Market Structure

PERFECT COMPETITION
Characteristics of Pure competitive
market
• A perfectly competitive market has the
following characteristics:
– There are many buyers and sellers in the
market.
– The goods offered by the various sellers are
largely the same.
– Firms can freely enter or exit the market.
Characteristics of pure competitive
market
• As a result of its characteristics, the
perfectly competitive market has the
following outcomes:
– The actions of any single buyer or seller in the
market have a negligible impact on the market
price.
– Each buyer and seller takes the market price
as given.
 Definition
• A competitive market has many buyers
and sellers trading identical products so
that each buyer and seller is a price taker.
– Buyers and sellers must accept the price
determined by the market.
Demand Curve facing a single firm
• Since no individual firm can affect the
market price
• demand curve facing each firm is perfectly
elastic
The Revenue of a Competitive firm
• Total revenue for a firm is the selling price
times the quantity sold.
TR = (P  Q)
– Total revenue is proportional to the amount of
output
The Revenue of a competitive firm
• Average revenue tells us how much
revenue a firm receives for the typical unit
sold.
• Average revenue is total revenue divided
by the quantity sold.
 The Revenue of a competitive firm
• In perfect competition, average revenue
equals the price of the good.
T o tal rev en u e
A v erag e R ev en u e =
Q u an tity

P rice  Q u an tity

Q u an tity

 P rice
The Revenue of a Competitive firm
• Marginal revenue = additional revenue received
from the sale of an additional unit of output.
• In mathematical terms: Marginal revenue is the
change in total revenue from an additional unit
sold.
MR =TR/ Q
• For competitive firms, marginal revenue equals
the price of the good.
• As long as the price of a product is constant,
price and marginal revenue are the same
Profit maximisation and the supply
curve of a competitive firm
• The goal of a competitive firm is to
maximize profit.
• This means that the firm will want to
produce the quantity that maximizes the
difference between total revenue and total
cost.
• Numerical example
 Profit Maximisation
• The firm produces where MR = MC
• Recall that P = MR
• Profit maximization occurs at the quantity
where MR equals MC.
Profit Maximisation
Profit Maximising level of output
Economic Profits>0
 Profit maximising output
• When MR > MC  increase Q
• When MR < MC  decrease Q
• When MR = MC  Profit is maximized.
 Firm’s short run decision to shut
down
• A shutdown refers to a short-run decision not to
produce anything during a specific period of time
because of current market conditions.
• Exit refers to a long-run decision to leave the
market
• The firm considers its sunk costs when deciding
to exit, but ignores them when deciding whether
to shut down.
– Sunk costs are costs that have already been
committed and cannot be recovered
 Shut down
• The firm shuts down if the revenue it gets
from producing is less than the variable
cost of production.
– Shut down if TR < VC
– Shut down if TR/Q < VC/Q
– Shut down if P < AVC
 Shut down
• Suppose that P < ATC. Since the firm is
experiencing a loss, should it shut down?
• Shut down in the short run only if the loss
that occurs where MR = MC exceeds the
loss that would occur if the firm shuts
down (= fixed cost)
• Stay in business if TR > VC. This implies
that P > AVC. Shut down if P < AVC.
Economic loss (AVC<P< ATC)
Shut down
Break– even price
 Break-even price
• If price = minimum point on ATC curve,
economic profit = 0.
• Owners receive normal profit.
• No incentive for firms to either enter or
leave the market.
P<AVC
 P<AVC
• A perfectly competitive firm will produce at
the level of output at which P = MC, as
long as P > AVC
 Firm’s long run decision to exit or
enter a firm
• In the long run, the firm exits if the revenue it
would get from producing is less than its total
cost.
• This would occur when the firm is not even
covering its AVC
• A firm will enter the industry if such an action
would be profitable.
– Enter if TR > TC
– Enter if TR/Q > TC/Q
– Enter if P > ATC
Short-run supply curve
 Supply curve
• The portion of the marginal-cost curve that
lies above average variable cost is the
competitive firm’s short-run supply curve.
 Long run
• Firms enter if economic profits > 0
– market supply increases
– price declines
– profit declines until economic profit equals zero (and
entry stops)
• Firms exit if economic losses occur
– market supply decreases
– price rises
– losses decline until economic profit equals zero
Long run equilibrium
 Long run and short run Supply
curve of the firm
• Short-Run Supply Curve
– The portion of its marginal cost curve that lies
above average variable cost.
• Long-Run Supply Curve
– The marginal cost curve above the minimum
point of its average total cost curve.
 The supply curve in a competitive
firm
• Market supply equals the sum of the
quantities supplied by the individual firms
in the market.
The short run: Market supply with a
fixed number of firms
• For any given price, each firm supplies a
quantity of output so that its marginal cost
equals price.
• The market supply curve reflects the
individual firms’ marginal cost curves.
 The Long Run: Market Supply with
Entry and Exit
• Firms will enter or exit the market until
profit is driven to zero.
• In the long run, price equals the minimum
of average total cost.
• The long-run market supply curve is
horizontal at this price.
 The Long run: market supply with
entry and exit
• At the end of the process of entry and exit,
firms that remain must be making zero
economic profit.
• The process of entry and exit ends only
when price and average total cost are
driven to equality.
• Long-run equilibrium must have firms
operating at their efficient scale.
Long run equilibrium and economic
efficiency
• Two desirable efficiency properties
(assuming no market failure)
– P = MC (Social marginal benefit = social
marginal cost)
– P = minimum ATC
 Why do competitive firms stay in
business if they make zero profit
• Profit equals total revenue minus total
cost.
• Total cost includes all the opportunity
costs of the firm.
• In the zero-profit equilibrium, the firm’s
revenue compensates the owners for the
time and money they expend to keep the
business going.
 A SHIFT IN DEMAND IN THE
SHORT AND LONG RUN
• An increase in demand raises price and
quantity in the short run.
• Firms earn profits because price now
exceeds average total cost.
• Show diagrams
 Why the long run supply curve
might slope upwards
• Some resources used in production may
be available only in limited quantities.
• Firms may have different costs.
 Why the long run supply curve
might slope upward
• Marginal Firm
– The marginal firm is the firm that would exit
the market if the price were any lower.
Consumer and producer surplus
• Consumer surplus = net gain from trade
received by consumers (MB > P for
consumers up to the last unit consumed)
• Producer surplus = net gain received by
producers (P > MC up to the last unit sold)
Consumer and Producer Surplus

Consumer surplus
 Gains from trade
• Gains from trade = consumer surplus +
producer surplus
 Summary
• Because a competitive firm is a price
taker, its revenue is proportional to the
amount of output it produces.
• The price of the good equals both the
firm’s average revenue and its marginal
revenue.
 Summary
• To maximize profit, a firm chooses the
quantity of output such that marginal
revenue equals marginal cost.
• This is also the quantity at which price
equals marginal cost.
• Therefore, the firm’s marginal cost curve is
its supply curve.
 Summary
• In the short run, when a firm cannot
recover its fixed costs, the firm will choose
to shut down temporarily if the price of the
good is less than average variable cost.
• In the long run, when the firm can recover
both fixed and variable costs, it will choose
to exit if the price is less than average total
cost.
 Summary
• In a market with free entry and exit, profits
are driven to zero in the long run and all
firms produce at the efficient scale.
• Changes in demand have different effects
over different time horizons.
• In the long run, the number of firms
adjusts to drive the market back to the
zero-profit equilibrium.