Eco 6351Economics for Managers

Chapter 6. Competition

Prof. Vera Adamchik

Outline

• Perfect Competition

• The Firm’s Short-Run Decision

• The Firm’s Supply Curve

• Output, Price, and Profit in the Short Run

• Output, Price, and Profit in the Long Run

Perfect Competition Perfect competition occurs in a market where:

– There are many sellers and buyers – Firms offer a standardized (identical) product– Firms can easily enter into or exit from the

market– Firms in the industry have no advantage over

potential new entrants– Firms and buyers are well informed about the

prices of the products of each firm in the industry

• First, market demand and market supply determine the price that the firm takes as given. In perfect competition, each firm is a price taker.

• The firm’s demand curve is perfectly elastic.

• The firm can sell any quantity it chooses at this price.

[See Figure 6.2 on p.132 in the textbook.]

Price in Perfect Competition

• Total revenue = Price x Quantity

• The firm’s short-run problem is to chose the output that maximizes profit

• Economic profit =

Total Revenue minus Total Cost

The Firm’s Short-Run Decision

Profit Maximization

• We can find the profit-maximizing output by looking at either:

– total cost and total revenue, or

– marginal cost and marginal revenue.

Total Revenue and Total Cost Approach

• Profit = TR – TC

• The firm maximizes Profit with respect to Q.

• In the total revenue and total cost approach, the firm calculates profit at each output level and selects the output level where profit is greatest.

Marginal Revenue and Marginal Cost Approach

• Profit = TR – TC.• The firm maximizes Profit with respect to Q.• From algebra, we know that the profit

function is at its maximum when the first derivative of this function (that is, its slope) is zero. Thus, the profit function is maximized when

dTR/dQ - dTC/dQ = 0 or, in other words, when MR = MC.

Marginal Revenue and Marginal Cost Approach

• The firm maximizes its profit when MR = MC.

• The firm should increase output whenever MR > MC, and lower output when MR < MC.

• Profit is maximized when MR = MC. In perfect competition, MR = Price. Thus, we can rewrite that profit is maximized when Price = MC.

• However, profit maximization does not guarantee a profit.

• When price equals marginal cost, average total cost (ATC) can be greater than, equal to, or less than price.

• Profit maximization can mean loss minimization.

The Firm’s Short-Run Decision

• Figure shows the three possible outcomes:– economic profit– break even– economic loss

The Firm’s Short-Run Decision

• Here, the firm makes an economic profit.

• The price is $25 and the profit-maximizing quantity is 9.

• ATC is less than Price=AR=MR.

The Firm’s Short-Run Decision

• Here, the firm breaks even.

• The price is $20 and the profit-maximizing quantity is 8.

• ATC equals Price=AR=MR.

The Firm’s Short-Run Decision

• Here, the firm incurs an economic loss.

• The price is $17 and the profit-maximizing quantity is 7.

• ATC exceeds Price=AR=MR.

The Firm’s Short-Run Decision

The Firm’s Supply Curve

• A perfectly competitive firm's supply curve shows how the firm's profit maximizing output varies as the market price varies.

• A perfectly competitive firm's supply curve is the firm's marginal cost curve above the point of minimum average variable cost.

Output, Price, and Profit in the Short Run

• In short-run:

– The number of firms is fixed, that is, firms cannot enter or exit the industry

– Each firm has a fixed amount of capital

Short-Run Equilibrium

• In short-run equilibrium, firms might:

– earn an economic profit

– earn normal profit (break even)

– incur an economic loss.

Output, Price, and Profit in the Long Run

• In long-run:

– The number of firms is not fixed, that is, firms can enter or exit industry

– Each firm can change the amount of capital, that is, choose its plant size

• In long-run equilibrium economic profits are zero.

Output, Price, and Profit in the Long Run

Adjustment to Long-Run Equilibrium

1. If firms in the industry are earning economic profits, these profits serve as signals for entry.

2. As new firms enter the industry, the industry supply curve shifts rightward, the market price falls and quantity exchanged in this market increases.

Adjustment to Long-Run Equilibrium

3. When the market price has fallen to minATC, all firms in this industry break even. That is, all firms are earning zero economic profit, or normal profit.

4. At this point, entry ceases and the industry is in long-run equilibrium.

Adjustment to Long-Run Equilibrium

1. If firms in the industry are incurring economic losses, these losses serve as signals for exit.

2. As exit takes place, industry supply decreases.The industry supply curve shifts leftward, the market price rises and quantity exchanged in this market decreases.

Adjustment to Long-Run Equilibrium

3. When the market price has risen to minATC, all firms in this industry break even. That is, all firms are earning zero economic profit, or normal profit.

4. At this point, exit ceases and the industry is in long-run equilibrium.