Chap5

1

CHAPTER 5 CHAPTER 5

MARKET STRUCTURE:

PERFECT COMPETITION

Chapter OutlineChapter Outline

5.1 Characteristic

5.2 Short-run Decision: Profit Maximization

5.3 Short-run Decision: Minimizing Loss

5.4 Long-run Adjustment

5.5 External Changes: Consumer Preference & Technology

5.6 Efficiency of Perfect Competition2

Perfect CompetitionPerfect Competition

Definition:◦A market structure with many fully informed buyers and sellers of standardized product and no obstacles to entry or exit of firms in the long run.

◦For example: hypermarket (Giant, Carrefour, Tesco).

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5.1 Characteristic5.1 CharacteristicMany firms

◦A single firm’s production is relatively very small compare to the market demand. Therefore, cannot influence market price.

◦Each firm takes market price as given→ price takerHomogenous product

◦product/service has no unique characteristic, so consumers don’t care which firm they buy from.

◦Example: Agricultural products such as oil, iron and others.

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5.1 Characteristic5.1 Characteristic

• Perfect information◦Firms are price taker because buyers & sellers

are well informs about price. ◦No transaction cost assumed. ◦Firm only decide how much to produce.

Free entry / exit◦No legal, technology, capital, incumbent

advantage or others constraint to entry/exit. ◦New firms enter (existing firms exit) if industry

earning above (negative) normal profit.

5

6

d$4

Output (bushels)

Price$ per bushel

Firm Industry

D

$4

S

Price$ per bushel

Output (millions of bushels)

100

Figure: Market Equilibrium and Firm’s Demand Curve

Price

taker

Example: The market price of corn of $4 per bushel is determined by the market intersection of the market demand and supply curve.◦Each firm is so small relative to the market that each has no

impact on the market price.◦Anyone who charges more than the market price sell no corn

because find no buyers.

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The goal of a competitive firm is to maximize profit.

How the firm maximize profit?1. Total Approach:

Maximizing the Positive difference between TR – TC.

2. Marginal Approach: MR = MC (profit maximizing condition)

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Profit-Maximizing Level of OutputProfit-Maximizing Level of OutputIf q is output of the firm, then total

revenue is price of the good times quantity◦Total Revenue (TR) = P x Q

Costs of production depends on output◦Total Cost (TC) = TC x Q

Profit () = Total Revenue - Total Cost

TCTRq )(

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The goal of the firm is to maximize profits, the difference between total revenue and total cost.

A firm maximizes profit when MR = MC.

◦Marginal revenue (MR) -----the change in total revenue associated with a change in quantity.

◦Marginal cost (MC) ----- the change in total cost associated with a change in quantity.

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5.2 Short-run Decision: 5.2 Short-run Decision: Profit Maximization Profit Maximization

Profit:

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MCMRQ

Q

TC

Q

TR

Q

TCTR

0Q

MCMR

MCMR

0

Π maximize when

MR = MC = P (one price for every level of output & the whole market/industry )

» Profit maximization condition

Firm will produce up to the point where the price of its output is just equal to short-run MC (P=MC)

Total Revenue, Average Revenue and Total Revenue, Average Revenue and Marginal Revenue for a competitive Marginal Revenue for a competitive

firmfirm

Quantity sold

Price

(RM)

TR

(RM)

AR

(RM)

MR

(RM)

0 20 0 20 20

1 20 20 20 20

2 20 40 20 20

3 20 60 20 20

4 20 80 20 20

5 20 100 20 20

6 20 120 20 20

7 20 140 20 20

8 20 160 20 2012

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Graphical Illustration of TR, AR and MR for a Competitive Firm

TR

AR = MR=D

1 2 3 4 5 6 7 8 9 10

160

140

120

100

80

60

40

20

0

Pri

ce

an

d r

ev

enu

e

Quantity Demanded (sold)

Profit maximization – Profit maximization – Numerical example Numerical example

Quantity TR

(RM)

TC

(RM)

PROFIT

(RM)

MR

(RM)

MC

(RM)

0 0 10 -10 - -

1 20 14 6 20 4

2 40 22 18 20 8

3 60 34 26 20 12

4 80 50 30 20 16

5 100 70 30 20 20

6 120 94 26 20 24

7 140 122 18 20 28

8 160 154 6 20 3214

15

160

140

120

100

80

60

40

20

0

To

tal r

eve

nu

e a

nd

to

tal c

ost

TotalRevenue

TotalCost

MaximumEconomic

ProfitsRM30

Break-Even Point(Normal Profit)

Break-Even Point(Normal Profit)

1 2 3 4 5 6 7 8

1. TOTAL REVENUE-TOTAL COST APPROACH

TOTAL REVENUE-TOTAL REVENUE-TOTAL COST APPROACHTOTAL COST APPROACH

Firm selects output to maximize the difference between revenue and cost

We can graph the total revenue and total cost curves to show maximizing profits for the firm

Distance between revenues and costs show profits

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2. MARGINAL REVENUE-2. MARGINAL REVENUE-MARGINAL COST APPROACHMARGINAL COST APPROACH

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q2

10

20

30

40

Price

50

MC

0 1 2 3 4 5 6 7 8 9 10 11Outputq*

AR=MR=PA

q1 : MR > MC; ↑ outputq2: MR < MC; ↓ output

q*: MR = MC

q1

Lost Profit for q2 > q*

Lost Profit for q1 < q*

Profit is maximized where MR = MC

Profit increases until it is maxed at q*

Choosing Output: Short RunChoosing Output: Short Run

The point where MR = MC, the profit maximizing output is chosen

◦MR=MC at quantity of 8

◦At a quantity less than 8, MR>MC so more profit can be gained by increasing output

◦At a quantity greater than 8, MC>MR, increasing output will decrease profits

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The Relationship Between MR and The Relationship Between MR and MC:MC:

→ A firm can increase its profit by increasing output.

→ A firm can reduce its losses by decreasing output.

→ Profits are at a maximum

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MR > MC

MR < MC

MR = MC

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Short Run EquilibriumShort Run Equilibrium1. Supernormal profits• economic profits • (P > ATC) or (TR > TC)

2. Normal profits • Breakeven or zero profit• (P = ATC) or (TR = TC)

3. Subnormal profits• Economic losses• (P < ATC) or (TR < TC)• continue the production if (ATC > P > AVC)• Shut down the operation if (ATC > P < AVC)

Supernormal Profit Supernormal Profit (Economic Profit)(Economic Profit)

Definition◦Profit earned by a competitive firm when its

total revenue is more than total cost (TR>TC) or price is greater than ATC (P>ATC).

Calculation:TR = 5 x 9 = 45TC = 3 x 9 = 27 = (TR – TC) = (45 – 27) = 18

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22

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

MR=AR=P

ATC

Economic Profit

RM5

RM3

Supernormal Profit/ Economic Profit

Minimum point of ATC

Breakeven/ Normal ProfitBreakeven/ Normal Profit

Definition◦When total revenue is equal to total cost (TR=TC)

or price equal to ATC (P=ATC), there are no profit or no losses. Firm has only able to cover its costs.

Calculation:TR = 5 x 9 = 45TC = 5 x 9 = 45 = (TR – TC) = (45 – 45) = 0

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24

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

MR=AR

ATC

RM5

Breakeven/ Normal Profit

Minimum point of ATC

Economic losses/ Economic losses/ Subnormal profitSubnormal profit

• Definition◦Losses incurred by a competitive firm when total

revenue is less than total cost (TR < TC) or when the equilibrium price falls below ATC (P < ATC.

◦The firm incurs losses because would not able to cover its costs.

• Calculation: TR = 5 x 6 = 30 TC = 7 x 6 = 42 = (TR – TC) = (30 – 42) = -12

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26

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

MR=AR

ATC

Economic Loss

RM5RM7

Economic losses/ Subnormal profit

5.3 Short Run Decision: Minimizing Loss Losses

◦If (TR<TC) or (P>ATC)

Two conditions:◦Keep operating (ATC>P>AVC)

If the operating profit is positive (TR – TVC > 0), the firm can use this operating profit to offset fixed costs and reduce total losses.

◦Shut down (ATC>P<AVC)If the operating profit is negative (TR – TVC < 0), the firm suffers operating losses that push total losses above fixed costs.

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28

Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

MR=ARAVCATC

Economic Loss

PATC

Subnormal Profit (ATC>P>AVC)): (i) Keep Operating

AVC

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Co

st a

nd

Rev

enu

e

1 2 3 4 5 6 7 8 9 10

MC

MR=ARAVCATC

Economic Loss

P

ATC

Subnormal Profits (ATC>P<AVC):(ii) Shutdown

AVC

Shutting Down in the Short RunShutting Down in the Short Run

Shutting down is not the same as going out of business.

In the short run, even a firm that shuts down keeps its productive capacity intact that when demand increases enough, the firm will resume operation.

If market conditions look grim and are not expected to increase, the firm may decide to leave the market a long run decision

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Summary: Summary: Firm Decisions in the Long Run & Firm Decisions in the Long Run & Short RunShort Run

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SR CONDITION SR DECISION LR DECISION

Profits TR > TC operate Expand + new firms enter

Losses 1. With operating profit operate Contract + firms exit

(TR TVC) (losses < FC)

2. With operating losses shut down: Contract + firms exit

(TR < TVC) losses = FC

• In the SR, firms have to decide how much to produce in the current scale of plant.

• In the LR, firms have to choose among many potential scales of plant.

Short Run Supply CurveShort Run Supply CurveCompetitive firms determine the quantity

to produce where P = MC

Competitive firms supply curve is portion of the marginal cost curve above the AVC curve

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33

Co

st a

nd

Rev

enu

e, (

do

llar

s) MC

AVC

ATC

Quantity Supplied

P1

P2

P3

P4

P5

Q2 Q3 Q4 Q5

Marginal Cost & Short-Run Supply

Do notProduce

Below AVC(< P2)

Normal Profit

Shut down point

Subnormal profit

Supernormal profit

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Co

st a

nd

Rev

enu

e, (

do

llar

s)

MR1

Quantity Supplied

MR2

MR3

MR4

MR5

P1

P2

P3

P4

P5

Q2 Q3 Q4 Q5

Marginal Cost & Short-Run Supply

Short-RunSupply Curve

Supply

NoProductionBelow AVC

Short-Run Supply CurveShort-Run Supply Curve

As long as the price covers average variable cost, the firm will supply the quantity resulting from the intersection of its upward-sloping marginal cost curve and its marginal revenue, or demand curve.

Thus, that portion of the firm’s marginal cost curve that rises above the lowest point on its average variable cost curve becomes the short-run firm supply curve.

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5.4 Long Run Adjustment

In the long run, there is an adequate time for the firm to make changes and adjustment to the production process.

All inputs are variable in the long run.Perfect competitive firm only earn zero

economic profit (normal profit).Its mean that TR is just enough to cover

TC ( = TR – TC = 0)This is due to the effect of free entry

and exit.

Profit maximization in the LRProfit maximization in the LRFree entry:

◦When firm earn economic profit > 0 in the SR:Encourage NEW firms to enter the market.Market supply increase (SS curve shift rightward).

Equilibrium price drop >> individual firm will also lower their price (price taker) until profit is eliminated.

When economic profit = 0, no incentive for firm to come in.

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Try this!!Try this!!

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Profit Maximization in the LRProfit Maximization in the LRFree exit:

◦When firm earn economic profit < 0 in the SR: Incentive for existing (losing) firms to exit the market.

Market supply drop (SS curve shift leftward).

Equilibrium price rise >> individual firm will also increase their price (price taker) until profit is eliminated.

When economic profit = 0, no incentive for firm to come in.

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Try this!!Try this!!

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5.5 External Changes:5.5 External Changes: Consumer Preference Consumer Preference

& & TechnologyTechnology

Changing preference: ◦Increase in Demand◦Decrease in Demand

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(1) Changing Preference

Increase in demand

Firm Industry

When preference increase:

◦DD curve shift rightward, quantity & price increase.

◦Existing firm gain positive economic profit.◦Incentive for expansion or new firms entry.◦Market SS increase: SS curve shift rightward, qty increase but price drop until each firm earn zero economic profit.

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44

S1

MCATC

P

Q q1

P

Q Q1

IndustryFirm(price taker)

P1 P1

MR

D1

Before Increase in Demand

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DD increases – DD curve shift left – P↑ - Q↑ - supernormal profit – new firms enter

MR

D1

MCATC

P

Q q1 q2

P

Q Q1 Q2


P2

P1

P2

P1

D2

EconomicProfits

S1

MR1

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New entry – SS ↑ - Q↑ - P↓ - (P = ATC) normal profit

MR

D1

MCATC

P

Q q1

P

Q


P2

P1

P2

P1

D2

Zero EconomicProfits

S1

S2

q2 Q1Q2Q3

IMP

OR

TA

NT

!!

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Changing Preference:

Decrease in demand

IndustryFirm

When preference drop:

◦DD curve shift leftward, quantity & price decrease.

◦Existing firm suffer economic losses.◦Incentive for contraction or exit.◦Market SS decrease: SS curve shift leftward, qty

drop but price increase until each firm earn zero economic profit.

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Before decrease in demand:Before decrease in demand:

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S1

MCATC

P

Qq1

P

Q Q1


P1 P1

D1

MR

50

MR

D1

MCATC

P

Q q1

P

QQ2Q1


P1

P2

P1

P2

D2

EconomicLosses

S1

q2

DD decreases – DD curve shift right – P↓ - Q↓ - subnormal profit – existing firms exit

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MR

D1

MCATC

P

Q q1

P

Q Q2 Q1


$60

50

40

$60

50

40

D2

ZeroEconomic Profits

S1

S3

Q3q2

Existing firms exit – SS ↓ - Q↓ - P↑:(P = ATC) normal profit

IMP

OR

TA

NT

!!

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(2) Advancing Technology: Technology Improvements

(a)(a) Adopt new technology Adopt new technology (b)(b) Old technology firm Old technology firm

Economic lossPositive economic profit

New firms entry

SS up, P down

Profit reducing

Produce at lower cost

ExitAdopt newtechnology

SS down, P up

Zero economic profit Zero economic profit

5.6 Efficiency of Perfect 5.6 Efficiency of Perfect Competition Competition

What will be produced?◦Efficient allocation of resources among firm.

How will it be produced? ◦Efficient distribution of outputs among

households.

Who will get what is produced?◦Producing what people want: The efficient mix

of output.

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Efficient Allocation of Resources Among Firm

◦Producing allocation using the best available-lowest cost - technology. If more output can be produced with the same

amount of inputs; it would make some people better off.

◦Inputs allocated across firms in the best possible way.The assumptions that factor markets are competitive and open, that all firms pay the same prices for inputs, and that all

firms maximize profits leads to the conclusion that the allocation of resources

among firms is efficient. 54

Efficient Distribution of Outputs Among Households:

◦Household are free to choose among all the goods and services in the market. Subject to purchasing power constraint (income &

wealth). Depend on the budget constraint.

As long as everyone shops freely in the same markets, no redistribution of final

output among people will make them better off.

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Producing What People Want (The Efficient Mix of Output):

◦Produce at P = MC.◦Price reflects households’ willingness to pay.

By purchasing a product, individual reveal that it is worth as least as much as the other things that the same money could buy.

◦Marginal cost reflects the opportunity cost of the resources needed to produce a good. Society will produce the efficient mix output if all

firms equate price and marginal cost.

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Summary: Summary: Firm Decisions in the Long Run & Firm Decisions in the Long Run & Short RunShort Run

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SR CONDITION SR DECISION LR DECISION

Profits TR > TC operate Expand + new firms enter

Losses 1. With operating profit operate Contract + firms exit

(TR TVC) (losses < FC)

2. With operating losses shut down: Contract + firms exit

(TR < TVC) losses = FC

• In the SR, firms have to decide how much to produce in the current scale of plant.

• In the LR, firms have to choose among many potential scales of plant.

Output (unit)

Total cost

(RM)

Variable cost

(RM)

1 15 10

2 21 16

3 28 23

4 37 32

5 50 45

6 68 63

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a) Calculate the equilibrium output if the price of the product is RM9 per unit.

b) Calculate the total profit or loss at the equilibrium output.

c) What is the condition for this firm?

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QUESTIONS:

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