Firms in their Environment:Market Structure Classified according to three conditions: 1. Number of firms in the Market (Industry) 2. Product differentiation

Firms in their Environment:Market Structure• Classified according to three conditions: 1. Number of firms in the Market (Industry) 2. Product differentiation

(Are firms products identical or slightly different)

3. Ease of Entry into and Exit from the industry• There are 4 Market Structures to study: Perfect Competition Monopoly Monopolistic Competition Oligopoly(few firms)• We will start with Perfect Competition, then move to the

opposite extreme(no competition) Monopoly.• The latter two lie between Perfect competition and

Monopoly in terms of competitiveness and are sometimes called imperfect competition.

Examples of Perfectly competitive markets

• There are not many markets or industries that are perfectly competitive…

…agricultural markets(corn, wheat, fruit, vegetables) and other commodity markets come closest….

...Stock and Bond markets also are very competitive.

Why have a theory that has few “real” industries to study?

• If is an “as if” theory. It shows how firms behave as industries get closer to competitive conditions.

• It also shows the benefits to the consumer and the economy of competitive conditions

Competitive Markets and the Competitive Firm (Perfect Competition)

4 Assumptions that make up Competitive markets1. There are many buyers and sellers.

No individual seller is very large and makes up only a small part of total market share.

2. The industry produces a homogeneous product.

Each firm produces an identical product

3. Information on prices, technology, and profit opportunities are freely available

4. There is free entry and exit into and out of the industry.New firms find it easy to enter and compete with existing

firms. Failing firms find it easy to quit producing

Implications from the 4 assumptions of Perfect Competition

1. Many small firmssmall firms are producing the exact same productexact same product (Products of different firms are perfect substitutes)

• No single firm can affect market supply If a firm attempted to raise price, then consumers

would not buy any goods from that firm and purchase them from other firms...

…each firm is a Price taker: A firm takes the market price as given and decides how

much to produce based on this price that is determined that is determined in the market.in the market.

Implications from the 4 assumptions2. Firms will not pay attentionwill not pay attention to production decisions

made by other firms…

...since every firm is a price takerprice taker and smallsmall (compared to the entire market), no individual firm can affect the market share or profitabilityrofitability of another firm.

3. A distinction must be made between the market(industry) and the individual firm...

…a firm is small enough that it can sell all it desires at a constant price (This comes from being a price taker)

• Therefore, the demand curve faced by a single firm is perfectly elasticperfectly elastic at the market price.

How Perfect Competition Arises•When firm’s minimum efficient scale is small relative to market demand so there is room for many firms in the industry.

•When each firm is perceived to produce a good or service that has no unique characteristics (a commodity), so consumers don’t care which firm they buy from.

Price (per Bushel)

Q {Corn(Bushels per week)}

q {Corn(Bushels per week)}

Price (per Bushel)

S

D

$12

Competitive marketA representative firm in the market

$12 d

500,000 500

• Price is determined in the market by the interactions of ALL buyers and sellers (Demand & Supply)…

…since a single firm is small it cannot control the price it charges…… it can’t raise price(lose all it’s customers) and it has no incentive

to lower price (because it can’t sell much more)...

The firm will sell all it can at the given market price.

Profit maximization by a competitive firm The competitive firm only has control over how

much OUTPUT to produce; it’s Price to charge is determined in the market.

Question: How does the firm determine the amount of output that will maximize:

Economic profit = Total Revenue (TR) - Total cost(TC)

q{Corn(Bushels per week)}

$12 d = price

Price (per Bushel) Economic profit = Total Revenue (TR) - Total cost(TC)Firm wants the gap between TR and TC to be at it’s greatest.

Average revenue = Total revenue/quantity; price x quantity/quantityAverage revenue = Price ! Average revenue is the price of the good.

500

Now we need to discuss the revenue of the competitive firm...Total revenue = Price x quantity. What is average revenue(AR)?

=AR

50 51

How much additional revenue will this firm earn by selling the next unit of this good? (From 50 to 51 bushels per week)

The firm earns $12 from selling the 51st unit.

Additional revenue from selling one more unit of the good

Implication: Marginal revenue is equal to the price of the good! Because the competitive firm does not have to lower price to sell more goods

Marginal revenue(MR) is the additional revenue gained from selling the next unit of the good (MR = change in TR / change in q)

Marginal revenue =($612 - $600) / (51 -50) = $12 / 1 = $12

= MR


$12 d = price = AR = MR

Price (per Bushel) Economic profit = Total Revenue (TR) - Total cost(TC)

Consider an output level of 100. MR > MC for this level of output500

MC

100

$4

To determine the profit maximizing output level we need to add the Marginal cost curve to our graph.

Should this firm produce the next unit of the good? YES! Why?

101

$4.25

MR for the 101st unit is $12, but MC is only $4.25The next unit of the good adds more to revenue than to cost which means that Total profit is GETTING LARGER.

Profit will increase ncrease as long as MR > MC. It declines if MC > MR.


$12 d = price = AR = MR


How do we determine how much profit the firm makes?

500

MC

Profit will increase increase as long as MR > MC Profit will decline if MC > MR. Profit will be maximized when MR = MC! Since P = MRP = MR for a competitive firm: P = MC!

250

Firms expand outputbecause it adds to profit

Going beyond MR=MC causes profitto decrease and firms cut output.

MR = MC means firms are making as much profit as possible.


$12 d = price = AR =MR


500

MC

250

At 250, the ATC is $10(per bushel) and the price is $12(per bushel)Profit per unit = (P - ATC). In this case($12 - $10) or $2 per bushel.

ATC

$10

A

B

AVC

Can compare Price (AR) to Average cost (ATC) at the profit maximizing level of output

Profit per unit(Average profit) = $2

Total profit = Profit per unit x number of units

Total Profit = $500

Total Cost = $2,500

Total Revenue =$3,000

This firm makes an Economic profit of $500 ($500 better than the firm’s next best alternative) It is possible for a competitive firm to make an Economic profit in the SHORT RUN.

How much profit the firm makes depends on the market price.

= $500

}

In the SHORT RUN a competitive firm may earn an Economic profit, but depending on price it could:

• Make a normal profit (zero economic profit)• Make an economic loss

(But continue to operate in the short run)

• Make an economic loss (But shut down immediately in the short run)

Show each possibility with our graph of the firm


d = price = AR =MR

Price (per Bushel)

500

MC

200

ATC

A

AVCTotal Profit = $0

Total Cost = $1,900


$9.50

A Competitive Firm making a NORMAL PROFIT

Profit per unit(average profit) = $0

If the market price is $9.50 instead of $12 this firm:

P = MC

2) Will now make a normal profit since P = ATC at the profit maximizing level of outputNotice that when the firm makes a normal profit it is producing output at minimum ATC.

1) Will now produce 200 bushels of corn instead of 250 (P =MC)

$12P =ATC


d = price = AR =MR

Price (per Bushel)

500

MC

180

ATC

A

AVC

Economic Loss = $360

Total Costs = $1,800


$8

A Competitive Firm making an Economic Loss, but operating.

If the market price is $8 then this firm:

2) Will make an Economic Loss since P < ATC at the profit maximizing level of output

1) Will produce 180 bushels of corn (P =MC)

$12

If this firm is doing worse than their next best alternative why do they operate in the short run under the above circumstances?

$10Economic Loss }

Loss per unit =$2 (If operate)


d = price = AR =MR

Price (per Bushel)

500

MC

180

ATC

A

AVC

$8


$12

$10Economic Loss }


}AFC =$3

Because they have FIXED COSTS in the short run!If a firm shuts down it must still PAY it’s fixed costs.

Which loss is smaller: Operating or paying FIXED COSTS?

Total Fixed Cost =$540 ( Loss if shut down)

$7




In this case, Operating losses are smaller thanare smaller than Fixed Costs, so it will be better for this firm to operate in the short run. How will the firm know when to shut down in the short run?


d = price = AR =MR

Price (per Bushel)

500

MC

180

ATC

A

AVC

$8


$12

$10Economic Loss }


}AFC =$3


$7



Notice: When the firm operates it earns revenue, but it also incurs variable costs.

Total variable cost

= $1,260

Is total revenue greater than total variable costs?YES! With some revenue left over to pay off some of the fixed costs. This is shown on the graph in two ways: 1) Loss per unit(if operate){$2} is less than AFC{$3} 2) Price (AR) is greater than AVC



d = price = AR =MR

Price (per Bushel)

500

MC

160

ATC

AVC

$8

$6.75

The Shut-Down Point

Total variable cost

Total Revenue

=

$10.13 Shut Down point (P = AVC)

At the point where P = AVC, Operating losses = Fixed costs.If price were to fall any further, Operating losses > Fixed costs and the firm would shut down immediately to minimize losses.When P = AVC, P = MC. Which means MC = AVC... ...AVC will be at it’s minimum.


d = price = AR =MR

Price (per Bushel)

500

MC

150

ATC

AVC

$6

A Competitive firm that Shuts Down in the Short Run

Total Variable cost = $1,065

Total Revenue = $900

$10.70

Shut Down point (P = AVC)$7.10

Loss per unit = $4.70 (If operate)



Total EconomicOperating Loss = $705

<

This is a case of price being too low to produce any output.Operating losses > Fixed cost and this firm will produce nothing.nothing. It will take a loss of $540 (Fixed cost) rather than $705

AFC = $3.60

The Supply curve for the firm and the industry

• Just as we used consumer theory to derive a demand curve, we can use perfect competition to derive a supply curve.

• Remember the law of Supply:

As the price of a good increases firms are willing and able to make more of the product available for sale.

Is this true for a perfectly competitive firm?


$12

Price (per Bushel) The Supply Curve

500

MC

250

When price increases the firm responds by producing more, because it it PROFITABLE to do so.

ATCAVC

$6.75$8

$9.50

$14

160180

200 270

A firm will maximize profit when P =MC.

$6.75 is the lowest price that will start this firm to produce in the short run. If the price of the good(determined in the market) increases, how does the firm respond?This firm is willing and able to produce more output as the price of the good increases.

It will increase production to where P = MC.

This is exactly the same as the Law of Supply!

What is the supply curve for the firm?

It is the MC curve above the Shut down point!

= SUPPLY CURVE


$12

Price (per Bushel) The Supply Curve

500

MC

250

ATC

AVC

$6.75$8

$9.50

$14

160180

200 270

A firm will maximize profit when P =MC.

= SUPPLY CURVE

The MC curve (above the AVC curve) is the SUPPLY CURVE for the firm.

The reason the Supply curve is upward sloping (a positive relationship) is because MC rises as output increases...…the firm needs a higher price to produce more because MC increases. Why is the MC curve shaped that way?

Because of diminishing Marginal returns!

$ $ $

Output Output Output

Industry or Market A firm in Industry A firm in the Industry

Market S = Sum of all firms MC

MC

AVC

MC

AVC$8

$10

90,000 95,000 200 220 235 260

The market supply curve is the SUM of ALL FIRMS marginal cost curves above the AVC curve

The competitive firm and Industry in the LONG RUN

There are 3 conditions that must be met for a competitive firm(and industry) to be in long run equilibrium:

1) There is no incentive for any new firm to enter or any existing firm to exit.

2) There is no incentive to change the amount of output produced by the firm

3) No firm has an incentive to change it’s scale of operations.

Using our theory of Perfect Competition how are these 3 conditions met?

Price (per Bushel)

$12

Price (per Bushel)

500,000Q(Corn) q (Corn)

500

S

D

Competitive market A representative firm

$12 d=MR

MC

ATC

Economic profit

250

Condition 1)Condition 1)

Assumption 4 states there is free entry and exit... …new firms will have an IncentiveIncentive to EnterEnter the IndustryIndustry (to gain economic profit) New firms entering the market shift the Supply curve to the right and cause the market price to DECLINE.

Existing firms have no cost or information advantage

Firms enter as long as economic profit can be madeFirms stop entering when there is zero economic profit (Normal Profit)

d’$9.50

200

S’

$9.50

560,000

Suppose firms in this industry are making economic profit

Economic Loss

Price (per Bushel) Price (per Bushel)

600,000Q(Corn) q (Corn)

500

S

D


d=MR

MC

ATC

180

Condition 1)Condition 1)

d’$9.50

200

S’

$9.50

560,000

AVC

$8$8

If firms in an industry are making economic losses, some firms will have an incentive to EXIT the industry in the LONG RUN (Doing worse than their next best alternative)As firms EXIT the industry the market supply curve shifts to the left and the market price starts rising.Enough firms must EXIT the industry so there is no longer any incentive for remaining firms to EXIT.This occurs when remaining firms are making a NORMAL profit


Q(Corn) q (Corn)

500

D


MC

ATC

Condition 1) & 2)Condition 1) & 2)

d’$9.50

200

S’

$9.50

560,000

AVC

Condition 1(firms have no incentive to enter or exit the industry) is met when firms in that industry make NORMAL PROFIT. This means that P = ATC in the long runMoreover, condition 2 is met; Firms have no incentive to change output: Firms maximize profit when P = MC in the long run(& short run)

0200

Price (per bushel)

q(corn)…the firm has an incentive to expand their scale of operations to

MAKE MORE PROFIT.At the price of $9.50 this firm(and others like it) can lower costs by

expanding plant size…

SRATC1MC1

LRAC

$9.50

Here is the situation from the previous slide except we now add the LRAC curve: This firm is not in long run equilibrium...

d

Condition 3)

...but it can’t last because other existing firms will have an incentive to do the same thing……and new firms will enter too in response to the ECONOMIC profit to be made...

MC2

SRATC2

450

0200

Price (per bushel)

q(corn)

SRATC1MC1

LRAC

$9.50 d

Condition 3)

MC2

SRATC2

450

d’

380

E

This drives down the market price until no furtherincentive remains to enter…

$3.50

...Firms in the industry make only NORMAL profit (P = SRATC)Firms also are maximizing profit ( P = MC)At point E, MC = SRATC, which means that SRATC is minimized MC = SRATC = LRAC which means that LRAC is also minimized

0

Price (per bushel)

q(corn)

LRAC

Condition 3)

MC2

SRATC2

d’

380

E$3.50

Condition 3 (firm has no incentive to change scale of operations) is satisfied when....

…the cost of production will be as low as possible. This is true at point E: P = MC = SRATC = LRAC Firms are: Maximizing profit = Normal profit =

Minimizing costs

Applying the theory of Perfect Competition

Responses to Demand changes• Long run Industry Supply curve(LRIS)• How does a perfectly competitive industry respond to

changes in the economy?• Are firms responsive to consumers wants?• How do prices respond in the short and long runs to

changes in demand?• It depends on what happens to costs for firms in an

industry.• Depending on the size of the INDUSTRY in the economy

costs may stay the same, rise, or even fall.• In the LONG RUN this will effects the price that will be

charged.

d


Q(Corn in thousands)

q (Corn)

500

D


MC

ATC

d$9.50

200

S

$9.50

560

A

A

D’

$11B

Now Consumers want more of this product...

Assume that costs for the Firm and Industry don’t change as Market Market outputoutput changes (COSTS ARE CONSTANT)(COSTS ARE CONSTANT)

600

$11 d’

240

B

Economic Profit

Firms respond to the higher price by moving up their MC curve to produce more and make Economic profit (This is a SR equilibrium)

Price MUST return to the previous level because it is the only price where firms make a normal profit, etc.

=C

S’

C

640

Point A is in Long run equilibrium

This price increase is temporary because new firms will enter to get the economic profit. The supply curve increases…...


Q(Corn in thousands)

q (Corn)

500

D


MC

ATC

d$9.50

200

S

$9.50

560

A

A

D’

$11B

B

=C

S’

C

640

Point A is in Long run equilibrium

By connecting points A & C (both long run equilibrium) we get….

…a Long Run Industry Supply curve(LRIS) This curve shows how the INDUSTRY responds to changes in

Demand in the LONG RUN. This is a case where costs don’t change, hence it is called… …a CONSTANT COSTS INDUSTRY

LRIS

Price (per Bushel)

q (Corn)

Price (per Bushel)

D

Competitive market A representative firm 500

Per unit costs increase as Industry output expands…

Industry may be a large portion of the economy and when demand for resources increases, it bids up the price of resources.

LRACA

S

$9.50

AA

D’

$10.25

B

S’

C

LRACB

C

Q(Corn in thousands)560 615

$11

INCREASING COSTS INDUSTRY

LRIS

Price (per Bushel)

q (Corn)

Price (per Bushel)

D

Competitive market A representative firm 500

Per unit costs decline as Industry output expands…why?Perhaps costs of inputs fall because producing parts for this

industry is cheaper if produced in bulk.Computer chips became cheaper as more computers were built.

LRACA

S

$9.50

AA

D’

$9

B

S’

CLRIS

C

Q(Corn in thousands)560 665

$11

DECREASING COSTS INDUSTRY

LRACB

Changes in Technology How does a competitive firm and Industry react to an improvement in technology?

Price (per Bushel)

Q(Corn) q (Corn)

Price (per Bushel)S1

D

$12


$12

500

• Suppose that a single firm starts to use a new corn seed that needs less fertilizer to grow; this lowers cost of production…..

…the LRAC curve will shift downward, reflecting the lower costs.

LRAC1

Q1

LRAC2

…until it reaches the new minimum average costs.

Insight: Anything Anything that changes the cost of production in a competitive industry will be passed along as a price change.

S2

$9 $9

Q2

S’S’’

That firm will enjoy economic profit…temporarily. Since information is freely available, other firms will have an

incentive to do the same thing, new firms enter, and….

Here is a firm and an Industry with a given technology (LRAC1)

Evaluating Perfect Competition

Efficiency

Two types of Efficiencya) Allocative efficiency...a condition that makes it makes it

impossibleimpossible to improve the satisfaction received by consumers (Maximizing Consumer Surplus)

• For allocative efficiency to occur the maximum price the consumer is willing to pay for a good would be just equal to what it cost the producer to make it.

b) Productive efficiency...producing the good at the lowest possible opportunity cost.

PrIce

Quantity

Demand = MB(Marginal Benefit)

Supply = MC(Marginal Cost)

Maximum price the consumer is willing to pay for a good would be just equal to what it cost the producer to make it.

Allocative Efficiency

MB = what a consumer would give up to get the next unit of the good

MC = the opportunity cost of producing the next unit of the good

In equilibrium, P = MC (Profit Maximization) P = MC (Profit Maximization) ……Under Perfect Competition price is equal to the cost of producing the good.

Also, P = MB in equilibriumP = MB in equilibrium (shown by the intersection of the demand curve and the price line.

P = MC = MBP = MC = MB : Consumers are paying just what it costs to produceConsumers are paying just what it costs to produce the good in perfect competition: Allocative efficiency

PE

QE

Consumer Surplus Consumer surplus will

be as great as possible under competitive conditions

PrIce

Quantity


Supply = MC(Marginal Cost)



Producer Surplus: The difference between the price of the good and the cost to produce the good (MC).

PE

QE

Consumer Surplus

P = MC = MBP = MC = MB

Producer Surplus

The yellow shaded area represents the gain from ALL producers in the competitive market.

Under Perfectly competitive conditions the sum of Consumer surplus and producer surplus is at it’s Maximum.

PrIce

Quantity


Supply = MC



PE

QE

Allocative Efficiency implies competitive markets will produce the amount of the good that consumers desire.Example: If MB1 > MC1 consumers and producers can be made better off producing more of the good.On the other hand: If MB < MC consumers and producers can be made better off producing less of the good.

Q1

MB1

MC1

A net loss in Consumer or Producer surplus from under or overproduction is called a Deadweight loss

Price

Quantity quantity

PriceCosts

D


d

Competitive firms must produce at lowest average costs in long run equilibrium because free entry or exit of firms forces them to do so.

P = MC = SRATC = LRAC which makes LRAC & SRAC at their minimum

Competitive markets are productively efficient.

MC

qe

S

Productive Efficiency

SRATC

PE

QE

LRAC

Limitations of Competitive Marketsa) It is only and “as if” theory. There are not very

many perfectly competitive markets.

b) Standardized products may not be preferable for consumers.

Consumers may be willing to pay more for differentiated(Slightly different) goods.

c) Economic profit may be needed to encourage firms to engage in Research and Development.

d) Some products may require large firms to take advantage of economies of scale.

Coming Next: Market Failure• Monopoly & Imperfect Competition:

Firms having some control over their price

• Public Goods: Goods or services that benefit more than one person at a time and no person can be exclude from consuming them

Example: National Defense, Fire, Police, etc

• Externalities: Costs or benefits from an activity imposed or bestowed on person(s) not involved with that activity

Examples: Pollution, vaccinations

Documents

Firms in their Environment:Market Structure Classified according to three conditions: 1. Number of firms in the Market (Industry) 2. Product differentiation