Microeconomic Analysis Competitive Firms and Markets Reading: Perloff, Chapter 8 Marco Pelliccia mp63@soas.ac.uk
Outline Competition Profit Maximisation Competition in the Short Run Competition in the Long Run Zero Profits for Competitive Firms in the Long Run
Price-Taking Behaviour Competition implies that firms are rivals for the same group of consumers Economic definition of competition is that each firm is a price taker No single firm has the ability to influence the price If a firm tries to raise the price, then its sales drop to zero as consumers use alternative firms
Conditions for price-taking behaviour 1. Consumers believe that all firms sell identical products 2. Firms freely enter and exit the market 3. Buyers and sellers know the prices charged by firms 4. Transaction costs are low
Competitive Firm s Demand Curve The residual demand curve faced by a given firm in a perfectly competitive industry will be flat
Elasticity of Residual Demand Curve The elasticity of the residual demand will be greater in absolute value than that of the market r 0 D p D p S p is dd dp dd dp where Q p quantity produced by the quantity produced by n i i r r p q dd dp dd dp D p Q 0 dd dp Q q ds dp p q is n 1 the market demand, 0 Q Q ds dp each firm, 0 ds dp p Q 0 0 Q q p q all 0 Q Q 0 0 and Q 0 q other firms Q n D p is 0 n 1 q S p r the
Economic Profit economic profit - revenue minus economic cost. π = R C Recall that economic profit must include any opportunity costs, i.e., value of the best alternative uses of assets employed If no real alternative to an investment is available, then compare the profit with the interest that the money used for investment could have earned
Two Steps in Maximising Profit The firm s profit function is: π(q) = R(q) C(q). To maximize its profit, any firm must answer two questions: Output decision - If the firm produces, what output level, q*, maximises its profit or minimises its loss? Shutdown decision - Is it more profitable to produce q* or to shut down completely?
Output Rules Output Rule 1: The firm sets its output where its profit is maximized. Output Rule 2: A firm sets its output where its marginal profit is zero. 8-9
Output Rules marginal revenue (MR) - the change in revenue a firm gets from selling one more unit of output: MR =dr/dq marginal profit - the change in profit a firm gets from selling one more unit of output. The change in the firm s profit is: Marginal profit(q) = MR(q) MC(q). 8-10
Output Rules Output Rule 3: A firm sets its output where its marginal revenue equals its marginal cost: max q d 0 dq q R q C q dr dq dc dq MR(q) = MC(q). 8-11
Maximizing Profit 8-12
Shutdown Rule The firm may be maximising profit, but still making a loss In this case, it may be better off shutting down operations It must compare the operating loss with the fixed cost Example: R = 2000, VC = 1000, FC = 3000 The firm makes an operating loss of 2000 (profit = R VC FC) If it shuts down, then it makes a loss of 3000 since it receives no revenues and incurs no variable costs (but still has to pay fixed costs): π = $3,000 = FC Therefore, the firm should operate as long as revenues are high enough to cover its variable costs In the long run, since all costs are variable, the firm should operate only if it can cover all costs
Necessary Condition for Profit Maximisation Recall that profit is maximised when marginal revenue equals marginal cost In a perfectly competitive industry, each firm is a price taker Therefore, marginal revenue is simply the price MR = p Hence, the necessary condition for profit maximisation is that price equals marginal cost MC(q) = p
p, $ per ton Cost, r e v e n u e, Thousand $ How a Competitive Firm Maximizes Profit (a) 4,800 2,272 1,846 * Cost, C R e v e n ue 840 (b) 426 100 0 100 140 284 * = $426,000 (q) q, Thousand met r ic tons of lime per y ear 10 MC A C 8 e p = MR * = $426,000 6.50 6 0 140 284 q, Thousand met r ic tons of lime per y ear
p, $ per ton Cost, r e v e n u e, Thousand $ How a Competitive Firm Maximizes Profit (a) 4,800 2,272 1,846 * Cost, C R e v e n ue 840 (b) 426 100 0 100 140 284 * = $426,000 (q) q, Thousand met r ic tons of lime per y ear 10 MC A C 8 e p = MR * = $426,000 6.50 6 0 140 284 q, Thousand met r ic tons of lime per y ear
Effect of Taxation
Short-Run Shutdown Decision In the original AC curve, the minimum occurs at $6/unit If the market price drops below this level, then the firm makes a loss if it continues to operate The firm will shut down only if its revenue is less than its short-run variable cost: pq < VC In other words, it will shut down if p < AVC While plotting the average cost, it is also necessary to include the AVC Decision rule: if market price drops below the minimum of the AVC, then shut down
The Short-Run Shutdown Decision
As the market price fluctuates, so does the firm s output if it maximises profit The changes in the price trace out the firm s short-run supply curve It is simply the marginal cost curve above the minimum of the AVC
How the Profit-Maximizing Quantity Varies with Price
Short-Run Supply: Effect of an Increase in Factor Prices Recall that an increase in the price of an input causes the supply curve to shift to the left This occurs because the increase in the price of each unit shifts both the AVC and MC curves upwards At the new equilibrium, less is produced as the higher AVC cuts into profit
Effect of an Increase in the Cost of Materials on the Vegetable Oil Supply Curve
Short-Run Market Supply The market supply in the short run is simply the horizontal sum of all the individual firms supply curves If the firms are identical, then the market supply curve has the same minimum Market supply curve is more elastic than firm supply
Short-Run Market Supply with Five Identical Lime Firms
Short-Run Market Supply: Heterogeneous Firms If the firms have different AVC curves, then the market supply curve is staggered
Short-Run Market Supply with Two Different Lime Firms
Short-Run Competitive Equilibrium Construct the industry supply curve by horizontally summing the supply curves of all the firms in the industry Its intersection with market demand yields the competitive equilibrium for the industry At the firm level, the output is indicated by the intersection of the MC curve with the market price Each firm produces an identical quantity and earns identical profit A shift in the demand curve reduces market price and quantity As a result, each firm also produces less In this case, it incurs a loss
p, $ per ton p, $ per ton Short-Run Competitive Equilibrium in the Lime Market (a) Fi r m (b) Ma r k et 8 S 1 8 D 1 S 7 6.97 6.20 A C B e 1 A C A VC 7 D 2 E 1 5 e 2 5 E 2 0 q 2 = 50 q 1 = 215 0 Q 2 = 250 Q 1 = 1,075 q, Thousand met r ic tons of lime per y ear Q, Thousand met r ic tons of lime per y ear
Solved Problem
Long-Run Supply Curve In the long run, all costs are variable This implies that the firm s shutdown decision in the long run is stop producing only if it cannot cover all costs In the short run, it was to shut down if it cannot cover variable costs In the long run, the firm s supply curve is the long-run MC curve above the minimum of its long-run AC curve It can make a larger plant in the long run if it expects the price to be higher
The Short-Run and Long-Run Supply Curves
Long-Run Market Supply Curve Long-run market supply curve is still the horizontal sum of the individual firm long-run supply curves However, it is also necessary to know the number of firms in the market In the long run, each firm can decide to enter or exit the market depending on its prospects for making long-run profits If a firm believes that it can make a long-run run profit (loss), then it enters (exits) the market There is no entry or exit when the long-run profit level is zero In some industries, such as manufacturing, mining, and utilities, there are barriers to entry and exit
Long-Run Market Supply Curve with Identical Firms and Free Entry Recall that in the short run, the industry supply curve was flatter, i.e., more price elastic, than the supply curve of an individual firm Specifically, the more firms there were, the flatter was the industry supply curve In the long run, since there is no barrier to entry, new firms enter the industry, thereby causing the industry supply curve to become flatter until it is simply a horizontal line at the minimum of the long-run AC
Long-Run Firm and Market Supply with Identical Vegetable Oil Firms
Long-Run Market Supply Curve with Limited Entry or Differing Firms When entry is limited, then the long-run market supply curve is upward sloping as in the short run When firms differ, then the long-run market supply curve is also upward sloping because there is a limited number of low-cost firms
Application: Upward-Sloping Long-Run Supply Curve for Cotton
Long-Run Competitive Equilibrium The intersection of the long-run supply and demand curves determines the competitive equilibrium The market supply is horizontal at the minimum of the AC assuming identical firms with no entry barriers In the short run, it is upward sloping The market demand is downward sloping
The Short-Run and Long-Run Equilibria for Vegetable Oil
Zero Long-Run Profit In the long run, all firms make zero economic profit with free entry Still earning enough to cover the opportunity cost of staying in business, i.e., each firm is making as much profit as it would be in another endeavour If entry is limited, then rents can be charged on the scarce resource that is used