Transcript Chapter 12

ECONOMICS 5e
Michael Parkin
CHAPTER
12
Perfect Competition
Learning Objectives
• Define perfect competition
• Explain how price and output are
determined in a competitive industry
• Explain why firms sometimes shut down
temporarily and lay off workers
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-2
Learning Objectives (cont.)
• Explain why firms enter and leave an
industry
• Predict the effects of a change in demand
and of a technological advance
• Explain why perfect competition is efficient
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-3
Learning Objectives
• Define perfect competition
• Explain how price and output are
determined in a competitive industry
• Explain why firms sometimes shut down
temporarily and lay off workers
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-4
Perfect Competition
Characteristics of Perfect Competition
• Many firms, each selling an identical product.
• Many buyers.
• No restrictions on entry into the industry.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-5
Perfect Competition
Characteristics of Perfect Competition
• Firms in the industry have no advantage over
potential new entrants.
• Firms and buyers are well informed about
prices of the products of each firm in the
industry.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-6
Perfect Competition
As a result of these characteristics, perfect
competitors are price takers.
Price takers
Firms that cannot influence the price of a good
or service.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-7
Learning Objectives
• Define perfect competition
• Explain how price and output are
determined in a competitive industry
• Explain why firms sometimes shut down
temporarily and lay off workers
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-8
Economic Profit and Revenue
The firm’s goal is to maximize economic
profit.
Total cost is the opportunity cost - including
normal profit.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-9
Economic Profit and Revenue
Total revenue is the value of a firm’s sales.
• Total revenue = P  Q
Marginal revenue (MR)
• Change in total revenue resulting from a one-unit
increase in quantity sold.
Average revenue (AR)
• Total revenue divided by the quantity sold—revenue
per unit sold.
In perfect competition, Price = MR = AR
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-10
Economic Profit and Revenue
Suppose Sidney sells his sweaters
in a perfectly competitive market.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-11
Demand, Price, and Revenue
in Perfect Competition
Quantity
sold
(Q)
(sweaters
per day)
Price
(P)
Total
revenue
(dollars
per
TR = P  Q
sweater) (dollars)
8
25
9
25
10
25
Copyright © 1998 Addison Wesley Longman, Inc.
Marginal
revenue
MR  TR / Q
(dollars per
additional sweater)
Average
revenue
(AR = TR/Q
(dollars
per sweater)
TM 12-12
Demand, Price, and Revenue
in Perfect Competition
Quantity
sold
(Q)
(sweaters
per day)
Price
(P)
Total
revenue
(dollars
per
TR = P  Q
sweater) (dollars)
8
25
200
9
25
225
10
25
250
Copyright © 1998 Addison Wesley Longman, Inc.
Marginal
revenue
MR  TR / Q
(dollars per
additional sweater)
Average
revenue
(AR = TR/Q
(dollars
per sweater)
TM 12-13
Demand, Price, and Revenue
in Perfect Competition
Quantity
sold
(Q)
(sweaters
per day)
Price
(P)
Total
revenue
(dollars
per
TR = P  Q
sweater) (dollars)
8
25
200
9
25
225
10
25
250
Copyright © 1998 Addison Wesley Longman, Inc.
Marginal
revenue
MR  TR / Q
(dollars per
additional sweater)
Average
revenue
(AR = TR/Q
(dollars
per sweater)
25
25
TM 12-14
Demand, Price, and Revenue
in Perfect Competition
Quantity
sold
(Q)
(sweaters
per day)
Price
(P)
Total
revenue
(dollars
per
TR = P  Q
sweater) (dollars)
8
25
200
9
25
225
10
25
250
Copyright © 1998 Addison Wesley Longman, Inc.
Marginal
revenue
MR  TR / Q
(dollars per
additional sweater)
25
25
Average
revenue
(AR = TR/Q
(dollars
per sweater)
25
25
25
TM 12-15
Demand, Price, and Revenue
in Perfect Competition
Sidney’s demand
and marginal revenue
50
50
S
Market
demand
curve
25
Sidney’s
demand
curve
MR
25
Sidney’s total revenue
Total revenue (dollar per day)
Price (dollars per sweater)
Price (dollars per sweater)
Sweater market
TR
a
225
D
0
9
20
Quantity (thousands
of sweaters per day)
Copyright © 1998 Addison Wesley Longman, Inc.
0
10
20
Quantity (sweaters per day)
0
9
20
Quantity (sweaters per day)
TM 12-16
Learning Objectives
• Define perfect competition
• Explain how price and output are
determined in a competitive industry
• Explain why firms sometimes shut down
temporarily and lay off workers
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-17
The Firm’s Decisions in
Perfect Competition
A firm’s task is to make the maximum
economic profit possible, given the
constraints it faces.
In order to do so, the firm must make two
decisions in the short-run, and two in the
long-run.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-18
The Firm’s Decisions in
Perfect Competition
Short-run
A time frame in which each firm has a given
plant and the number of firms in the industry is
fixed
Long-run
A time frame in which each firm can change
the size of its plant and decide to enter the
industry.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-19
The Firm’s Decisions in
Perfect Competition
In the short-run, the firm must decide:
• Whether to produce or to shut down.
• If the decision is to produce, what quantity to
produce.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-20
The Firm’s Decisions in
Perfect Competition
In the long-run, the firm must decide:
• Whether to increase of decrease its plant size.
• Whether to stay in the industry or leave it.
We will first address the short-run.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-21
Total Revenue, Total Cost,
and Economic Profit
Quantity Total
(Q)
revenue
(sweaters
(TR)
Per day)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Copyright © 1998 Addison Wesley Longman, Inc.
(dollars)
Total
cost
(TC)
Economic
profit
(TR – TC)
(dollars)
(dollars)
0
25
50
75
100
125
150
175
200
225
250
275
300
325
TM 12-22
Total Revenue, Total Cost,
and Economic Profit
Quantity
(Q)
(sweaters
Per day)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Copyright © 1998 Addison Wesley Longman, Inc.
Total
revenue
(TR)
Total
cost
(TC)
Economic
profit
(TR – TC)
(dollars)
(dollars)
(dollars)
0
25
50
75
100
125
150
175
200
225
250
275
300
325
22
45
66
85
100
114
126
141
160
183
210
245
300
360
TM 12-23
Total Revenue, Total Cost,
and Economic Profit
Quantity
(Q)
(sweaters
Per day)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
Copyright © 1998 Addison Wesley Longman, Inc.
Total
revenue
(TR)
Total
cost
(TC)
Economic
profit
(TR – TC)
(dollars)
(dollars)
(dollars)
0
25
50
75
100
125
150
175
200
225
250
275
300
325
22
45
66
85
100
114
126
141
160
183
210
245
300
360
-22
-20
-16
-10
0
11
24
24
40
42
40
30
0
-35
TM 12-24
Total revenue & total cost
(dollars per day)
Total Revenue, Total Cost,
and Economic Profit
TC
TR
300
Economic
loss
225
Economic
profit =
TR - TC
183
100
Economic
loss
0
4
9
12
Quantity (sweaters per day)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-25
Total Revenue, Total Cost,
and Economic Profit
Profit/loss
(dollars per day)
Economic profit/loss
42
20
0
4
-20
-40
Copyright © 1998 Addison Wesley Longman, Inc.
Economic
profit
Economic
loss
Profit
maximizing
quantity
9
12
Profit/
loss
Quantity
(sweaters
per day)
TM 12-26
Marginal Analysis
Using marginal analysis, a comparison is
made between a units marginal revenue and
marginal cost.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-27
Marginal Analysis
If MR > MC, the extra revenue from selling one
more unit exceeds the extra cost.
• The firm should increase output to increase profit.
If MR < MC, the extra revenue from selling one
more unit is less than the extra cost.
• The firm should decrease output to increase profit.
If MR = MC economic profit is maximized.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-28
Profit-Maximizing Output
Quantity Total
(Q) revenue
(sweaters (TR)
per day)
7
8
9
10
11
(dollars)
Marginal
revenue
(MR)
(dollars per
additional
sweater)
Total
cost
(TC)
(dollars
Marginal
cost
(MC)
Economic
(dollars per
profit
additional
(TR – TC)
sweater)
(dollars)
175
200
225
250
275
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-29
Profit-Maximizing Output
Quantity Total
(Q) revenue
(sweaters (TR)
per day)
7
8
9
10
11
(dollars)
175
200
225
250
275
Copyright © 1998 Addison Wesley Longman, Inc.
Marginal
revenue
(MR)
(dollars per
additional
sweater)
Total
cost
(TC)
(dollars
Marginal
cost
(MC)
Economic
(dollars per
profit
additional
(TR – TC)
sweater)
(dollars)
25
25
25
25
TM 12-30
Profit-Maximizing Output
Quantity Total
(Q) revenue
(sweaters (TR)
per day)
7
8
9
10
11
(dollars)
175
200
225
250
275
Copyright © 1998 Addison Wesley Longman, Inc.
Marginal
revenue
(MR)
(dollars per
additional
sweater)
25
25
25
25
Total
cost
(TC)
(dollars
Marginal
cost
(MC)
Economic
(dollars per
profit
additional
(TR – TC)
sweater)
(dollars)
141
160
183
210
245
TM 12-31
Profit-Maximizing Output
Quantity Total
(Q) revenue
(sweaters (TR)
per day)
7
8
9
10
11
(dollars)
175
200
225
250
275
Copyright © 1998 Addison Wesley Longman, Inc.
Marginal
revenue
(MR)
(dollars per
additional
sweater)
25
25
25
25
Total
cost
(TC)
(dollars
141
160
183
210
245
Marginal
cost
(MC)
(dollars per
additional
sweater)
Economic
profit
(TR – TC)
(dollars)
19
23
27
35
TM 12-32
Profit-Maximizing Output
Quantity Total
(Q) revenue
(sweaters (TR)
per day)
7
8
9
10
11
(dollars)
175
200
225
250
275
Copyright © 1998 Addison Wesley Longman, Inc.
Marginal
revenue
(MR)
(dollars per
additional
sweater)
25
25
25
25
Total
cost
(TC)
(dollars
141
160
183
210
245
Marginal
cost
(MC)
(dollars per
additional
sweater)
19
23
27
35
Economic
profit
(TR – TC)
(dollars)
34
40
42
40
30
TM 12-33
Marginal revenue & marginal cost
(dollars per day)
Profit-Maximizing Output
30
25
20
Profitmaximization
point
MC
Loss from
10th sweater
MR
Profit from
9th sweater
10
0
8
9
10
Quantity (sweaters per day)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-34
The Firm’s Short-Run
Supply Curve
Fixed costs must be paid in the short-run.
Variable-costs can be avoided by laying off
workers and shutting down.
Firms shut down if price falls below the
minimum of average variable cost.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-35
Marginal revenue & marginal cost
(dollars per day)
A Firm’s Supply Curve
MC = S
31
MR2
25
MR1
Shutdown
point
AVC
s
MR0
17
0
7
9 10
Quantity (sweaters per day)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-36
Marginal revenue & marginal cost
(dollars per day)
A Firm’s Supply Curve
S
31
25
17
0
s
7
9 10
Quantity (sweaters per day)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-37
Short-Run Industry Supply Curve
Short-run industry supply curve
Shows the quantity supplied by the industry at
each price when the plant size of each firm and
the number of firms remain constant.
It is constructed by summing the quantities
supplied by the individual firms.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-38
Industry Supply Curve
Price
Quantity supplied
by Sidney
Quantity supplied
by industry
(dollars
(sweaters
(sweaters
per sweater)
per day)
per day)
a
17
0 or 7
0 to 7,000
b
2
8
8,000
c
25
9
9,000
d
31
10
10,000
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-39
Price (dollars per sweater)
Industry Supply Curve
40
S1
30
20
0
Copyright © 1998 Addison Wesley Longman, Inc.
6
7
8
9
10
Quantity (thousands of sweaters per day)
TM 12-40
Output, Price, and Profit
in Perfect Competition
Industry demand and industry supply
determine the market price and industry
output.
Changes in demand bring changes to
short-run industry equilibrium.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-41
Price (dollars per sweater)
Short-Run Equilibrium
Increase in demand:
price rises and firms
increase production
S
25
Decrease in demand:
price falls and
20firms
decrease production
D2
17
D1
D3
0
6
7
8
9
10
Quantity (thousands of sweaters per day)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-42
Profits and Losses
in the Short-Run
At short-run equilibrium firms may:
• Earn a profit
• Break even
• Incur an economic loss.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-43
Profits and Losses
in the Short-Run
If price equals average total cost a firm
breaks even.
If price exceeds average total cost, a firm
makes an economic profit.
If price is less than average total cost, a firm
incurs an economic loss.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-44
Price (dollars per chip)
Three Possible Profit Outcomes
in the Short-Run
30.00
25.00
Normal profit
MC
Break-even
point
20.00
ATC
AR = MR
15.00
0
Copyright © 1998 Addison Wesley Longman, Inc.
8
10
Quantity (millions of chips per year)
TM 12-45
Price (dollars per chip)
Three Possible Profit Outcomes
in the Short-Run
30.00
Economic profit
MC
ATC
25.00
AR = MR
Economic
Profit
20.33
15.00
0
9 10
Quantity (millions of chips per year)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-46
Price (dollars per chip)
Three Possible Profit Outcomes
in the Short-Run
Economic loss
30.00
MC
ATC
25.00
20.14
17.00
0
Copyright © 1998 Addison Wesley Longman, Inc.
Economic
loss
AR = MR
7
10
Quantity (millions of chips per year)
TM 12-47
Learning Objectives (cont.)
• Explain why firms enter and leave an
industry
• Predict the effects of a change in demand
and of a technological advance
• Explain why perfect competition is efficient
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-48
Long-Run Adjustments
Forces in a competitive industry ensure only
one of these situations is possible in the
long-run.
Competitive industries adjust in two ways:
• Entry and exit
• Changes in plant size
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-49
Entry and Exit
The prospect of persistent profit or loss
causes firms to enter or exit an industry.
If firms are making economic profits, other
firms enter the industry.
If firms are making economic losses, some
of the existing firms exit the industry.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-50
Entry and Exit
This entry and exit of firms influence price,
quantity, and economic profit.
Let’s investigate the effects of firms entering or
exiting an industry.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-51
Price (dollars per sweater)
Entry and Exit
Entry
increases
supply
S1
S0
S2
23
Exit
decreases
supply
20
17
D1
0
6
7
8
9
10
Quantity (thousands of sweaters per day)
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-52
Entry and Exit
Important Points
As new firms enter an industry, the price
falls and the economic profit of each
existing firm decreases.
As firms leave an industry, the price rises
and the economic loss of each remaining
firm decreases.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-53
Changes in Plant Size
When a firm changes its plant size, it can
lower its costs and increase its economic
profit.
Let’s see how a firm can increase its profit
by increasing its plant size.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-54
Price (dollars per sweater)
Plant Size and
Long-Run Equilibrium
Short-run profit
maximizing point
40
MC0
SRAC0
LRAC
MC1
SRAC1
25
MR0
20
MR1
m
14
6
Copyright © 1998 Addison Wesley Longman, Inc.
Long-run
competitive
equilibrium
8
Quantity (sweaters per day)
TM 12-55
Long-Run Equilibrium
Long-run equilibrium occurs in a competitive
industry when firms are earning normal profit and
economic profit is zero.
Economic profits draw in firms and cause existing
firms to expand.
Economic losses cause firms to leave and cause
existing firms to scale back.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-56
Long-Run Equilibrium
So in long-run equilibrium in a competitive
industry, firms neither enter nor exit the industry
and firms neither expand their scale of operation
nor downsize.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-57
Learning Objectives (cont.)
• Explain why firms enter and leave an
industry
• Predict the effects of a change in demand
and of a technological advance
• Explain why perfect competition is efficient
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-58
Changing Tastes and
Advancing Technology
Demand has fallen tremendously for
tobacco, trains, TV and radio repair, and
sewing machines.
Demand has increased dramatically for
microwave utensils, paper plates, and flash
memories.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-59
Changing Tastes and
Advancing Technology
What happens in a competitive
industry when a permanent
change in demand occurs?
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-60
A Decrease in Demand
S1
Firm
S0
Price and Cost
Price
Industry
P0
P0
P1
P1
MC
ATC
MR0
MR1
D0
D1
0
Q2 Q1
Copyright © 1998 Addison Wesley Longman, Inc.
Q0
Quantity
q1
q0
Quantity
TM 12-61
External Economies
and Diseconomies
External economies
Factors beyond the control of an individual firm
that lower its costs as the industry increases.
External diseconomies
Factors outside the control of a firm that raise
the firm’s costs as industry output increases.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-62
External Economies
and Diseconomies
We will use this information to develop a
long-run industry supply curve.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-63
Long-Run Changes in
Price and Quantity
Decreasing-cost industry
Price
Price
Increasing-cost industry
Price
Constant-cost industry
S0
Ps
S1
LSA
P0
S2
LSB Ps
S0
Ps
P2
P0
D1
D1
D0
Q0
Qs Q1
Quantity
Copyright © 1998 Addison Wesley Longman, Inc.
Q0
D0
Qs Q2
Quantity
S0
S3
P0
P3
LSC
D1
Q0
Qs
D0
Q3
Quantity
TM 12-64
Changing Tastes and
Advancing Technology
Technological change
New technology allows firms to produce at lower
costs.
This causes their cost curves to shift downward.
Firms adopting the new technology make an
economic profit.
This draws in new technology firms.
Old technology firms disappear, the price falls,
and the quantity produced increases.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-65
Learning Objectives (cont.)
• Explain why firms enter and leave an
industry
• Predict the effects of a change in demand
and of a technological advance
• Explain why perfect competition is efficient
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-66
Competition and Efficiency
Resources are used efficiently when there is:
• Consumer efficiency
• Producer efficiency
• Exchange efficiency
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-67
Competition and Efficiency
Consumer efficiency is achieved when it is not
possible for consumers to become better off — to
increase utility — by reallocating their budgets.
• On the household’s demand curve
• External benefits
Producer efficiency occurs when a firm is producing
at any point on its marginal cost curve, or
equivalently, on its supply curve.
• External costs
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-68
Competition and Efficiency
Exchange efficiency occurs when all the gains
from trade have been realized (i.e. consumer and
producer surplus).
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-69
Efficiency of Competition
Price
S
B0
P*
Consumer
surplus
Efficient allocation
Producer
surplus
C0
D
Q0
Copyright © 1998 Addison Wesley Longman, Inc.
Q*
Quantity
TM 12-70
Efficiency of Perfect Competition
Perfect competition enables resources to be used
efficiently if there are no external benefits and
external costs.
• External costs and external benefits
• Goods providing external benefits would be underproduced,
while goods providing external costs would be overproduced.
• Monopoly
• Monopoly restricts output below its competitive level to raise
price and increase profit.
Copyright © 1998 Addison Wesley Longman, Inc.
TM 12-71