CHAPTER EIGHT PERFECT COMPETITION

Four Basic Market Types How firms establish their price and output levels in order to achieve their objective of profit maximization (or loss minimization)? The answer to this depends on the market structure in which the firm is operating. Market structure refers to the number and the relative size of the firms in an industry There are four main types of market structure: Perfect competition, Monopoly, Monopolistic Competition, and Oligopoly It is important to note that: (1) these markets may change over time from one structure to another, and (2) some real life markets may not fit well in any of these four structures Perfect Competition o Perfect competition refers to a market in which there are large number of relatively small firms selling an identical (standardized) product, and large number of buyers who are indifferent from whom to buy. o None of the buyers or sellers has market Power, which refers to the ability to influence the market price of a good or service. Each firm is a price taker. o Very easy market entry and exit. o Information is available to all. o Non-price competition is not possible

Page 1 of 16

o Firm cannot earn positive economic profit in the long run. o Examples: the markets for agricultural product (corn, wheat, coffee), financial instruments (stocks, bonds, foreign exchange), precious metals (gold, silver, platinum) and the global petroleum industry Monopoly o Monopoly refers to one firm that produces the entire market supply of a particular unique good or service that has no close substitutes. o The firm is the industry o It has market power. It is a price maker. o It is very difficult or impossible for any other firm to enter this market. o This firm makes high economic profit subject to regulations. o Firm earn positive economic profit in the long run. o Non-price competition is not necessary o Examples of pure monopoly are not easy to find. Electricity and water industry in some countries, patent laws sometimes provide companies with temporary monopolies, a company that is so dominant might be said to exhibit monopolistic status (such as Microsoft) Monopolistic Competition o Monopolistic competition is a market in which large number of relatively small firms producing similar but differentiated products. o There are many of monopolistic competitive firms in any given city or area of the city. The start-up capital is relatively low, so it is fairly easy to start these types of business. Each one tries its best to stand out among its many competitors by differentiating its product. o Each firm maintains some control of its own price. o It is easy to enter or exit this market.
Page 2 of 16

o Non-price competition very important o In the long run, economic profit of any firm in this type of markets is zero. o Examples: Small industries such as retail and service establishments (restaurants, boutiques, luggage stores, shoe stores, stationary stores, repair shops, laundries, beauty parlors) Oligopoly o Oligopoly is a market in which a small number of firms producing all or most of the market supply of a particular good or service. o The product may be identical (standardized) or differentiated. o This market is generally considered to be for large firms. o It is difficult to enter this market. o Non-price competition very important among firms selling differentiated products o Firms in this market can make positive economic profit based on whether they compete with each other severely or they have some kind of mutual agreements regarding prices, market share and products. o Examples: manufacturing sector, oil refining, certain types of computer hardware and software, chemical and plastics, steel, automobile, soft drinks, airline travel, banking industry, insurance companies, telecommunications, etc

Page 3 of 16

Pricing and Output Decisions in Perfect Competition

Perfectly competitive market exists when: 1. Each firm (seller/producer) is small relative to market demand firm cannot affect market demand. 2. No unique characteristics of each firms product consumers are indifferent about from which firm to buy. This implies that a firm in competitive market 1. Firm receives the same marginal revenue from the sale of each additional unit of product; equal to the price of the product (MR=P) 2. Average revenue is also equal to price (AR=P) 3. No limit to the total revenue that the firm can gain in a perfectly competitive market. 4. The firms objective is to maximize its profit in the short run. If it cannot earn a profit, then it seeks to minimize its loss. The Basic Business Decision: entering a market on the basis of the following questions: o How much should we produce to maximize profit? o If a loss rather than a profit is incurred, will it be worthwhile to continue in this market in the long run (in hopes that we will eventually earn a profit) or should we exit?

Market demand curve vs. firm demand curve It is important to distinguish between the market demand curve and the demand curve facing a particular firm. The equilibrium market price is determined by the interaction of market demand and market supply curves. The market demand curve for a product is downward sloping (less than infinite). The market supply curve is upward sloping
Page 4 of 16

 However, the demand curve facing the perfectly competitive firm is different. Since the output of each firm is such a very small share of this total output, no individual firm can affect the market price and therefore is a price taker. The perfectly competitive firm faces a horizontal, perfectly elastic demand curve (with price elasticity of demand equal to infinity). At a fixed price, the firm sells any quantity it wants. No matter of what is the quantity sold the firm charges the same price, i.e., P = D
Market P S Firm

D Q q

Given the fixed price and the horizontal demand curve, the perfectly competitive firm faces two decisions in the short run and two decisions in the long run. o Production decisions in SR: the firm has to decide on a. Whether to produce or shut down temporarily? b. If it is to produce, how much to produce? And how much profit will it earn? o Investment decisions in LR: the firm has to decide on a. Whether to enter, stay or leave the industry b. If the firm is already in the market, whether to expand or downsize the plant

Page 5 of 16

SHORT RUN DECISION: THE PRODUCTION DECISION Since a competitive firm cannot affect market price (a price taker), it has to decide what is the amount of output that will maximize the firm's total economic profit (or minimize loss) To find the amount of output that maximizes profit we can use the total analysis or marginal analysis

Total Analysis approach: Profit is maximized at Q* where TR-TC is highest Compare the total revenue and total cost schedules and find the level of output that either maximizes the firms profits or minimizes its loss. Total profit is less than TR TR = P * Q. Since a perfectly competitive firm can sell all of its output at one price, the total revenue curve of a perfectly competitive firm is an upward sloping straight line, with slope equal to market (equilibrium) price (P*) In order to calculate profit, we also have to see how costs vary with the rate of output in the short-run. TC is the opportunity cost of production, which includes normal profit. Total costs (TFC + TVC) increase as output expands. At first, they rise slowly due to the increasing marginal returns, and then they increase more quickly due to the diminishing marginal returns. Since profit depends on the difference between TR and TC, profit is maximized when TR exceeds TC by the largest amount; i.e., where the vertical distance between TR curve and TC curve is the largest. The point in which the curves have the largest vertical distance between TR curve and TC curve is the profit-maximizing rate of output (point m).

Page 6 of 16

TC TR Loss TR Break-even Points R

C

Max Profit Break-even Points Loss

0 Profit

Q Q* b Max Profit

Profit 0 Loss a Q* Q b Loss

Marginal Analysis approach: What an additional unit of output brings in revenue is its marginal revenue (MR) and what it costs to produce is its marginal cost (MC). A firm that wants to maximize its profit (or minimize its loss) should produce a level of output at which the additional revenue received from the last unit is equal to the additional cost of producing that unit; i.e., MR=MC.

Page 7 of 16

P, MR,MC

MC

P = MCmaintain Q

P =MR =D P > MCQ P < MCQ

Q Q*

Since perfect competition structure implies MR=P, the MR=MC rule may be restated as P=MC. Equating MR (or P) to MC shows us the efficient level of output. However, this level of output does not tell us whether the firm is maximizing profit or minimizing loss. To determine whether a firm is earning an economic profit or incurring an economic loss, we compare the firms average total cost, ATC, at the profit maximizing output with the market price. Profit = TR TC = (P - AC) Q* 1. Total economic profit is maximized if P=MC above ATC (P > ATC) 2. Total economic profit is zero (normal profit) if P = MC = ATC Break-even point @ minimum AC. 3. Total economic loss is minimized if P=MC below ATC (P < ATC)

1) Profit Maximization: Making Positive Economic Profit If ATC curve is added to the diagram, a profit-maximizing firm will produce at the level of output (Q*) at which P = MC > ATC

Page 8 of 16

P, MR,Costs

MC ATC

P=5 A=3

C B

P =MR=AR=D

Q* = 20

TR = P Q = 5 * 20 = 100 TC = ATC Q = 3 * 20 = 60 Total economic profit =TR TC = (P-ATC) * Q= 2 * 20 = 40 If a firm is receiving positive economic profits, the owners are receiving a return on their investment that exceeds what they could receive if their resources had been used in an alternative occupation.

2) Zero Economic Profit (Normal Profit) If P = MC = min ATC, firm is earning zero economic profit, i.e., is earning normal profit (this is known also as break-even point)
P, MR,Costs MC ATC P P =MR =D

Q*

Total profit = (P ATC) * Q, But since P = ATC then (P-ATC) = 0 total profit = 0

Page 9 of 16

3) Loss Minimization and the Temporary Shutdown Decision If P < ATC at the level of output at which MR = MC, the firm will incur economic loss.
P, MR,Costs MC ATC A=8 P=5 P =MR =D

Q*=20

Total economic profit = (P-ATC)*Q = -3 * 20 = -60 Economic loss Now, with this loss, should the firm continue its operations? If the firm suffers a loss, what is the best action? Remember that: Profit = (P ATC) * Q, and that ATC = AFC + AVC Therefore, Profit = (P AFC - AVC) * Q Remember also that fixed costs must be paid even if output = 0. Thus, if the firm shuts down its operation it has to pay the fixed costs To determine this, we have to compare the firm's loss if it stays in business with its loss if it shuts down. If the firm decides to shut down, its revenue will equal zero and its costs will equal its fixed costs. (Remember, fixed costs must be paid even if the firm shuts down.) Thus, the firm receives an economic loss equal to its fixed costs if it shuts down. The firm will stay in business in the short run even if it receives an economic loss as long as its loss is less than its fixed costs. This will occur if the revenue received by the firm is large enough to cover its variable costs and some of its fixed costs.
Page 10 of 16

 In mathematical terms, this means that the firm will stay in business as long as TR = P x Q > TVC Contribution Margin (CM): the amount by which total revenue exceeds total variable cost: CM = TR TVC If the contribution margin is positive, the firm should continue to produce in the short run in order to cover some of the fixed cost, otherwise it should shutdown. Dividing both sides of the above expression by Q, we can say that the firm will stay in business as long as P > AVC Consider the situation illustrated by the diagram below. In this case, losses are minimized in the short run at the level of output at which MR = MC. This occurs at an output level of Q1. Since the level of average total cost (ATC) exceeds the market price (P1), this firm receives economic losses. But as long as the price is greater than AVC this firm will choose to stay in business in the short run. If the firm were to shut down, it would lose its fixed costs. TFC =AFC * Q1 = ac *Q1

P, Costs MC c b P1 a P2 P3 ATC AVC

Q3 Q2

Q1

Page 11 of 16

 A comparison of the firm's losses if it shuts down with its losses if it continues to operate in the short run (bc *Q1) indicates that this firm will receive lower losses if it decides to remain in business in the short run. If the firm produce the amount of output Q2 at price P2, it is producing at the shut-down point where, P = MC = min AVC. The shutdown point is the output and price at which the firm just covers its TVC, where P = MC = min AVC. Shutdown Point: the lowest price at which the firm would still produce. At the shutdown point, the price is equal to the minimum point on the AVC. This is where selling at the price results in zero contribution margin. The loss of operation here is equal to the loss of shutting down (Loss = TFC). Although firm is indifferent of producing or shutting down, many firms continue to produce hoping for price improvement as well as to keep customers from going to other producers, and to save the cost of maintenance when it starts re-operating in the future. The minimum amount of output that the perfectly competitive firm could be produced is Q2 where P = min AVC (shutdown point) A firm should shut down only if the losses from continuing production exceeds fixed costs, i.e., a firm should shut down only if P < AVC (or TR < TVC). Therefore, shutdown the firm at any level of output where P < AVC. This possibility is illustrated in the diagram at P3 If the price falls below the shutdown point, revenues fail to cover the fixed costs and the variable costs. The firm would be better off if it shut down and just paid its fixed costs. Note that a shutdown (a SR decision) does not necessarily mean a firm is exiting the business. Leaving the business is a LR decision.

Page 12 of 16

 In LR, of course, firms will leave the industry if economic losses are received (remember, there are no fixed costs in the long run.) Example: What is the profit maximizing output for a perfectly competitive firm selling its product at $10, with the following cost structure? Q 4 5 6 7 8 TFC 10 10 10 10 10 TVC MC 19 25 34 45 57

The Firm Short-run Supply Curve For a competitive firm, MC defines the lowest price a firm will accept for a given quantity of output. In this sense, the MC curve is the supply curve; it tells us how quantity supplied respond to price. The supply curve is upward sloping because of increasing MC. If more quantities needed to be produced price must increase to cover the rising MC. Since the firm will shutdown if P falls below minimum AVC, the supply curve does not exist below min AVC. Therefore, the MC curve, above the shutdown point (above the min AVC), is the short run supply curve for a competitive firm.

Page 13 of 16

Pricing and Output Decisions in Perfect Competition in the LR

In the long run, two adjustments are possible: 1. Existing firms may adjust plant size 2. Entry and exit of firms is possible Both actions will affect market supply and a new market price is established Existence of economic profit: 1. Invites existing firms to expand plant size 2. invites entry of new firms 3. This shifts the supply curve to the right, decreases price and reduces profits until economic profit is wiped out.
S1 P S2 P, MR,Costs Sn P1 P2 P1 P2 ATC MC

Pn

Pn

D 0 Q 0 Qn Q2 Q1 Q

Economic loss causes exit of firms or shrink plant size which shifts the supply curve to the left, increases price and reduces loss until it is eliminated.

Page 14 of 16

 Thus, the price in the competitive market in the long-run will settle at the point where firms earn only normal profit (zero economic profit).

Observations in perfectly competitive markets: The earlier the firm enters a market, the better its chances of earning above-normal profit (assuming a strong demand in the market). As new firms enter the market, firms that want to survive and perhaps thrive must find ways to produce at the lowest possible cost, or at least at cost levels below those of their competitors. Firms that find themselves unable to compete on the basis of cost might want to try competing on the basis of product differentiation instead.

Page 15 of 16

Using Calculus:
Total analysis: find Q* that maximize by differentiating function. Marginal analysis: set MR equal to MC and solve for Q* that maximize . Example: Given P = 170 - 5Q and TC = 40 +50Q + 5Q2. Find optimal output level Q* that maximize

1. A firm operating in perfectly competitive firm has the following total cost function TC = 6000 + 400Q 20Q2 + Q3 a. What is the lowest (minimum) price at which the firm will shut down in the SR? b. If the market price is $310, what would be the profit maximizing firm

2. Given P = 170 -5Q TC = 40 + 50Q + 5Q2 Find Q that will max profit

Page 16 of 16