Level 5 Economics: Theory of the Firm [2]

Economic Principles Economic Environment

Level 5 Economics: Theory of the Firm [2]Learning Outcome Three

Theory of the Firm:2. Profit Maximisation under

Perfect Competition

Perfect Competition S&R, S fig 6.1

• markets in which there are so many buyers and so many sellers that no individual buyer or seller can affect the market price– individual sellers are price-takers;

they decide on quantity only

• firms produce a homogeneous product– each firm produces identical products

• eg the product is unbranded

• no entry-barriers for new firms• close examples of perfectly competitive industries?

• market gardeners, taxi drivers, home handymen

Revenue curve for a competitive firm• with many (eg 1,000) similar small firms in

the market, each firm (with 0.1% of market) is too small to shift the market supply curve\ if just one fig supplier produces (say 20%) more

than before, the market price does not change• eg if each firm initially supplies 160 packs of figs, market output increases from 160,000 to 160,032 (0.02%)

marginal revenue is always the price

– contrast with all firms raising output by 20%• in this case, the market supply curve shifts 20% to right• eg market output increases from 160,000 to 192,000example in which all firms increase output from 160 to 192

160 170 180 190 200 210 220 230 240 250 $6.50

$7.00

$7.50

Prices Experienced by Competitive Firms when one firm increases produc-tion

0.1% market share 1,000 firms

1% market share 100 firms

5% market share 20 firms

output (Q) of individual firm

ma

rke

t-c

lea

rin

g p

ric

e (

P)

pe

r it

em

so

ld

back20% increase in output by only 1 firm means 0.02% increase in market output

Fig Market

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Consider market with 1,000 identical firms

160 170 180 190 200 210 220 230 240 250 $4.50

$5.00

$5.50

$6.00

$6.50

$7.00

$7.50

Prices Experienced by Competitive Firms when all firms increase production by same amount

000s; output (Q) of all firms if 1,000 firms in total

mar

ket-

clea

rin

g p

rice

(P

) p

er it

em s

old

market demand curve

when all or most firms increase output there is a significant increase (right-shift) in the market supply curve

under perfect competition,marginal revenue equals price

• an individual firm under perfect competition can sell as much as it supplies at the current market price, so long as– each firm's output remains small relative to the

industry's output– competitor firms do not change their output

quantities

• also, by definition,– average revenue always equals price– total revenue (TR) = price (P) x quantity (Q) = AR x Q

S&R, S fig 6.2

Key Assumption: Firms maximise Profits• Profit () equals S&R, S fig 7.1

– total revenue (TR) minus total cost (TC)

• Profit-maximising Quantity– firms maximise profit at quantity (Q) when

marginal cost (MC) = (MR) marginal revenue

– with perfect competition, MR = price• so, in a perfectly competitive market, a profit-

maximising firm supplies the quantity for which:• marginal cost = marginal revenue = price

S&R, S fig 7.2 also 7.11

fig 7.2 again

Types of Profit in Short-run Equilibrium• applying the MC=MR rule to establish Qe:

S&R, S fig 7.3

• maximising profit or minimising loss– economic profit > 0 [economic profit]

• above-normal (supernormal) profit– economic profit < 0 [economic loss]

• below-normal (subnormal) profit• is typically an accounting profit above zero

– economic profit = 0; [break-even point]• normal profit; accounting profit always above-zero

• what happens if the market price falls?

Varying Profits and Losses

supply curve for individual firm(see fig 7.5)

can shut-down (Q=0) in the short run if stopping production gives a smaller loss

Long-run Equilibrium of the Firmlong-run allows for entry & exit of firms

• economic profits eliminated S&R, S fig 7.6

(eg arising from an increased demand, high P)– some firms enter the industry– increase in market supply– result: long-run decrease in market price

• economic losses resolved(eg arising from decreased demand, low P)– some firms exit the industry– decrease in market supply– result: long-run increase in market price

Under Perfect Competition, in long-run equilibrium, Profits are Maximised at Zero

• at normal profits, firms produce at their technical optimum, at the appropriate scale– price equals minimum long-run average cost– price stabilises at the low point of the LAC curve

• in the long run, firms that do not maximise profits end up with economic losses– competition is more about

market discipline thanmarket freedom

• real-world competition is imperfect to some degree

Price also equals Marginal Benefit• The price paid for a product represents the

happiness from marginal use of that product• remember Henry and his chocolate bars

• In an efficient market:– price = marginal benefit = marginal cost

• eg price is a measure of the last bit of happiness and unhappiness

• "price = marginal cost" is a condition for efficiency– otherwise , efficiency gains can be realised:

• if price > marginal cost, there will be increased net benefits if more resources are allocated to that good

• if price < marginal cost, there will be increased net benefits if fewer resources are allocated to that good and more resources are allocated to other goods

textbook (4e) ch.7 p146/7, Q2textbook (5e) ch.7 p150/1, Q2

solution

ex sheet 3ba (mainly on costs)

Homework

7 Which one of the following does not occur in perfect competition?

a No single firm can exert a significant influence on the market price of the good.

b There are many buyers. c There are significant restrictions on entry into the industry. d Firms and buyers are completely informed about the output

and input prices of the industry.

8 A firm has total revenue of $100m, explicit costs of $90mand implicit costs of $20million. Its pure economic profit is

a $80million b $70million

c $10million d -$10million

9 All firms maximise their profits at the output level where

a price equals marginal cost b marginal revenue equals marginal cost c marginal revenue equals price d price is greater than average cost

Net Benefits• Consumer (household) point of view

happiness – unhappiness = welfare

• Producer (firm) point of viewtotal revenue – total cost = profit

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