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1 Perfect Competition Prof. Nikhil Monga 1 Perfect Competition Prof. Nikhil Monga

OBJECTIVES 2 To understand market morphology To understand Perfect Competition To understand the features OBJECTIVES 2 To understand market morphology To understand Perfect Competition To understand the features of Perfect Competition To understand the short run price and output for the competitve industry and firm.

Market 3 Defined as the institutional relationship between buyers and sellers. Market refers to Market 3 Defined as the institutional relationship between buyers and sellers. Market refers to the interaction between buyers and sellers of a good (or service) at a mutually agreed upon price. Such interaction may be at a particular place, or may be over telephone, or even through the Internet! Sellers and buyers may meet each other personally, or may not ever see each other, as in E-commerce. Thus market may be defined as a place, a function, a process.

4 § Markets may be characterized on the basis of: § § § Number, 4 § Markets may be characterized on the basis of: § § § Number, size and distribution of sellers in any market Whether the product is homogeneous or differentiated Number and size of buyers: Freedom to enter into or exit from the market Thus we have: § § Perfect Competition Monopoly Monopolistic competition Oligopoly

Market Morphology Type of market Number of firms Nature of product Perfect competition Very Market Morphology Type of market Number of firms Nature of product Perfect competition Very Large Homogeneous (undifferentiated) Very Large Agricultural commodities, Stock market, Bullion market , unskilled labor Monopolistic competition Many Differentiated Many Retail stores, FMCG Oligopoly Few Undifferentiated or differentiated Few Cars, computers, universities Monopoly Single Unique Many Indian Railways. DUOPOLY Two Undifferentiated or differentiated Few Coke and Pepsi 5 Number of buyers Examples

Features of Perfect Competition 6 Perfect competition may be defined as that market where Features of Perfect Competition 6 Perfect competition may be defined as that market where very large number of sellers sell homogeneous good to very large number of buyers while buyers and sellers have perfect knowledge of market conditions § Features Presence of large number of buyers and sellers § Homogeneous product Eg Unbranded Spices § Freedom of entry and exit § Perfect knowledge § Perfectly elastic demand curve § Price determined by market and Firm is a price taker. §

Price Taking 7 The perfectly competitive firm is said to be a pricetaker, because Price Taking 7 The perfectly competitive firm is said to be a pricetaker, because it takes the market price as given and has no control over the price. Why? . . .

8 If the firm tried to charge a higher price, it would lose all 8 If the firm tried to charge a higher price, it would lose all its business. Customers could go elsewhere to buy the same product for less. Since the firm is very small, it can sell as much as it wants at the market price. So there’s no reason to charge a lower price.

9 The demand curve for the product of the perfectly competitive firm shows how 9 The demand curve for the product of the perfectly competitive firm shows how much can be sold at specific prices. Let’s see what it would look like. . . The firm can sell as little or as much as it wants at the market price. Suppose, for example, the market price is $5.

10 The firm can sell 10 units for $5. price $ 5 10 quantity 10 The firm can sell 10 units for $5. price $ 5 10 quantity

11 The firm can sell 20 units for $5. price $5 20 quantity 11 The firm can sell 20 units for $5. price $5 20 quantity

12 The firm can sell 30 units for $5. price $5 30 quantity 12 The firm can sell 30 units for $5. price $5 30 quantity

13 The firm can sell 40 units for $5. price $5 40 quantity 13 The firm can sell 40 units for $5. price $5 40 quantity

14 The firm can sell 50 units for $5. price $5 50 quantity 14 The firm can sell 50 units for $5. price $5 50 quantity

15 So all these points are on the demand curve for the firm’s product. 15 So all these points are on the demand curve for the firm’s product. price $ 5 quantity

16 Connecting these points, we have the demand curve for the firm’s product. price 16 Connecting these points, we have the demand curve for the firm’s product. price $ demand 5 quantity

17 The demand curve for the perfectly competitive firm’s product is a horizontal line 17 The demand curve for the perfectly competitive firm’s product is a horizontal line at the market price demand quantity

18 Recall: Total Revenue = Price x Quantity TR = P Q 18 Recall: Total Revenue = Price x Quantity TR = P Q

Recall: Marginal Revenue (MR) 19 Marginal Revenue is the additional revenue earned from selling Recall: Marginal Revenue (MR) 19 Marginal Revenue is the additional revenue earned from selling one additional unit of output. MR = DTR / DQ If MR>MC, we can increase total profit by producing more If MR

Short run equilibrium of a firm 20 Over a short period, firm can face Short run equilibrium of a firm 20 Over a short period, firm can face four situations as mentioned below MR> ATC Supernormal Profit MR= ATC Normal Profit MR

21 The demand curve (D) and the MR curve for the perfectly competitive firm’s 21 The demand curve (D) and the MR curve for the perfectly competitive firm’s product. price market price D = MR quantity

Optimal Output Level 22 To maximize profit, the firm will produce at the output Optimal Output Level 22 To maximize profit, the firm will produce at the output level where MR = MC. So the firm will produce where the MR and MC curves intersect.

Costs in Short Run Costs C O TFC Quantity Costs TFC O Quantity Fixed Costs in Short Run Costs C O TFC Quantity Costs TFC O Quantity Fixed Costs Do not vary with output; e. g. plant, machinery, building. Total Fixed Cost (TFC) curve is a straight line, parallel to the quantity axis, indicating that output may increase to any level without causing any change in the fixed cost. In the long run plant size may increase hence FC curve may be step like, where each step showing FC in a particular time period.

Average and Marginal Cost 24 Average Cost (AC) is total cost per unit of Average and Marginal Cost 24 Average Cost (AC) is total cost per unit of output. Average Fixed Cost (AFC) is fixed cost per unit of output (AFC= TFC/Q) Average Variable Cost (AVC) is variable cost per unit of output (AVC= TVC/Q) Marginal cost (MC) is the change in total cost due to a unit change in output. AC is equal to the ratio of TC and units of output. (TC/Q) AC=AFC+AVC MCQ= TCQ-1 Since the fixed component of cost cannot be altered, MC is virtually the change in variable cost per unit change in output. Also known as rate of change in total cost.

Average and Marginal Cost Functions AC/MC MC ATC AVC AFC O Quantity Contd… AC Average and Marginal Cost Functions AC/MC MC ATC AVC AFC O Quantity Contd… AC curve is U shaped When both AFC and AVC fall, AC also falls and when AVC rises AC starts increasing. When average costs decline, MC lies below AC. When average costs are constant (at their minimum), MC equals AC. MC passes through the lowest point of AC curves. When average costs rise, MC curve lies above them.

Market Demand Curve and Firm’s Demand Curve 26 Market equilibrium is at the point Market Demand Curve and Firm’s Demand Curve 26 Market equilibrium is at the point of intersection (E) of the market demand market supply curves, where equilibrium output for the industry is given at Q* and price at P*. Each perfectly competitive firm, being a price taker, takes the equilibrium price from the market as given at P*. Price Market Demand INDUSTRY Market Supply S Price FIRM D E P* S O P=AR=MR D Q* Output O Output

Short Run Price and Output for the Competitive Industry and Firm 27 In short Short Run Price and Output for the Competitive Industry and Firm 27 In short run an individual firm may be in equilibrium and may earn Supernormal profit: Normal profit: Losses: AR>AC AR=AC AR

Supernormal Profit 28 MR>ATC Price MC P* E A ATC AR=MR B O Q* Supernormal Profit 28 MR>ATC Price MC P* E A ATC AR=MR B O Q* Quantity E is point of equilibrium as MC=MR and MC cut MR from below. At point E, MR>ATC & MR=AR Firm is in equilibrium at OQ* output at market price P*, where both the conditions of equilibrium are fulfilled. TR= OP*EQ* (TR= AR. Q) TC= OABQ* (TC=AC. Q) Profit = AP*EB = (OP*EQ*-OABQ*) This is the supernormal profit made by the firm in the short run, because the market price P* (AR) is greater than average cost.

Normal Profit 29 AC=AR=MC=MR Price MC ATC P* E AR=MR O Q* Quantity In Normal Profit 29 AC=AR=MC=MR Price MC ATC P* E AR=MR O Q* Quantity In the short run some firms may earn only normal profit (when average revenue is equal to average cost). E is point of equilibrium as MC=MR and MC cut MR from below. At point E, MR=ATC & MR=AR Firm is in equilibrium at OQ* output at market price P*, where both the conditions of equilibrium are fulfilled. TR= OP*EQ* TC= OP*EQ* TR=TC Firm makes normal profit, and actually ends up producing at the break even level of output.

Losses 30 Price AR<AC MC A P* ATC B AR=MR E O Q* Quantity Losses 30 Price ARE, it implies AR

Exit or Shut Down of Production 31 MC FIRM ATC AVC Price R F Exit or Shut Down of Production 31 MC FIRM ATC AVC Price R F G P* E AR=MR O Q* Quantity • A firm incurring losses in the short run will not withdraw from the market, but will wait for market conditions to improve in the long run. E is point of equilibrium as MC=MR, it produces Q amount of output, the firm incur average total cost of F, while it earns Average revenue E, At equilibrium F>E, the firm incur the loss of EF per unit of output produced. Since total earned revenue is OPEQ and total cost is ORFD. The loss is too much to continue, as this firm AVC is also above AR=MR so it should be shut down

32 Super normal Profit Normal Profit Losses Shut down point 32 Super normal Profit Normal Profit Losses Shut down point

Long Run Price and Output for the Industry and the Firm 33 In the Long Run Price and Output for the Industry and the Firm 33 In the long run perfectly competitive firms earn only normal profits. AR=MR=MC=AC The reason is the unrestricted entry into and exit of firms from the industry in the long run. When existing firms enjoy supernormal profits in the short run new firms are attracted to the industry to gain profits. When firms are making losses in the short run, some may be forced to leave the industry in the long run. The supply of the commodity in the market increases. Assuming no change in the demand side, this lowers the price level. Their exit from the industry causes a reduction in the supply of the product and as a result the equilibrium price rises. This process of adjustment continues up to the point where the price line becomes tangential to the AC curve.

Long Run Price and Output for the Industry and the Firm 34 Price P Long Run Price and Output for the Industry and the Firm 34 Price P 1 P* P 2 O • Prevailing price is OP 1, Equilibrium at Point E 1 and AR=MR=MC=AC Output OQ 1 • Firms earn supernormal LMC profit (AR>AC) LAC • This will attract more firms, E 1 increase in supply will reduce E* AR=MRthe price till AC=AR, i. e. at P* E 2 • Prevailing price is OP 2, Equilibrium at Point E 2 and Output OQ 2 • Firms earn loss (AR

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36 MONOPOLY 36 MONOPOLY

Introduction 37 § § A monopoly (from the Greek word “mono” meaning single and Introduction 37 § § A monopoly (from the Greek word “mono” meaning single and “polo” meaning to sell) is that form of market in which a single seller sells a product (good or service) which has no substitute. Monopoly exists when there is no close substitute to the product and also when there is a single producer and seller of the product § E. g. Indian Railway is a monopoly, since there is no other agency in the country that provides railway service. Pure monopoly is that market situation in which there is absolutely no substitute of the product, and the entire market is under control of a single firm. § 37

Features 38 § § § Single seller § The entire market is under control Features 38 § § § Single seller § The entire market is under control of a single firm. Single product § A monopoly exists when a single seller sells a product which has no substitute or, at least, no close substitute in the market. No difference between firm and industry § There is a single firm in the industry Independent decision making § Firm is regarded as a price maker Restricted entry § Existence of barriers leads to the emergence and/or 38 survival of a monopoly

Types of Monopoly 39 § § Legal Monopoly § Created by the laws of Types of Monopoly 39 § § Legal Monopoly § Created by the laws of a country in the greater public interest. § To prevent disparity in distribution of wealth, or imbalanced growth of the economy(State electricity Boards) Economic Monopoly § Created due to superior efficiency of a particular player. § Technical know-how restrained in the hold of single § Control over scarce and key raw materials § Economies of Scale 39

40 § Natural Monopoly § § § Size of the market is so small 40 § Natural Monopoly § § § Size of the market is so small that it can accommodate only one player Economies of Scale Regional Monopoly § Geographical or territorial aspects also help in creation of monopolies.

Sources of Monopoly 41 Restriction by Law Control over key Raw Materials Specialized Know Sources of Monopoly 41 Restriction by Law Control over key Raw Materials Specialized Know How Economies of Large Scale Small Market Size

Demand MR Curves § The demand curve of the monopolist is highly price inelastic Demand MR Curves § The demand curve of the monopolist is highly price inelastic because there is no close substitute and consumers have no or very little choice. Revenue, Cost O 42 MR AR Quantity § It is not perfectly inelastic because pure monopoly does not exist in real life. § Hence it faces a normal downward sloping demand (AR) curve. § MR curve corresponds. 42

Price and Output Decisions in Short Run 43 § § § The monopolist cannot Price and Output Decisions in Short Run 43 § § § The monopolist cannot set both price and quantity at its own will. In order to maximize profit a monopoly firm follows the rule of MR=MC when MC is rising. A monopoly firm may earn supernormal profit or even subnormal profit in the short run. The negative slope of the demand curve is instrumental for chances of monopoly profits in the short run. In the short run, the firm would reap the benefits of supplying a product which not only is unique, but also has negligible cross elasticity. Price, Revenue, Cost AR>AC MC AC B PE A E AR MR O QE Quantity 43

44 AR 44 AR

Price and Output Decisions in Short Run Price, Revenue, Cost AR=AC Price, Revenue, Cost Price and Output Decisions in Short Run Price, Revenue, Cost AR=AC Price, Revenue, Cost MC AR

Price and Output Decisions in Long Run § It would try to reduce cost Price and Output Decisions in Long Run § It would try to reduce cost of production § Otherwise it would close down in the long run. § Monopolist would try to earn at least normal profit in the long run and may earn supernormal profit due to entry restrictions in the market. § If in the long run a monopoly firm earns supernormal profit § This would attract competition and high price would make it possible for a new entrant to survive. § To retain its monopoly power, the firm may have to resort to a low price and earn only normal profit even in the long run to create an economic barrier to new entrants. 46 46

47 47

MONOPOLISTIC COMPETITION MONOPOLISTIC COMPETITION

Lecture Plan Introduction Features of Monopolistic Competition Identification of industry Demand Marginal Revenue Curves Lecture Plan Introduction Features of Monopolistic Competition Identification of industry Demand Marginal Revenue Curves of a Firm Price and Output Decisions in Short Run Price and Output Decisions in Long Run Monopolistic Competition and Advertising Comparison between Monopolistic Competition, Monopoly and Perfect Competition

Objectives To understand the nature of imperfect competition or monopolistic competition. To analyze the Objectives To understand the nature of imperfect competition or monopolistic competition. To analyze the pricing and output decisions of a monopolistically competitive firm in the short run and long run.

Introduction Introduced by Joan Robinson (The Economics of Imperfect Competition, 1933) and Edward H. Introduction Introduced by Joan Robinson (The Economics of Imperfect Competition, 1933) and Edward H. Chamberlin (The Theory of Monopolistic Competition, 1933) It is a market situation in which a relatively large number of producers offer similar but not identical products. A combination of perfect competition and monopoly. Imperfect competition because a large number of sellers sell heterogeneous or differentiated products and buyers have preferences for specific sellers. Monopolistic, because each of these sellers makes the product unique by some differentiation and has control over the small section of market, just like a monopolist.

Features of Monopolistic Competition Features: Large number of buyers and sellers Heterogeneous products. Selling Features of Monopolistic Competition Features: Large number of buyers and sellers Heterogeneous products. Selling costs exist Independent decision making. Imperfect knowledge. Unrestricted entry and exit.

Demand Marginal Revenue Curves of a Firm • Normal downward sloping demand curve (AR Demand Marginal Revenue Curves of a Firm • Normal downward sloping demand curve (AR Curve) as all the firms in the industry sell close substitutes. • Demand is highly elastic and slope of demand curve is flatter Price, Reven ue O M R A R Quant ity • If a firm increases the price of its product slightly, it will lose some, but not all of its customers. • if it lowers the price slightly, it will gain some, but not all of the customers of its rivals. • MR curve lies below AR curve

Price and Output Decisions in Short Run Joan Robinson: Each firm has a monopoly Price and Output Decisions in Short Run Joan Robinson: Each firm has a monopoly over its product. When product is differentiated, firm has some monopoly power. Firms have limited discretion over price, due to the existence of consumer loyalty for specific brands. The reason for supernormal profit in short run, is supplying a product which is differentiated, or at least perceived to be different by the consumer.

Price & Output Decisions in Short Run Firm maximizes profit where (i) MR=MC; (ii) Price & Output Decisions in Short Run Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR when MC is rising. Profit maximising output OQE and Price OPE Price, Reven ue, Cost M C PE B A A C E O QE M R Quant ity A R Total revenue = OPEBQE Total cost =OAEQE Supernormal profit =APEBE since price OPE > OA (AR>AC)

Price & Output Decisions in Short Run Firm maximizes profit where (i) MR=MC; (ii) Price & Output Decisions in Short Run Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR when MC is rising. Profit maximising output OQE and Price OPE Price, Reven ue, Cost A PE O E M C B QE M R Quant ity A C A R Total revenue = OPEBQE Total cost =OAEQE Loss =APEBE since price OPE < OA (AR

Price & Output Decisions in Long Run Firm maximizes profit where (i) MR=MC; (ii) Price & Output Decisions in Long Run Firm maximizes profit where (i) MR=MC; (ii) MC cuts MR when MC is rising. Profit maximising output OQE and Price OPE Price, Reven ue, Cost PE O M C B QE M R Quant ity A C A R Total revenue = OPEBQE Total cost =OAEQE Normal profit = No loss no gain since AR=AC

Price & Output Decisions in Long Run • Just like perfect competition, in monopolistic Price & Output Decisions in Long Run • Just like perfect competition, in monopolistic competition too all the firms would earn normal profits in the long run. • In the long run supernormal profit would attract new firms to the industry till all the firms earn only normal profits. • Losses, will force firms to exit the industry till remaining firms in the market earn only normal profits. • If all the firms only normal profit there will be no tendency to enter or exit the market.

Oligopoly Oligopoly

Lecture Plan Introduction Features of Oligopoly Duopoly Lecture Plan Introduction Features of Oligopoly Duopoly

Objectives To examine the nature of an oligopoly market. To understand the indeterminate demand Objectives To examine the nature of an oligopoly market. To understand the indeterminate demand curve for a firm under oligopoly To look into the various models of price and output decisions under oligopoly.

Introduction Derived from Greek word: “oligo” (few) “polo” (to sell) A few dominant sellers Introduction Derived from Greek word: “oligo” (few) “polo” (to sell) A few dominant sellers sell differentiated or homogenous products under continuous consciousness of rivals’ actions. Oligopoly looks similar to other market forms; as there can be many sellers (like in monopolistic competition), but a few very large sellers dominate the market. Products sold may be homogenous (like in perfect competition), or differentiated (like in monopolistic competition). Entry is not restricted but difficult due to requirement of investments. One aspect which differentiates oligopoly from all other market forms, is the interdependence of various firms: no player can take a decision without considering the action (or reaction) of rivals.

Features of Oligopoly Few Sellers: small number of large firms compete Product: Some industries Features of Oligopoly Few Sellers: small number of large firms compete Product: Some industries may consist of firms selling identical products, while in some other industries firms may be selling differentiated products. Entry Barriers: No legal barriers; only economic in nature Huge investment requirements Strong consumer loyalty for existing brands Economies of scale

Features of Oligopoly Non Price Competition: Firms are continuously watching their rivals, each of Features of Oligopoly Non Price Competition: Firms are continuously watching their rivals, each of them avoids the incidence of a price war. P 1 A B P 2 Market share of A O Market share of B • Two firms A & B sell a homogenous product and sell at P 1. • Firm A lowers the price to gain market share. • B fears loss of its customers and retorts by lowering the price below that of A. • A further reduces the price and this process continues. • The two firms reach P 2. • Both realize that this price war is not helping either of them and decide to end the war. • Price again stabilises at P 2.

Features of Oligopoly Indeterminate Demand Curve • Pric D 1 e • D D Features of Oligopoly Indeterminate Demand Curve • Pric D 1 e • D D 1 O D Quan tity • • Price and output determination is very complex as each firm faces two demand curves. Demand is not only affected by its own price or advertisement or quality, but is also affected by the price of rival products, their quality, packaging, promotion and placement. When the firm increases the price it faces more elastic demand (D 1 D 1) When it reduces the price it faces less elastic demand (DD)

DEMAND FORECASTING DEMAND FORECASTING

What is forecasting? Forecasting is the process of using past events to make systematic What is forecasting? Forecasting is the process of using past events to make systematic predictions about future outcomes or trends.

Forecasting It is the prediction of future events on the basis of Historical data Forecasting It is the prediction of future events on the basis of Historical data Opinions Trend events Or known future variables

Why do we need Demand forecasting Reduces the cost Reduces the investment risk know Why do we need Demand forecasting Reduces the cost Reduces the investment risk know about the market (have a general idea of market ) reduce the problem of decision change the strategies of company in time Aids decision making Informs planning and resource allocation decisions If data is of high quality, can be accurate

 Limitations Data not always reliable or accurate Data may be out of date Limitations Data not always reliable or accurate Data may be out of date The past is not always a guide to the future Qualitative data may be influenced by peer pressure Difficulty of coping with changes to external factors out of the business’s control – e. g. economic policy, political developments, natural disasters – hurricanes, earthquakes, etc.

 Some businesses use alternative methods: Astrologers! Is such a strategy any better or Some businesses use alternative methods: Astrologers! Is such a strategy any better or worse than using quantitative or qualitative methods?

Forecasting Horizons 72 Long Range(more than 2 years) Medium Range (3 months to 2 Forecasting Horizons 72 Long Range(more than 2 years) Medium Range (3 months to 2 years) Short Range( Less than 3 months)

Steps to Forecasting 73 Determine the use or objectives of forecasting Select the items Steps to Forecasting 73 Determine the use or objectives of forecasting Select the items to be forecast Determine the time horizon of the forecast Select the suitable forecasting method Collect the data Validate the forecasting model Make the forecast Implement the results

The Main Forecasting Techniques Qualitative Quantitative The Main Forecasting Techniques Qualitative Quantitative

Qualitative Methods 75 Executive Committee Consensus (based on wisdom of senior managers through discussion) Qualitative Methods 75 Executive Committee Consensus (based on wisdom of senior managers through discussion) Delphi Method (series of questionnaire by panel experts) Survey of Sales force (opinion of sales force) Expert Evaluation Technique

Advantages 76 Ability to predict changes in sales pattern Allow decision makers to incorporate Advantages 76 Ability to predict changes in sales pattern Allow decision makers to incorporate rich data sources consisting of their intuition, experience and expert judgement.

Disadvantages 77 Expensive and time intensive Lead to inconsistencies in judgment due to moods Disadvantages 77 Expensive and time intensive Lead to inconsistencies in judgment due to moods and/or emotions of forecasters as well as due to the repetitive decision making inherent in generating multiple individual product forecasts. The future ability to forecast accurately may be reduced when a forecaster tries to justify rather than understand, a forecast that proves to be inaccurate information.

78 The forecast suffers due to Forecasters only consider readily available and/or recently perceived 78 The forecast suffers due to Forecasters only consider readily available and/or recently perceived information The forecasters are unable to process large amounts of complex information The forecasters are overconfident about their ability to forecast accurately The impact of anchoring (initial forecast) on the forecasts Political factors within organization as well between the organizations effects the forecasts.