Introduction to economics: perfect competition

Chapter Perfect Competition INTRODUCTION TO ECONOMICS 2e / LIEBERMAN & HALL CHAPTER / PERFECT COMPETITION ©2005, South-Western/Thomson Learning Slides by John F Hall Animations by Anthony Zambelli Perfect Competition  To determine structure of any particular market, we begin by asking  How many buyers and sellers are there in the market?  Is each seller offering a standardized product, more or less indistinguishable from that offered by other sellers • Or are there significant differences between the products of different firms?  Are there any barriers to entry or exit, or can outsiders easily enter and leave this market?  Answers to these questions help us to classify a market into one of four basic types  Perfect competition  Monopoly  Monopolistic  Oligopoly Lieberman & Hall; Introduction to Economics, 2005 The Three Requirements of Perfect Competition  Large numbers of buyers and sellers, and  Each buys or sells only a tiny fraction of the total quantity in the market  Sellers offer a standardized product  Sellers can easily enter into or exit from market Lieberman & Hall; Introduction to Economics, 2005 A Large Number of Buyers and Sellers  In perfect competition, there must be many buyers and sellers  How many? • Number must be so large that no individual decision maker can significantly affect price of the product by changing quantity it buys or sells Lieberman & Hall; Introduction to Economics, 2005 A Standardized Product Offered by Sellers  Buyers not perceive significant differences between products of one seller and another  For instance, buyers of wheat not prefer one farmer’s wheat over another Lieberman & Hall; Introduction to Economics, 2005 Easy Entry into and Exit from the Market  Entry into a market is rarely free—a new seller must always incur some costs to set up shop, begin production, and establish contacts with customers  But perfectly competitive market has no significant barriers to discourage new entrants • Any firm wishing to enter can business on the same terms as firms that are already there  In many markets there are significant barriers to entry  Legal barriers  Existing sellers have an important advantage that new entrants can not duplicate • Brand loyalty enjoyed by existing producers would require a new entrant to wrest customers away from existing firms  Significant economies of scale may give existing firms a cost advantage over new entrants Lieberman & Hall; Introduction to Economics, 2005 Easy Entry into and Exit from the Market  Perfect competition is also characterized by easy exit  A firm suffering a long-run loss must be able to sell off its plant and equipment and leave the industry for good, without obstacles  Significant barriers to entry and exit can completely change the environment in which trading takes place Lieberman & Hall; Introduction to Economics, 2005 Is Perfect Competition Realistic?   Assumptions market must satisfy to be perfectly competitive are rather restrictive In vast majority of markets, one or more of assumptions of perfect competition will, in a strict sense, be violated  Yet when economists look at real-world markets, they use perfect competition more often than any other market structure  Why is this?  Model of perfect competition is powerful  Many markets—while not strictly perfectly competitive—come reasonably close   We can even—with some caution—use model to analyze markets that violate all three assumptions Perfect competition can approximate conditions and yield accurate-enough predictions in a wide variety of markets Lieberman & Hall; Introduction to Economics, 2005 Figure 1: The Competitive Industry and Firm The intersection of the market supply and the market demand curve… Price per Ounce Market The typical firm can sell all it wants at the market price… Price per Ounce S $400 $400 D Ounces of Gold per Day determine the equilibrium market price Lieberman & Hall; Introduction to Economics, 2005 Firm Demand Curve Facing the Firm Ounces of Gold per Day so it faces a horizontal demand curve Goals and Constraints of the Competitive Firm  Perfectly competitive firm faces a cost constraint like any other firm  Cost of producing any given level of output depends on  Firm’s production technology  Prices it must pay for its inputs Lieberman & Hall; Introduction to Economics, 2005 10 Figure 8(a/b): From Short-Run Profit To Long-Run Equilibrium Market Firm S1 Price per Bushel A $4.50 Dollars With initial supply curve S1, market price is $4.50… $4.50 So each firm earns an economic profit MC A d ATC D 900,000 Lieberman & Hall; Introduction to Economics, 2005 Bushels per Year 9,000 Bushels per Year 32 Figure 8(c/d): From Short-Run Profit To Long-Run Equilibrium Market Firm S1 Price per Bushel S2 Dollars MC A $4.50 A d ATC $4.50 E 2.50 2.50 E d1 D Bushels 900,000 1,200,000 per Year Profit attracts entry, shifting the supply curve rightward… Lieberman & Hall; Introduction to Economics, 2005 5,000 9,000 until market price falls to $2.50 and each firm earns zero economic profit Bushels per Year 33 From Short-Run Loss to Long-Run Equilibrium  What if we begin from a position of loss?  Same type of adjustments will occur, only in the opposite direction   In a competitive market, economic losses continue to cause exit until losses are reduced to zero When there are no significant barriers to exit  Economic loss will eventually drive firms from the industry • Raising market price until typical firm breaks even again Lieberman & Hall; Introduction to Economics, 2005 34 Distinguishing Short-Run from LongRun Outcomes  In short-run equilibrium, competitive firms can earn profits or suffer losses  In long-run equilibrium, after entry or exit has occurred, economic profit is always zero   When economists look at a market, they automatically think of short-run versus long-run  Choose the period more appropriate for the question at hand Basic Principle #7: Short-Run versus Long-Run Outcomes  Markets behave differently in the short-run and the long run  In solving a problem, we must always know which of these time horizons we are analyzing Lieberman & Hall; Introduction to Economics, 2005 35 The Notion of Zero Profit in Perfect Competition We have not yet discussed plant size of competitive firm  The same forces—entry and exit—that cause all firms to earn zero economic profit also ensure   In long-run equilibrium, every competitive firm will select its plant size and output level so that it operates at minimum point of its LRATC curve Lieberman & Hall; Introduction to Economics, 2005 36 Perfect Competition and Plant Size  Figure 9(a) illustrates a firm in a perfectly competitive market  But panel (a) does not show a true long-run equilibrium  How we know this? • In long-run typical firm will want to expand • Why?   Because by increasing its plant size, it could slide down its LRATC curve and produce more output at a lower cost per unit By expanding firm could potentially earn an economic profit • Same opportunity to earn positive economic profit will attract new entrants that will establish larger plants from the outset  Entry and expansion must continue in this market until the price falls to P*  Because only then will each firm—doing the best that it can do— earn zero economic profit Lieberman & Hall; Introduction to Economics, 2005 37 Figure 9: Perfect Competition and Plant Size With its current plant and ATC curve, this firm earns zero economic profit As all firms increase plant size and output, market price falls to its lowest possible level Dollars Dollars MC1 P1 LRATC LRATC ATC1 d1 = MR1 MC2 ATC P* E The firm could earn positive profit with a Output per and all firms earn q1 larger plant, q* Period producing here zero economic profit and produce at minimum LRATC Lieberman & Hall; Introduction to Economics, 2005 d2 = MR2 Output per Period 38 A Summary of the Competitive Firm in the Long-Run  Can put it all together with a very simple statement  At each competitive firm in long-run equilibrium • P = MC = minimum ATC = minimum LRATC  In figure 9(b), this equality is satisfied when the typical firm produces at point E  Where its demand, marginal cost, ATC, and LRATC curves all intersect  In perfect competition, consumers are getting the best deal they could possibly get Lieberman & Hall; Introduction to Economics, 2005 39 A Change in Demand    Short-run impact of an increase in demand is  Rise in market price  Rise in market quantity  Economic profits What happens in long-run after demand curve shifts rightward?  Market equilibrium will move from point A to point C Long-run supply curve  Curve indicating quantity of output that all sellers in a market will produce at different prices • After all long-run adjustments have taken place Lieberman & Hall; Introduction to Economics, 2005 40 Figure 10: An Increasing-Cost Industry INITIAL EQUILIBRIUM Market Price per Unit Firm Dollars MC S1 ATC1 P1 P1 A A d1 = MR1 D1 Q1 Lieberman & Hall; Introduction to Economics, 2005 Output per Period q1 Output per Period 41 Figure 10: An Increasing-Cost Industry NEW EQUILIBRIUM Price per Unit Market S1 B PSR P1 S2 C C P2 P1 A MC B PSR SLR P2 Firm Dollars d = MRSR ATC2 SR ATC1d = MR A d1 = MR1 D2 D1 Output per Q1 QSR Q2 Period Lieberman & Hall; Introduction to Economics, 2005 q1 q1 q1 Output per Period 42 Increasing, Decreasing, and Constant Cost Industries Increase in demand for inputs causes price of those inputs to rise  This type of industry (which is the most common) is called an increasing cost industry   Entry causes input prices to rise • Shifts up typical firm’s ATC curve  Raises market price at which firms earn zero economic profit  As a result, long-run supply curve slopes upward Lieberman & Hall; Introduction to Economics, 2005 43 Increasing, Decreasing, and Constant Cost Industries  Other possibilities  Industry might use such a small percentage of total inputs that— even as new firms enter—there is no noticeable effect on input prices • Called a constant cost industry  Entry has no effect on input prices, so typical firm’s ATC curve stays put  Market price at which firms earn zero economic profit does not change  Long-run supply curve is horizontal  Decreasing cost industry, in which entry by new firms actually decreases input prices • Entry causes input prices to fall  Causes typical firm’s ATC curve to shift downward  Lowers market price at which firms earn zero economic profit  As a result, long-run supply curve slopes downward Lieberman & Hall; Introduction to Economics, 2005 44 Market Signals and the Economy     In real world, demand curves for different goods and services are constantly shifting As demand increases or decreases in a market, prices change Economy is driven to produce whatever collection of goods consumers prefer In a market economy, price changes act as market signals, ensuring that pattern of production matches pattern of consumer demands  When demand increases, a rise in price signals firms to enter  market, increasing industry output When demand decreases, a fall in price signals firms to exit market, decreasing industry output Lieberman & Hall; Introduction to Economics, 2005 45 Market Signals and the Economy  Market signal  Price changes that cause firms to change their production to more closely match consumer demand  No single person or government agency directs this process  This is what Adam Smith meant when he suggested that individual decision makers act for the overall benefit of society • Even though, as individuals, they are merely trying to satisfy their • own desires As if guided by an invisible hand Lieberman & Hall; Introduction to Economics, 2005 46 [...]... Maximization in Perfect Competition Dollars TR $2,800 TC Maximum Profit per Day = $700 2,100 550 Slope = 400 1 2 Lieberman & Hall; Introduction to Economics, 2005 3 4 5 6 7 8 9 10 Ounces of Gold per Day 14 Figure 2(b): Profit Maximization in Perfect Competition Dollars MC $400 D = MR 1 2 Lieberman & Hall; Introduction to Economics, 2005 3 4 5 6 7 8 9 10 Ounces of Gold per Day 15 The Total Revenue and Total Cost... viewing firm’s search for the profit-maximizing output level  At each output level, subtract total cost from total revenue to get total profit at that output level  Total Profit = TR - TC Lieberman & Hall; Introduction to Economics, 2005 16 The Marginal Revenue and Marginal Cost Approach Firm should continue to increase output as long as marginal revenue > marginal cost  Remember that profit-maximizing... axis Lieberman & Hall; Introduction to Economics, 2005 23 Competitive Markets in the Short- Run  Short-run is a time period too short for firm to vary all of its inputs  Quantity of at least one input remains fixed  Let’s extend concept of short-run from firm to market as a whole  Conclusion  In short-run, number of firms in industry is fixed Lieberman & Hall; Introduction to Economics, 2005 24... exits Requires market supply curve to shift rightward enough, and the price to fall enough • So that each existing firm is earning zero economic profit In a competitive market, positive economic profit continues to attract new entrants until economic profit is reduced to zero Lieberman & Hall; Introduction to Economics, 2005 31 Figure 8(a/b): From Short-Run Profit To Long-Run Equilibrium Market Firm... of firms in market Lieberman & Hall; Introduction to Economics, 2005 25 Short-Run Equilibrium  How does a perfectly competitive market achieve equilibrium?  In perfect competition, market sums buying and selling preferences of individual consumers and producers, and determines market price • Each buyer and seller then takes market price as given   Each is able to buy or sell desired quantity Competitive... Competitive firms can earn an economic profit or suffer an economic loss Lieberman & Hall; Introduction to Economics, 2005 26 Figure 6: Perfect Competition Individual Demand Curve Quantity Demanded at Different Prices Quantity Supplied at Different Prices Added together Market Demand Curve Individual Supply Curve Added together Quantity Demanded by All Consumers at Different Prices Quantity Supplied by All... supply curve will shift rightward causing several things to happen  Market price begins to fall  As market price falls, demand curve facing each firm shifts downward  Each firm—striving as always to maximize profit—will slide down its marginal cost curve, decreasing output Lieberman & Hall; Introduction to Economics, 2005 30 From Short-Run Profit to Long-Run Equilibrium  This process of adjustment—in... from the price, across to the firm’s MC curve, and then down to the horizontal axis, or  As price of output changes, firm will slide along its MC curve in deciding how much to produce  Exception  If the firm is suffering a loss large enough to justify shutting down • It will not produce along its MC curve • It will produce zero units instead Lieberman & Hall; Introduction to Economics, 2005 21 Figure... noticeable difference in market quantity supplied • So cannot affect market price Lieberman & Hall; Introduction to Economics, 2005 11 The Demand Curve Facing a Perfectly Competitive Firm  Means Small Time has no control over the price of its output  Simply accepts market price as given • In perfect competition, firm is a price taker   Treats the price of its output as given and beyond its control... an existing firm adds a new product to its line Exit can occur in different ways  Firm may go out of business entirely, selling off its assets and  freeing itself once and for all from all costs Firm switches out of a particular product line, even as it continues to produce other things Lieberman & Hall; Introduction to Economics, 2005 29 From Short-Run Profit to Long-Run Equilibrium  As we enter