Chap5

CHAPTER 5 MARKET STRUCTURE: PERFECT COMPETITION

Chapter Outline 5.1 Characteristic 5.2 Short-run Decision: Profit Maximization 5.3 Short-run Decision: Minimizing Loss 5.4 Long-run Adjustment 5.5 External Changes: Consumer Preference & Technology 5.6 Efficiency of Perfect Competition

Perfect Competition Definition: A market structure with many fully informed buyers and sellers of standardized product and no obstacles to entry or exit of firms in the long run. For example: hypermarket (Giant, Carrefour, Tesco).

5.1 Characteristic Many firms A single firm’s production is relatively very small compare to the market demand. T herefore, cannot influence market price. Each firm takes market price as given -> price taker Homogenous product product/service has no unique characteristic, so consumers don’t care which firm they buy from. Example: Agricultural products such as oil, iron and others.

5.1 Characteristic Perfect information Firms are price taker because buyers & sellers are well informs about price. No transaction cost assumed. Firm only decide how much to produce. Free entry / exit No legal, technology, capital, incumbent advantage or others constraint to entry/exit. New firms enter (existing firms exit) if industry earning above (negative) normal profit.

Firm Industry 100 Figure: Market Equilibrium and Firm’s Demand Curve Price taker d $4 Output (bushels) Price $ per bushel D $4 S Price $ per bushel Output (millions of bushels)

Example: The market price of corn of $4 per bushel is determined by the market intersection of the market demand and supply curve. Each firm is so small relative to the market that each has no impact on the market price. Anyone who charges more than the market price sell no corn because find no buyers.

The goal of a competitive firm is to maximize profit. How the firm maximize profit? 1. Total Approach : Maximizing the Positive difference between TR – TC. 2. Marginal Approach : MR = MC ( profit maximizing condition )

Profit-Maximizing Level of Output If q is output of the firm, then total revenue is price of the good times quantity Total Revenue (TR) = P x Q Costs of production depends on output Total Cost (TC) = TC x Q Profit (  ) = Total Revenue - Total Cost

The goal of the firm is to maximize profits, the difference between total revenue and total cost. A firm maximizes profit when MR = MC. Marginal revenue (MR) -----the change in total revenue associated with a change in quantity. Marginal cost (MC) ----- the change in total cost associated with a change in quantity.

5.2 Short-run Decision: Profit Maximization Profit: Π maximize when MR = MC = P (one price for every level of output & the whole market/industry ) » Profit maximization condition Firm will produce up to the point where the price of its output is just equal to short-run MC (P=MC)

Total Revenue, Average Revenue and Marginal Revenue for a competitive firm Quantity sold Price (RM) TR (RM) AR (RM) MR (RM) 0 20 0 20 20 1 20 20 20 20 2 20 40 20 20 3 20 60 20 20 4 20 80 20 20 5 20 100 20 20 6 20 120 20 20 7 20 140 20 20 8 20 160 20 20

Graphical Illustration of TR, AR and MR for a Competitive Firm TR AR = MR=D 1 2 3 4 5 6 7 8 9 10 160 140 120 100 80 60 40 20 0 Price and revenue Quantity Demanded (sold)

Profit maximization – Numerical example Quantity TR (RM) TC (RM) PROFIT (RM) MR (RM) MC (RM) 0 0 10 -10 - - 1 20 14 6 20 4 2 40 22 18 20 8 3 60 34 26 20 12 4 80 50 30 20 16 5 100 70 30 20 20 6 120 94 26 20 24 7 140 122 18 20 28 8 160 154 6 20 32

160 140 120 100 80 60 40 20 0 Total revenue and total cost Total Revenue Total Cost Maximum Economic Profits RM30 Break-Even Point (Normal Profit) Break-Even Point (Normal Profit) 1 2 3 4 5 6 7 8 1. TOTAL REVENUE-TOTAL COST APPROACH

TOTAL REVENUE- TOTAL COST APPROACH Firm selects output to maximize the difference between revenue and cost We can graph the total revenue and total cost curves to show maximizing profits for the firm Distance between revenues and costs show profits

2. MARGINAL REVENUE- MARGINAL COST APPROACH A q 1 : MR > MC; ↑ output q 2 : MR < MC; ↓ output q * : MR = MC Profit is maximized where MR = MC Profit increases until it is maxed at q* q 2 10 20 30 40 Price 50 MC 0 1 2 3 4 5 6 7 8 9 10 11 Output q * AR=MR=P q 1 Lost Profit for q 2 > q* Lost Profit for q 1 < q*

Choosing Output: Short Run The point where MR = MC, the profit maximizing output is chosen MR=MC at quantity of 8 At a quantity less than 8, MR>MC so more profit can be gained by increasing output At a quantity greater than 8, MC>MR , increasing output will decrease profits

The Relationship Between MR and MC: -> A firm can increase its profit by increasing output. -> A firm can reduce its losses by decreasing output. -> Profits are at a maximum MR > MC MR < MC MR = MC

Short Run Equilibrium Supernormal profits economic profits (P > ATC) or (TR > TC) 2. Normal profits Breakeven or zero profit (P = ATC) or (TR = TC) 3. Subnormal profits Economic losses (P < ATC) or (TR < TC) continue the production if (ATC > P > AVC) Shut down the operation if (ATC > P < AVC)

Supernormal Profit (Economic Profit) Definition Profit earned by a competitive firm when its total revenue is more than total cost (TR>TC) or price is greater than ATC (P>ATC). Calculation: TR = 5 x 9 = 45 TC = 3 x 9 = 27  = (TR – TC) = (45 – 27) = 18

Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR=P ATC Economic Profit RM5 RM3 Supernormal Profit/ Economic Profit Minimum point of ATC

Breakeven/ Normal Profit Definition When total revenue is equal to total cost (TR=TC) or price equal to ATC (P=ATC), there are no profit or no losses. Firm has only able to cover its costs. Calculation : TR = 5 x 9 = 45 TC = 5 x 9 = 45  = (TR – TC) = (45 – 45) = 0

Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR ATC RM5 Breakeven/ Normal Profit Minimum point of ATC

Economic losses/ Subnormal profit Definition Losses incurred by a competitive firm when total revenue is less than total cost (TR < TC) or when the equilibrium price falls below ATC (P < ATC. The firm incurs losses because would not able to cover its costs. Calculation : TR = 5 x 6 = 30 TC = 7 x 6 = 42  = (TR – TC) = (30 – 42) = -12

Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR ATC Economic Loss RM5 RM7 Economic losses/ Subnormal profit

5.3 Short Run Decision: Minimizing Loss Losses If (TR<TC) or (P>ATC) Two conditions: Keep operating (ATC>P>AVC) If the operating profit is positive (TR – TVC > 0), the firm can use this operating profit to offset fixed costs and reduce total losses. Shut down (ATC>P<AVC) If the operating profit is negative (TR – TVC < 0), the firm suffers operating losses that push total losses above fixed costs.

Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR AVC ATC Economic Loss P ATC Subnormal Profit (ATC>P>AVC)): (i) Keep Operating AVC

Cost and Revenue 1 2 3 4 5 6 7 8 9 10 MC MR=AR AVC ATC Economic Loss P ATC Subnormal Profits (ATC>P<AVC): (ii) Shutdown AVC

Shutting Down in the Short Run Shutting down is not the same as going out of business. In the short run, even a firm that shuts down keeps its productive capacity intact  that when demand increases enough, the firm will resume operation. If market conditions look grim and are not expected to increase, the firm may decide to leave the market  a long run decision

Summary: Firm Decisions in the Long Run & Short Run In the SR, firms have to decide how much to produce in the current scale of plant. In the LR, firms have to choose among many potential scales of plant. SR CONDITION SR DECISION LR DECISION Profits TR > TC operate Expand + new firms enter Losses 1. With operating profit operate Contract + firms exit ( TR  TVC ) (losses < FC) 2. With operating losses shut down: Contract + firms exit ( TR < TVC ) losses = FC

Short Run Supply Curve Competitive firms determine the quantity to produce where P = MC Competitive firms supply curve is portion of the marginal cost curve above the AVC curve

Cost and Revenue, (dollars) MC AVC ATC Quantity Supplied P 1 P 2 P 3 P 4 P 5 Q 2 Q 3 Q 4 Q 5 Marginal Cost & Short-Run Supply Do not Produce Below AVC(< P 2 ) Normal Profit Shut down point Subnormal profit Supernormal profit

Cost and Revenue, (dollars) MR 1 Quantity Supplied MR 2 MR 3 MR 4 MR 5 P 1 P 2 P 3 P 4 P 5 Q 2 Q 3 Q 4 Q 5 Marginal Cost & Short-Run Supply Short-Run Supply Curve Supply No Production Below AVC

Short-Run Supply Curve As long as the price covers average variable cost , the firm will supply the quantity resulting from the intersection of its upward-sloping marginal cost curve and its marginal revenue, or demand curve. Thus, that portion of the firm’s marginal cost curve that rises above the lowest point on its average variable cost curve becomes the short-run firm supply curve.

5.4 Long Run Adjustment In the long run, there is an adequate time for the firm to make changes and adjustment to the production process. All inputs are variable in the long run. Perfect competitive firm only earn zero economic profit (normal profit) . Its mean that TR is just enough to cover TC (  = TR – TC = 0) This is due to the effect of free entry and exit.

Profit maximization in the LR Free entry : When firm earn economic profit > 0 in the SR: Encourage NEW firms to enter the market. Market supply increase (SS curve shift rightward). Equilibrium price drop >> individual firm will also lower their price (price taker) until profit is eliminated. When economic profit = 0 , no incentive for firm to come in.

Profit Maximization in the LR Free exit : When firm earn economic profit < 0 in the SR: Incentive for existing (losing) firms to exit the market. Market supply drop (SS curve shift leftward). Equilibrium price rise >> individual firm will also increase their price (price taker) until profit is eliminated. When economic profit = 0 , no incentive for firm to come in.

5.5 External Changes: Consumer Preference & Technology Changing preference: Increase in Demand Decrease in Demand

(1) Changing Preference Increase in demand Firm Industry

When preference increase : DD curve shift rightward , quantity & price increase. Existing firm gain positive economic profit . Incentive for expansion or new firms entry . Market SS increase : SS curve shift rightward, qty increase but price drop until each firm earn zero economic profit .

S 1 MC ATC MR D 1 Before Increase in Demand P Q q1 P Q Q1 Industry Firm (price taker) P1 P1

DD increases – DD curve shift left – P ↑ - Q ↑ - supernormal profit – new firms enter MR D 1 MC ATC D 2 Economic Profits S 1 MR 1 P Q q1 q2 P Q Q1 Q2 Industry Firm (price taker) P2 P1 P2 P1

New entry – SS ↑ - Q↑ - P↓ - (P = ATC) normal profit MR D 1 MC ATC D 2 Zero Economic Profits S 1 S 2 q2 Q1Q2Q3 IMPORTANT!! P Q q1 P Q Industry Firm (price taker) P2 P1 P2 P1

Changing Preference : Decrease in demand Industry Firm

When preference drop: DD curve shift leftward , quantity & price decrease. Existing firm suffer economic losses . Incentive for contraction or exit . Market SS decrease : SS curve shift leftward, qty drop but price increase until each firm earn zero economic profit.

Before decrease in demand: S 1 MC ATC D 1 MR P Q q1 P Q Q1 Industry Firm (price taker) P1 P1

MR D 1 MC ATC D 2 Economic Losses S 1 q2 DD decreases – DD curve shift right – P ↓ - Q ↓ - subnormal profit – existing firms exit P Q q1 P Q Q2Q1 Industry Firm (price taker) P1 P2 P1 P2

MR D 1 MC ATC D 2 Zero Economic Profits S 1 S 3 Q3 q2 Existing firms exit – SS ↓ - Q↓ - P↑: (P = ATC) normal profit IMPORTANT!! P Q q1 P Q Q2 Q1 Industry Firm (price taker) $60 50 40 $60 50 40

(2) Advancing Technology: Technology Improvements (a) Adopt new technology (b) Old technology firm Economic loss Positive economic profit New firms entry SS up, P down Profit reducing Produce at lower cost Exit Adopt new technology SS down, P up Zero economic profit

5.6 Efficiency of Perfect Competition What will be produced? Efficient allocation of resources among firm. How will it be produced? Efficient distribution of outputs among households. Who will get what is produced? Producing what people want: The efficient mix of output.

Efficient Allocation of Resources Among Firm Producing allocation using the best available-lowest cost - technology. If more output can be produced with the same amount of inputs; it would make some people better off . Inputs allocated across firms in the best possible way. The assumptions that factor markets are competitive and open , that all firms pay the same prices for inputs, and that all firms maximize profits leads to the conclusion that the allocation of resources among firms is efficient.

Efficient Distribution of Outputs Among Households: Household are free to choose among all the goods and services in the market. Subject to purchasing power constraint (income & wealth). Depend on the budget constraint. As long as everyone shops freely in the same markets, no redistribution of final output among people will make them better off .

Producing What People Want (The Efficient Mix of Output): Produce at P = MC . Price reflects households’ willingness to pay. By purchasing a product, individual reveal that it is worth as least as much as the other things that the same money could buy. Marginal cost reflects the opportunity cost of the resources needed to produce a good . Society will produce the efficient mix output if all firms equate price and marginal cost.

Output (unit) Total cost (RM) Variable cost (RM) 1 15 10 2 21 16 3 28 23 4 37 32 5 50 45 6 68 63

Calculate the equilibrium output if the price of the product is RM9 per unit. Calculate the total profit or loss at the equilibrium output. What is the condition for this firm? QUESTIONS:

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