Market Structure and Perfect Competitive Firm

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Market Structure and Perfect Competitive Firm

• Hall and Lieberman, 3rd edition, Thomson
  South-Western, Chapter 8

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Overview

• What you will learn from this lecture
• Market structure
• 3 Requirements for perfect competition
• Demand curve for a competitive firm
• Supply curve for a competitive firm
• How is the profit is maximized? At which output
  level?
• How is profit or loss is measured using graphs?

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Part I Market Structure

• Sellers want to sell at the highest possible
  price
• Buyers seek lowest possible price
• All trade is voluntary
• different goods and services are sold in vastly
  different ways
• Economists think about market structure
• Characteristics of a market that influence
  behavior of buyers and sellers when they come
  together to trade

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Types of Market

• For any particular market, we ask
• How many buyers and sellers are there in the
  market?
• Is each seller offering a standardized product,
  more or less indistinguishable from that offered
  by other sellers?
• Are there any barriers to entry or exit, or can
  outsiders easily enter and leave this market?
• Four basic types of market
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly

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Part II. The Three Requirements of Perfect
Competition

• Large numbers of buyers and sellers
• Each buys or sells only a tiny fraction of the
  total quantity in the market
• Sellers offer a standardized product
• Sellers can easily enter into or exit from market
• Significant barriers to entry and exit can
  completely change the environment in which
  trading takes place
• Examples?

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i. A Large Number of Buyers and Sellers

• In perfect competition, there must be many buyers
  and sellers
• How many?
• Number must be so large that no individual
  decision maker can significantly affect price of
  the product by changing quantity it buys or sells

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ii. Selling Standardized Products

• Buyers do not perceive significant differences
  between products of one seller and another
• For instance, buyers of wheat do not prefer one
  farmers wheat over another

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iii. Easy Entry into and Exit from the Market

• Easy Entry
• no significant barriers to discourage new
  entrants
• any firm wishing to enter can do business on the
  same terms as firms that are already there
• Easy exit
• A firm suffering a long-run loss must be able to
  sell off its plant and equipment and leave the
  industry for good, without obstacles

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iii. Easy Entry into and Exit from the Market

• In many markets there are significant barriers to
  entry
• Legal barriers
• Existing sellers have an important advantage that
  new entrants can not duplicate
• Brand loyalty
• Cost advantage of existing firms from significant
  economies of scale

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The U.S. Market is characterized by entry and
exitExample Job creation and destruction in
manufacturing

• Annual averages
• 10 of jobs disappear forever
• 9 of jobs appear for the first time
• Shutdowns responsible for 23 of job destruction
• Start-ups responsible for 16 of job creation
• Haltiwanger, Davis and Schuh, Job Creation and
  Job Destruction. MIT Press. 1996.

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Is Perfect Competition Realistic?

• Assumptions are rather restrictive
• In reality, one or more of assumptions will be
  violated in vast majority of markets
• Yet economists use perfect competition more often
  than any other market structure
• Why?
• Model of perfect competition is powerful
• Many markets come reasonably close to be perfect
  competitive
• Perfect competition can approximate conditions
  and yield accurate-enough predictions in a wide
  variety of markets

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Even if conditions for perfectly competitive
markets are not satisfied

• Assumptions are close enough for predictions of
• Firm entry or exit
• Price increase or decrease
• Increase or decrease in industry quantity
• Increase or decrease in firm quantity

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Part III. The Perfectly Competitive Firm

• What is occurring in a competitive market is
  quite different from the view we get when looking
  at a perfect competitive firm.
• entirely different picture
• In learning about competitive firm, must also
  discuss competitive market in which it operates

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Figure 1 The Competitive Industry and Firm
Market
Firm
S
400
400
Demand Curve Facing the Firm
D
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Goals and Constraints

• Perfectly competitive firm faces a cost
  constraint when producing any given level of
  output
• Firms production technology
• Prices it must pay for its inputs
• Cost function for a perfectly competitive firm is
  standard

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The Demand Curve Facing a Perfectly Competitive
Firm

• Demand curve is horizontal, or infinitely price
  elastic
• Why?
• Output is standardized
• No matter how much a firm decides to produce, it
  cannot make a noticeable difference in market
  quantity supplied
• So cannot affect market price
• Firm is a price taker
• Treats the price of its output as given and
  beyond its control
• Its only decision is how much output to produce
  and sell

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Cost and Revenue

• MR at each quantity is the same as the market
  price
• MR Price
• marginal revenue curve and demand curve facing
  firm are the same
• A horizontal line at the market price

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Profit Maximization The Total Revenue and Total
Cost Approach

• Firms profit per unit
• ( Revenue per unit ) ( cost per unit )
• ?profit per unit P ATC
• Total Profit TR TCQ(P-ATC)
• TR and TC approach
• Pick out the output level where there is biggest
  difference between TR and TC
• Most direct way of viewing firms search for the
  profit-maximizing output level

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Figure 2a Profit Maximization find greatest TR
- TC
TR
TC
2,800
Maximum Profit per Day 700
2,100
550
Slope 400
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Profit Maximization The Marginal Revenue and
Marginal Cost Approach

• Profit-maximizing output is found where MC curve
  crosses MR curve from below
• Or where P MC
• Firm should continue to increase output as long
  as pMRgtMC
• Requires no new concepts or techniques

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Figure 2b Profit Maximization Find MR MC from
below
MC
400
D MR
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Measuring Total Profit Graphically

• How to measure profit or loss?
• Find the optimal output level Q from profit
  maximization
• P MC or using TR TC method
• At Q , find the ATC, unit cost for producing
  that amount of outputs
• Pointing out the difference between P and ATC
  along the vertical axis
• The area (P-ATC) X Q is
• Profit if PgtATC
• Loss if PltATC

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Figure 3a Measuring Profit if P gt ATC
Economic Profit
ATC
MC
Profit per Ounce (100)
d MR
400
300
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Figure 3b Measuring Loss if P lt ATC
Economic Loss
MC
Loss per Ounce (100)
ATC
300
d MR
200
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The Firms Short-Run Supply Curve

• A competitive firm is a price taker
• Then decides how much output it will produce at
  that price
• Whenever the market price is set at a new level,
  the best output level will be determined by
  firms, using the MR and MC approach
• Exception
• If the firm is suffering a loss large enough to
  justify shutting down, it will not produce along
  its MC curve
• Zero output produced instead

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Figure 4 Short-Run Supply Under Perfect
Competition
(a)
(b)
ATC
Firm's Supply Curve
MC
3.50
d1MR1
3.50
2.50
2.50
d2MR2
2.00
2.00
d3MR3
AVC
1.00
1.00
d4MR4
0.50
0.50
d5MR5
1,000
4,000
7,000
2,000
4,000
7,000
2,000
5,000
5,000
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The Shutdown Price and Supply Curve

• Shutdown price is the price at which a firm is
  indifferent between producing and shutting down
• Supply curve has two parts
• Whenever PgtAVC, supply curve coincides with MC
  curve
• Whenever PltAVC, firm will shut down
• A vertical line segment at zero units of output
• Figure 4 For all prices below 1the shutdown
  priceoutput is zero and the supply curve
  coincides with vertical axis

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The (Short-Run) Market Supply Curve

• The shut run market supply curve is obtained from
  the aggregation of individual firms supply curve
• summing quantities of output supplied by all
  firms in market at each price
• As we move along the market supply curve, we are
  assuming that two things are constant
• Fixed inputs of each firm
• Number of firms in market

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Figure 5 Deriving The Market Supply Curve
Market Supply Curve
Firm's Supply Curve
3.50
3.50
2.50
2.50
2.00
2.00
1.00
1.00
0.50
0.50
400,000
700,000
2,000
4,000
7,000
200,000
500,000
5,000
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Summary

• 3 Requirements for perfect competition
• many sellers and buyers
• standardized products
• free entry and exit
• Demand curve for a competitive firm is perfect
  elastic (horizontal line)
• MR P
• Supply curve for a competitive firm is discrete
• is MC when Pgt AVC
• is zero when PltAVC
• 2 approaches to maximize profit by choosing
  output level
• Maximized difference between TR and TC
• MR MC
• Profit can be measured using graphs