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Perfect Competition, Cost &Output Determination

Lecture 6

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After studying this chapter you will be able to

Define perfect competition

Explain how firms make their supply decisions and whythey sometimes shut down temporarily and lay offworkers

Explain how price and output in an industry aredetermined and why firms enter and leave the industry

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Jasa Ojek

Mengapa tarif ojek dari stasiun UI ke FE adalah sebesarRp5000?

Berapa banyak tukang ojek?

Berapa banyak penumpang?

Apakah jasa ojek homogen?

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What Is Perfect Competition?

Perfect competit ion is an industry in which

Many firms sell identical products to many buyers.

There are no restrictions to entry into the industry.

Established firms have no advantages over new ones. Sellers and buyers are well informed about prices.

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How Perfect Competit ion Arises

Perfect competition arises: When firms minimum efficient scale is small relative to

market demand so there is room for many firms in the

industry.

And when each firm is perceived to produce a good orservice that has no unique characteristics, so consumers

dont care which firm they buy from.

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Price Takers

In perfect competition, each firm is a price taker.A price takeris a firm that cannot influence the price of agood or service.

No single firm can influence the priceit must take theequilibrium market price.

Each firms output is a perfect substitute for the output ofthe other firms, so the demand for each firms output isperfectly elastic.

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Economic Profit and Revenue

The goal of each firm is to maximize economic profit,which equals total revenue minus total cost.

Total cost is the opportunity cost of production, which

includes normal profit.

A firms total revenue equals price, P, multiplied byquantity sold, Q, or P Q.

A firms marginal revenue is the change in total revenuethat results from a one-unit increase in the quantity sold.

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Figure 11.1 illustrates a firms revenue concepts.

Part (a) shows that market demand and market supplydetermine the market price that the firm must take.

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Figure 11.1(b) shows the firms total revenue curve (TR)the relationship between total revenue and quantity sold.

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Figure 11.1(c) shows the marginal revenue curve (MR).

The firm can sell any quantity it chooses at the market price,

so marginal revenue equals price and the demand curve forthe firms product is horizontal at the market price.

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The demand for the firms product is perfectly elasticbecause one of Cindys sweaters is a perfect substitute for

the sweater of another firm.The market demand is not perfectly elastic because asweater is a substitute for some other good.

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The Firms Decisions in Perfect

Competition

A perfectly competitive firm faces two constraints:

1. A market constraint summarized by the market priceand the firms revenue curves.

2. A technology constraint summarized by firms productcurves and cost curves (like those in Chapter 10).

The goal of the firm is to make maximum economic profit,

given the constraints it faces.

So the firm must make four decisions: Two in the short runand two in the long run.

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Competition

Short-Run Decisions

In the short run, the firm must decide:

1. Whether to produce or to shut down temporarily.

2. If the decision is to produce, what quantity to produce.

Long-Run Decisions

In the long run, the firm must decide:

1. Whether to increase or decrease its plant size.

2. Whether to stay in the industry or leave it.

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Competition

Profit-Maximizing Output

A perfectly competitive firm chooses the output thatmaximizes its economic profit.

One way to find the profit-maximizing output is to look atthe firms the total revenue and total cost curves.

Figure 11.2 on the next slide looks at these curves along

with the firms total profit curve.

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The Firms Decisions

in Perfect Competition

Part (a) shows the totalrevenue, TR, curve.

Part (a) also shows the

total cost curve, TC, whichis like the one in Chapter10.

Total revenue minus totalcost is economic profit (orloss), shown by the curve

EP in part (b).

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The Firms Decisions


At low output levels, the firmincurs an economic lossitcant cover its fixed costs.

At intermediate outputlevels, the firm makes aneconomic profit.

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The Firms Decisions


At high output levels, the

firm again incurs aneconomic lossnow thefirm faces steeply rising

costs because ofdiminishing returns.

The firm maximizes itseconomic profit when itproduces 9 sweaters aday.

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Competition

Marginal Analysis

The firm can use marginal analysis to determine the profit-maximizing output.

Because marginal revenue is constant and marginal costeventually increases as output increases, profit ismaximized by producing the output at which marginalrevenue, MR, equals marginal cost, MC.

Figure 11.3 on the next slide shows the marginal analysisthat determines the profit-maximizing output.

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Competition

IfMR >MC, economicprofit increases if outputincreases.

IfMR

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Competition

Profits and Losses in the Short Run

Maximum profit is not always a positive economic profit.

To determine whether a firm is making an economic profit

or incurring an economic loss, we compare the firmsaverage total cost at the profit-maximizing output with themarket price.

Figure 11.4 on the next slide shows the three possibleprofit outcomes.

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Competition

In part (a) price equals average total cost and the firm

makes zero economic profit (breaks even).

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Competition

In part (b), price exceeds average total cost and the firm

makes a positive economic profit.

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Competition

In part (c) price is less than average total cost and the firm

incurs an economic losseconomic profit is negative.

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Competition

The Firms Short-Run Supply Curve

A perfectly competitive firms short run supply curve showshow the firms profit-maximizing output varies as themarket price varies, other things remaining the same.

Because the firm produces the output at which marginalcost equals marginal revenue, and because marginalrevenue equals price, the firms supply curve is linked toits marginal cost curve.

But there is a price below which the firm produces nothing

and shuts down temporarily.

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Competition

Temporary Plant Shutdown

If price is less than the minimum average variable cost, thefirm shuts down temporarily and incurs an economic lossequal to total fixed cost.

This economic loss is the largest that the firm must bear.

If the firm were to produce just 1 unit of output at a price

below minimum average variable cost, it would incur anadditional (and avoidable) loss.

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Competition

The shutdown point is the output and price at which thefirm just covers its total variable cost.

This point is where average variable cost is at its

minimum.It is also the point at which the marginal cost curvecrosses the average variable cost curve.

At the shutdown point, the firm is indifferent betweenproducing and shutting down temporarily.

It incurs a loss equal to total fixed cost from either action.

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Competition

If the price exceeds minimum average variable cost, thefirm produces the quantity at which marginal cost equalsprice.

Price exceeds average variable cost, and the firm coversall its variable cost and at least part of its fixed cost.

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The Firms Decisions


Short-Run Supply Curve

Figure 11.5 shows how thefirms short-run supply curve

is constructed.If price equals minimumaverage variable cost, $17 in

this example, the firm isindifferent between producingnothing and producing at theshutdown point, T.

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The Firms Decisions


If the price is $25, the firmproduces 9 sweaters aday, the quantity at whichP =MC.

The blue curve in part (b)traces the firms short-runsupply curve.

If the price is $31, the firmproduces 10 sweaters aday, the quantity at which

P =MC.

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Competition

Short-Run Industry Supply Curve

The short-run industry supply curve shows the quantity

supplied by the industry at each price when the plant sizeof each firm and the number of firms remain constant.

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Competition

Figure 11.6 shows thesupply curve for anindustry that has 1,000

firms like Cindys.

The quantity supplied bythe industry at any given

price is the sum of thequantities supplied by allthe firms in the industry at

that price.

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Competition

At a price equal tominimum average variablecostthe shutdownpricethe industry supply

curve is perfectly elasticbecause some firms willproduce the shutdown

quantity and others willproduces zero.

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Output, Price, and Profit in Perfect

Competition

Short-Run Equilibrium

Short-run industry supplyand industry demanddetermine the market

price and output.

Figure 11.7 shows ashort-run equilibrium.

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Competition

A Change in Demand

An increase in demandbring a rightward shift ofthe industry demand

curve: the price rises andthe quantity increases.

A decrease in demandbring a leftward shift of theindustry demand curve:the price falls and thequantity decreases.

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Competition

Long-Run Adjustments

In short-run equilibrium, a firm may make an economicprofit, break even, or incur an economic loss.

Which of these outcomes occurs determines how theindustry adjusts in the long run.

In the long run, the firm may:

Enter or exit an industry

Change its plant size

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Competition

Entry and Exit

New firms enter an industry in which existing firms makean economic profit.

Firms exit an industry in which they incur an economicloss.

Figure 11.8 on the next slide shows the effects of entry

and exit.

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Competition

Effects of Entry

As new firms enter anindustry, industry supplyincreases.

The industry supply curveshifts rightward.

The price falls, thequantity increases, andthe economic profit ofeach firm decreases.

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Competition

The Effects of Exit

As firms exit an industry,industry supply decreases.

The industry supply curveshifts leftward.

The price rises, the

quantity decreases, andthe economic loss of eachfirm remaining in the

industry decreases.

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Competition

Changes in Plant Size

A firm changes its plant size whenever doing so isprofitable.

If average total cost exceeds the minimum long-runaverage cost, the firm changes its plant size to loweraverage costs and increase economic profit.

Figure 11.9 on the next slide shows the effects of changesin plant size.

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Competition

If the price is $25 a sweater, the firm is making zero

economic profit with the current plant.

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Competition

But if the LRAC curve is sloping downward at the current

output, the firm can increase profit by expanding the plant.

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Competition

As the plant size increases, the firms short-run supply

increases, the average total cost falls, and its economicprofit increases.

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Competition

As all firms in the industry change their plant size, industry

supply increases, the market price falls, and economicprofit decreases.

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Competition

Long-run equilibrium occurs when each firm is producing

at minimum long-run average cost and is making zeroeconomic profit.

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Competition

Long-Run Equilibrium

Long-run equilibrium occurs in a competitive industrywhen:

Economic profit is zero, so firms neither enter nor exitthe industry.

Long-run average cost is at its minimum, so firms dont

change their plant size.

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Changing Tastes and Advancing

TechnologyA Permanent Change in Demand

A decrease in demand shifts the market demand curveleftward. The price falls and the quantity decreases.

Figure 11.10 illustrates the effects of a permanent decrease

in demand when the industry is in long-run equilibrium.

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STOP

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TechnologyA decrease in demand shifts the industry demand curveleftward. The market price falls, and each firm decreases

the quantity it produces.

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TechnologyThe market price is now below each firms minimumaverage total cost, so firms incur economic losses.

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TechnologyEconomic losses induce some firms to exit, whichdecreases the industry supply and the price starts to rise.

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TechnologyAs the price rises, the quantity produced by the industrycontinues to decrease as more firms exit, but each firm

remaining in the industry starts to increase its quantity.

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TechnologyA new long-run equilibrium occurs when the price has risen toequal minimum average total cost. Firms do not incur

economic losses, and firms no longer exit the industry.

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TechnologyThe main difference between the initial and new long-runequilibrium is the number of firms in the industry.

Fewer firms produce the equilibrium quantity.

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TechnologyA permanent increase in demand has the opposite effectsto those just described and shown in Figure 11.9.

An increase in demand shifts the demand curve rightward.The price rises and the quantity increases.

Economic profit induces entry, which increases short-runsupply and shifts the short-run industry supply curverightward.

As industry supply increases, the price falls and themarket quantity continues to increase.

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TechnologyWith a falling price, each firm decreases production in amovement along the firms marginal cost curve (short-run

supply curve).

A new long-run equilibrium occurs when the price hasfallen to equal minimum average total cost so that firms donot make economic profits, and firms no longer enter theindustry.

The main difference between the initial and new long-runequilibrium is the number of firms in the industry. In thenew equilibrium, a larger number of firms produce theequilibrium quantity.

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TechnologyExternal Economics and Diseconomies

The change in the long-run equilibrium price following apermanent change in demand depends on externaleconomies and external diseconomies.

External economies are factors beyond the control of anindividual firm that lower the firms costs as the industryoutput increases.

External diseconomies are factors beyond the control ofa firm that raise the firms costs as industry outputincreases.

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TechnologyIn the absence of external economies or externaldiseconomies, a firms costs remain constant as industry

output changes.

Figure 11.11 illustrates the three possible cases andshows the long-run industry supply curve.

The long-run industry supply curve shows how thequantity supplied by an industry varies as the market price

varies after all the possible adjustments have been made,including changes in plant size and the number of firms inthe industry.

Ch i T t d Ad i

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Technology

Figure 11.11(a) shows that

in the absence of externaleconomies or externaldiseconomies, an increase

in demand does not changethe price in the long run.

The long-run industry supply

curve LSA is horizontal.

Ch i T t d Ad i

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Technology

Figure 11.11(b) shows that

when external diseconomiesare present, an increase indemand brings a higher pricein the long run.

The long-run industry supplycurve LSB is upward sloping.

Ch i T t d Ad i

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Technology

Figure 11.11(c) shows thatwhen external economiesare present, an increase indemand brings a lowerprice in the long run.

The long-run industry

supply curve LSC isdownward sloping.

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Technology

Technological ChangeNew technologies are constantly discovered that lowercosts.

A new technology enables firms to produce at a loweraverage cost and a lower marginal costfirms costcurves shift downward.

Firms that adopt the new technology make an economicprofit.

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Technology

New-technology firms enter and old-technology firmseither exit or adopt the new technology.

Industry supply increases and the industry supply curve

shifts rightward.The price falls and the quantity increases.

Eventually, a new long-run equilibrium emerges in which

all firms use the new technology, the price equalsminimum average total cost, and each firm makes zeroeconomic profit.

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Competition and Efficiency

Efficient Use of Resources

Resources are used efficiently when no one can be madebetter off without making someone else worse off.

This situation arises when marginal social benefit equals

marginal social cost.

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Choices, Equilibrium, and Efficiency

We can describe an efficient use of resources in terms of

the choices of consumers and firms coordinated in marketequilibrium.

Choices

A consumers demand curve shows how the best budgetallocation changes as the price of a good changes.

So consumers get the most value out of their resources atall points along their demand curves.

With no external benefits, the market demand curve is themarginal social benefit curve.

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A competitive firms supply curve shows how the profit-maximizing quantity changes as the price of a good

changes.

So firms get the most value out of their resources at allpoints along their supply curves.

With no external cost, the market supply curve is themarginal social cost curve.

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Equilibrium and Efficiency

In competitive equilibrium, resources are used efficientlythe quantity demanded equals the quantity supplied, somarginal social benefit equals marginal social cost.

The gains from trade for consumers is measured byconsumer surplus.

The gains from trade for producers is measured by

producer surplus.

Total gains from trade equal total surplus, and in long-runequilibrium total surplus is maximized.

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Figure 11.12 illustrates an

efficient allocation ofresources in a perfectlycompetitive industry.

In part (a), each firm isproducing at the lowestpossible long-run average

total cost at the price P*and the quantity q*.

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Figure 11.12(b) shows themarket.

Along the market demandcurve D =MSB,consumers are efficient.

Along the market supplycurve S =MSC, producers

are efficient.

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The quantity Q* and priceP* are the competitive

equilibrium values.

So competitive equilibriumis efficient.

Total surplus, the sum ofconsumer surplus and

producer surplus ismaximized.

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THE END

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