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Competitive firms and Markets
Perloff chapter 8
Competition
• Firms are price takers.– Firm’s demand curve is horizontal.
• Reasons for a horizontal demand curve:– Identical products from different firms;– Freedom of entry and exit;– Perfect knowledge of prices;– Low transaction costs.
• Where all conditions are satisfied: Perfect Competition.
Profit
• R – C• Definition of R straightforward.• Costs:
– Business profit includes only explicit costs, e.g. workers wages and materials.
– Owner doesn’t take a salary, what remains is profit.
– Economic profit uses opportunity cost.
– Suppose profit was £20000 but you could earn a salary of £25000, what should you do?
Profit maximisation, Profit
> 0 < 0
q* Quantity, q, Unitsper day
Profit
11
*
0
Source: Perloff
Output decision
• Produce where profit is maximised.
Profit maximisation, Profit
> 0 < 0
q* Quantity, q, Unitsper day
Profit
11
*
0
Source: Perloff
Output decision
• Produce where profit is maximised.
• Produce where marginal profit is zero.
• Marginal cost equals marginal revenue.– q)R(q) – C(q)– Marginal Profit(q) = MR(q) – MC(q) = 0– MR(q) = MC(q)
Shutdown rule
• Shutdown if it reduces its loss.– In the short-run, shutting down means revenue and
variable costs are zero.
– It must continue to cover fixed costs.
– R-VC-F=2000-1000-3000=-2000
– R-VC-F=500-1000-3000=-3500
• Shutdown if revenue is less than avoidable cost.– This rule is applicable in the long and short run.
Short-run output decision
• MC=MR
• R=pq
• MC=p
Cost, revenue,Thousand $
2841400
q me per year
2,272
4,800
426
1,846
100
–100
1
MR = 8
* = $426,000
*
(q)
Cost, C Revenue
p, $ per ton
e
2841400 q , Thousand metric tons of lime per year
8
6.50
6
10
p = MR
* = $426,000
AC
MC
, Thousand metric tons of li
Short run shutdown decision
• Shutdown if revenue less than avoidable cost.– In short run avoidable costs are variable costs.
AVCp
q
VC
q
pq
VCpq
Short run shutdown decisionp, $ per ton
10050 140 q, Thousand metric tons of lime per year
AVC
AC
MC
p
a
e
b
0
5.14
5.50
6.006.12
5.00
A = $62,000
B = $36,000
Short run supply curve of the firmp, $ per ton
q3 = 215 q4 = 285q1 = 50 q2 = 140
e1
e2
e3
e4
p2
p1
p3
p4
0q, Thousand metric tons of lime per year
6
7
8
5
AVC
MC
AC
S
Industry SR supply curve with 5 identical firms
p, $ per ton
14050 175
q, Thousand metric tonsof lime per year
6.47 6.47
6
7
p, $ per ton
7
5
0
AVC
(a) Firm
MC
200150
10050 250 700
Q, Thousand metric tonsof lime per year
6
5
0
(b) Market
S3
S 4
S5
S2S1 S1
Industry SR supply curve with 2 different firms
p, $ per ton
100 140 165 215 315 45025 50
S2 SS1
0q, Q, Thousand metric tons of lime per year
6
7
8
5
SR equilibrium in the market
p, $ per ton
q1 = 215q2 = 50 Q1 = 1,075Q2 = 2500
q, Thousand metric tonsof lime per year
Q, Thousand metric tonsof lime per year
6.97
6.206
5
0
5
6
7
8
7
8
e2
e1
E2
S
E1
p, $ per ton
(a) Firm (b) Market
AVC
AC
D2
S1D1
A
C
B
Supply curve of the firm in the long-run
p, $ per unit
50 110 q, Units per year
2524
28
35
20
0
p
SRAC
LRMC
LRAC
SRMC
SRAVC
BA
S SR SLR
Long run adjustment of the industry
• All factors are variable.• Entry and exit are possible.
– Entry occurs with positive long-run profits– Exit occurs with long-run losses
• Identical firms:– All firms make a loss when P<min(LAC), industry
supply is zero.– All firms make a profit if P>min(LAC), number of firms
is indeterminate. Note that elasticity of the industry supply curve increases with the number of firms.
Long run industry supply curve
p, $ per unit
150
LRAC
LRMC
(a) Firm
q, Hundred metric tons of oil per year
10
S1
0
p, $ per unit
(b) Market
Q, Hundred metric tons of oil per year
Long-run market supply10
0
Upward sloping long run industry supply curve
• Limited entry– New firms cannot enter because of legislative control.– New firms only enter when profits exceed the costs of entry.
• Firms differ– Minimum LAC is lower for some firms than others.– Number of low LAC firms is limited.
• Input prices vary with output– Increasing cost (firms in one industry account for much of
the supply of a particular input).– Decreasing cost (economies of scale in the input supplier)
Differing firms: the LR supply curve for cotton
0.71
Price, $ per kg
0 1 2 3
Iran
United States
Nicaragua, Turkey
BrazilAustralia
Argentina
Pakistan
4 5 6 6.8
Cotton, billion kg per year
1.081.15
1.27
1.43
1.56
1.71 S
Increasing cost industry
p, $ per unit
q1q2 Q1 = n1q1 Q2 = n2q2q, Units per year Q, Units per year
p1
p2
e2
e1
E2
S
E1
p, $ per unit
(a) Firm (b) Market
AC2
MC 2
MC 1
AC1
Decreasing cost industry
p, $ per unit
q1 q2 Q1 = n1 q1 Q2 = n2 q2q, Units per year Q, Units per year
p1
p2
e2
e1
E2
S
E1
p, $ per unit
(a) Firm (b) Market
AC2
MC2MC1
AC1
Long run competitive equilibrium
, $ per ton
e1
f2
1000 150 165
q, Hundred metric tonsof oil per year
1110
7
MC
AVC
(a) Firm
AC
p, $ per ton
F1E1
F2E2
1,5000 2,000 3,300 3,600
Q, Hundred metric tonsof oil per year
1110
7
(b) Market
D 1
SSR
S LR
D2
f
Profit in the long run
• Free entry– Entry occurs to the point where profits are zero
– No profit in long-run equilibrium
– Economic profit is revenue minus opportunity cost.
• Restricted entry– Entry is often limited because of a limited quantity of
an input eg. land.
– Profits become rent.
Economic Rentp, $ per bushel
q *
* = Rent
q, Bushels of tomatoes per year
AC (including rent)
AC (excluding rent)
MC
p*