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Chapter 9: Perfect Competition
•Thus far we have examined how the consumer and firm attempt to optimize their decisions
•The results of this optimization depend on the set-up of the economy
•In this course we will examine the extreme set-ups: Perfect Competition and Monopoly
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Chapter 9: Perfect CompetitionIn this chapter we will cover:
9.1 Perfect Competition Characteristics9.2 Economic and Accounting Profit9.3 PC Profit Maximization9.4 PC Short Run Supply and Equilibrium9.5 PC Long Run Supply and Equilibrium9.6 PC Costs9.7 Economic Rent9.8 Producer Surplus
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1)Fragmented Industry-Many buyers and sellers-No one buyer or seller has an effect on the industry-Each firm and consumer is a price taker (uses market price)
2) Homogeneous products-All firms produce identical products-No quality differences, no brand loyalty
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3) Perfect Information-Buyers and sellers have full information, especially regarding prices
4) No barriers to entry or exit-No input is restricted to potential customers or firms-Any firm or customer can enter or exit the market in the long run
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As a result, we have:
• Many buyers and sellers• Buying and selling identical goods
At a given, set price.
Note: although we are examining a market for outputs, a similar analysis can apply to the market for inputs
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As seen before,
Accounting Costs = Explicit CostsEconomic Costs = Explicit Costs + Implicit
Costs
Furthermore,
Accounting Profit = Revenue – Explicit Costs
Economic Profit = Revenue – Explicit Costs - Implicit Costs
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EconomicCosts
Revenue
EconomicProfit
ImplicitCosts
ExplicitCosts
Revenue
AccountingProfit
ExplicitCosts
Economist’sView
Accountant’sView
Profit: Economists vs Accountants
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Implicit Costs are the BEST ALTERNATIVE return of ALL of an agent’s input (time, money, etc).
Alternately, an agent’s time could earn a wage elsewhere.(ie: Work at Simtech for $3000 a month)
An agent’s money both isn’t used currently and can be used elsewhere.(ie: Investing $5,000 @ 10% instead of using it to start a business gives an implicit cost of $500)
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Mikey opens up a specialized mousepad company. Spending $5,000 a month on space and supplies, Mikey makes $8,000 a month.
Alternately, Mikey could work at Donald Duckpads Inc for $1,500 a month or at a reasearch lab for $1,000 a month.
Mikey could invest in bonds at 10% return or in stocks at 2% return. Calculate accounting and economic profit
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Best alternatives: Donald Inc ($1,500) and Bonds ($500). (Since he can do both simultaneously.)
Accounting Profits = Revenue – Explicit Costs=$8,000-$5,000=$3,000
Economic Profit = Revenue – Explicit Costs - Implicit Costs
=$8,000 - $5,000 - $1,500 - $500=$1,000
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While previously we studied cost minimizing, in reality a firm is more concerned with maximizing its profits.
Total Revenue: TR(Q)=PQTotal Cost: TC(Q) as found in previous chapters
ie: TC(Q)=100+2Q
Profit =Total Revenue – Total Cost: π(Q)=TR(Q)-TC(Q)
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TC(Q) in general is derived as follows:
Originally: TC=wL+rK (1)Tangency Condition: L=f(K) (2)Production Function: Q=f(L,K) (3)(2) + (3) Q=f(L) and
L=f(Q) (4)(2) + (4) K=f(Q) (5)(1) + (4) + (5) TC=wf(Q)+rf(Q)
TC=f(Q)
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For Example:
Originally: TC=wL+rK (1)Tangency Condition: L=K (2)Production Function: Q=2(LK)1/2 (3)(2) + (3) Q=2L and
L=Q/2 (4)(2) + (4) K=Q/2 (5)(1) + (4) + (5) TC=wQ/2+rQ/2
TC=(w+r)Q/2
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Definition: Marginal revenue is the change in revenue when output changes
Marginal revenue is the slope of the total revenue curve.
Since the PC firm is a price taker, the additional revenue gained from 1 additional output is equal to P.
PQ
QTRQMR
)(
)(
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As seen previously, marginal cost changes as production increases.
If for the next unit, MR>MC, that unit should be produced, as it yields profit.
If for the last unit, MC>MR, that unit should not have been produced, as it decreases profit.
Therefore profit is maximized where MC=MR=P
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Example: Profit Maximization Condition
Total Cost, Total Revenue, Total Profit ($/yr)
q (units per year)
q (units per year)
Total revenue = pq
P, MR15
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MC
Total profit
Total Cost
6 30
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The previous curves are expressed by:
TC(q) = 242q - .9q2 + (.05/3)q3
MC(q) = 242 - 1.8q + .05q2
P = 15At profit maximizing point: 1) P = MC
But this occurs twice. At one point, profit is maximized, at another minimized. Therefore, in order to MAXIMIZE profit:
2) MC must be rising
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In the paper industry, MC=20+2Q (which is always rising), where Q=100 reams of paper. Find the cost-maximizing quantity if P=30 or P=40
Solution: P=MC30=20+2Q
5=Q
P=MC40=20+2Q
10=Q
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In the short run, the firm either produces or temporarily shuts down, thus facing costs:
STC(Q) = SFC + NSFC + TVC(q) when q > 0SFC when q = 0
SFC: Sunk Fixed costs – unavoidable sunk costsNSFC: Non-sunk Fixed costs – fixed costs that are avoidable if the firm temporarily shuts downTVC: Total Variable Costs; depends on output
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Definition: The firm’s Short run supply curve tells us how the profit maximizing output changes as the market price changes.
3 Cases:
Case 1: all fixed costs are sunkCase 2: all fixed costs are non-sunkCase 3: some fixed costs are sunk
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Case 1: all fixed costs are sunk NSFC=0 STC=TVC(q) + SFC
If the firm chooses to produce a positive output, P = SMC defines the short run supply curve of the firm. But…
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The firm will choose to produce a positive output only if:
(q) > (0) …or…Pq – TVC(q) – SFC > -SFC Pq – TVC(q) > 0 P > AVC(q)
Definition: The price below which the firm would opt to produce zero is called the shut down price, Ps. In this case, Ps is the minimum point on the AVC curve.
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Therefore, the firm’s short run supply function is defined by:
1. P=SMC, where SMC slopes upward as long as P > Ps
2. 0 where P < Ps
This means that a perfectly competitive firm may choose to operate in the short run even if economic profit is negative.
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Example: Short Run Supply Curve of the Firm, NSFC = 0
Quantity (units/yr)
$/yr
AVC
SAC
SMC
Ps
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At prices below SAC but above AVC, profits are negative if the firm produces…but the firm loses less by producing than by shutting down because of sunk costs.
Example:
STC(q) = 100 + 20q + q2
SFC = 100 (nb: this is sunk)TVC(q) = 20q + q2
AVC(q) = 20 + qSMC(q) = 20 + 2q
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a. The minimum level of AVC is the point where AVC = SMC or…
20+q = 20+2qq = 0 AVC minimized at p=20
b. The firm’s short run supply curve is, then:
P < Ps = 20: qs = 0P > Ps = 20: P = SMC
P = 20+2q qs = ½P - 10
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Case 2: all fixed costs are non-sunk
SFC=0 STC=TVC(Q)+NSFC
If the firm chooses to produce a positive output, P = SMC defines the short run supply curve of the firm. But…
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The firm will choose to produce a positive output only if:
(q) > (0) …or…
Pq – TVC(q) - NSFC > 0
P > AVC(q) + AFC(q) = SAC(q)
Now, the shut down price, Ps is the minimum of the SAC curve
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Quantity (units/yr)
$/yr
AVC
SAC
SMC
Ps
Example: Short Run Supply Curve of the Firm, All Fixed Costs Non-Sunk
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Case 3: Short Run Supply Curve(Some costs are sunk):
NSFC≠0, SFC ≠0
Average Nonsunk Cost = Average Variable Cost + Average Nonsunk Fixed Cost
ANSC=AVC + NSFC/Q
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The firm will choose to produce a positive output only if:
(q) > (0) Pq – TVC – SFC - NSFC > -SFC Pq – TVC - NSFC > 0 P > AVC + NSFC/Q = ANSC
Definition: The price below which the firm would opt to produce zero is called the shut down price, Ps. In this case, Ps is the minimum point on the ANSC curve.
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Therefore, the firm’s short run supply function is defined by:
1. P=SMC, where SMC slopes upward as long as P > Ps
2. 0 where P < Ps
This means that a perfectly competitive firm may choose to operate in the short run even if economic profit is negative.
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Example: Short Run Supply Curve of the Firm
Quantity (units/yr)
$/yr
AVC
SAC
SMC
Ps
ANSC
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If all fixed costs are sunk,(AVC=ANSC)
Shut down if P<AVC (low)
If all fixed costs are nonsunk,(ANSC=SAC)
Shut down if P<SAC (high)
If some fixed costs are sunk, some nonsunk,Shut down if P<ANSC (middle)
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A firm will produceIf
It can cover its Non-Sunk Costs
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Thus far we have seen that the individual firm’s short run supply curve comes from their marginal cost curve.
Definition: The market supply at any price is the sum of the quantities each firm supplies at that price.
The short run market supply curve is the HORIZONTAL sum of the individual firm supply curves. (Just as market demand is the HORIZONTAL sum of individual demand curves)
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Example: From Short Run Firm Supply Curve to Short Run Market Supply Curve
Q (m units/yr)q (units/yr)
$/unit $/unit
300 400 5000 0
30
242220
1.2 mill
Individual supply curvesper firm. 1000 firms of eachtype SMC3
SMC2
SMC1
Market supply
Typical firm: Market:
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Definition: A short run perfectly competitive equilibrium occurs when the market quantity demanded equals the market quantity supplied.
ni=1 qs(P) = Qd(P)
Qs(P)= Qd(P)
and qs(P) is determined by the firm's individual profit maximization condition.
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Typical firm: Market:
Example: Short Run Perfectly Competitive Equilibrium
SMCSAC
AVC
Ps
P*
Demand
Supply
$/unit $/unit
Q*q* Units/yr m. units/yr
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300 identical firms
Qd(P) = 60 – PSTC(q) = 0.1 + 150q2
SMC(q) = 300qNSFC = 0 AVC(q) = 150q
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a. Short Run Equilibrium
Profit maximization condition: P = SMC
P = 300q
qs(P) = P/300 (for each firm)Qs(P) = P (for industry)
Qs(P) = Qd(P) P = 60 – P
P*= 30q* = 30/300=.1Q* = 30
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b. Do firms make positive profits at the market equilibrium?
SAC = STC/q = .1/q + 150q
When each firm produces .1, SAC per firm is: .1/.1 + 150(.1) = 16
Therefore, P* > SAC so profits are positive.
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Comparative Statics in theShort Run
•As seen in previous chapters, the entry or exit of firms or consumers, among other things, can shift the market demand and supply curves
•Shifts in the market demand and supply curves will shift the equilibrium quantity as seen in chapters 1 and 2
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In the short run, capital is fixed and firms may temporarily operate under an economic profit or loss.
In the long run, capital can change and firms can enter and leave the market, resulting in zero economic profit.
Remember that in the long run, all costs are nonsunk (they are all avoidable at zero output)
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Just as in the short run the firm operated at:
P=SMC
In the long run the firm operates atP=MC
SMC≠MC (in general) since costs are reduced in the long run.
Only at LR profit maximization is SMC=MC (because the short run is operating at the LR optimal capital point: Point A next slide)
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In the long run, this firm has an incentive to change plant size to level K1 from K0:
P
6 q
$/unit
(000 units/yr)
SMC0 SAC0
1.8
SAC1
SMC1
MC
AC•
AA
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In the long run, a firms supply curve isThe firm’s LR MC curve above AC.
For if P>AC, Profits>0.Since Profits = (PxQ)-(ACxQ)
As in the short run, market supply is the horizontal sum of individual firm supply.
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Long Run Supply Curve:
P
6 q
$/unit
(000 units/yr)1.8
SMC1
MC
ACS
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Long Run Perfectly Competitive Equilibrium occurs when:
1)Each firm maximizes profit with regards to output and capital (P=MC)
2)Each firm’s economic profit is zero (as firms keep entering until the price is pushed down to zero profits) (P=AC)
3)Market Demand=Market Supply
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Long Run Perfectly Competitive Equilibrium
Typical Firm Market
ACMC
SAC
SMC
P*
q*=50,000 q Q
$/unit$/unit
Market demand
Q*=10M.
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•to increase production, a firm must increase inputs
•Increasing MARKET output could change costs, therefore changing equilibrium price
•A CONSTANT COST INDUSTRY is an industry where changes in output do not affect the price of inputs
•This determines the LR supply curve
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-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2, lowering price back to P1
Typical Firm Market
D1
S1
SACSMC
P1
q Q
$/unit$/unit
P2
S2
D2
LS
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•Industry-specific inputs are scarce inputs used primarily by one industry
-ie:Plutonium is only used in the nuclear industry
•Changes in production will have an impact on the market for industry-specific inputs
•An INCREASING COST INDUSTRY is an industry where increases in output increase the price of inputs
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-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2, increasing costs and lowering price to P3 (>P1)
Typical Firm Market
D1
S1
SAC1
SMC1
P1
q Q
$/unit$/unit
P2
P3
SAC3
SMC3
S2
D2
LS
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•Some industries require a small amount of an expensive input
-ie: Blue Ray CD Drive
•An increase in input demand may drive down input prices by reducing input AC
•A DECREASING COST INDUSTRY is an industry where increases in output decrease the price of inputs
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-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2, decreasing costs and lowering price to P3 (<P1)
Typical Firm Market
D1
S1
SAC1
SMC1
P1
q Q
$/unit$/unit
P2
P3
SAC3
SMC3
S2
D2
LS
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Although economic profit is possible in the short run,
In the long run the entry of firms will push economic profit to zero
This entry could increase, decrease, or not change the
equilibrium price.
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• In general, we assume that all workers are identical.
• In reality, some workers are masters; they are more productive than their peers.
• The cost savings of a master worker is their ECONOMIC RENT
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Joe is an amazing worker that works in a button factory. While most workers can only press one or two buttons at a time,
Joe can press a dozen.
A normal worker produces buttons at an average cost of 5 cents, but Joe can
make buttons at an average cost of 1 cent each. If Joe produced buttons at a cost of 5 cents each, he’d be hired to
produce 900 a day.
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Economic Rent = Cost SavingsER = (0.05-0.01)900
ER = $36
The economic rent from a master worker (Joe) is $36 a day.
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• If a firm is able to employ a master worker at a normal worker’s wage, that worker’s economic rent becomes the firm’s economic profit
• In a perfectly competitive industry, in all likelihood a master worker will be stolen by other firms at higher wages until his wage matches his productivity
• Master workers therefore often provide no profit in perfect competition
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Definition: Producer Surplus is the area above the supply curve and below the price. It is a monetary measure of the benefit that producers derive from producing a good at a particular price.
Note that the producer earns the price for every unit sold, but only incurs the SMC for each unit. This is why the difference between the P and SMC curve measures the total benefit derived from production.
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Producer Surplus, Individual Firm
Quantity (units/yr)
$/yr
ANSC
SMC
PProducerSurplus
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Further, since the market supply curve is simply the sum of the individual supply curves…which equal the marginal cost curves…the difference between price and the market supply curve measures the surplus of all producers in the market.
Note that producer’s surplus does not deduct fixed costs, so it does not equal profit!
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Market Producer Surplus
Q
P
Market Supply Curve
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Producer Surplus = (1/2)BHPS=(1/2)800(40)PS=16,000
10
800
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Producer surplus is the difference between total revenue and total nonsunk costs;
Producer Surplus=TR-NSFC-TVC
In the short run, if Producer Surplus>SFC, economic profit is
possible.
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In the long run, no costs are fixed,
Therefore Producer Surplus = Economic Profit
BUT
In the long run, Economic Profit=0
How?
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An industry has an upward sloping supply if it employs scarce resources (increasing cost industry – master growers)
Producer Surplus is therefore the economic rent captured by the master worker or owner of the input
In the LR PC: Producer Surplus=Economic Rent
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Long Run Producer Surplus = Economic Rent
Q
P
LS
50
10
800
D
EconomicRent
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Chapter 9 Key ConceptsPerfect competition features:
Many buyers and sellersHomogeneous productsPerfect InformationNo Barriers to Entry
Perfect competition results in a single, equilibrium price that no one consumer or firm can influenceEconomists include implicit costs in their economic profits (Accountants do not)
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Chapter 9 Key ConceptsTotal cost (TC) depends on total output (Q)Marginal revenue is the change in total revenue from one additional output (Q)A firm will produce where MR=MCA firm’s supply curve is its MC curve above its shut-down point
A firm will operate if it can cover its variable costsIn the SR, this could cause a loss
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Chapter 9 Key ConceptsIn the LR, costs can vary with the entry of firms
This can affect equilibrium priceSkilled workers produce economic rent, which is often captured by higher wagesProducer Surplus is the area between price and the supply curve
This is before fixed costsIn the long run, Producer Surplus is captures by skilled workersEconomics > Accounting
