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Perfect Competition Completely Unrealistic Yet Entirely Relevant
Market Structures In Economics, we identify four basic market structures. A market structure reflects three basic characteristics Number of firms in the market Product differentiation Ease of entry into the market
Four Market Structures Perfect Competition – many firms selling the same product Monopolistic Competition – many firms selling differentiated products Oligopoly – few firms selling differentiated (yet very similar) products Monopoly – a great board game, ALWAYS buy the railroads if you can! HA HA Seriously, that is the LAST “monopoly is a board game” joke for the year…well, maybe. In reality, a monopoly is always one firm selling a unique product.
Perfect Competition Very many firms Generally, the firms are very small, could be just one person who works for him or herself. Wide selling radius In perfect competition, the small firm must sell its products in a wide market, usually nationally or internationally Standardized products The product produced by one firm cannot differ in any way from that produced by another No need for advertisement or any other forms of non-price competition Price-Takers A firm in perfect competition cannot set the price of their product The market will determine the price, the firm can only choose the quantity sold Attempts at changing the price by a firm will result in less than the profit maximized position Free Entry and Exit Firms may come and go with no barriers (legal, technological, financial, etc. )
Examples of Perfect Competition Truthfully, there are not many. Farming used to be a good example, but today most farms are owned by large corporations and entry into the market is very financially difficult for small farmers Stock Market Each share of a stock is exactly the same as the next share Why would the following NOT be perfectly competitive? Airline Industry Clothing Industry Television Broadcasting Private Education
The Industry and the Firm An industry is a place where many firms sell their products to many buyers. Within the industry, the supply curve reflects all of the supply curves of all of the firms added together. Within the industry, the demand curve reflects all of the demand curves of all of the buyers added together. The equilibrium point in the industry tells us two things. First, the price that all firms in the perfectly competitive industry MUST accept. Second, the total quantity of the product that will be produced by all of the firms in the industry. Since, each firm within a perfectly competitive industry is so small, they can choose to produce as much or as little as they want If they were large enough to have a significant market share, the industry would no longer be perfectly competitive.
rizo nta The Graph l. D em Price per Bushel in Chicago Ho and Cu D rve Note $3 A B C the E $3 Industry supply curve Q pri ce E S Industry demand curve Firm’s demand curve S D 0 1 2 3 4 Truckloads of Corn Sold by Farmer Jasmine per Year (a) 0 100 200 300 400 Total Sales in Chicago in Thousands of Truckloads per Year (b)
The Graph – What to Know The Difference Between the Industry and Firm For the firm, Marginal Revenue = Demand = Average Revenue = Price…or… Mr. Darp, seen here, is always horizontal at the market price
Let’s Get the Numbers Down CENSORED
Profit Maximization – Short Run We know that profit maximization occurs where MR = MC. In the case of a perfectly competitive firm, MR = P, so P = MC at the profit maximized level At this point, we can determine the quantity that will be produced by the firm. What happens to the quantity produced when the demand in the industry increases? What happens when the variable costs of production increase at each level of production?
The Short-Run Profit In order to determine the profit of the firm, we have to analyze the revenue and costs. We know, at the point of profit maximization, what the average revenue (AR) is. What is it? It’s the PRICE! (AR = P) Now, all we need to know is the average cost of each unit we product (ATC). Profit = P – ATC since this tells us how much profit will be made at the profit maximized level. Exercise: In the last table, identify the AVERAGE TOTAL COST for each level of production. Graph the MR, AR, MC, and AC.
MC AC $3. 00 2. 25 1. 50 0 it rof e. P Th Revenue and Cost per Bushel Identifying Short-Run Profit B D = MR = AR A Let’s identify 1. Total Revenue 2. Total Cost 50, 000 3. Total Profit Bushels of Corn per Year
Graphical Analysis The graph tells us The total revenue (big box) The total cost (the bottom portion) The total profit (the box between the AR (D) line and the total cost box) Complete #1 from Activity 34
Sometimes, Mr. Darp aint so nice… In the instance where MR. DARP is above ATC, the firm will be making economic profit (i. e. profit even with opportunity costs being accounted for). What might happen, however, if the industry demand were to fall? Let’s see…
Minimized Short-Run Losses When the ATC is above AR at the profit maximized point, the firm is actually going to lose money. In this instance, their loss is minimized. If they choose to produce at another level, the loss becomes worse. In the short-run, the firm will have a decision to make… Continue to operate in the short-run and lose money or Shut down and lose money Rule: In the short run, a firm will continue to operate if A. Profits are being made B. Losses are smaller than fixed costs (revenue is above the average variable cost curve)/
Graphically Speaking In the short run, a firm will remain open when MR=D=AR=P is above the ATC curve or MR=D=AR=P is below the ATC curve but above the AVC curve In the short run, a firm will shut-down when MR=D=AR=P is below the AVC curve In your notes, draw an example of each. Note: that in the short-run, the firms supply curve is its MC curve above the AVC curve.
So, what happens in the long run? Firms, in the long run, will be able to escape from fixed costs if they wish to. Under the condition where a firm is taking any kind of loss in the short run, the firm will exit the industry in the long-run… Under any condition where a firm is making a profit in the short-run, the firm will continue to operate. . .
Exit and Entry In the long run, firms can exit with no trouble. Other firms can also enter the industry with no trouble. What will cause a firm to leave the industry in the long-run? What will cause a firm to enter the industry in the long-run? The next step…
Industry Supply As firms enter and exit the industry, the industry supply curve is affected. If there is above zero-economic profit being made by firms in and industry, more firms will enter the industry… If more firms enter the industry, the supply of the industry will shift to the right… What will happen to price? What will this do to the profit maximizing firm that is making profit in the short-run?
Competition in the Long-Run Mo re f Firm Pf Industry (1, 000 firms) S 0 AC alls … e $3. 00 2. 25 s… MC a D 0 D 1 b 40 45 50 Price per Bushel MR DA R irm D (1, 600 firms) S 1 E $3. 00 A 2. 25 S 0 D S 1 50 72 Quantity of Corn in Thousands of Bushels Quantity of Corn in Millions of Bushels (a) (b)
Long-Run Profit As more firms enter, those firms making an economic profit will see their profit shrink… This process will continue until all firms in the long-run are making ZERO ECONOMIC PROFITS. The long-run condition for firms in perfect competition is ZERO ECONOMIC PROFITS… Under this condition, MR=MC=ATC. The same situation occurs for firms that are taking losses…
Losses and Zero Economic Profit If firms are taking losses in the short-run, they will exit in the long-run…. As firms exit, the industry supply curve shifts to the left… What will happen to the industry price? What will happen for firms taking losses in the short-run that stay open? Again, the price will rise until all firms operating in long-run equilibrium are making ZERO ECONOMIC PROFIT.
What does this mean? Fact: In perfect competition, firms will operate with ZERO-ECONOMIC PROFIT. Fact: In perfect competition, firms will operate at maximized efficiency. Firms that survive in the long-run will produce at the lowest point on their ATC curve. Fact: In perfect competition, consumers will pay the lowest price possible for any given good or service. Not Fact: Perfect competition is real and alive and well…