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Econ 281 Chapter09.ppt - University of Alberta - Edmonton_ Alberta

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					    Chapter 9: Perfect Competition

•Thus far we have examined how the
consumer and firm attempt to optimize their
decisions

•The results of this optimization depend on
the set-up of the economy

•In this course we will examine the extreme
set-ups: Perfect Competition and Monopoly
                                        1
     Chapter 9: Perfect Competition
In this chapter we will cover:
Perfect Competition Characteristics
Economic and Accounting Profit
PC Profit Maximization
PC Short Run Supply and Equilibrium
PC Long Run Supply and Equilibrium
PC Costs
Economic Rent
Producer Surplus
                                       2
1) Fragmented Industry
   -Many buyers and sellers
   -No one buyer or seller has an effect on the
   industry
   -Each firm and consumer is a price taker (uses
   market price)

2) Homogeneous products
   -All firms produce identical products
   -No quality differences, no brand loyalty
                                               3
3) Perfect Information
   -Buyers and sellers have full information,
   especially regarding prices

4) No barriers to entry or exit
   -No input is restricted to potential customers
   or firms
   -Any firm or customer can enter or exit the
   market in the long run
                                                4
As a result, we have:

• Many buyers and sellers
• Buying and selling identical goods

At a given, set price.

Note: although we are examining a market for
  outputs, a similar analysis can apply to the
  market for inputs
                                             5
As seen before,

Accounting Costs = Explicit Costs
Economic Costs = Explicit Costs + Implicit Costs

Furthermore,

Accounting Profit = Revenue – Explicit Costs
Economic Profit = Revenue – Explicit Costs
                        - Implicit Costs
                                               6
     Profit: Economists vs Accountants
          Economist’s              Accountant’s
             View                     View


           Economic
             Profit                 Accounting
                                      Profit
            Implicit
Revenue      Costs                                Revenue
                        Economic
                        Costs
            Explicit                 Explicit
            Costs                    Costs

                                                    7
Implicit Costs are the BEST ALTERNATIVE return
  of ALL of an agent’s input (time, money, etc).

Alternately, an agent’s time could earn a wage
   elsewhere.
(ie: Work at Simtech for $3000 a month)

An agent’s money both isn’t used currently and
   can be used elsewhere.
(ie: Investing $5,000 at 10% instead of starting a
   business gives an implicit cost of $500)
                                              8
Mikey opens up a specialized mousepad company.
Spending $5,000 a month on space and supplies,
Mikey makes $8,000 a month.

Alternately, Mikey could work at Donald Duckpads
Inc for $1,500 a month or at a reasearch lab for
$1,000 a month.

Mikey could invest in bonds at 10% return or in
stocks at 2% return. Calculate accounting and
                                                  9
economic profit
Best alternatives: Donald Inc ($1,500) and Bonds
($500).

Accounting Profits = Revenue – Explicit Costs
              =$8,000-$5,000
              =$3,000
Economic Profit = Revenue – Explicit Costs
                              - Implicit Costs
              =$8,000 - $5,000 - $1,500 - $500
              =$1,000
                                              10
While previously we studied cost minimizing, in
reality a firm is more concerned with maximizing
its profits.

Total Revenue: TR(Q)=PQ
Total Cost: TC(Q) as found in previous chapters
               ie: TC(Q)=100+2Q

Profit =Total Revenue – Total Cost:
          π(Q)=TR(Q)-TC(Q)
                                            11
TC(Q) in general is derived as follows:

Originally:               TC=wL+rK     (1)
Tangency Condition:       L=f(K)       (2)
Production Function:      Q=f(L,K)     (3)
(2) + (3)                 Q=f(L) and
                          L=f(Q)       (4)
(2) + (4)                 K=f(Q)       (5)
(1) + (4) + (5)           TC=wf(Q)+rf(Q)
                          TC=f(Q)
                                             12
For Example:

Originally:            TC=wL+rK    (1)
Tangency Condition:    L=K         (2)
Production Function:   Q=2(LK)1/2  (3)
(2) + (3)              Q=2L and
                       L=Q/2       (4)
(2) + (4)              K=Q/2       (5)
(1) + (4) + (5)        TC=wQ/2+rQ/2
                       TC=(w+r)Q/2
                                         13
Definition: Marginal revenue is the change in revenue when
output changes

Marginal revenue is the slope of the total revenue curve.

Since the PC firm is a price taker, the additional revenue
gained from 1 additional output is equal to P.
                      TR (Q)
             MR (Q)          P
                        Q
                                                       14
As seen previously, marginal cost changes as production
increases.

If for the next unit, MR>MC, that unit should be produced,
as it yields profit.

If for the last unit, MC>MR, that unit should not have been
produced, as it decreases profit.

Therefore profit is maximized where   MC=MR=P          15
     Total Cost, Total Revenue, Total Profit ($/yr)

                        Total revenue = pq
     Total Cost
                       Example: Profit Maximization Condition


         15             Total profit
                                       q (units per year)




                       MC
15                                      P, MR

                                                                16
     6            30                   q (units per year)
The previous curves are expressed by:

TC(q) = 242q - .9q2 + (.05/3)q3
MC(q) = 242 - 1.8q + .05q2
P = 15
At profit maximizing point: 1) P = MC

But this occurs twice. At one point, profit is
maximized, at another minimized. Therefore, in
order to MAXIMIZE profit:

2) MC must be rising
                                          17
In the paper industry, MC=20+2Q (which is always
rising), where Q=100 reams of paper. Find the cost-
maximizing quantity if P=30 or P=40

Solution:             P=MC
                    30=20+2Q
                       5=Q

                      P=MC
                    40=20+2Q
                                              18
                      10=Q
In the short run, the firm either produces or
temporarily shuts down, thus facing costs:

STC(Q) = SFC + NSFC + TVC(q)          when q > 0
         SFC                          when q = 0

SFC: Sunk Fixed costs – unavoidable sunk costs
NSFC: Non-sunk Fixed costs – fixed costs that are
avoidable if the firm temporarily shuts down
TVC: Total Variable Costs; depends on output 19
Definition: The firm’s Short run supply curve
tells us how the profit maximizing output changes
as the market price changes.

3 Cases:

Case 1: all fixed costs are sunk
Case 2: all fixed costs are non-sunk
Case 3: some fixed costs are sunk
                                            20
Case 1: all fixed costs are sunk
     NSFC=0
    STC=TVC(q) + SFC
    If the firm chooses to produce a positive
    output, P = SMC defines the short run
    supply curve of the firm. But…


                                            21
     The firm will choose to produce a
     positive output only if:

     (q) > (0) …or…
     Pq – TVC(q) – SFC > -SFC 
     Pq – TVC(q) > 0 
     P > AVC(q)
Definition: The price below which the firm
would opt to produce zero is called the shut
down price, Ps. In this case, Ps is the
minimum point on the AVC curve.
                                         22
Therefore, the firm’s short run supply function is
defined by:

   1. P=SMC, where SMC slopes upward as
long as P > Ps
    2. 0 where P < Ps


This means that a perfectly competitive firm
may choose to operate in the short run even if
economic profit is negative.
                                             23
$/yr   Example: Short Run Supply Curve of the Firm, NSFC = 0




                              SMC
                                       SAC



                                          AVC


                                                Ps



                                             Quantity (units/yr)
                                                           24
  At prices below SAC but above AVC, profits
are negative if the firm produces…but the firm
loses less by producing than by shutting down
because of sunk costs.

     Example:

        STC(q) = 100 + 20q + q2

        SFC    = 100 (nb: this is sunk)
        TVC(q) = 20q + q2
        AVC(q) = 20 + q
        SMC(q) = 20 + 2q                   25
 a. The minimum level of AVC is the point
 where AVC = SMC or…

 20+q = 20+2q
 q = 0
 AVC minimized at p=20

b. The firm’s short run supply curve is, then:

   P < Ps = 20: qs = 0
   P > Ps = 20: P = SMC 
            P = 20+2q 
            qs = ½P - 10                    26
Case 2: all fixed costs are non-sunk
    SFC=0
    STC=TVC(Q)+NSFC

    If the firm chooses to produce a
    positive output,
     P = SMC defines the short run
    supply curve of the firm. But…
                                       27
The firm will choose to produce a positive
output only if:

(q) > (0) …or…

Pq – TVC(q) - NSFC > 0 

P > AVC(q) + AFC(q) = SAC(q)



Now, the shut down price, Ps is the
minimum of the SAC curve                28
 $/yr   Example: Short Run Supply Curve of the Firm, All
        Fixed Costs Non-Sunk


                           SMC
                                    SAC



Ps                                     AVC




                                       Quantity (units/yr)
                                                     29
Case 3: Short Run Supply Curve
        (Some costs are sunk):
        NSFC≠0, SFC ≠0

Average Nonsunk Cost = Average Variable Cost +
Average Nonsunk Fixed Cost

    ANSC=AVC + NSFC/Q
                                         30
     The firm will choose to produce a
     positive output only if:

     (q) > (0)
     Pq – TVC – SFC - NSFC > -SFC 
     Pq – TVC - NSFC > 0 
     P > AVC + NSFC/Q = ANSC
Definition: The price below which the firm
would opt to produce zero is called the shut
down price, Ps. In this case, Ps is the
minimum point on the ANSC curve.
                                         31
Therefore, the firm’s short run supply function is
defined by:

   1. P=SMC, where SMC slopes upward as
long as P > Ps
    2. 0 where P < Ps


This means that a perfectly competitive firm
may choose to operate in the short run even if
economic profit is negative.
                                             32
$/yr   Example: Short Run Supply Curve of the Firm




                              SMC
                                       SAC

                                         ANSC

                                          AVC
                                                Ps




                                             Quantity (units/yr)
                                                           33
If all fixed costs are sunk,
                      (AVC=ANSC)
               Shut down if P<AVC (low)

If all fixed costs are nonsunk,
                      (ANSC=SAC)
              Shut down if P<SAC (high)

If some fixed costs are sunk, some nonsunk,
           Shut down if P<ANSC (middle)       34
       A firm will produce
                 If
It can cover its Non-Sunk Costs


                            35
Thus far we have seen that the individual firm’s
short run supply curve comes from their marginal
cost curve.
Definition: The market supply at any price is the
sum of the quantities each firm supplies at that
price.
The short run market supply curve is the
HORIZONTAL sum of the individual firm supply
curves. (Just as market demand is the
HORIZONTAL sum of individual demand curves)
                                          36
Example: From Short Run Firm Supply Curve to Short Run Market Supply Curve
   Typical firm:                                       Market:
              Individual supply curves
              per firm. 1000 firms of each
              type      SMC3
  $/unit                  SMC2       $/unit
                                SMC1
                                                              Market supply
30




24
22
20


  0             300 400 500                  0                           1.2
                                                                         37    mill
                              q (units/yr)                       Q (m units/yr)
Definition: A short run perfectly competitive
equilibrium occurs when the market quantity
demanded equals the market quantity supplied.

    ni=1 qs(P) = Qd(P)
    Qs(P)= Qd(P)

    and qs(P) is determined by the firm's
    individual profit maximization condition.
                                           38
 Example: Short Run Perfectly Competitive Equilibrium

     Typical firm:                               Market:
$/unit                                  $/unit




                                                           Supply


                     SMC
                           SAC
P*
                           AVC                             Demand
Ps

                     q*          Units/yr                      39
                                                     Q*    m. units/yr
300 identical firms

Qd(P) = 60 – P
STC(q) = 0.1 + 150q2
SMC(q) = 300q
NSFC = 0
AVC(q) = 150q

                       40
a. Short Run Equilibrium

Profit maximization condition: P = SMC
                               P = 300q

  qs(P) = P/300 (for each firm)
  Qs(P) = P (for industry)

Qs(P) = Qd(P)  P = 60 – P
P*= 30
q* = 30/300=.1
Q* = 30                            41
b. Do firms make positive profits at the
market equilibrium?

SAC = STC/q = .1/q + 150q

When each firm produces .1, SAC per firm
is: .1/.1 + 150(.1) = 16

Therefore, P* > SAC so profits are positive.


                                           42
          Comparative Statics in the
                Short Run

•As seen in previous chapters, the entry or exit of
firms or consumers, among other things, can shift
the market demand and supply curves

•Shifts in the market demand and supply curves
will shift the equilibrium quantity as seen in
chapters 1 and 2



                                              43
In the short run, capital is fixed and firms may
   temporarily operate under an economic profit
   or loss.

In the long run, capital can change and firms can
   enter and leave the market, resulting in zero
   economic profit.

Remember that in the long run, all costs are
  nonsunk (they are all avoidable at zero output)
                                             44
  Just as in the short run the firm operated at:
                      P=SMC

      In the long run the firm operates at
                     P=MC

SMC≠MC (in general) since costs are reduced in
  the long run.
Only at LR profit maximization is SMC=MC
  (because the short run is operating at the LR
  optimal capital point: Point A next slide)
                                             45
    $/unit   In the long run, this firm has an incentive to change
             plant size to level K1 from K0:
                                   MC
                             A                        AC
P
             SMC0 SAC0
                                 •
                                      SAC1




                        SMC1




                                                      q (000 units/yr)
                                                              46
              1.8                6
In the long run, a firms supply curve is
   The firm’s LR MC curve above AC.

         For if P>AC, Profits>0.
      Since Profits = (PxQ)-(ACxQ)

As in the short run, market supply is the
 horizontal sum of individual firm supply.

                                           47
    $/unit   Long Run Supply Curve:

                               MC
                                S     AC
P




                       SMC1




                                      q (000 units/yr)
                                              48
              1.8             6
Long Run Perfectly Competitive Equilibrium
  occurs when:

1) Each firm maximizes profit with regards to
   output and capital (P=MC)
2) Each firm’s economic profit is zero (as firms
   keep entering until the price is pushed down to
   zero profits) (P=AC)
3) Market Demand=Market Supply
                                             49
     Long Run Perfectly Competitive Equilibrium
 Typical Firm                          Market
$/unit                        $/unit




                MC                Market demand
          SAC        AC

P*

            SMC



            q*=50,000     q              Q*=10M.   50   Q
•to increase production, a firm must increase inputs

•If we assume that the market for inputs is a perfectly
competitive market, one industry’s input choices
have no effect on market price

•A CONSTANT COST INDUSTRY is an industry
where changes in output do not affect the price of
inputs

•This determines the LR supply curve             51
-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2,
lowering price to P1
 $/unit                       $/unit

                                       S1
          SMC
                    SAC                         S2
P2

                                                     LS
P1
                                                          D2

                                             D1

     Typical Firm         q            Market        52    Q
•Industry-specific inputs are scarce inputs used
primarily by one industry
  -ie:Plutonium is only used in the nuclear industry

•Changes in production will have an impact on
the market for industry-specific inputs

•An INCREASING COST INDUSTRY is an
industry where increases in output increase the
price of inputs                              53
-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2,
lowering price to P3 and increasing costs
 $/unit                        $/unit

               SMC3
                                        S1
          SMC1    SAC3                       S2
                                                   LS
P2
P3
P1
                    SAC1
                                                             D2

                                              D1

     Typical Firm          q            Market          54    Q
•Some industries require a small amount of an
expensive input
 -ie: Blue Ray CD Drive

•An increase in input demand may drive down
input prices by reducing input AC

•A DECREASING COST INDUSTRY is an
industry where increases in output decrease the
price of inputs                             55
-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2,
lowering price to P3 and decreasing costs
 $/unit                         $/unit


              SMC1                       S1
      SMC3
                     SAC1
P2                                                 S2
                     SAC3
P1
                                                    LS
P3                                                      D2

                                              D1

     Typical Firm           q            Market    56    Q
Although economic profit is possible in
           the short run,

In the long run the entry of firms will
     push economic profit to zero


                                   57
• In general, we assume that all workers are
  identical.
• In reality, some workers are masters; they are
  more productive than their peers.

• The cost savings of a master worker is their
  ECONOMIC RENT


                                            58
Joe is an amazing worker that works in a button
   factory. While most workers can only press
  one or two buttons at a time, Joe can press a
                     dozen.

A normal worker produces buttons at an average
   cost of 5 cents, but Joe can make buttons at
      an average cost of 1 cent each. If Joe
    produced buttons at a cost of 5 cents each,
        he’d be hired to produce 900 a day.
                                           59
        Economic Rent = Cost Savings
            ER = (0.05-0.01)900
                 ER = $90

The economic rent from a master worker (Joe) is
                    $90 a day.



                                          60
• If a firm is able to employ a master worker at
  a normal worker’s wage, that worker’s
  economic rent becomes the firm’s economic
  profit
• In a perfectly competitive industry, in all
  likelihood a master worker will be stolen by
  other firms at higher wages until his wage
  matches his productivity
• Master workers therefore often provide no
  profit in perfect competition               61
Definition: Producer Surplus is the area above
the supply curve and below the price. It is a
monetary measure of the benefit that producers
derive from producing a good at a particular price.


   Note 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.
                                             62
$/yr   Producer Surplus, Individual Firm


                         SMC


                               ANSC

                                       P
       Producer
       Surplus




                                   Quantity (units/yr)
                                                 63
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 surplus of all producers in the
market.

  Note that producer’s surplus does not deduct
  fixed costs, so it does not equal profit!

                                             64
         Market Producer Surplus
     P

                          Market Supply Curve


50


                   Producer Surplus = (1/2)BH
                   PS=(1/2)800(40)
                   PS=16,000
10

                                      Q    65
                800
Producer surplus is the difference between total
        revenue and total nonsunk costs;

   Producer Surplus=TR-NSFC-TVC

      In the short run, if Producer
     Surplus>SFC, economic profit is
                 possible.
                                            66
In the long run, no costs are fixed,

Therefore Producer Surplus = Economic Profit

BUT

In the long run, Economic Profit=0

How?
                                           67
An industry has an upward sloping supply if it
  employs scarce resources (increasing cost
  industry – master growers)

Producer Surplus is therefore the economic rent
  captured by the master worker or owner of the
  input

In the LR PC: Producer Surplus=Economic Rent
                                             68
          Long Run Producer Surplus =
     P    Economic Rent

                          LS



50
     Economic
     Rent


                                    D
10

                                        Q   69
                800

				
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