ECA III – THE PRICE SYSTEM

LECTURE: VPERFECT COMPETITION

I. GENERAL INTRODUCTION

A. Market Structure Theory1. When the theory of “Micro Economics” was

originally introduced (1881) there were only two alternative positions for a firm:• Perfect Competition• Monopoly

2. These Market Structures Theoretical &/or Philosophical counterparts

3. If fairness reigned, the market was “Good” & hence competitive (Perfectly)

I. GENERAL INTRODUCTION

According to general precepts of our economic system {Capitalism}, the most efficient allocation of scarce resources is the Perfectly {Unrestricted – Governmentally; Geographically} Competitive Market.

4. If these (above) conditions were not met; the market would be Imperfect (& therefore at the time) Monopolistic, i.e. “BAD”– There are definite political & indeed physichological overtones

(i.e. Control) present

I. GENERAL INTRODUCTION

5. At that time, from a purely economical perspective, the distinction between the two markets was the # of firms– Perfect Competition : ∞– Monopoly : 1

6. As time progressed markets developed beyond these two markets.• Early 1900’s: Oligopoly• 1930’s: Monopolistic Competition

7. Once these markets evolved. It became problematic to try and distinguish all of these new markets from those already established

I. GENERAL INTRODUCTION

Perfect Competition

Monopolistic Competition Oligopoly Monopolistic

Competition

∞ 6 – [∞-1] 2 or 3 - 5 1

HomogeneousHomogeneous

↓Heterogeneous

Heterogeneous↓

HomogeneousHeterogeneous

Number of Firms

Nature of Product

Perfectly Competitive

Perfectly Non -

CompetitiveImperfect Competition

II. BASIC MODEL OF THE FIRM (REV. & COST)

A. Motivations for the firm– Profit– Stock Price Maximization– “Green”• Environmentally Friendly• Produce Products to help other firms (Air Filters; Sewage

Treatment Plants)

– Social Conscience– Maximize Market Share (Product Markets)

B. Here, we focus on Profit Vs Accounting Profit

II. BASIC MODEL OF THE FIRM (REV. & COST)

C. Economic Profit Vs Accounting Profit– Economic Cost: Value of all resources used in

production (Opportunity Cost)– Explicit Cost: Out of pocket cost (Specific Payment)– Implicit Cost: Foregone Opportunities– Economic Profit: (Total Rev.) – (Total Economic Cost)

Example Total Revenue Merchandise Sold

- Explicit Costs Wages

Rent

Taxes

Accounting Profit

- Implicit Costs Owners Wages (ie. % of Profit), Act. Yield

Economic Profit

II. BASIC MODEL OF THE FIRM (REV. & COST)

Profit Maximization

1. Total Revenue (TR) = Price x Quantity

2. Average Revenue (AR) =Total Revenue

Output Quantity

3. Marginal Revenue (MR) =Change in Total Revenue

Change in Quantity

4. Marginal Cost (MC) =Change in Total Cost

Change in Quanity

Relative Positions:

MR > MC → ↑ Output

MR < MC → ↓ Output

MR = MC → Equilibrium

Graphically General Model

II. BASIC MODEL OF THE FIRM (REV. & COST)

MC

AC

Demand = Average Revenue

OutputMarginal RevenueO

C

AR

E

T

Q

II. BASIC MODEL OF THE FIRM (REV. & COST)

Total Revenue: OQRATotal Cost: OQTC

Abnormality or Economic Profit: Because AR > AC at Equilibrium & is specifically determined

∏ = TR – TC∏ = OQRA - OQTC∏ = CTRA

A. Basic Logic1. Demand establishes Revenues (TR = P X Q)2. Production & Cost establish Supply3. Profit Maximization at

MARGINAL REVENUE = MARGINAL COST

B. Assumptions1. Markets are unrestricted (i.e. Open Exit & Open Entry)2. Infinite number of Buyers & Sellers3. Homogeneous Product4. Free Mobility of Factors5. Perfect Price Knowledge

II. PERFECT COMPETITION

C. Equilibrium (Short Run) [Price Takers]

II. PERFECT COMPETITION

Equilibrium Output: oq*Equilibrium Price: op*

Equilibrium Profits: ∏ = TR - TC

D. Conclusions:1. Demand Curve for the firm is Infinitely Elastic

(i.e. Flat) at The Market Price (p*)A. Firms are called Price TakersB. The only decision they make is what quantity to

produce at p*C. If the firm ↑ P : No SalesD. If the firm ↓ P : Needless loss of Revenues

II. PERFECT COMPETITION

2. Three (Statistically) possible S/T Alternatives

II. PERFECT COMPETITION

MC

AC

O

P*

q* q

P

AR=MR

Normal Profits: AR = AC

Profit Earned(What Kind?)(Where?)

II. PERFECT COMPETITION

Any attempt by the Firm to lower costs will be copied immediately, so that there is no advantage to do it in the first place.

MC

AC

O

P*

q* q

P

AR=MR

Abnormal: AR > AC(Economic)

Profit Earned(Not Possible)(Why Not?)

3. The two decisions that the firm must make– How much to produce @ P*?– Shut Down or Stay Open?

4. On the surface it appears that if the firm is incurring a loss, it should always & immediately shut down, not necessarily true.

II. PERFECT COMPETITIONMC

AC

O

P*

q* q

P

AR=MR

Loss Incurred

Loss

E

5. Total Costs = Fixed Cost + Variable Costs– Variable costs = F (Output)

VC = O Output = O– Fixed Costs = F (Time)

Even if Output = O FC = “+” (Must be paid, even if output=O

6. Therefore, a perfectly competitive firm will continue to produce, even if there is a loss, as long as The Operating Loss < The shutdown Loss.

7. This usually occurs at TR > TVC Price←Average Revenue > Average Variable CostorTotal Revenue > Total Variable Cost

II. PERFECT COMPETITION

E. Equilibrium (Long Run) 3 Possibilities – Constant/Increasing/Decreasing

II. PERFECT COMPETITION

1. CONSTANT COSTS

A. Start at equilibrium (S/T) [E1 & e1]At Q1 (Industry) q1 (Firm) chargingP1 (for both the industry and the firm)

B. Something happens to the change (↑) Demands (into L/T) and D1 shifts to D2, resulting in new equilibrium point (at E2 & e2)Price has increased (P1 to P2), therefore the firms demand curve ↑s to D2 = AR2 & the firms equilibrium point is now at e2 (at q2 and P2)

C. This results in abnormal profit because AR > AC at P2,q2. This causes more firms to enter the market and supply curve shifts to S2.

II. PERFECT COMPETITION

D. This results in a new equilibrium point at E3 (at Q3, P1)

E. Abnormal Profits have been eliminated and system reestablishes equilibrium at e1 (for the firm)Q: If the firms quantity ends at q1, how is it possible for the industry to be producing at Q3?

Conclusion: For perfect competition (L/T) with constant costIf demand ↑ with constant costs, P ↑ and then returns to its original

level

II. PERFECT COMPETITION

II. PERFECT COMPETITION

2. INCREASING COSTS

A. Start at equilibrium (S/T) (at e,E1)Q: What is original output and price for industry and firm?

B. Demand into L/T ↑’s (D1 → D2) intersecting original supply curve at E2. This causes an increase in the market price which is carried over to each firm.

C. The firm is now earning abnormal (or economic) profits, which causes more firms to enter the industry

D. Since more firms are entering the industry this causes two things to occur simultaneously.

1. Since Factors are limited, this causes a “Bidding War” which increases the firms cost(AC1 → AC2 & MC1 → MC2)

II. PERFECT COMPETITION

2. This causes the market supply curve to shift to S2

3. L/T Equilibrium is reestablished at (e3,E3)

4. S* represents the L/T Market supply curve for increasing cost industries

Conclusion: Perfect Competition (L/T) with the increasing cost.As Demand in the ling term increases (with increasing cost industries), Price ↑&↓ but not to its original level.

II. PERFECT COMPETITION