Chapter 3

Perfect Competition

Outline. Firms in perfectly competitive markets

The Short-Run Condition for Profit Maximisation

Adjustments in the long run

Applying the Perfect Competitive Model

The goal of profit maximisation Firms' main objective is to maximise profit.

This assumption is not specific to perfect competition: it is made whatever the type of market structure that is considered

Economic profit is defined as the difference between total revenues and total costs. Total costs include opportunity and implicit costs.

Example A firm produces 100 units of output per week using 10 units of capital and 10 units of labour. The capital belongs to the firm. The weekly price of each factor is 10$ per unit and output sells for 2,5$ per unit.

Total revenue per week is 250$. Total cost is 100$ spent on labour (explicit cost) + 100$

spent on capital (opportunity cost) Economic profit is 250 – 200 = 50$

The goal of profit maximisation (ctd) If the opportunity cost of the resources

owned by the firm are considered as generating a normal profit, the economic profit is the profit in excess to this normal profit

Economists assume that the goal of firms is to maximise profit . Simplifying assumption

Numerous challenges

Idea: firms do their best to maximse profit

The four conditions for perfect competition Four conditions

1. Firms sell a standardised product 2. Firms are price-takers: every individual firm

considers the market price as given 3. Factors of production are perfectly mobile in

the long run4. Firms and consumers have perfect

information

Do they make sense? In most cases, strictly speaking: NO But can tell us something

Outline. The Short-Run Condition for Profit

Maximisation

Adjustments in the long run

Applying the Perfect Competitive Model

Maximising profit in the short run Example: Assume that a firm is characterised by

the short-run total cost curve we saw in Chapter 2. This firm experiences first increasing and then

decreasing returns to is variable input. Assume that it can sell its product at a price P0 =

18$/unit.

One characteristic of the competitive firm is that it considers the market price as given . So, the total revenue of the firm is given by:

TR = P0.Q

The profit of the firm is given by:

P = TR – TC

Maximising profit in the short run (ctd1)

The firm's problem is to maximise profit P = TR – TC = P0.Q - TC

First-order condition:

Second-order condition:

dQ

dTCP

dQ

d 0

MCP 0

002

2

2

2

dQ

dMC

dQ

TCd

dQ

d

0dQ

dMC

Maximising profit in the short run (ctd2) The firm maximises its profit when choosing a level of

production such that its marginal revenue is strictly equal to its marginal cost

0

0 PdQ

QdP

dQ

dTRMR

The shut-down condition

The market price must exceed the minimum value of the average variable cost. Otherwise the firm will do better, in the short-run, if shutting down .

Under perfect competition, the average revenue is:

If P0 is lower than the minimum of the average variable cost curve, losses are minimum if the firm shuts down

0

0 PQ

QP

Q

TRAR

The shut-down condition (ctd1)

The shut-down condition (ctd2) The 2 rules :

(i) price equals marginal cost on the rising portion of the marginal cost curve and

(ii) price must exceed the minimum value of the average variable cost curve

define the short-run supply curve of the perfectly competitive firm.

Note that

For P below the minimum of the AVC, the firm will supply 0 output

For P between the minimum of the AVC and the minimum of the ATC, the firm will provide positive output

In this range of prices, the firm will lose money (make negative profits) because

(P – ATC).Q = P < 0

But covers its variable costs and even makes some money on top of it:

(P – AVC).Q > 0

The short-run competitive industry supply For any given level of price, it is the sum

of the amounts that firms are willing to supply at this price.

When firms are identical: If each firm has a supply curve Qi = a + b.P If there are n firms in the industry

The total industry supply is just: Q = n Qi = n.a + n.b.P

The short-run competitive industry supply (ctd) For an industry composed of 2 firms:

The short-run competitive equilibrium

Positive Profits

The short-run competitive equilibrium Negative profits

Efficiency of the short-run competitive equilibrium Competitive markets result in allocative

efficiency, i.e. they fully exploit the possibilities for mutual gains through exchange

The producer surplus

The firm's gain compared with the alternative of producing nothing () is:

= (P – ATC).Q* - (-FC)

Producer surplus:

[P – (ATC – FC/Q*)].Q* = [P – AVC].Q*

because AVC = ATC – FC/Q

It is the difference between what the firm actually gets (P.Q*) and the minimum it was requiring to supply a positive output (AVC.Q*)

The producer surplus (ctd)

The aggregate producer surplus on the market

Outline. Adjustments in the long run

Applying the Perfect Competitive Model

The long-run market equilibrium In the long run, all inputs are variable so that a

firm will choose to go out of business if it cannot earn a "normal" profit in its current industry

In the long run

If firms in an industry make positive economic profits, other firms are going to enter this industry. This will drive the market price down because supply is going to increase.

If firms make negative profits, the opposite movement will take place.

The long-run market equilibrium (ctd)

Allocative Efficiency This long-run market equilibrium has a

number of nice efficiency properties:

The equilibrium price is equal to the long-run and short-run marginal cost so that all possibilities for mutually beneficial trade are exhausted.

All producers earn only a normal rate of profit.

All these properties define what is called allocative efficiency.

The long-run competitive industry supply curve With U-shaped LAC curves

Changing input prices and long-run supply So far, we have assumed that input prices did not

vary with the amount of output produced

However, for a number of very large industries, the amount of inputs purchased constitutes a substantial share of the market

When this happens, the price of inputs increases as output rises. This generates a pecuniary diseconomy.

In this case, the long-run curve is upward sloping even if individual LAC curves are U-shaped

These are called increasing cost industries

Increasing cost industries

Decreasing cost industries In some cases, an increase in the volume

of output may reduce the price of inputs.

This is the case if the increase in the demand for the input creates an incentive for innovation resulting in lower production costs for those inputs (e.g. computers).

In this case there is a pecuniary economy and the long-run industry supply curve is downward sloping.

These are called decreasing cost industries.

The elasticity of supply The price elasticity of supply is the percentage

change in supply in response to a given change in

prices P/P

Q/Q

Q

P

P

Qs

The elasticity of supply (ctd) So, it can be re-written as:

In the short-run the supply curve is upward sloping so that the elasticity of supply will be positive.

For industries with a long-run horizontal supply curve, the elasticity is infinite.

Q

P

Slopes 1

Outline. Applying the Perfect Competitive Model

The perfect competitive model: to what extent is it useful (useless)? No industries strictly satisfy the 4

conditions of perfect competition

Still, it may be a useful tool, in particular because its long-run properties apply in a large number of industries

Example:decrease in the number of small family farms which are increasingly replaced by large corporate ones.

Corporate and Family Farms

Price support policies In this particular case, resource mobility is

far from being perfect.

Many farmers are strongly attached to their land

Programs supporting the price of agricultural products

These programs have failed miserably

The failure of price support programs

Changes in the EC policy As a way of protecting the long-term viability of

family farms the agricultural price support could not have been more ill-conceived. More efficient ways to aid family farmers would have

been a reduction in income taxes or even, more directly, cash grants.

This is actually what the European Commission has realised recently.

"Severing the link between subsidies and production (usually termed decoupling’) will enable EU farmers to be more market-orientated. They will be free to produce according to what is most profitable for them while still enjoying a required stability of income".