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Chapter 9

Chapter 9 - Perfect Competition.docx

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ECON 101
Robert Gateman

9.1 Market Structure and Firm Behavior 11-14-2012 Market structure – all features that may affect the behavior and performance of the firms in a market  Number and size of sellers  Knowledge about one another’s actions  Freedom of entry  Degree of differentiation Competitive Market Structure  Firms have market power when they can influence the price or terms under which their product is sold  Competitiveness of the market is the degree to which individual firms lack market power  A market is said to have a competitive structure when its firms have little or no market power. The more market power the firms have, the less competitive the market structure is.  Extremes: zero market power (perfect competition) – accept the price set by the market demand and supply  Perfectly competitive market structure – no one firms has power over the market Competitive Behavior  Degree to which individual firms actively vie with one another for business  Note: Distinction between behavior and structure  Perfectly competitive markets do not compete actively with each other Significance of Market Structure  Market structure plays a central role in determining firms’ behavior and its overall efficiency The Theory of Perfect Competition 11-14-2012 Common in agricultural and raw-material markets The Assumptions of Perfect Competition  Homogenous product  Consumers know the nature of the product and the price of each firm  Firms output (where firm’s LRAC min) is small compared to industry’s total output  Freedom of entry and exit – no legal deterrents or prohibitions  First three assumptions imply that a firm is a price taker o Firm can alter its rate of production and sales without affecting market price  No market power  Degree of market power – because firms in a perfectly competitive industry are small relative to the industry, no one firm has the power to influence the price of the product The Demand Curve for a Perfectly Competitive Firm  Even though the demand curve for the entire industry is negatively sloped, each firm in a perfectly competitive market faces a horizontal demand curve because variations in the firm’s output have no significant effect on price.  Perfectly elastic demand curve – firm’s effect on total industry output will be negligible o Even though market demand is inelastic Total, Average and Marginal Revenue  Total revenue = p * Q  Average revenue = p (revenue per unit sold)  Marginal revenue = change in TR/change in Q  As long as firm’s own level of output cannot affect price, then MR = AR = Price (horizontal line)  For a firm in perfect competition, price equals marginal revenue. 9.3 Short-Run Decisions 11-14-2012 Put the cost and revenue information together to determine the level of output Should the firm produce at all?  If it produces nothing, it will have an operating loss equal to its fixed costs.  Worthwhile to product if revenue exceeds variable cost. o If not, then the firm loses more by producing than not producing at all.  Rule 1: A firm should not produce at all if the TVC exceeds total revenue. Equivalently, the firm should not produce at all if the average variable cost exceeds the market price.  Shut down price – price at which firm can just cover its average variable cost (P=AVC). How much should the firm produce?  Unit-by-unit basis  As long as that unit adds more to revenue than it does to cost, profits will increase o MR > MC  Last unit produced should add as much to revenue as it does to cost o Stop producing when MR=MC  Rule 2: If it is worthwhile for the firm to produce at all, the firm should produce the output at which marginal revenue equals marginal cost. o Where marginal cost equals market price (as long as price exceeds AVC)  Market determines the price, then the firm picks the quantity of output  Total cost vs. Total revenue curves – pick level of Q where there is the largest positive gap between TR and TC Short Run Supply Curves The Supply Curve for One Firm  Firm’s supply curve is the portion of the marginal cost curve that is above the average variable cost curve  For prices below AVC  supply is 0 The Supply Curve for an Industry  Industry supply curve is the horizontal sum of the marginal cost curve of all the firms Short Run Equilibrium in a Competitive Market  Price and output at which industry demand equals short-run industry supply and all firms are maximizing their profits  Determined by collective actions of all the firms and collective actions of all households  Each firm is producing where MC = MR (Price); maximizing profits already  When an industry is in short-run equilibrium, Qd = Qs, and each firm is maximizing profits given market price.  In short-run industry Eq, a firm can be producing positive, negative or no profits (just breaking even) o Losses is when price > average total cost  Profits = (p-ATC) * Q or TR-TC  Profit per unit = price – ATC  Some firms will continue producing even though they are making losses  Worthwhile to keep producing if price exceeds AVC (but not worthwhile to replace capital equipment as it wears out) 9.4 Long-Run Decisions 11-14-2012 Short-run – given number of firms and given plant size Long-run – both firm’s and firm’s plant size are variable  Assumption: all firms have the same technology, same set of cost curves Entry and Exit  Short-run equilibrium – firms can be making a profit, loss or just breaking even  Because costs include OC of capital, o If firms are just breaking even, they could do just as well by investing their capital elsewhere o No incentive for firms to leave the industry if economic profits are zero o If new firms expect to just break even, there is no incentive to enter the industry An Entry Attracting Price  If all firms are making positive profits, new firms will enter the industry  All firms making a profit  entry of new firms  industry supply increases  Eq price will go down  new and old firms need to adjust to this new price  New firms will continue to enter until all firms are just covering their total costs – zero profit equilibrium  Profits in a competitive industry are a signal for the entry of new firms; the industry will expand, pushing price down until economic profits fall to zero. An Exit Inducing Price  When market price > minimum AVC, the firm will shut down and exit the industry  If firms are making losses, but market price is still above min AVC (shut down point), there will be gradual exit from the industry.  Firms making losses  gradual exit of firms  supply cu
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