perfect competition topic 5. characteristics pure competition large number of sellers & buyers...

Perfect Competition Topic 5

Characteristics

Pure Competition• large number of sellers & buyers• homogenous (identical) products• low barriers to entry (free entry and exit from

the industry)

Perfect Competition• large number of sellers & buyers• homogenous (identical) products• low barriers to entry• perfect market knowledge• perfect mobility of FoP’s

Lead to faster adjustment

Price takers & Price makers

Demand curve for a Price taker

Demand curve for a Price maker

Demand curve for a Price taker

• The demand curve facing a perfectly competitive firm is perfectly elastic, meaning that the firm can sell as many units as it wants at the market price, but cannot sell any quantity if it charges more than the market price.

• The firm has no market power, no pricing power at all. It is just a small player in a large market….. It is a price taker.

Demand curve for a Price maker

• Downward sloping.

• It is just matter of how steep the curve is.

• The more market power a firm has, the steeper is the demand curve.

• The characteristic of a downward sloping demand curve is that, normally, if a firm raises the price of its product, it needs not lose all its customers, and if it wants to sell more, it has to cut price.

Demand curve for Individual firm under PC

P = AR = MR

Firm’s D curve

Market D curve

Revenue Concepts under PC

• Total revenue (TR): Total number of dollars (or dong) received by a firm from the sale of a product. • TR = P x Q

• Average revenue (AR): Total revenue per unit of a product sold• AR = TR/Q = (P x Q) / Q = P

• Marginal Revenue (MR): Additional revenue received resulting from the sale of an extra unit of output

• MR = = = P ΔTR

ΔQ

P. ΔQ

ΔQ

$131$131 131131

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00 11 22

33445566778899

1010

$ 0$ 0131131262262393393524524655655786786917917

104810481179117913101310

] $131$131131131131131131131131131131131131131131131131131131131

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ProductProductPricePrice

(Average(Average Revenue)Revenue)

TotalTotalRevenueRevenue

MarginalMarginalRevenueRevenue

QuantityQuantityDemandedDemanded

(Sold)(Sold)

TRP

rice,

ave

rage

and

mar

gina

l rev

enue

,to

tal r

even

ue (

dolla

rs)

PP

Quantity demanded (sold)1 2 3 4 5 6 7 8 9 10

917917

786786

655655

524524

393393

262262

131131

00

D = MRP = AR = MR

Profit Maximisation in the Short Run

Two approaches to profit maximisation:

• Total Revenue minus Total Cost Approach

• Marginal Revenue, Marginal Cost Approach

IMPORTANT!Rules for Profit Maximisation

• Optimum output where: TR – TC = largest

or

• Optimum output where: MR = MC– or MR closest to MC but MR > MC– MC cuts MR curve from below

Total Revenue – Total Cost Approach (Price = $131)

0 1 23456789

10

TotalCost

TotalProduct

TotalFixedCost

TotalVariable

CostTotal

Revenue Profit

$ 100 100 100100100100100100100100100

$ 090

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$ 100190270340400470550640750880

1030

$ 0131262393524655786917

104811791310

– $100 – 59

– 8+ 53

+ 124+ 185+ 236+ 277+ 298+ 299+ 280

0 1 23456789

10

100100100100100100100100100100

100

090

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1030

]]]]]]]]]

]

TotalCost

TotalProduct

TotalFixedCost

TotalVariable

CostMarginal

Cost

TotalEconomicProf./Loss

Price =MarginalRevenue

Profit Maximisation: MR, MC Approach

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013

015

0

$ $ 131131131131131131131131131131131131131131131131131131131131

– $100– 59

– 8+ 53

+ 124+ 185+ 236+ 277+ 298+ 299+ 280

fig

O O

S

D

(a) (a) IndustryIndustry

P $

Q (millions)

Pe

(b) (b) FirmFirm

ARD = AR

= MR

MC

Qe

Short-run equilibrium of industry and firm under Perfect Competition

Q (thousands)

Copyright 2001 Pearson Education Australia

IMPORTANT!Rules for Profit Maximisation

• Optimal output is where MR = MC or MR closest to MC but MR > MC MC cuts MR curve from below

IMPORTANT !Rules for Profit maximization

Short Run

P ≥ AVC

• In the short run, fixed costs will be incurred whether or not the firm produces. So this means that total revenue must be at least equal to total variable cost for the firm to continue producing.

If P < AVC, firm should shut down

IMPORTANT !Rules for Profit maximization

Long Run

P ≥ ATC

• In the long run, firms have the option of closing down and going out of business, so total revenue must at least cover total costs ( all costs ).

If P < ATC, firm should shut down

fig

O O

S

D

(a) (a) Industry Industry

P $

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR

= MR

MC

Qe

ATC

AC

SR Profit maximisation under Perfect Competition

Q (thousands)


fig

O O

S

D


P $

Q (millions)

Pe

(b) (b) Firm Firm

ARD = AR= MR

MC

Qe

ATC

AC

SR Profit maximisation under Perfect Competition

Q (thousands)


fig

O O

((a) a) Industry Industry

P $

P1

Q (millions)

S

D

(b) (b) Firm Firm

AR1

D1 = AR1

= MR1

MC

Qe

ATC

AC

SR Loss minimisation under Perfect Competition

Q (thousands)


AVC

fig

Short-run shut-down point

O O


P $

P2

Q (millions)

S

D2

(b) (b) Firm Firm

AR2

D2 = AR2

= MR2

MC ATC

AVC

Q


Q1

Long run Equilibrium under PC

• Under PC P = min. ATC = MR = MC why?

fig

Long-run equilibrium under PC

O OD

(a) (a) IndustryIndustry

P $

Q (millions)

P1

(b) (b) FirmFirm

ATC

AR1

S1

D1

Q (thousands)


fig

O O

S1

D

(a) (a) IndustryIndustry: As firms making : As firms making supernormal profits , new firms supernormal profits , new firms will enter the industry. S curve will enter the industry. S curve shifts to right. Price fallsshifts to right. Price falls..

P $

Q (millions)

P1

(b) Firm(b) Firm

AR1

ATC

PL ARL

QL

Se

D1

DL


Q (thousands)


fig

O O

S1

D

(a) (a) IndustryIndustry: As firms making : As firms making losses , some firms will leave losses , some firms will leave the industry. S curve shifts to the industry. S curve shifts to left. Price risesleft. Price rises..

P $

Q (millions)

P1

(b) Firm(b) Firm

AR1

ATC

PL ARL

QL

Se

D1

DL


Q (thousands)


Long run Equilibrium

• .

Long run Equilibrium

• Key characteristics of PC:– large number of sellers & buyers– identical products– freedom of entry & exit

• Implication (or conclusion)– Firms in PC cannot earn economic profits in

the long run

Efficiency

Allocative efficiency:

• Resources are allocated among firms and industries to obtain a mix of products most desired by society (consumers)

Productive efficiency:

• The least costly methods of production are used (ie. goods are produced at the lowest possible costs)

Efficiency and Perfect Competition

• Price of product X = the relative worth of product X to the society (or the marginal benefit/satisfaction the society gets from an additional unit of X) .

• Marginal Cost of product X is the cost of producing an additional unit of X

(MC measures the sacrifice of other goods in using resources to produce more of X)

Efficiency and Perfect Competition

• Allocative efficiency: P > MC : resources are under allocated P < MC : resources are over allocated P = MC : resources are best allocated/utilised

• Productive efficiency: P = min ATC

(For more details, read Jackson pp. 276 – 77)

Assessment of Perfect Competition

Pros• Productive efficiency: min AC (ie. firms produce

at the least-cost output)• Allocative efficiency: P = MC • Consumer gains from low prices (ie. maximum

consumer surplus) • Speed of resource reallocation• No power groups

Cons• Less scope for R&D• Almost no product variety

Short-Run Supply Curve

• For the individual firm: the SR supply curve is the MC curve above the AVC curve

• For the entire industry: horizontal sum of firms’ MC curves above AVC

P = MC: Short-Run Supply CurveP

Q

MC

AVCAVC

ATCATCC

ost

s an

d r

even

ues

(d

oll

ars)

At every price, theMR = MC point

changes the quantitybeing exchanged...


Q

MC

AVCAVC

ATCATC

Co

sts

and

rev

enu

es (

do

llar

s)

MR3

Record thequantity being

supplied foreach price

Q3

P3


Q

MC

AVCAVC

ATCATC

Co

sts

and

rev

enu

es (

do

llar

s)

MR3

Q3

MR2

At a lower pricea lower quantitywill be supplied

Q2

P2

P3


Q

MC

AVCAVC

ATCATC

Co

sts

and

rev

enu

es (

do

llar

s)

MR3

Q3

MR2

Q2

P2

P3

At a higher pricea greater quantitywill be supplied

QQ44

Break-evenBreak-even(normal profit)(normal profit)

pointpoint

MRMR44P4


Q

MC

AVCAVC

ATCATC

Co

sts

and

rev

enu

es (

do

llar

s)

MR3

Q3

MR2

Q2

P2

P3

QQ44


pointpoint

MRMR44

Q5

MR5P4

P5


Q

MC

AVCAVC

ATCATC

Co

sts

and

rev

enu

es (

do

llar

s)

MR3

Q3

MR2

Q2

P2

P3

QQ44


pointpoint

MRMR44

Q5

MR5P4

P5

MR1P1 Firm should notproduce unless

revenue is at leastable to meet AVC


Q

MC

AVCAVC

ATCATC

Co

sts

and

rev

enu

es (

do

llar

s)

MR3

Q3

MR2

Q2

P2

P3

QQ44


pointpoint

MRMR44

Q5

MR5P4

P5

MR1P1 The MarginalCost Curve at points above

AVC represents the short-runsupply curve


Q

MC

AVCAVC

ATCATC

Co

sts

and

rev

enu

es (

do

llar

s)

MR3

Q3

MR2

Q2

P2

P3

QQ44

MRMR44

Q5

MR5P4

P5

MR1P1

Short-runShort-runsupply curvesupply curve

(red)(red)

P = MC: Short-Run Supply Curve

PP

Q

MCMC11

AVCAVC11

If costs increase...the supply curveeffectively shiftsto the left

MCMC22

AVCAVC22

P = MC: Short-Run Supply Curve

PP

Q

MCMC22

AVCAVC22

MCMC11

AVCAVC11

If costs decrease...the supply curveeffectively shiftsto the right

perfect competition topic 5. characteristics pure competition large number of sellers & buyers...

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