Perfect Competition
Chapter 12
Costs and Supply Decisions
• How much should a firm supply?
▫ Firms and their managers should attempt to
maximize profits (Profits = Revenues – Costs)
▫ Select a pricing strategy that induces a demand for
a product that generates highest revenue relative
to the cost of production of that level of supply.
• Profits depends on response of revenues to
changes in production quantities.
Perfect Competition/ Price Taking
• We think of some markets as characterized by
perfect competition
▫ In competitive markets, no firm has the market
power to set their own price.
• Firms in perfectly competitive markets take their
price as given.
China Price Download
MES and Market
Structure
$
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Non-differentiated goods
Large number of firms
All firms are small relative to the market
Free entry and exit.
Many “small” firms
in the market.
Q
• If MES is relatively small in comparison with market
demand:
Revenues and Perfect
Competition
• Revenues = Price * Quantity
• Average Revenue = Price
• Marginal Revenue is the extra revenue
generated by selling an extra good.
▫ If production by a firm doesn’t shift the price,
marginal revenue is the price.
Profit Maximization:
Short Run
• In the short-run, firm may only have a limited
number of avenues along which they may vary
production.
• Cost of producing each good is likely to increase.
But as long as the extra revenue that the good
brings in exceeds the extra cost, it will be profitable
to produce it.
• Maximize profits by producing up to that point that
price is equal to marginal cost. Beyond that,
producing more goods only subtracts from profits.
Increase Production until
marginal cost reaches the price level.
P
MC
P
ATC
Q*
Q
Revenues are price × quantity
MC
P
P
ATC
Revenues
Q*
Q
Profits:
Revenues - Costs
MC
P
P
Profits
ATC
Costs
Q*
Q
Profit Maximization: Price is 80
Output
(Loaves)
2.00
Average
Total
Costs
535
10.00
115
20.00
75
30.00
68
40.00
70
50.00
75
60.00
82
Marginal
Marginal
Costs
Revenues Revenues
160.00
15.00
80.00
800.00
35.00
80.00
1600.00
55.00
80.00
2400.00
75.00
80.00
3200.00
95.00
80.00
4000.00
115.00
80.00
4800.00
Profits
-910.00
-350.00
100.00
350.00
400.00
250.00
-100.00
What if prices drop?
MC
P
P
Breakeven point
ATC
-Profits
P'
Costs
Q**
Q
• The average total cost of production (when marginal
cost equals price) is above the new lower price.
▫ If the firm sets production at a level such that price
equals marginal cost, but that is the best they can do in
the short run.
▫ Firms only decision is to vary production costs along
those dimensions that are available.
• Should the firm shut down?
▫ No. The firm has paid costs which cannot be retrieved
[SUNK COSTS]. Since the firm cannot change this,
they should ignore these sunk costs in making their
marginal decision.
▫ As long as prices exceeds variable costs, produce.
Profit Maximization: Price is 60
Output
Average Average
Total
Variable Marginal
Marginal
(Loaves) Costs
Costs
Costs Revenues Revenues
2.00
535
35
120.00
10.00
60.00
10.00
115
15
600.00
35.00
60.00
20.00
75
25
1200.00
55.00
60.00
30.00
68
35
1800.00
75.00
60.00
40.00
70
45
2400.00
95.00
60.00
50.00
75
55
3000.00
115.00
60.00
60.00
82
65
3600.00
Profits
-950.00
-550.00
-300.00
-250.00
-400.00
-750.00
-1300.00
When should the firm
stop production in the short-run?
MC
P
Breakeven point
AVC
ATC
P
P'
Dropout point
Q**
Q
Profit Maximization: Price is < 10
Output
Average Average
Total
Variable Marginal
Marginal
(Loaves) Costs
Costs
Costs Revenues Revenues
2.00
535
35
20.00
10.00
10.00
10.00
115
15
100.00
35.00
10.00
20.00
75
25
200.00
55.00
10.00
30.00
68
35
300.00
75.00
10.00
40.00
70
45
400.00
95.00
10.00
50.00
75
55
500.00
115.00
10.00
60.00
82
65
600.00
Dropout!
Profits
-1050.00
-1050.00
-1300.00
-1750.00
-2400.00
-3250.00
-4300.00
Adjustment in the Long Run
• In the longer run, firms are able to adjust the
size of their plant. (adjust the number of
machines in the factory, adjust the number of oil
rigs).
• If profits are positive. Firms will seek to build
new equipment as they compete for profits.
• If profits are negative, firms will shut down
equipment and sell it, or possibly go out of
business.
▫ Firms will adjust their physical plant until they are
making profits again.
Final Exam
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•
•
•
When 3 Feb 2013 (Sunday) 10:30-13:00.
Where L1: 3007 L2: 3008.
What: In class material, through here
How: The format of the exam will be similar to
the midterm or the practice exams with a
combination of multiple choice, short answer,
calculation, and graphing questions.
• Students should bring a calculator, writing
instruments and an A4 sheet of paper with
handwritten notes (must be handwritten, no
Xerox or printout) on both sides.
Profit maximization and the supply
curve
• In the short-run, firms produce up to that point
where price equal marginal cost.
• Supply curve is the sum of the supply curves of
the different firms in the market.
• In the long-run, capacity will be adjusted to the
point where profits are zero (i.e. where marginal
cost equals average total cost).
• Long run ATC curve is collection of points
where MC = ATC and is the long-run supply
curve.
Firm Level Supply Curve:
Short Run
P
SFirm 1
SR ATC
P*
MC
Output
In the short run, MC curve is the relationship between firm price and production
Firm Level Supply Curve:
Short Run
P
SFirm 2
SR ATC
P*
MC
Output
Industry Level Supply
Curve:Short Run
P
SFirm 1 +SFirm 2 +SFirm 3
SIndustry
Output
In the short run, the sum of the MC curves is the relationship between price and industry
production
Short Run Response to Increase in Demand
Increase Variable Inputs
P
D
SIndustry
2
P**
1
P*
D'
Q*
Q**
Output
Firm Level Supply Curve:
Short Run
P
2
P**
SFirm 1
SR ATC
1
P*
MC
q*
q**
Output
In the short run, MC curve is the relationship between firm price and production
Short-run profits
attract new entrants
P
Profits
2
P**
SFirm 1
Profits
SR ATC
MC
q*
q**
Output
In the short run, MC curve is the relationship between firm price and production
New Entrants in the Long Run
Supply Increases and Price Drops
P
D
SIndustry +SFirm N+ 1
2
P**
3
P**
1
P*
D'
Q* Q** Q***
Output
Firm Level Response
to New Entrants: Reduce Output
P
2
P**
3
SFirm 1
SR ATC
P***
1
P*
MC
q* q*** q**
Output
In the short run, MC curve is the relationship between firm price and production
New Entrants as Long as Profits at MES
Supply Increases and Price Drops
P
D
+SFirm N+ 1 +SFirm N+ J
SIndustry
2
P**
3
P**
P*
1
4
D'
Q* Q** Q*** Q**** Output
Firm Level Response to New
Entrants: Reduce Output
P
2
P**
3
P***
SFirm 1
SR ATC
1,4
P*
MC
q* q*** q**
Output
In the short run, MC curve is the relationship between firm price and production
Long Run, Supply is Flat along MES of New
Entrants
P
D
SIndustry
+SIndustry
2
P**
P**
P*
1
4
D'
SLR
Q* Q** Q*** Q****Output
Long Run Supply Curve
• If all firms are exactly the same, then new firms
have same MES as old firms and supply curve is
flat.
• In some cases, like oil drilling, new firms may
have higher MES than old firms and supply
curve is upward sloping.
• Long run supply curve is flatter, more elastic
than short-term supply curve.
Long Run Equilibrium
• Firms are making zero profits.
• Firms will be producing at their minimum
efficient scale and at a minimum of ATC
Learning Outcomes
Students should be able to
• Characterize a perfectly competitive market.
• Calculate total revenue, marginal revenue and
profit for a firm in a competitive market.
• Describe the supply curve in a competitive
market in both the short and long run.