College of Education

School of Continuing and Distance Education 2014/2015 – 2016/2017

ECON 101

Introduction to Economics1

Session 11 –Market Structures(Perfect Competition)

Lecturer: Mrs. Hellen A. Seshie-Nasser, Department of Economics Contact Information: haseshie@ug.edu.gh

Session Overview

• The conditions of the market that firms operate in influence the behavior of firms.

• The influence of the market depends on the nature of the product involved and the number of firms competing for market share.

• This session provides analysis of the competitive market and its influence (combined with costs) on the behavior of firms operating in this market structure.

Slide 2 Mrs. Hellen Seshie-Nasser, Dept .of Economics,

University of Ghana

Session Objectives

• At the end of the session, the student should be able to: – Understand the competitive market structure. – Identify and explain the assumptions/characteristics of the

competitive market – Understand the competitive firm – Understand how price and output is determined in the competitive

market. – Understand how the firm is a price-taker. – Be able to calculate Total Revenue, Average Revenue and Marginal

Revenue of the firm. – Understand equilibrium of the firm and how a competitive firm

determines its output. – Have a good understanding of the graphical determination of

profit-maximizing output by the firm. – Understand short and long run profitability of the competitive firm.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 3

Session Outline

The key topics to be covered in the session are as follows:

• The Competitive Market (characteristics)

• Price determination in the Competitive Market

• Production Decisions and Profit Maximization/Equilibrium

• Profit in the Short Run

• The Firms short run decision to shutdown

• The competitive firms’ supply curve

• Profit in the long run

Slide 4

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Reading List

• Lipsey R. G. and K. A. Chrystal. (2007). Economics. 11th Edition. Oxford University Press.

• Bade R. and M. Parkin. (2009). Foundations of Microeconomics. 4th Edition. Boston: Pearson Education Inc.

• Begg. D. Fischer S. and R. Dornbusch. (2003). Economics. 7th Edition. McGraw-Hill .

Slide 5

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Market Structures

• Market is normally defined as a group of firms and buyers in touch with each other to buy or sell goods for services.

• Market structure refers to the conditions under which competition occurs in a market.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 6

What is a 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/homogeneous. E.g. Sachet water

– Firms can freely enter or exit the market.

– There is perfect information / knowledge in the 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 determined price as given.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 7

Revenue

• 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 sold by the 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.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 8

• Average revenue equals the price of the good.

Average Revenue =Total revenue

Quantity

Price Quantity

Quantity

Price

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.

The Revenue of a Competitive Firm

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 9 Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Table 1: Total, Average, and Marginal Revenue for a Competitive Firm

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 10

Profit Maximization

• 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.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 11

Table 2: Profit Maximization: A Numerical Example

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 12

Profit Maximization for a Competitive Firm

Quantity 0

Costs and

Revenue

MC

ATC

AVC

MC 1

Q 1

MC 2

Q 2

The firm maximizes profit by producing the quantity at which marginal cost equals marginal revenue.

Q MAX

P = MR 1 = MR 2 P = AR = MR

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 13 Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Profit Maximization

• Profit maximization occurs at the quantity where marginal revenue equals marginal cost.

– When MR > MC increase Q

– When MR < MC decrease Q

– When MR = MC profit is maximized.

• However, for the competitive firm, Price = MR, and the equilibrium can be re-written as

P = MC

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 14

Profit as the Area between Price and Average Total Cost

Copyright © 2004 South-Western

(a) A Firm with Profits

Quantity 0

Price

P = AR = MR

ATC MC

P

ATC

Q

(profit-maximizing quantity)

Profit

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 15

Loss as the Area between Price and Average Total Cost

Copyright © 2004 South-Western

(b) A Firm with Losses

Quantity 0

Price

ATC MC

(loss-minimizing quantity)

P = AR = MR P

ATC

Q

Loss

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 16

Copyright © 2004 South-Western

(c) A Firm with zero economic / normal profit

Quantity 0

Price

ATC MC

(loss-minimizing quantity)

P = AR = MR P ATC,

Q

Zero Economic/Normal Profit

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 17

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.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 18

The 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.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 19

The Firm’s Short-Run Decision to Shut Down

• 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.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 20

The Firm’s Short-Run Decision to 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 < TVC

– TR/Q < TVC/Q

– Thus, shut down if P < AVC

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 21

Loss as the Area between Price and

Average Total Cost

Copyright © 2004 South-Western

(b) A Firm with Losses

Quantity 0

Price

ATC MC

(loss-minimizing quantity)

P = AR = MR P

ATC

Q

Loss

AVC1

AVC2

A firm making loss but with AVC1 will continue to produce. But a firm making loss, with AVC2 will shut down

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 22

The Competitive Firm’s Short Run Supply Curve

MC

Quantity

ATC

AVC

0

Costs

Firm

shuts

down if

P < AVC

Firm ’ s short-run

supply curve

If P > AVC, firm will

continue to produce

in the short run.

If P > ATC, the firm

will continue to

produce at a profit.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 23

The Firm’s Long-Run Decision to Exit or Enter a Market

• The portion of the marginal-cost curve that lies above average variable cost is the competitive firm’s short-run supply curve.

• In the long run, the firm exits if the revenue it would get from producing, is less than its total cost.

– Exit if TR < TC

– Exit if TR/Q < TC/Q

– Exit if P < ATC

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 24

The Supply Curve in a Competitive Market

• Market supply equals the sum of the quantities supplied by the individual firms in the market.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 25

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.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 26

Figure 6: Market Supply with a Fixed Number of Firms

Copyright © 2004 South-Western

(a) Individual Firm Supply

Quantity (firm) 0

Price

MC

1.00

100

$2.00

200

(b) Market Supply

Quantity (market) 0

Price

Supply

1.00

100,000

$2.00

200,000

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 27

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.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 28

Figure 7: Market Supply with Entry and Exit

Copyright © 2004 South-Western

(a) Firm ’ s Zero-Profit Condition

Quantity (firm) 0

Price

(b) Market Supply

Quantity (market)

Price

0

P = minimum ATC

Supply

MC

ATC

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 29

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.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 30

A Shift in Demand in the Short Run 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.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 31

Figure 8: An Increase in Demand in the Short Run and Long Run

Firm

(a) Initial Condition

Quantity (firm) 0

Price

Market

Quantity (market)

Price

0

D Demand, 1

S Short-run supply, 1

P 1

ATC

Long-run supply

P 1

1 Q

A

MC

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 32

Figure 8: An Increase in Demand in the Short Run and Long Run

Market Firm

(b) Short-Run Response

Quantity (firm) 0

Price

MC ATC Profit

P 1

Quantity (market)

Long-run supply

Price

0

D 1

D 2

P 1

S 1

P 2

Q 1

A

Q 2

P 2

B

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 33

Figure 8: An Increase in Demand in the Short Run and Long Run

P 1

Firm

(c) Long-Run Response

Quantity (firm) 0

Price

MC ATC

Market

Quantity (market)

Price

0

P 1

P 2

Q 1 Q 2

Long-run supply

B

D 1

D 2

S 1

A

S 2

Q 3

C

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 34

Why the Long-Run Supply Curve Might Slope Upward

• Some resources used in production may be available only in limited quantities.

• Firms may have different costs.

• Marginal Firm

– The marginal firm is the firm that would exit the market if the price were any lower.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 35

The Firm’s Long-Run Decision to Exit or Enter a Market

• 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

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 36

Figure 4 : The Competitive Firm’s Long-Run Supply Curve

Copyright © 2004 South-Western

MC = long-run S

Firm exits if P < ATC

Quantity

ATC

0

Costs Firm ’ s long-run supply curve

Firm enters if P > ATC

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 37

The Supply Curve in a Competitive Market

• The competitive firm’s long-run supply curve is the portion of its marginal-cost curve that lies above average total cost.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana Slide 38

Figure 4: The Competitive Firm’s Long-Run Supply Curve

Copyright © 2004 South-Western

MC

Quantity

ATC

0

Costs

Firm ’ s long-run supply curve

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 39

The Supply Curve in a Competitive Market

• 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.

Mrs. Hellen Seshie-Nasser, Dept .of Economics, University of Ghana

Slide 40