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
• p=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
p, Profit
p*
Profit
Dp < 0
Dp > 0
1
0
Source: Perloff
1
q*
Quantity, q, Units
per day
Output decision
• Produce where profit is maximised.
Profit maximisation
p, Profit
p*
Profit
Dp < 0
Dp > 0
1
0
Source: Perloff
1
q*
Quantity, q, Units
per day
Output decision
• Produce where profit is maximised.
• Produce where marginal profit is zero.
• Marginal cost equals marginal revenue.
– p(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.
– p=R-VC-F=2000-1000-3000=-2000
– p=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
Cost, revenue,
Thousand $
Cost, C
4,800
1
2,272
• MC=MR
• R=pq
• MC=p
MR=
8
p*
1,846
426
100
0
–100
Revenue
p (q)
p* = $426,000
140
284
q , Thousand metric tons of li me per year
p, $ per ton
10
MC
AC
e
8
p = MR
p * = $426,000
6.50
6
0
140
284
q , Thousand metric tons of lime per year
Short run shutdown decision
• Shutdown if revenue less than avoidable
cost.
– In short run avoidable costs are variable costs.
pq  VC
pq VC

q
q
p  AVC
Short run shutdown decision
p, $ per ton
MC
AC
b
6.12
6.00
AVC
A = $62,000
5.50
B = $36,000
5.14
5.00
a
0
50
p
e
100
140
q, Thousand metric tons of lime per year
Short run supply curve of the
firm
p, $ per ton
S
e4
8
p4
e3
7
AC
p3
AVC
e2
6
p2
e1
p1
5
MC
0
q 1 = 50
q 2 = 140
q 3 = 215
q 4 = 285
q, Thousand metric tons of lime per year
Industry SR supply curve with 5
identical firms
(a) Firm
(b) Market
p, $ per ton
7
p, $ per ton
7
S1
S1
S2
S3
S4
6.47
AVC
6.47
6
6
5
5
S5
MC
0
50
140 175
q, Thousand metric tons
of lime per year
0
50 150 250
100 200
700
Q, Thousand metric tons
of lime per year
Industry SR supply curve with 2
different firms
p, $ per ton
S2
8
S1
S
7
6
5
0
25 50
100 140 165
215
315
450
q, Q, Thousand metric tons of lime per year
SR equilibrium in the market
(a) Firm
(b) Market
p, $ per ton
p, $ per ton
8
8
S1
e1
7
6.97
A
B
S
D1
7
E1
AC
D2
6.20
6
AVC
6
C
5
0
5
e2
q 2 = 50
q 1 = 215
q, Thousand metric tons
of lime per year
0
E2
Q 2 = 250
Q 1 = 1,075
Q, Thousand metric tons
of lime per year
Supply curve of the firm in the
long-run
p, $ per unit
S SR
S LR
LRAC
SRAC
SRAVC
p
35
B
A
28
25
24
20
LRMC
SRMC
0
50
110
q, Units per year
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
(a) Firm
(b) Market
p, $ per unit
S
p, $ per unit
1
LRAC
Long-run market supply
10
10
LRMC
0
0
150
q, Hundred metric tons of oil per year
Q, Hundred metric tons of oil per year
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)
Price, $ per kg
Differing firms: the LR supply
curve for cotton
Iran
1.71
United States
1.56
Nicaragua, Turkey
1.43
Brazil
1.27
1.15
1.08
0.71
0
S
Australia
Argentina
Pakistan
1
2
3
4
5
6
6.8
Cotton, billion kg per year
Increasing cost industry
(a) Firm
(b) Market
p, $ per unit
p, $ per unit
MC 2
MC 1
AC 2
S
AC 1
p2
p1
e2
E2
e1
q1 q 2
E1
q, Units per year
Q 1 = n 1q 1 Q 2 = n 2q 2
Q, Units per year
Decreasing cost industry
(b) Market
(a) Firm
p, $ per unit
MC1
p, $ per unit
MC 2
AC 1
AC 2
e1
p1
E1
e2
E2
p2
S
q1 q2
q, Units per year
Q 1 = n1 q 1 Q2 = n 2 q2
Q, Units per year
Long run competitive
equilibrium
(a) Firm
(b) Market
, $ per ton
p, $ per ton
MC
D1
D2
AC
S SR
f2
11
10
F2
AVC
e
11
10
f1
7
0
E 2 S LR
E1
F1
7
100 150 165
q, Hundred metric tons
of oil per year
0
1,500 2,000
3,300 3,600
Q, Hundred metric tons
of oil per year
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 Rent
p, $ per bushel
MC
AC (including rent)
AC (excluding rent)
p*
p* = Rent
q*
q, Bushels of tomatoes per year