2004 Perfect Competition Lecture Slides.ppt

Market structure

1. Perfect Competition 1
MARKET STRUCTURE,
PERFECT COMPETITION

2. Perfect Competition 2
INTRODUCTION
The basic assumption of the
traditional theory of the firm is
profit maximization.

3. Perfect Competition 3
We look at a firm’s
OUTPUT PRICING
and
policies
How shd a firm produce?
How much can it produce?
How much shd it charge?
How much can it charge?

4. Perfect Competition 4
Market structure refers to the
way a market is organized or
the manner in which exchange
takes place between
consumers and producers, and
this is affected by the degree
of competition in the market.

5. Perfect Competition 5
No. of sellers
Nature of product
Entry condition
Perfect knowledge
Factor mobility

6. Perfect Competition 6
The features of the four market
structures are as follows :
Type of
Market
No. of
firms
Freedom of entryNature of
product
Examples
PC ManyUnrestrictedHomogeneous Stocks
and
shares
MC ManyUnrestrictedDifferentiatedHairdress
ers
OligopolyFew Restricted Differentiated or
Undifferentiated
Cars, Oil
MonopolyOne Restricted Unique Power
Grid

7. Perfect Competition 7
1. FIRM – THE PROFIT MAXIMIZER
Profit = total revenue – total cost

8. Perfect Competition 8
PROFIT = TR-TC
Economic Accounting
TC includes
implicit and
explicit costs
TC includes
only explicit
costs

9. Perfect Competition 9
Implicit cost – the next best
alternative earnings which the
entrepreneur could have earned if
his resources were used elsewhere
•Foregone rental of own premises
•Forgone salary
•Forgone interest/profit

10. Perfect Competition 10
Explicit cost – the costs which
firms have to incur/pay for
•wages
•Costs of raw materials
•Cost of machinery

11. Perfect Competition 11
2. COSTS & REVENUE TO THE FIRM
costs revenue

12. Perfect Competition 12
Total Revenue :
•-Total earnings per time period
• TR = P x Q

13. Perfect Competition 13
Average Revenue : Revenue
per unit of output
•AR = TR/Q

14. Perfect Competition 14
TR= P x Q
AR= TR / Q
Note: AR= P x Q / Q
= P

15. Perfect Competition 15
Marginal Revenue : Extra
revenue by selling an additional
unit of output.
•MR = TRn- TRn-1

16. Perfect Competition 16
TR= P x Q
AR= TR / Q
MR= TR / Q

17. Perfect Competition 17
•Normal profit
•Supernormal profit
•Sub-normal profit

18. Perfect Competition 18
Normal Profit => TR-TC=0
the minimum amount of profit
a firm must acquire to induce
it to remain in the industry
i.e. economic profit = 0

19. Perfect Competition 19
Supernormal Profit =>TR>TC
the firm is making an extra profit
over the normal profit level.
i.e. economic profit is positive.

20. Perfect Competition 20
Subnormal Profit =>TR<TC
the firm is making less than its
normal profit level.
i.e. economic profit is negative.

21. Perfect Competition 21
6.1 PERFECT COMPETITION
(PC)

22. Perfect Competition 22
Objectives of lesson
At the end of the lesson
• able to relate the characteristics of PC to
the demand curve of the firm and the
industry and to distinguish the difference
between them.
•able to relate the characteristics of PC to
its total and marginal revenue curve and
why MR is always equal to AR in the PC
market.

23. Perfect Competition 23
3.1 Characteristics
(a) A large no. of buyers and sellers
No single buyer or seller can
control the market i.e. no
influence over the market
price of the product.

24. Perfect Competition 24
3.1 Characteristics
(b) Homogeneous product
Perceived as perfect
substitutes => prices remain
uniform.

25. Perfect Competition 25
6.1 Characteristics
(c) Perfect knowledge
Buyers fully aware of
prices charged by other
firms, product quality &
availability.
Sellers fully aware of
prices, costs and market
opportunities.

26. Perfect Competition 26
3.1 Characteristics
(d) Complete freedom of entry/exit
•No barriers to entry
•Complete factor mobility in
the LR

27. Perfect Competition 27
6.2 Q. Is PC a realistic model?
It must be noted that few industries in the
world possess these characteristics.
Closest examples:
•Agricultural products e.g. wheat, fresh fruits
•Financial markets for stocks and bonds.

28. Perfect Competition 28
Q. What is the use of studying PC then ?
It provides an important
benchmark for comparison
with other market structures.

29. Perfect Competition 29
3.2 DD & revenue curves of a PC firm
Because of its characteristics, the
demand curve of a PC firm is
perfectly elastic. i.e. at whatever
supply, the price would remain the
same.

30. Perfect Competition 30
Fig.2
0
0
Mkt/industry DD curve Individual PC firm’s DD curve
Price/unit
Price/unit
Qty sold
Qty sold
S
Pm
D
Qm
DPm

31. Perfect Competition 31
If the market price is not affected by the
individuals’ output as in this case, then
its demand curve , its AR curve, and its
MR curve all coincide on the same
horizontal line.
Price = AR = MR

32. Perfect Competition 32
Table1
Price
($)
Qty of Output
(Q)
TR
(P x Q)
AR
(TR/Q)
MR
( TR/ Q)
5 10
5 20
5 30
5 40
5 50

33. Perfect Competition 33
Table1
Price
($)
Qty of Output
(Q)
TR
(P x Q)
AR
(TR/Q)
MR
( TR/ Q)
5 10 50
5 20100
5 30150
5 40200
5 50250

34. Perfect Competition 34
Table1
Price
($)
Qty of Output
(Q)
TR
(P x Q)
AR
(TR/Q)
MR
( TR/ Q)
5 10 505
5 201005
5 301505
5 402005
5 502505

35. Perfect Competition 35
Table1
Price
($)
Qty of Output
(Q)
TR
(P x Q)
AR
(TR/Q)
MR
( TR/ Q)
5 10 505 5
5 201005 5
5 301505 5
5 402005 5
5 502505 5

36. Perfect Competition 36
Fig.3
0
0
PC firm’s TR curve PC firm’s AR and MR curves
Revenue
Revenue,
Price
Output
Output
TR
P=AR=MR=D
TR= P x Q
i.e. TR = f (Q)
5

37. Perfect Competition 37
6.4 Profit maximizing conditions
Using:
1.Total revenue - total cost approach
2. Marginal revenue = Marginal cost approach

38. Perfect Competition 38
Cost,
revenue
$
output
TR
TC
Fig.4 Profit Maximization – TR-TC Approach
0
B
A
Qe
Profit maximizing
output level

39. Perfect Competition 39
Cost,
revenue
$
output
TR
TC
Fig.4 Profit Maximization – TR-TC Approach
0
B
A
Qe
MC=MR

40. Perfect Competition 40
output
P=AR=MR=D
MC
Fig.5 Profit Maximization: MR=MC Approach
0
P
Qe
Profit maximizing
point
Q
Cost,
revenue
$
?

41. Cost,
revenue
$
Cost,
revenue
$
output
output
TCTR
Qe
Qe
P=AR=MR=D
MC

42. Perfect Competition 42
For output to be at the profit-
maximizing level,
MC=MR, and MC curve cuts
MR curve from below.
Remember:
output
$
MC
MR

43. Perfect Competition 43
Objectives of lesson
At the end of the lesson, you should be
• to define what is an equilibrium
position.
•able to derive the type of profits earned
in the SR from the graphs.

44. Perfect Competition 44
6.5 The SR equilibrium of a PC firm
In the SR, a PC firm can be in
equilibrium earning either:
Normal profit, or
Supernormal profit, or
subnormal profit.

45. output
$
AR
AC
output
$
AR
AC
output
$
AR
AC
output
$
MC
MR
Profit
maximizing
equilibrium

46. output
$ AC
Q
1
Q
2
To compute TC:

47. Perfect Competition 47
output
P=AR=MR=D
MC
Fig.6 A PC firm makes normal profit in the SR
0
P
Qe
Profit maximizing
point (MC=MR)
Cost,
revenue
$
AC
E

48. Perfect Competition 48
output
P=AR=MR=D
MC
Fig.7 A PC firm makes supernormal profit
in the SR
0
P
Qe
Cost,
revenue
$
AC
E
F
C

49. At the prevailing market price OP, the firm will
be in equilibrium at point E, where MC=MR and
MC cuts MR from below.
The equilibrium output that the firm will produce
is OQe. At this output level, AR is greater than
AC.
The total revenue from the sales of OQe output is
OQeEP, the total cost of producing OQe output is
OQeFC => the firm will be making supernormal
profit represented by the area CFEP.

50. Perfect Competition 50
output
P=AR=MR=D
MC
Fig.8 A PC firm makes subnormal profit
in the SR
0
P
Qe
Cost,
revenue
$
AC
E
1
E
2
C

51. At the equilibrium point E
1
, with an output of
OQe, AR is less than AC. The firm is making
losses.
The total revenue from the sales of OQe output is
OQeE
1P , the total cost of producing OQe output
is OQeE
2C=> the economic losses (subnormal
profit) is represented by the area PE
1
E
2
C

52. Perfect Competition 52
6.6 The SR shut down conditions
of a PC firm
As long AR AVC, the firm
should continue production.

53. Perfect Competition 53
Objectives of lesson
At the end of the lesson, you should be
• to tell if the firm immediately shuts
down if it does not make profits.
•to explain the shut-down position of the
firm in the SR and why it is the shut-
down position.

54. Perfect Competition 54
P=AR=MR=D
Fig.9 A PC firm makes subnormal profit
in the SR, not shut down yet (AR >AVC)
Cost,
revenue
$
output
MC
0
P
Qe
AC
E
1
E
2
C
AVC
F G

55. Perfect Competition 55
output
MC
0
Qe
AC
E
1
E
2
C
AVC
P
Cost,
revenue
$
P=AR=MR=D
Fig.10 A PC firm makes subnormal profit
in the LR, shuts down (AR <AVC)

56. Perfect Competition 56
6.7 The LR equilibrium of the PC firm
•Free entry and exit
•Perfect knowledge
• Supernormal profit
=> existing firm expands
=> attract new firms to enter

57. Perfect Competition 57
6.7 The LR equilibrium of the PC firm
Subnormal profit
=> some firms may leave
=> remaining ones contract
plant size

58. Perfect Competition 58
6.7 The LR equilibrium of the PC firm
Hence, the LR equilibrium of
the PC firm occurs when it is
earning normal profits, and has
no incentive to expand or
contract its production plant.

59. Fig.12
Price
/Unit
Cost/
Rev $
Qty
Qty
Q
0Q
1
P
0
P
1
S
0
S
1
D
P
0
P
1
MC
AR
0
=MR
0
AR
1
=MR
1
SRAC
LRAC
q
T
q
1

60. Perfect Competition 60
6.7 The LR equilibrium of the PC firm
The PC firm attains its LR equilibrium
when it is producing at T, where the
output level is Oq using the most
efficient plant size (represented by
SRAC).
Price = LRAC=LRMC=SRAC=SRMC

61. Perfect Competition 61
Characteristics of the Long Run Equilibrium for a
Perfect Competitive Firm
At the long run equilibrium output level, the PC
firm has achieved economic efficiency.
Economic efficiency –
efficiency in the use of resources is called
pareto-efficiency, or pareto-optimality
2 conditions:
1.Productive efficiency
2.Allocative efficiency

62. Perfect Competition 62
(i)Productive efficiency

The firm uses all its FOP and
techniques available at the lowest
cost per unit of output.
In the LR, PC firms produce at the
minimum point of the LRAC
curve
=> no wastage of resources
$
P=MR
output
MC AC

63. Perfect Competition 63
(ii) Allocative efficiency
Producers produce what the
consumers want.
No one can be made better off without
someone else made worse off.
(P=)MR=MC
(P=MR)What
consumer is willing to
pay for the extra unit
Cost of producing
the extra unit
$
P=MR
output
MC AC

64. Allocative efficiency (P=MC)
•Efficiency in the allocation of resources represented
by P=MC
•When P>MC, the value consumers place on the last
unit of good exceeds the opportunity cost of
producing it, so society will benefit if more of the
good is produced; the converse is true.
$
P=MR
output
MC AC
P>MC
Under-allocation
of resources

65. Perfect Competition 65
•At output levels when P>MC, there is
under-allocation of resources in the
production of the good,

66. Perfect Competition 66
$
P=MR
output
MC AC
P<MC
Over-allocation
of resources
At output levels where P<MC, too much resources
are used in the production of the good.(over-
allocation of resources)

67. Only when P=MC that no one can be
made better off without someone else
made worse off.
$
P=MR
output
MC AC

68. Perfect Competition 68
6.8 The SR supply curve of a PC firm
•The supply curve of a PC firm shows
the level of output the firm is willing to
supply at each price level.
•MC=MR and
•(P=)AR AVC
SR supply curve ?

69. Perfect Competition 69
Fig.15
Price
/Unit
Cost/
Rev $
Qty
Qty
Q
4
Q
1
P
1
P
4
P
1
P
2
MC
AC
AVC
P
2
P
3 P
3
P
4
Q
4
Q
1
Firm’s SR
supply curve
The SR supply curve of a PC firm

70. Perfect Competition 70
Fig.16 The SR supply curve of the PC industry
$
$ $
Firm A Firm B Industry (Firm A+B)
QQQ
P
MC
A MC
B
MC
A+B
40 50 90

71. Perfect Competition 71
7.1 Perfect Competition- Merits
(a)Economic efficiency –
efficiency in the use of resources is called
pareto-efficiency, or pareto-optimality
2 conditions:
1.Productive efficiency
2.Allocative efficiency

72. Perfect Competition 72
7.1 Perfect Competition- Merits
(b) Absence of Sales promotion expenditure
=>no wastage of resources

73. Perfect Competition 73
7.2Perfect Competition- Demerits
(a)Lack of variety
(b)Lack of economies of scale
(c)Little incentive for R&D
(d)Instability of prices and income

75. Perfect
Competition
Characteristics:
•Many buyers/sellers
•Homogeneous pdt
•Perfect knowledge
•Free entry & exit of firm
Firm is a price
taker =>
•No influence
over price
•DD is
perfectly
elastic
•AR=MR
In the LR, firm only
earns normal profit
Main objective: to max profit
Approach:
•TR-TC
•MR-MC
Firm:
•Produce where MC=MR, and
•MC cuts MR from below
•Types of profit: 1. Normal 2. Supernormal 3. Subnormal
•When should the firm shut down? (P<AVC)
Industry:
All firms in the LR
only earn normal
profit
Supply curve:
•SR:for firm => upward
sloping portion of MC above
AVC
•Industry: horizontal
summation of SS of all firms
Merits:
Pareto optimality
•Productive efficiency => min AC
•Allocative efficiency => P=MC
Demerits:
pls refer