Market: Perfect Competition
Agenda for discussion
Market structure Perfect Competition Market Demand and Market Supply The Competitive Firms Demand Curve Equilibrium of the industry in the perfect competition Equilibrium of the firm: Profit Maximization The Shutdown Point
Market structure
The characteristics of a market that influence how trading takes place
1. How many buyers and sellers? 2. Products: standardized or significantly different? 3. Barriers to entry/exit ?
Market structure
Types of markets
Perfect competition Monopoly Monopolistic competition Oligopoly
Perfect Competition: Characteristics
Many buyers and sellers
no individual decision maker can significantly affect the price of the product
Standardized product
buyers do not perceive differences between the products
Sellers can easily enter/exit the market
no significant barriers to discourage new entrants
Perfect Competition: Characteristics
Each firm attempts to maximize profits Each firm is a price taker
its actions have no effect on the market price
Information is perfect Transactions are costless
Market Demand curve of the Industry
To derive the market demand curve, we sum the quantities demanded at every price
px Individual 1s demand curve px Individual 2s demand curve px Market demand curve
px*
x1
x1*
x2 x
x2*
X x
X*
x1* + x2* = X*
Market Supply Curve of the industry
To derive the market supply curve, we sum the quantities supplied at every price
P Firm As supply curve sA P sB P Firm Bs supply curve Market supply curve S
P1
q1A
quantity
q1B
quantity
Q1
Quantity
q1A + q1B = Q1
Equilibrium of Industry under perfect competition
Sl. No. Price ( in Rs.) Market Market Supply Demand (Pen) = total (Pen) = total of of individual individual demand demand 2500 2400 2200 400 500 600 Equilibrium Or Disequilibrium
1 2 3
5 10 15
Disequilibrium Disequilibrium Disequilibrium
4
5 6 7
20
25 30 35
2000
1800 1500 1200
1000
1300 1500 1800
Disequilibrium
Disequilibrium Equilibrium Disequilibrium
8
9 10 11 12
40
45 50 55 60
1000
800 500 400 100
2000
2500 2800 3000 3500
Disequilibrium
Disequilibrium Disequilibrium Disequilibrium Disequilibrium
Perfect Competition
Individual Demand Curve Quantity Demanded at Different Prices Quantity Supplied at Different Prices Individual Supply Curve
Added together Market Demand Curve Quantity Demanded by All Consumers at Different Prices
Added together Quantity Supplied by All Firms at Different Prices Market Supply Curve
Market Equilibrium
P S D
Quantity Demanded by Each Consumer
Quantity Supplied by Each Firm
Equilibrium of the firm: Break even point Total Cost and Total Revenue
Total Revenue
Total Cost
The amount that the firm receives for the sale of its output. The amount that the firm pays to buy inputs.
Profit is the firms total revenue minus its total cost.
Profit = Total revenue - Total cost
Equilibrium of the firm: Break even point Total Cost and Total Revenue
Quantity Price Total Revenue 400 800 1200 1600 2000 Total Cost Break even point
1 2 3 4 5
400 400 400 400 400
550 1000 1200 1500 1700 Break even point
6
7 8
400
400 400
2400
2800 3200
1850
1950 2500 Maximum Profit
Equilibrium of the firm: Break even point Total Cost and Total Revenue
Price, TR And TC 2,800 1,950 Break Even point A
TR
TC Profit = TR-TC Maximum Profit = 850
550
Slope = 400
10 Quantity
Equilibrium of the firm: Marginal Cost and Marginal Revenue
Total Profit = TR TC Equilibrium of the firm : MR=MC
The Competitive Firms Demand Curve
1. The intersection of the market supply and the market demand curve Price Market S Price 3. The typical firm can sell all it wants at the market price Firm
400 D
Rs400
Demand Curve Facing the Firm
Output 2. determines the equilibrium market price
Output 4. so it faces a horizontal demand curve.
Profit Maximization
Price
(MR=MC)
Profit maximization MR=MC 400
MC
d = MR
10 Output
Profit Maximization
Total Profit = TR TC MR>MC increase output Maximize profit: MR=MC Measuring Total Profit
Profit per unit = P ATC
If P > ATC the firm earns profit If P < ATC the firm suffers a loss
Equilibrium of firm under perfect competition
Firm attains equilibrium by maximizing profit Profit = Revenue cost ( = R - C) ..(1) R and C are functions of the level of output Q. So appropriate condition for max value of profit
d /dq = 0 (necessary condition) d2 /dq2 < 0 (sufficient condition)
From (1) above d /dq = d/dq (R - C) = 0
= dR/dQ dC/dQ = 0 . i.e., MR MC = 0 or MC = MR (2)
Equilibrium of firm under perfect competition Under perfect competition the competitive seller is a price taker and not a maker as in the case of monopoly. Hence as the in the definition R = pq, the price p is a constant for the competitive seller. Therefore
dR/dQ = P = PQ i.e. MR = AR.. (3)
Now from (2) and (3) the necessary condition for equilibrium of firm under perfect competition can be restated as MC = MR = AR .(4)
Measuring Profit or Loss
Total profit = profit per unit *Q ATC Profit per unit=revenue per unit - cost per unit Profit per unit (`Rs.100) MC d = MR MR=MC Q=7
Price
400 300
Output
Measuring Economic Profit or Loss
Price Total loss = loss per unit *Q Loss per unit= cost per unit - revenue per unit Loss per Unit(100) MR=MC Q=5 300 200
MC
ATC d = MR Output
The Firms Short-Run Supply Curve
The firm takes the market price as given decides how much output to produce at that price Profit-maximizing output level: P=MC As price of output changes, firm will slide along its MC curve in deciding how much to produce
The Shutdown Point
Price at which a firm is indifferent between producing and shutting down If P>AVC produce If P<AVC shut down Firms supply curve
Is its MC curve for all prices above AVC
Short-Run Equilibrium
Competitive firms can earn economic
profit, or suffer an economic loss
The market sums buying and selling preferences of individual consumers and producers, and determines market price Each buyer and seller Takes market price as given Is able to buy or sell the desired quantity
Short-Run Equilibrium in Perfect Competition
1. When the demand curve is D1 and market equilibrium is here . . . Price 3.50 Market S 2. the typical firm operates here, earning economic profit in the short run. Firm Price MC ATC 3.50 Loss per unit at p =2 2.00 d1 d2 Profit per unit at p = 3.50 4,000 7,000
2.00
D1
D2
400,000 700,000
Output
Output
3. If the demand curve shifts to D2 and the market equilibrium moves here . . .
4. the typical firm operates here and suffers a short-run loss.
Competitive Markets in the Long Run
New firms can enter the market Existing firms can exit the market Profit and loss in the long run
Economic profit - outsiders enter the market Economic losses - firms exit the market
From SR Profit to LR Equilibrium
Economic profit attracts new entrants Market supply curve - shifts rightward Market price - falls Demand curve facing each firm - shifts downward Each firm - decreases output
Positive economic profit attracts new entrants until economic profit = 0
Long-Run Equilibrium
Market Price A 4.50 S1 With initial supply curve S1, market price is 4.50 Firm Price so each firm earns an economic profit. 4.50
MC A d ATC 1
900,000
Output
9,000
Output
From Short-Run Profit to Long-Run Equilibrium
Market Price A 4.50 4.50 S1 S2 Price
Firm
MC A d ATC 1 E
2.50
E D
2.50
d2
900,000 1,200,000
Profit attracts entry, shifting the supply curve rightward
Output
5,000
9,000
Output
until market price falls to Rs. 2.50 and each firm earns zero economic profit.
From SR Loss to LR Equilibrium
Economic losses - firms exit the market Market supply curve - shift leftward Market price - rises Demand curve facing each firm - shifts upward
Economic loses firms exit until economic loss = 0 In the LR, firms earn normal profit zero economic profit
Perfect Competition and Plant Size
In LR equilibrium, every firm will select
Plant size Output level
And
Operate at minimum point of LRATC curve
Perfect Competition and Plant Size
1. With its current plant and ATC curve the firm earns zero economic profit. Price MC1 P1 P* LRATC 3. As all firms increase plant size and output, market price falls to its lowest possible level . . . Price LRATC
ATC1
d1 = MR1
MC2 ATC
E
d2 = MR2
q1
Output
q*
Output
2. The firm could earn positive profit with a larger plant, producing here
4. and all firms earn zero economic profit and produce at minimum LRATC.
A Summary of the Competitive Firm in the LR
In long-run equilibrium, the competitive firm produces Q where: MC=minimum ATC=minimum LRATC=P Consumers are getting the best deal they could possibly get
Example
The long run cost function of a representative firm in an industry C = q3 10q2 + 50q. Determine the equilibrium price, aggregate quantity supplied and the number of firms in the industry when demand law for the product is D = 100 2p.
Example
The long run cost function of a firm is C = q3 8q2 + 20q. Prove that MC = AC at the minimum point of AC.
