Chapter 8: Competitive Firms and Markets

• We learned firms’ production and cost functions.

• In this chapter, we study how firms use those information to reach the most efficient outcome and how market equilibrium is determined.

What is competition?

• Economists are concerned with the intensity of competition in market because of its effect on the equilibrium.

• Various types of market structure:

• Market is “perfectly competitive” when each firm in the market is a “price-taker,” i.e., nobody can affect the equilibrium price.

Perfect competition

Monopoly/ Monopsony

Oligopoly/ Oligopsony

• A firm in a competitive market faces a horizontal demand curve.– The firm’s action does not influence the price.

DfirmA

q

P

P

S’firmA

0

Firm level

Q

P

P*

Smarket

0

Market level

Dmarket

S’’firmA

• Factors that make markets perfectly competitive:– Identical products– Free entry and exit– Both buyers and sellers know the prices– Low transaction costs (costs of search, negotiation,

monitoring, and enforcement)

• Examples: wheat market, stock exchange

• Perfect competition is the extreme case, but is useful to consider the various real-world market structures.

• A firm’s profit function:

• The firm maximizes its profit by choosing q.

• The maximum profit is obtained at q where the distance between revenue and cost curves are the greatest. This occurs when their slopes are equal, i.e., the optimum condition is:

Profit Maximization

( ) ( ) ( ) ( )q R q C q pq C q

( ) ( )dR q dC qp MC

dq dq

Competition in the SR

• Two-step decision– Optimum condition:– Shutdown option:(better shut down if profit is

less than the loss from FC)

• Thus, SR firm supply curve is MC above AVC.• What happens to optimum production level

– if the price of output increases?– If the price of inputs increase?

( )p MC q

FC

pq VC FC FC

pq VC or p AVC

SR Shut-down Decision

SR Supply Curve

When factor prices change…

• SR market supply is the horizontal sum of firm’s supply curves:

• SR competitive market equilibrium:

Dmarket(p) = Smarket(p)

( ) ( ) 1,2,...,iS p S p i n

With 5 identical firms

With 2 different firms

SR Market Equilibrium(5 identical firms)

With different firmsP

q

MC

P P

q q

Firm A Firm B Firm C

AVC

AVCAVC

MC MC

P*

AC

q’

AC

q’

SR Profit Maximization• In SR, a firm’s profit function is:

• Optimum condition:

Value of Marginal Product = Factor Price

( ) ( ) ( )

( , )

q R q C q

pf L K wL rK

( ) ( )

( , )L

dR q dC q

dq dq

df L Kp w or pMP w

dL

Competition in LR

• In LR, no fixed factor, so only the optimal condition matters.

• LR firm supply curve is MC above AC as:

• LR supply curve is more elastic than SR supply curve as fixed factor can be replaced in LR.

( )( ) ( ) 0

C qR q C q p AC

q

• LR market supply curve is the horizontal sum of firm supply as in SR.

• LR market supply curve is horizontal if:– Free entry and exit of firms– All firms have identical costs– Constant input prices

If all conditions hold

Free entry & exit, identical firms,but increasing-cost market:

Free entry & exit, identical firms, but decreasing-cost market

LR market supply with trade• An importing country’s supply is the sum of its

own + import supply curves.• Residual supply curve:

– The quantity that the market supplies that is not consumed by other demanders at any given price.

( ) ( ) ( )r oS p S p D p

Cf) Similar concept:

• Residual Demand Curve: the market demand that is not met by other sellers at any given price. Dr(p) = D(p) – So(p)

LR Competitive Equilibrium

Zero Profits for Competitive firms in LR

• Zero economic profits in LR under three assumptions because all firms operate at their minimum LRAC.

• Positive profits exist even in LR when some inputs are scarce fixed factors at industry level (not firm level as in SR), e.g., superior oil well, fertile land, and exceptional management ability.

• These are called economic rents and positive profits are returns to these factors.

• If we consider these rents as costs, then there is no profit in the LR.

Economic Rent

LR Profit Maximization

• In LR, a firm’s profit function is:

• Optimum condition: MPV = factor price

• Solution to the above leads to factor demand functions:

( ) ( , )q pf L K wL rK

( , )

( , )

L

K

df L Kp w or pMP w

dLdf L Kp r or pMP r

dK

L K

w rp

MP MP

* *( , , ) ( , , )L L p w r and K K p w r