Market Structure: Perfect Competition

Many buyers and sellers

Buyers and sellers are price takers

Product is homogeneous

Perfect mobility of resources

Economic agents have perfect knowledge

FIRMINDUSTRY

Diagrammatic representation

Cost/Revenue

Output/Sales

The industry price is determined by the demand and supply of the industry as a whole. The firm is a very small supplier within the industry and has no control over price. They will sell each extra unit for the same price. Price therefore = MR and AR

P = MR = AR

MC

The MC is the cost of producing additional (marginal) units of output. It falls at first (due to the law of diminishing returns) then rises as output rises.

AC

The average cost curve is the standard ‘U’ – shaped curve. MC cuts the AC curve at its lowest point because of the mathematical relationship between marginal and average values.

Q1

Given the assumption of profit maximisation, the firm produces at an output where MC = MR (Q1). This output level is a fraction of the total industry supply.

At this output the firm is making normal profit. This is a long run equilibrium position.

Perfect CompetitionDiagrammatic representation

Cost/Revenue

Output/Sales

P = MR = AR

MC

AC

Q1

Now assume a firm makes some form of modification to its product or gains some form of cost advantage (say a new production method). What would happen?

AC1

MC1

AC1Abnormal profit

Q2

Because the model assumes perfect knowledge, the firm gains the advantage for only a short time before others copy the idea or are attracted to the industry by the existence of abnormal profit. If new firms enter the industry, supply will increase, price will fall and the firm will be left making normal profit once again.

P1 = MR1 = AR1

The lower AC and MC would imply that the firm is now earning abnormal profit (AR>AC) represented by the grey area.

Average and Marginal costs could be expected to be lower but price, in the short run, remains the same.

625 5QD P 175 5QS P QD QS

625 5 175 5P P

450 10P

$45P

625 5 625 5(45) 400QD P

175 5 175 5(45) 400QS P

Firm’s Demand Curve = Market Price

= Marginal Revenue

Firm’s Supply Curve = Marginal Cost

where Marginal Cost > Average Variable Cost

Total Profits = TR -TCd = d(TR) - d(TC) = 0

dQ dQ dQ MR - MC = 0

MR = MCd(TR) = d(PQ) = P = MR

dQ dQ

Losses and Shutdown Decision

Quantity TFC TVC TC MC AVC ATC0 5 0 51 5 5 10 5 5.00 10.002 5 9 14 4 4.50 7.003 5 12 17 3 4.00 5.674 5 14 19 2 3.50 4.755 5 17 22 3 3.40 4.406 5 21 26 4 3.50 4.337 5 26 31 5 3.71 4.438 5 32 37 6 4.00 4.639 5 39 44 7 4.33 4.89

Losses and Shutdown Decision

0

2

4

6

8

10

12

0 1 2 3 4 5 6 7 8 9 10

MC

ATC

AVC

5

3.35

Quantity per period

Price, costper unit

Losses and Shutdown Decision

C

0

2

4

6

8

10

12

0 1 2 3 4 5 6 7 8 9 10

MC

ATC

AVC

5

3.35

Quantity per period

Price, costper unit

Losses and Shutdown Decision

B

C

0

2

4

6

8

10

12

0 1 2 3 4 5 6 7 8 9 10

MC

ATC

AVC

5

3.35

Quantity per period

Price, costper unit

Losses and Shutdown Decision

A

B

C

S

Pe

C

D

P1

Qe Quantity per period

Price per unit

Consumer Surplus

P = 45 - 0.5Q TC = Q3 - 8Q2 + 57Q + 2

= 7.5Q2 - 12Q – 2 – Q3

d = 15Q -12 - 3Q2

dQ

Q = 1 and Q = 4

d2 = -6Q + 15dQ2

d2 = 9 d2 = -9dQ2 dQ2

PROFIT MAXIMISATION

High degree of competition helps allocate resources to most efficient use

Price = marginal costs Normal profit made in the long run Firms operate at maximum efficiency Consumers benefit

Single seller and many buyers No close substitutes for product Significant barriers to resource mobility

Control of an essential input (OPEC) Patents or copyrights (Medicines/drugs) Economies of scale at large output (China) Government franchise

Abnormal profits in long run Possibility of price discrimination Prices in excess of MC

Demand curve for the firm is the market demand curve

Firm produces a quantity (Q*) where marginal revenue (MR) is equal to marginal cost (MC)

P = a - bQ

TR = PQ = (a - bQ)Q = aQ - bQ2

MR = d(TR) = a - 2bQ dQ

MR

D

OQ

P

MonopolyShort-Run Equilibrium

MC AC

MR

D

Pm

Qm

OQ

P

MonopolyShort-Run Equilibrium

Q* = 500

P* = $11

Q* = 700

P* = $9

Advantages:

Encourages R&D Encourages innovation Economies of scale can be gained – consumer may

benefit

Disadvantages:

Exploitation of consumer – higher prices Potential for supply to be limited - less choice Potential for inefficiency

Many sellers of differentiated (similar but not identical) products

Limited monopoly power (based on the uniqueness of their product)

Dominoes : quick delivery Maggi : 2 minutes Dettol : Hygiene

Perfect mobility of resources Downward-sloping demand curve Increase in market share by competitors

causes decrease in demand Easy entry and exit Differentiated products : Advertising costs

Profit = 0

Cost without selling expenses

Cost with selling expenses

In Mumbai, the movie market is monopolistically competitive. The long run demand equation & AC is given

P = 5 – 0.002Q AC = 6 – 0.004Q + 0.000001Q2

(a) To maximize profits, what should be the price & Q. (Q = 1000 & P = 3)

(b) How much profit will the firm earn? (0)

Hyundai has taken Mahindra Renault to High Court objecting to Mahindra’s plan to launch a compact car with the name 'Sandero' alleging that Mahindra is trying to cash on its popular brand Santro.

Asian Paints (label "Utsav”) vs Jaikishan Paints & Allied Products (label “ Utkarsh”) with similar name, color, layout.

Few sellers of a product Duopoly - Two sellers Pure oligopoly - Homogeneous product Differentiated oligopoly - Differentiated

product Non-price competition Barriers to entry High degree of interdependence between firms Abnormal profits Potential for collusion?

Economies of scale (Exide: distribution, Walmart)

Large capital investment required (Steel) Patented production processes (Drugs) Brand loyalty (Tata Salt) Control of a raw material or resource (Cement) Government franchise (Licenses)

Collusion Cooperation among firms to restrict competition in

order to increase profits Market-Sharing Cartel

Collusion to divide up markets Centralized Cartel

Formal agreement among member firms to set a monopoly price and restrict output

Examples: OPECDe Beers

Firms can ask for an equitable distribution of profits.

Cartel members have a strong incentive to cheat by selling more.

Monopoly profits may attract other firms.