Chapter 9 - Profit maximization in perfectly competitive markets. In this chapter students will be able to: Outline the conditions that characterize perfect competition, explain why it is appropriate to assume profit maximization on the part of firms, show why the fact that a competitive firm is a price taker implies that the demand curve for the firm is perfectly horizontal,...
Prepared by Dr. Della Lee Sue, Marist College MICROECONOMICS: Theory & Applications Chapter 9: Profit Maximization in Perfectly Competitive Markets By Edgar K. Browning & Mark A. Zupan John Wiley & Sons, Inc 12th Edition, Copyright 2015 Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Learning Objectives Outline the conditions that characterize perfect competition Explain why it is appropriate to assume profit maximization on the part of firms Show why the fact that a competitive firm is a price taker implies that the demand curve for the firm is perfectly horizontal Explain a competitive firm’s optimal output choice in the short run and how the firm’s shortrun supply curve may be derived through this output selection Describe the firm’s shortrun supply curve (continued) Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Learning Objectives (continued) Explain how the shortrun industry supply curve is derived Define the conditions characterizing longrun competitive equilibrium Understand how the longrun industry supply curve describes the relationship between price and industry output over the long run, taking into account how input prices may be affected by an industry’s expansion/contraction Analyze the extent to which the competitive market model applies Delineate the mathematics behind perfect competition Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Outline the conditions that characterize perfect competition 9.1 THE ASSUMPTIONS OF PERFECT COMPETITION Copyright © 2015 John Wiley & Sons, Inc. All rights reserved The Assumptions of Perfect Competition Large numbers of buyers and sellers Free entry and exit Product Homogeneity Perfect information Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Explain why it is appropriate to assume profit maximization on the part of firms 9.2 PROFIT MAXIMIZATION Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Profit Maximization Assumption: firms select an output level so as to maximize profit, defined as the difference between revenue and cost “Survivor Principle” – the observation that in competitive markets, firms that do not approximate profitmaximizing behavior fail, and that survivors are those firms that, intentionally or not, make the appropriate profitmaximizing decisions Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Show why the fact that a competitive firm is a price taker implies that the demand curve for the firm is perfectly horizontal 9.3 THE DEMAND CURVE FOR A COMPETITIVE FIRM Copyright © 2015 John Wiley & Sons, Inc. All rights reserved The Demand Curve for a Competitive Firm Price taker – a firm that takes prices as given and does not expect its output decisions to affect price =>horizontal demand curve Total revenue (TR) – price times the quantity sold Average revenue (AR) – total revenue divided by output Marginal revenue (MR) – the change in total revenue when there is a oneunit change in output Copyright © 2015 John Wiley & Sons, Inc. All rights reserved Figure 9.1 The Competitive Firm’s Demand Curve Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 10 Figure 9.9 – LongRun Competitive Equilibrium Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 31 Zero Profit When Firms’ Cost Curves Differ? When all firms in a competitive industry have identical cost curves, each firm earns zero economic profit in longrun equilibrium What happens if cost curves differ among firms? There is a tendency for factor inputs to receive compensation equal to their opportunity costs. This process leads to the zeroprofit equilibrium Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 32 Understand how the longrun industry supply curve describes the relationship between price and industry output over the long run, taking into account how input prices may be affected by an industry’s expansion/contraction 9.8 THE LONGRUN INDUSTRY SUPPLY CURVE Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 33 The LongRun Industry Supply Curve The longrun relationship between price and industry output It depends on whether input prices are constant, increasing, or decreasing as the industry expands or contracts Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 34 The LongRun Industry Supply Curve [Three Classifications] Constantcost industry: an industry in which expansion of output does not bid up input prices longrun average production cost per unit remains unchanged, and the longrun industry supply curve is horizontal Increasingcost industry: an industry in which expansion of output leads to higher longrun average production costs the longrun industry supply curve slopes upward Decreasingcost industry: an industry in which the longrun industry supply curve slopes downward Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 35 Figure 9.10 – LongRun Supply in a ConstantCost Industry Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 36 Figure 9.11 – LongRun Supply in an IncreasingCost Industry Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 37 Figure 9.12 – Technological Advances Shift the LongRun Supply Curve Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 38 Comments on the LongRun Supply Curve The longrun supply curve is not derived by summing the longrun marginal cost curves of an industry’s firms A movement along the longrun industry supply curve is accompanied with the assumptions that conditions of supply remain constant, such as: Technology conditions of input supply factors government regulations weather conditions (continued) Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 39 Comments on the LongRun Supply Curve (continued) Although the industry may never attain a longrun equilibrium in reality, what is important is that there is a tendency for the industry to move in the direction indicated by the theory Economic profit is zero along a competitive industry’s long run supply curve In reality, the process of adjustment from a shortrun equilibrium to a longrun equilibrium may vary from the theoretical description Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 40 Analyze the extent to which the competitive market model applies 9.9 WHEN DOES THE COMPETITIVE MODEL APPLY? Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 41 When Does the Competitive Model Apply? The assumptions of perfect competition are stringent and are likely to be satisfied fully in very few realworld markets However, many market come close enough to satisfying the assumptions of perfect competition to make the model useful And it is useful to assess the effect of deviations from the assumptions in a realworld market Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 42 Delineate the mathematics behind perfect competition 9.10 THE MATHEMATICS BEHIND PERFECT COMPETITION* *Denotes digitalonly content Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 43 The Mathematics Behind Perfect Competition Firstorder condition for finding the profitmaximizing output level: MC = P0 Secondorder condition: The slope of the marginal cost curve must be positive NOTE: Price is constant No distinction is made between longrun and shortrun profit maximization Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 44 The Mathematics Behind Perfect Competition Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 45 ... Show why the fact that a competitive firm is a price taker implies that the demand curve for the firm is perfectly horizontal 9. 3 THE DEMAND CURVE FOR A COMPETITIVE FIRM Copyright © 2015 John Wiley & Sons, Inc. All rights reserved The Demand Curve for a Competitive Firm... Market price and output: determined by interaction between shortrun industry supply curve and the market demand curve Copyright © 2015 John Wiley & Sons, Inc. All rights reserved 25 Figure 9. 7 The ShortRun Competitive ... TR rises in proportion to output since the price is constant TC rises slowly at first and then more rapidly as the plant facility becomes more fully utilized and MC rises Total profit tends to increase and then decrease as more is produced