Copyright (c)2014 John Wiley & Sons, Inc Chapter Perfectly Competitive Markets Chapter Nine Overview 1.1 Introduction Introduction 2.2 Perfect Competition Defined Perfect Competition Defined 3.3 The Profit Maximization Hypothesis The Profit Maximization Hypothesis 4.4 The Profit Maximization Condition The Profit Maximization Condition Short Run Equilibrium Short Run Equilibrium Short Run Supply Curve for the Firm Short Run Supply Curve for the Firm Short Run Market Supply Curve Short Run Market Supply Curve Short Run Perfectly Competitive Equilibrium Short Run Perfectly Competitive Equilibrium Producer Surplus Producer Surplus •• •• •• •• Copyright (c)2014 John Wiley & Sons, Inc 5.5 6.6 Long Run Equilibrium Long Run Equilibrium •• Long Run Equilibrium Conditions Long Run Equilibrium Conditions •• Long Run Supply Curve Long Run Supply Curve Chapter Nine Perfectly Competitive Markets AAperfectly perfectlycompetitive competitivemarket marketconsists consistsofoffirms firmsthat thatproduce produceidentical identicalproducts productsthat thatsell sellatat the thesame sameprice price Each Eachfirm’s firm’svolume volumeofofoutput outputisisso sosmall smallinincomparison comparisontotothe theoverall overallmarket marketdemand demandthat that Copyright (c)2014 John Wiley & Sons, Inc no nosingle singlefirm firmhas hasan animpact impacton onthe themarket marketprice price Chapter Nine Perfectly Competitive Markets - Conditions A.A Firms Firms produce produce undifferentiated undifferentiated products products inin the the sense sense that that consumers consumersperceive perceivethem themtotobe beidentical identical B.B.Consumers Consumershave haveperfect perfectinformation informationabout aboutthe theprices pricesall allsellers sellers Copyright (c)2014 John Wiley & Sons, Inc ininthe themarket marketcharge charge Chapter Nine Perfectly Competitive Markets - Conditions C.C Each Each buyer’s buyer’s purchases purchases are are soso small small that that he/she he/she has has an an imperceptible imperceptibleeffect effecton onmarket marketprice price D.D.Each Eachseller’s seller’ssales salesare aresososmall smallthat thathe/she he/shehas hasan animperceptible imperceptible effect effecton onmarket marketprice price Each Eachseller’s seller’sinput inputpurchases purchasesare aresososmall small that thathe/she he/sheperceives perceivesno noeffect effecton oninput inputprices prices E.E.All Allfirms firms(industry (industryparticipants participantsand andnew newentrants) entrants)have haveequal equal Chapter Nine Copyright (c)2014 John Wiley & Sons, Inc access accesstotoresources resources(technology, (technology,inputs) inputs) Implications of Conditions The Law of One Price: Conditions (a) and (b) imply that there is a single price at which transactions occur Price Takers: Conditions (c) and (d) imply that buyers and sellers take the price of the product as given when making their purchase and output decisions Copyright (c)2014 John Wiley & Sons, Inc Free Entry: Condition (e) implies that all firms have identical long run cost functions Chapter Nine The Profit Maximization Hypothesis Definition: Definition:Economic EconomicProfit Profit Sales SalesRevenue Revenue- -Economic Economic(Opportunity) (Opportunity)Cost Cost Example: Example: Chapter Nine Copyright (c)2014 John Wiley & Sons, Inc •• Revenues: Revenues:$1M $1M •• Costs Costsofofsupplies suppliesand andlabor: labor:$850,000 $850,000 •• Owner’s Owner’sbest bestoutside outsideoffer: offer:$200,000 $200,000 The Profit Maximization Hypothesis “Accounting Profit”: $1M - $850,000 = $150,000 “Economic Profit”: $1M - $850,000 - $200,000 = -$50,000 Business “destroys” $50,000 of wealth of owner Chapter Nine Copyright (c)2014 John Wiley & Sons, Inc • The Profit Maximization Condition • • • Assuming the firm sells output Q, its economic profit is: Where π = TR (Q) − TC (Q) TR(Q) = Total revenue from selling the quantity Q ⇒ TR (Q) = P × Q Copyright (c)2014 John Wiley & Sons, Inc • TC(Q) = Total economic cost of producing the quantity Q Chapter Nine The Profit Maximization Condition • Since P is taken as given, firm chooses Q to maximize profit Marginal Revenue: The rate which TR change with output ∆TR MR = ∆Q Since firm is a price taker, increase in TR from unit change in Q is equal to P Copyright (c)2014 John Wiley & Sons, Inc • • ∆(TR ) ∆( P * Q) MR = = =P ∆Q ∆Q Chapter Nine 10 Calculating Long Run Equilibrium Summarizing Summarizing long long run runequilibrium equilibrium –– “If “Ifanyone anyone can cando doit,it,you youcan’t can’t make make money moneyatatit” it” Or Or ifif the the firm’s firm’s strategy strategy isis based based on on skills skills that that can can be be easily easily imitated imitated oror resources resourcesthat thatcan canbe beeasily easilyacquired, acquired,ininthe thelong longrun runyour youreconomic economicprofit profitwill will Copyright (c)2014 John Wiley & Sons, Inc be becompeted competedaway away Chapter Nine 43 Long Run Market Supply Curve We Wehave havecalculated calculatedaapoint pointatatwhich whichthe themarket marketwill willbe beininlong longrun run equilibrium equilibrium This Thisisisaapoint pointon onthe thelong longrun runmarket marketsupply supplycurve curve This This curve curvecan canbe bederived derivedexplicitly, explicitly,however however Definition: Definition: The TheLong LongRun RunMarket MarketSupply SupplyCurve Curvetells tellsususthe thetotal totalquantity quantity ofofoutput outputthat thatwill willbe besupplied suppliedatatvarious variousmarket marketprices, prices,assuming assumingthat thatallall Copyright (c)2014 John Wiley & Sons, Inc long longrun runadjustments adjustments(plant, (plant,entry) entry)take takeplace place Chapter Nine 44 Long Run Market Supply Curve Since new entry can occur in the long run, we cannot obtain the long run market supply curve by summing the long run supplies of current market participants Instead, we must construct the long run market supply curve We reason that, in the long run, output expansion or contraction in the industry occurs along a horizontal line corresponding to the minimum level of long run average cost Copyright (c)2014 John Wiley & Sons, Inc If P > min(AC), entry would occur, driving price back to min(AC) If P < min(AC), firms would earn negative profits and would supply nothing Chapter Nine 45 Long Run Market Supply Curve $/unit Market $/unit n** = 18M/52,000 = 360 SS0 Typical Firm SS1 D1 MC D0 AC SAC 23 LS Copyright (c)2014 John Wiley & Sons, Inc 15 SMC q (000s) 50 52 10 Chapter Nine 18 46 Q (M.) Constant Cost Industry • Constant-cost Industry: An industry in which the increase or decrease of industry output does not Copyright (c)2014 John Wiley & Sons, Inc affect the price of inputs Chapter Nine 47 Increasing Cost Industry Increasing cost Industry: An industry which increases in industry output increase the price of inputs Especially if firms use industry specific inputs i.e scarce inputs that are used only by firms in a particular industry and no other industry Copyright (c)2014 John Wiley & Sons, Inc • Chapter Nine 48 Decreasing Cost Industry Decreasing-cost Industry: An industry in which increases in industry output decrease the prices of some or all inputs Copyright (c)2014 John Wiley & Sons, Inc • Chapter Nine 49 Economic Rent • Economic Rent: The economics rent that is attributed to extraordinarily productive inputs whose supply is scarce – Difference between the maximum value is willing to pay for the services of the input and input’s reservation value Reservation value: The returns that the owner of an input could get by deploying the input in its best alternative use outside the industry Copyright (c)2014 John Wiley & Sons, Inc • Chapter Nine 50 Economic Rent Economic rent is the shaded area Copyright (c)2014 John Wiley & Sons, Inc • Chapter Nine 51 Producer Surplus Definition: Definition: Producer ProducerSurplus Surplusisisthe thearea areaabove abovethe themarket marketsupply supplycurve curveand andbelow belowthe themarket marketprice price ItItisisaa monetary monetarymeasure measureofofthe thebenefit benefitthat thatproducers producersderive derivefrom fromproducing producingaagood goodatataaparticular particularprice price …that the producer earns the price for every unit sold, but only incurs the SMC for each unit This is why the difference between the P and SMC curve measures the total benefit derived from production Chapter Nine 52 Copyright (c)2014 John Wiley & Sons, Inc Note: Producer Surplus Further, since the market supply curve is simply the sum of the individual supply curves…which equal the marginal cost curves the difference between price and the market supply curve measures the Copyright (c)2014 John Wiley & Sons, Inc surplus of all producers in the market …that producer’s surplus does not deduct fixed Note: costs, so it does not equal profit Chapter Nine 53 Producer Surplus P Market Supply Curve P* Copyright (c)2014 John Wiley & Sons, Inc Producer Surplus Q Chapter Nine 54 Producer Surplus Producer surplus is area FBCE when price is $3.50 • Change in producer surplus is area P1P2GH when price moves from P1 to P2 Copyright (c)2014 John Wiley & Sons, Inc • Chapter Nine 55 Producer Surplus Q = 60 P • Given Market supply curve and P is the price in dollars per gallon • Find producer surplus when price is $2.50 per gallon • How much does producer surplus when price of milk increases from Copyright (c)2014 John Wiley & Sons, Inc $2.50 to $4.00 Chapter Nine 56 Producer Surplus Q = 60(2.50) = 150 • Area A = (1 / 2)( 2.50 − 0)(150000) • • When the price is $2.50 per gallon, 1,50,000 gallons of milk are sold per month = 187500 Producer surplus is triangle A Price increases from $2.50 to $4.00 the quantity supplied will increase to 240,000 gallons per month Area B = $225,000 • plus Area C = $67,500 Producer surplus will increase by areas B and area Copyright (c)2014 John Wiley & Sons, Inc C Producer Surplus = $292,000 per month Chapter Nine 57 ... maximization condition for a price-taking firm is P = MC Chapter Nine 11 Copyright (c)2014 John Wiley & Sons, Inc The Profit Maximization Condition Chapter Nine 12 The Profit Maximization Condition... Wiley & Sons, Inc “firm demand" = P (sells as much as likes at P) “firm supply" defined by MC curve? Not quite: Chapter Nine 13 Short Run Equilibrium For Forthe thefollowing, following,the theshort... theAVC AVCcurve curve Chapter Nine 17 Copyright (c)2014 John Wiley & Sons, Inc P > AVC(q) Short Run Supply Function Therefore, the firm’s short run supply function is defined by: P=SMC, where SMC