1 q2

SS2

Q2

p2

D2

Q3

SMC

LS


The long-run market supply curve can be derived indirectly by connecting the long-run equilibrium before and after the increase in market demand.- Why not derive it by horizontal summation of all firms’ long-run supply curve?

The long-run supply curve is horizontal at price equal to the minimum long-run average cost .- Free entry and exit always drive price to this level (zero profit)

- Constant-cost industry: It is assumed that entry of new firms will have no effect on input prices

Discussion Question 2: Beijing’s Silk Market (Xiushui Market)

The Silk Street attracts approximately 20,000 visitors daily (from 9am to 9pm) on weekdays and between 50,000 and 60,000 on weekends as of 2006.Many of the stalls have over the years gained local and international reputation for selling counterfeit luxury designer brands at relatively low prices.


In an opinion piece published in The Wall Street Journal on 17 June, 2008, Chinese Vice-Premier Wang Qishan mentioned that Beijing’s Silk Market has gone “through rectification and has since become a distribution centre of famous brands”. But in reality, many stalls have carried on selling counterfeit luxury designer brands despite growing pressures from the Chinese government and famous brand name companies.

“True, there is not much shouting or pulling at customers walking down the aisles full of handbag and shoe stalls. But if you are caught looking at a bag for more than two seconds, a saleslady quickly hisses at you: “ Want Gucci?” …”


According to the article, the problem persists because of weak enforcement of the intellectual property law.

“In reality the cost of proving a criminal charge is very high,” said National Copyright Administration deputy director – general Xu Chao. “It’s very difficult, hence the limited number of criminal arrests.”

(Source: SCMP, July 7, 2008)

a. Consider the counterfeiters industry, which is highly competitive. Suppose the government runs a confiscation program to arrest the counterfeiters from time to time. The program can only arrest limited number of counterfeiters. What would happen to the profits and prices of the remaining firms, which were not arrested in short run?

b. What would be the long run adjustment in the market after the confiscation program? Is this kind confiscation program an effective way to deal with the piracy problem?

Effects of the Confiscation Program

P

Q q

P ($)

LAC

LMC

SAC

SMC

S1

D

q1Q1

P1

Individual FirmMarket

S2

P2

Q2 q2

MR1

MR2

Discussion Question 2

c. Many people suggested other measures to be more effective, e.g. educating the youngsters about the importance of protecting the intellectual property rights were more effective ways to deal with piracy in long run. Do you agree?

Effects of Successful Education

P

Q q

P ($)

LAC

SAC

SMC

S1

D1

q1Q1

P1

Individual FirmMarket

P2

Q2 q2

D2

MR1

MR2

S2

LMC

Q3

Discussion Question 3: Fishermen in HK

A report published in Hong Kong Economics Times on 11 June 2008 concerns the fishing market in Hong Kong. It is reported that the diesel price increased by 2.4 times in a year, which raised the cost of fishing significantly. How would this regulation affect the market and individual fishermen in the short run and long run? (Source: Hong Kong Economic Times, 11 June, 2008)

Short-run Effects of Increase in (Variable) Cost

P

Q q

P ($)

SAC2

SMC2

S1

q1Q1

P1

Individual Firm Market

P2

Q2 q2

MR1

SAC1

SMC1

S2

LAC2

LAC1

MR2

D


If p < AVC, some fishermen may shutdown

“Because of the high diesel price, some fishermen’s two-day revenues of $4000 can only cover the diesel costs. Therefore, some of them have stopped fishing for some time,” said Mr. Lai.

Long-run Effects of Increase in Cost

P

Q q

P ($)

SAC2

SMC2

S1

q1Q1

P1

Individual Firm Market

P2

Q2 q2

MR1

SAC1

SMC1

S2

LAC2

LAC1

MR2

D

MR3

Q3q3

S2

P3


Starting from this year, some of the fishermen started to sell their boats to stop losses. Starting from January, 30 boats were sold in this year.

It leads to higher fish prices. Some of the fish prices rise by about 25%.


Suppose the book-printing industry is competitive and begins in a long-run equilibrium.

a. Hi-Tech Printing Company employs an extra-ordinary manager that sharply reduces the cost of administrative costs (i.e. fixed cost in the short run). What happens to Hi-Tech’s profits and the price of books in short run? Will it attract new firms to enter the market in long run?

b. Suppose you were the owner of Hi-Tech. What is the maximum amount that you would offer to keep the extra-ordinary manager to your own firm?


Q q

p p

p1

qA

Typical Firm B

SACB

SMCB

qB

Individual Firm A

SMCA

A 2ASAC

1ASAC

Economic rent is the returns that are derived from extraordinarily productive inputs, which is scarce.

perfect competition tutorial 8. page 2 firm’s output choice economists assume all firms maximize...

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