Chapter 3 Perfect Competition

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Chapter 3Perfect Competition
2
Outline.

• Firms in perfectly competitive markets
• The Short-Run Condition for Profit Maximisation
• Adjustments in the long run
• Applying the Perfect Competitive Model

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The goal of profit maximisation

• Firms' main objective is to maximise profit.
• ? This assumption is not specific to perfect
  competition it is made whatever the type of
  market structure that is considered
• Economic profit is defined as the difference
  between total revenues and total costs. Total
  costs include opportunity and implicit costs.
• Example A firm produces 100 units of output per
  week using 10 units of capital and 10 units of
  labour. The capital belongs to the firm. The
  weekly price of each factor is 10 per unit and
  output sells for 2,5 per unit.
• Total revenue per week is 250.
• Total cost is 100 spent on labour (explicit
  cost) 100 spent on capital (opportunity cost)
• Economic profit is 250 200 50

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The goal of profit maximisation (ctd)

• If the opportunity cost of the resources owned by
  the firm are considered as generating a normal
  profit, the economic profit is the profit in
  excess to this normal profit
• Economists assume that the goal of firms is to
  maximise profit .
• Simplifying assumption
• Numerous challenges
• Idea firms do their best to maximse profit

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The four conditions for perfect competition

• Four conditions
• Firms sell a standardised product
• Firms are price-takers every individual firm
  considers the market price as given
• Factors of production are perfectly mobile in the
  long run
• Firms and consumers have perfect information
• Do they make sense?
• In most cases, strictly speaking NO
• But can tell us something

6
Outline.

• The Short-Run Condition for Profit Maximisation
• Adjustments in the long run
• Applying the Perfect Competitive Model

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Maximising profit in the short run

• Example Assume that a firm is characterised by
  the short-run total cost curve we saw in Chapter
  2.
• This firm experiences first increasing and then
  decreasing returns to is variable input.
• Assume that it can sell its product at a price P0
  18/unit.
• One characteristic of the competitive firm is
  that it considers the market price as given .
• So, the total revenue of the firm is given by
• TR P0.Q
• The profit of the firm is given by
• P TR TC

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Maximising profit in the short run (ctd1)

• The firm's problem is to maximise profit
• P TR TC P0.Q - TC
• First-order condition
• Second-order condition

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Maximising profit in the short run (ctd2)

• The firm maximises its profit when choosing a
  level of production such that its marginal
  revenue is strictly equal to its marginal cost

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The shut-down condition

• The market price must exceed the minimum value of
  the average variable cost. Otherwise the firm
  will do better, in the short-run, if shutting
  down .
• Under perfect competition, the average revenue
  is
• If P0 is lower than the minimum of the average
  variable cost curve, losses are minimum if the
  firm shuts down

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The shut-down condition (ctd1)
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The shut-down condition (ctd2)

• The 2 rules
• (i) price equals marginal cost on the rising
  portion of the marginal cost curve and
• (ii) price must exceed the minimum value of the
  average variable cost curve
• define the short-run supply curve of the
  perfectly competitive firm.
• Note that
• For P below the minimum of the AVC, the firm will
  supply 0 output
• For P between the minimum of the AVC and the
  minimum of the ATC, the firm will provide
  positive output
• In this range of prices, the firm will lose money
  (make negative profits) because
• (P ATC).Q P lt 0
• But covers its variable costs and even makes some
  money on top of it
• (P AVC).Q gt 0

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The short-run competitive industry supply

• For any given level of price, it is the sum of
  the amounts that firms are willing to supply at
  this price.
• When firms are identical
• If each firm has a supply curve Qi a b.P
• If there are n firms in the industry
• The total industry supply is just
• Q n Qi n.a n.b.P

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The short-run competitive industry supply (ctd)

• For an industry composed of 2 firms

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The short-run competitive equilibrium Positive
Profits
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The short-run competitive equilibrium Negative
profits
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Efficiency of the short-run competitive
equilibrium

• Competitive markets result in allocative
  efficiency, i.e. they fully exploit the
  possibilities for mutual gains through exchange

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The producer surplus

• The firm's gain compared with the alternative of
  producing nothing (DP) is
• DP (P ATC).Q - (-FC)
• Producer surplus
• P (ATC FC/Q).Q P AVC.Q
• because AVC ATC FC/Q
• It is the difference between what the firm
  actually gets (P.Q) and the minimum it was
  requiring to supply a positive output (AVC.Q)

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The producer surplus (ctd)
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The aggregate producer surplus on the market
21
Outline.

• Adjustments in the long run
• Applying the Perfect Competitive Model

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The long-run market equilibrium

• In the long run, all inputs are variable so that
  a firm will choose to go out of business if it
  cannot earn a "normal" profit in its current
  industry
• In the long run
• If firms in an industry make positive economic
  profits, other firms are going to enter this
  industry. This will drive the market price down
  because supply is going to increase.
• If firms make negative profits, the opposite
  movement will take place.

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The long-run market equilibrium (ctd)
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Allocative Efficiency

• This long-run market equilibrium has a number of
  nice efficiency properties
• The equilibrium price is equal to the long-run
  and short-run marginal cost so that all
  possibilities for mutually beneficial trade are
  exhausted.
• All producers earn only a normal rate of profit.
• ? All these properties define what is called
  allocative efficiency.

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The long-run competitive industry supply curve

• With U-shaped LAC curves

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Changing input prices and long-run supply

• So far, we have assumed that input prices did not
  vary with the amount of output produced
• However, for a number of very large industries,
  the amount of inputs purchased constitutes a
  substantial share of the market
• When this happens, the price of inputs increases
  as output rises. This generates a pecuniary
  diseconomy.
• In this case, the long-run curve is upward
  sloping even if individual LAC curves are
  U-shaped
• These are called increasing cost industries

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Increasing cost industries
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Decreasing cost industries

• In some cases, an increase in the volume of
  output may reduce the price of inputs.
• This is the case if the increase in the demand
  for the input creates an incentive for innovation
  resulting in lower production costs for those
  inputs (e.g. computers).
• In this case there is a pecuniary economy and the
  long-run industry supply curve is downward
  sloping.
• These are called decreasing cost industries.

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The elasticity of supply

• The price elasticity of supply is the percentage
  change in supply in response to a given change in
  prices

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The elasticity of supply (ctd)

• So, it can be re-written as
• In the short-run the supply curve is upward
  sloping so that the elasticity of supply will be
  positive.
• For industries with a long-run horizontal supply
  curve, the elasticity is infinite.

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Outline.

• Applying the Perfect Competitive Model

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The perfect competitive model to what extent is
it useful (useless)?

• No industries strictly satisfy the 4 conditions
  of perfect competition
• Still, it may be a useful tool, in particular
  because its long-run properties apply in a large
  number of industries
• Exampledecrease in the number of small family
  farms which are increasingly replaced by large
  corporate ones.

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Corporate and Family Farms
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Price support policies

• In this particular case, resource mobility is far
  from being perfect.
• Many farmers are strongly attached to their land
• ? Programs supporting the price of agricultural
  products
• These programs have failed miserably

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The failure of price support programs
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Changes in the EC policy

• As a way of protecting the long-term viability of
  family farms the agricultural price support could
  not have been more ill-conceived.
• More efficient ways to aid family farmers would
  have been a reduction in income taxes or even,
  more directly, cash grants.
• This is actually what the European Commission has
  realised recently.
• "Severing the link between subsidies and
  production (usually termed decoupling) will
  enable EU farmers to be more market-orientated.
  They will be free to produce according to what is
  most profitable for them while still enjoying a
  required stability of income".