Chapter 6 – Production Behavior: Perfect Competition

This chapter examines perfect competition as a market structure.

It also develops the profit maximizing producer’s choice of output under perfect competition, and the formation of profits.

Finally, it examines how markets adjust to firms making excess profits, or suffering losses in perfect competition.

Perfect Competition: Key Characteristics

There are a large number of producers within a market for a certain good.

The goods within a market are homogeneous – there exist no quality differences, real or perceived, between the same good made by different producers.

Easy entry and exit (no barriers to entry).

Market Demand and Supply for Good in General

Consider, for example, eggs.

Market Demand – usual market demand curve for eggs, discussed in chapter 4.

Market Supply – usual market supply curve for eggs, discussed in chapter 5.

Market forms an equilibrium price (P*) and equilibrium quantity (Q*) of eggs.

Market Demand for the Individual Producer’s Good

Homogeneous goods individual producer’s eggs are perfect substitutes with other egg producers’ eggs.

Therefore, the Demand for the individual producer’s eggs is described as a horizontal line at the market equilibrium price P*.

Total Revenue for the Individual Producer

Perfect Competition: firms are price takers, they have no power over setting or changing the price of their product.

Total Revenue = (P*)(Q), where Q is the amount they decide to produce.

Total Cost for the Individual ProducerTotal Cost – the total expenditure the firm

spends due to its use of inputs (materials, labor, capital) to produce a certain amount of output.

-- Fixed Cost: the cost to the firm which remains the same no matter how

much it produces (including zero). -- Variable Cost: the cost to the firm which varies based upon how much it produces

Average and Marginal Cost

Average Cost (AC) – firm’s total cost per unit of output.

AC = (Total Cost)/Q

Marginal Cost (MC) – the change in total cost due to a change in output.

MC = (Total Cost)/Q

An Example: King David’s Production Function Output (Lunches) Labor Input (People) 0 0 10 1 25 2 50 3 70 4 86 5 95 6 101 7 104 8 93 9

Computing Total, Average, and Marginal Cost

One needs information about fixed cost, and cost per unit of labor.

For our numerical example, suppose that:

-- Fixed Cost (materials, machine

and building rental) = $100.

-- Each Person Costs $30.

King David’s Total Cost Labor Fixed Cost + Wage Cost = Total Cost 0 100 0 100 1 100 30 130 2 100 60 160 3 100 90 190 4 100 120 220 5 100 150 250 6 100 180 280 7 100 210 310 8 100 240 340 9 100 270 370

King David’s Average Cost (AC) and Marginal Cost (MC) Output (Q) Total Cost AC MC 0 100 -- -- 10 130 13.0 3.0 25 160 6.4 2.0 50 190 3.8 1.2 70 220 3.1 1.5 86 250 2.9 1.9 95 280 2.9 3.3 101 310 3.1 5.0 104 340 3.3 10.0 93 370 4.0 --

Characteristics of Average Cost and Marginal Cost Curves

Both are u-shaped,

When AC is decreasing, MC < AC.When AC is increasing, MC > AC.At the minimum point of the AC curve, MC = AC.

Upward sloping part of MC depicts Law of Diminishing Returns, “relevant region” of production choice.

The Production Decision and Producer Profits

To maximize profits, the individual producer chooses to produce (Q0) where P* = MC (marginal benefit of producing the additional unit equals the marginal cost of producing the additional unit.

Profit = (Total Revenue) – (Total Cost),

Profit = (P*)(Q0) – (Total Cost),

Profit = (P*)(Q0) – (AC)(Q0).

Producer Choice and Profits: King David’s

Suppose that the market price for Marshall Street lunches (P*) equals $10.00.

King David’s chooses output (Q0) where P* = MC.

They compute Profits as Profits = (P*)(Q0) – (AC)(Q0).

King David’s Production (P* = 10.0) Output (Q) Total Cost AC MC 0 100 -- -- 10 130 13.0 3.0 25 160 6.4 2.0 50 190 3.8 1.2 70 220 3.1 1.5 86 250 2.9 1.9 96 280 2.9 3.3 102 310 3.1 5.0 104 340 3.3 10.0 95 370 4.0 --

King David’s Production Choice and Profits

They choose an output level (Q0) where P* = MC, which corresponds to 104 lunches.

Total Revenue = (10.00)(104) = 1040.Total Cost = 340

[approximately (AC)(Q0), or (3.3)(104)].

Profit = 1040 - 340 = 700.

Economic Profit ()

Economic Profit () – Profits for a firm where Total Costs include the opportunity cost of the entrepreneur taking his/her talents to another industry.

Zero Economic Profit ( = 0) implies just enough accounting profits to keep the entrepreneur in the industry.

Positive Economic Profit ( > 0) implies accounting profits in excess of the “minimum requirement”.

A Graphical Description

Firms choose output (Q0) where P* = MC.

Total Revenue = Area of rectangle of width Q0 and height P*.

Total Cost = Area of rectangle of width Q0 and height AC (based upon the choice of Q0).

Profit () = Difference in areas.Profit () can be positive (wonderful), zero

(OK), or negative (firm considers closing).

Market Response to Positive ProfitsIf firms in the industry are making

positive profits, invites other firms to enter (no barriers to entry, or no market power).

Increases market supply (shifts market supply curve rightward), decreases P*.

Changes the output choice (Q0) and decreases the profits of the individual firm.

Market Response to Negative ProfitsIf firms in the industry are making

negative profits, some firms exit the industry.

Decreases market supply (shifts market supply curve leftward), increases P*.

Changes the output choice (Q0) and increases the profits of the (surviving) individual firms.

Perfect Competition in the Long-Run

Perfect Competition in the Long-Run: Zero Economic Profits ( = 0) Ultimate long-run position of markets

under perfect competition with the “nice assumptions”.

No incentive for new firms to enter the market.

No incentive for existing firms to exit the market.

The Agility of Markets Under Perfect Competition

The ability of firms to enter highly favorable markets or exit highly unfavorable markets creates “market-resolving” changes in the equilibrium price level.

As a result -- (1) firms don’t maintain permanent advantages and (2) unfavorable markets don’t stay unfavorable for the survivors.