Perfect Competition Model: where does it apply in PICs

Transcription

1 Perfect Competition Model: where does it apply in PICs Perfect competition is the core of the economic analysis of the operations of competitive markets: It is the foundation from which all departures are made: absolutely vital that this ideal model is understood. The definition of perfect competition is almost paradoxical: in that there is no real competition or rivalry amongst the suppliers: the market is perfectly impersonal: no individual can affect the price. This idea is the opposite of the entrepreneur s concept of competition.

2 Perfect Competition definition structural definition and performance definition Structural definition (the operating environment) numbers of firms entry and exit condition substitutability with other products Performance definition (the market outcomes) extent of difference between price and MC rate of profit price leadership or price followership taking place use of technological progress and innovation: are firms in comfort zones

3 1. Both producers and buyers are price takers 2. Homogenous product 3. Free mobility of resources. 1. While it may be sometimes argued that there are so many buyers and sellers that no one agent has any significant influence on the price; The real criterion is that no agent can influence the price, and each acts as if the price is given. 2. The product is homogenous: every firm s product is perfectly the same as any others: i.e. the buyer is quite neutral as to which firm he buys from. 3. All resources are perfectly mobile- freely able to move into any industry or out of that industry: applies to labour and capital alike; no barriers to entry at all: - not true where patents and copyrights exist - not true where increasing returns to scale industries can discourage entry of new firms.

4 4. All agents have perfect knowledge Consumer must know the prices and quality of all available products Producers must know the prices of their inputs and output, and the technology they can use. Owners of factors of production must know about all available incomes available to them. There must also be perfect knowledge not just about the present but also about the future: - clearly this is a very onerous condition especially in sectors like agriculture - indeed in many markets, eg stock markets, perfect knowledge about the future behaviour of stock and bond prices is an impossibility.

5 Why use such a model if the assumptions are so unrealistic? 1. There has to be abstraction- and this is the abstraction to the ideal - the best case scenario if you like. 2. It is claimed that the conclusions derived from this model, do describe what happens universally in the long run, where markets do approximate perfect competition. 3. If more relevant models are developed to suit specific circumstances, they become less relevant for other more general situations.

6 Equilibrium condition for profit maximisation: P = MC Hard way (tutorials). Easy way (calculus). Total Revenue and Total Costs are functions of the output y. Applies to monopoly situation and perfect competition Revenue = R(y) Cost = C(y) П = R(y) - C(y) As before, profit is at a maximum, where the first derivative wrt y = 0 dп = dr(y) - dc(y) = 0 dy dy dy dr/dy = Change in Revenue wrt a unit change in y = MR dc/dy = Change in Cost wrt a unit change in = MC Hence the first order condition: is that d П /dy = MR - MC = 0 or MR = MC

7 The second order condition is important to establish. (not satisfied in economies of scale case) As before at the profit maximum, the slope must go from +ve to 0 to -ve : ie be falling i.e. d 2 П /dy 2 = d 2 (MR - MC)/dy 2 must be < 0 П i.e d(mr)/dy - d(mc)/dy < 0 i.e. d(mr)/dy < d(mc)/dy y i.e. (Slope of the MR curve) must be < (Slope of the MC curve) Or put it the other way around: (Slope of the MC curve) must be > (Slope of the MR curve)

8 Under Perfect Competition the price is given: R(y) = p*y Cost = C(y) П = p*y - C(y) d П/dy = p - dc/dy = 0 i.e. p = dc/dy Hence p = MC is the profit maximising rule under perfect competition. d 2 П/dy 2 = dp/dy - d 2 C/dy) = = 0 - d(mc)/dy < 0 or d(mc)/dy > 0 i.e the slope of the MC curve, must be > 0 for profit maximisation. Under perfect competition, since the price is given, no decision on how much to sell by this producer has any effect on price- ie the price line is horizontal.

9 All you need for profit maximisation is the rule: p = MC MC p 0 Profit maximising output y 0 Does the firm actually make any profit? You don t know: until you know where the ATC curve falls. Could this firm therefore be making a loss? Of course: all you have to do is draw the ATC curve above the price line But what we can say is that the loss will be the smallest possible.

10 Could be making a profit if the ATC curve is where it is shown here MC ATC p 0 c 0 Profit maximising output where P = MC y 0 The ATC applicable at profit maximising output (C 0 ) is less than the price. Hence firm makes profit.

11 Equally, the firm could be making a loss if the ATC curve is where it is shown here MC ATC C 0 p 0 Profit maximising output y 0

12 For the moment, note what the firm supplies, given the price p 2 MC p 1 p 0 Profit maximising output If the price goes up to P1, the firm will supply y1 y 0 y 1 y 2 If the price goes up to P2, the firm will supply y2. In other words, for the firm, its MC curve is its supply curve. Minor point: only that part of the MC curve above the AVC: below that it wont supply.

13 The industry supply curve: aggregating horizontally all the individual firm supply (MC) curves MC 1 MC 2 MC firm 1 & 2 p 1 p 0 Profit maximising output y 0 y 1 y 1 +y 2 If the price goes up to P1, the firm will supply y1 If the price goes up to P2, the firm will supply y2. In other words, for the firm, its MC curve is its supply curve. (Minor point: only that part of the MC curve above the AVC: below that it wont supply.)

14 Continue the process for all firms And you end up with the industry supply curve: the usual upward sloping curve And intersection with the industry wide demand curve D then giving the equilibrium price and quantity price ($) D S P 0 Quantity Q 0

15 In the long turn, if a firm is making super-profits? MC D S 1 S 2 ATC p 1 c 1 y2 y 1 y 0 Other firms get to know about the super-profits (how?) Assuming free entry and exit, new firms attracted into the industry The Supply curve shifts to the right, with a lower equilibrium price This particular firm now equates the MC to the new price P1, and has a lower profit-maximising output And also a lower super-profit.

16 The process continues until the super-profits are competed away to zero MC D S 1 S 2 S n ATC p e =c e p e y e Price drops to the minimum of the ATC, at which point profits = 0 You have reached the ideal situation where: P e = MC = min. ATC i.e the value placed by consumers on the commodity = marginal cost of producing it = minimum ATC of producing that commodity. In tutorials, show the opposite process: what happens if some firms are making a loss in the short term.

17 Which parts of the typical PIE (Pacific Island Economy) may be described as perfectly competitive as defined? With what methodology would you approach this question? Structural criteria? Performance criteria? Industries? Products? Workers Employers? Firms? National accounts?