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Western University
Economics 2150A/B

P a g e | 1 Ch 9 – Besanko I. competitive market - a market with many buyers and sellers trading identical products so that each buyer and seller is a price taker. A) Four characteristics of a perfectly competitive market  a. Fragmented market: Many buyers and sellers so all are Price takers b. Undifferentiated products: Identical goods no matter who produces them. c. Perfect information about prices – perfect info on prices and quality. d. Equal access to resources: Free entry and exit in the long run.  B) Implications for the operation f competitive markets: 1. All participants are price takers. 2. Law of one price: transactions between buyers and sellers occur at a single market price. 3. Free entry C) Examples of near perfect competition: 1. Commodities markets – wheat, copper, etc. 2. Market for Roses 3. Catfish farming -highly fragmented (>1000 in U.S. alone) -perfect info on prices – monthly reports of catfish prices -undifferentiated product – catfish from one farm is a perfect substitute for catfish from another -Free entry – low costs of entry, MES is 80-100 ponds, well-understood technology II. Profit maximization by a Price taking firm A. NOTES: 1. All firms (even in non competitive markets) maximize profits where MR = MC. 2. In prefect competition, MR=P because of horizontal demand curve; so perfectly competitive firms max profit where P = MC. 3. profit π = TR(Q) – TC(Q) 4. profit π = q x (P – AC) B. Economic profit, not accounting profit, is the relevant profit for firm decision-making Economic costs include both explicit and implicit costs. Typical implicit costs are: 1) foregone income, i.e. the opportunity cost of the owner’s time, and 2) foregon interest, i.e. the opportunity cost of capital. EVA (economic value added) – a widely used measure of economic profit = accounting profit – minimum return on invested capital demanded by the firm’s investors. A positive EVA means that the company delivered a return on invested capital greater than that demanded by its investors. EX: 9.1. The annual accounting statement of revenues and costs for a local flower shop shows the following: Revenues $250,000 Supplies $25,000 Employee Salaries $170,000 If the owners of the firm closed its operations, they could rent out the land for $100,000. They would then avoid incurring any of the expenses for employees and supplies. Calculate the shop’s accounting profit and its economic profit. Would the owners be better off operating the shop or shutting it down? Explain. The accounting costs are Supplies $25,000 Employee Salaries $170,000 TotalAccounting Cost$195,000 Accounting profit = Revenue – Accounting Cost = $250,000 - $195,000 = $55,000 The economic costs are Supplies $25,000 Employee Salaries $170,000 Opportunity cost of land $100,000 Total Economic Cost $295,000 Economic profit = Revenue – Economic Cost = $250,000 - $295,000 = - $45,000 The negative economic profit indicates that the owners would be better off by $45,000 if they shut down the shop and rent out the land. P a g e | 3 C. Profit maximization in Perfect Competition 1. chooses q to max profit given the market price 2. maximizes profit π when both of the following conditions hold: a. P = MC b. MC is increasing NOTE: There are two places where P=MC, one is a profit min and one is a profit max. At the maximum, MC will be increasing. A P.C. firm faces a horizontal demand curve at the market price, P. D. Short – Run 1. At least one input (such as plant size) is fixed. 2. Number of firms in the industry is fixed – no entry or exit E. SR Costs for P.C. firm (output sensitive costs) (unavoidable cost even if Q=0) (avoidable only when Q = 0) Ex: Rose-growing firm. If the firm produces 0 output, it can stop using pesticide and fertilizer, which are variable costs. The long-term lease on the land is a sunk fixed cost if the land cannot be sublet to another farmer for another use. The costs of heating the greenhouses is a nonsunk fixed cost – it does not depend on output if Q>0 but it can be avoided when the firm shuts down and Q=0. F. SR supply curve for P.C. firm when all fixed costs are sunk TFC = NSFC +SFC Now NSFC = 0. So TFC = SFC → the relationship from principles about total costs: STC = TFC + TVC. Dividing by Q, we get the usual average relationship from principles: SAC = AFC + AVC Firm’s SR supply = MC above minimum AVC. (shutdown) P a g e | 5 As long as the firm covers its AVC, it should continue to operate in the SR at a loss. As long as P>AVC, the firm reduces its loss by continuing to operate. If the firm shuts down and Q=0, then the loss=TFC. If the firm operates at P>AVC, it can reduce the loss by TFC – q x (P – AVC). See graph below... Ex: This is why restaurants remain open at lunchtime when there are few customers. As long as the TR from customers > TVC (the cost of the chef and waitress to produce meals), then the restaurant should stay open at lunch. Ex: 9.8 Dave’s Fresh Catfish is a northern Mississippi farm that operates in the perfectly competitive catfish farming industry. Dave’s short-run total cost curve is STC(Q)=400+2Q+0.5Q , where Q is the number of catfish harvest per month. The corresponding short-run marginal cost curve is SMC(Q)=2+Q . All of the fixed costs are sunk. AVC (a) What is the equation for the average variable cost ( )? (b) What is the minimum level of average variable costs? (c) What is Dave’s short-run supply curve? (a) TVC=2Q+0.5Q 2 so AVC=TVC/Q=2+0.5Q. AVC Q SMC=AVC (b) The minimum level of occurs at the where , or 2+Q=2+0.5Q Q=0 , or . The minimum level ofAVC is thus 2. (c) Since all fixed costs are sunk, the firm will not produce if the price is below the minimum AVC level of ., or 2. For prices above 2, the quantity supplied is found by equating 2+Q=P Q=P−2 price to marginal cost, or , which implies . Thus, the firm’s short-run supply curve is P a g e | 7 s(P)=0,if P<2 . s(P)=P –2if P2 G. SR supply with sunk and nonsunk fixed costs TFC = SFC + NSFC The only difference in the analysis is that we need to treat NSFC like a variabl
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