MicroEconomics 5e by besanko braeutigam chapter 09

Copyright (c)2014 John Wiley & Sons, Inc.

Chapter 9

Perfectly Competitive Markets

1


Chapter Nine Overview
1.1.

Introduction
Introduction

2.2.

Perfect Competition Defined
Perfect Competition Defined

3.3.

The Profit Maximization Hypothesis
The Profit Maximization Hypothesis

4.4.

The Profit Maximization Condition
The Profit Maximization Condition
Short Run Equilibrium
Short Run Equilibrium

Short Run Supply Curve for the Firm
Short Run Supply Curve for the Firm
Short Run Market Supply Curve
Short Run Market Supply Curve
Short Run Perfectly Competitive Equilibrium
Short Run Perfectly Competitive Equilibrium
Producer Surplus
Producer Surplus

••
••
••
••

Copyright (c)2014 John Wiley & Sons, Inc.

5.5.

6.6. Long
Run Equilibrium
Long Run Equilibrium
•• Long
Run Equilibrium Conditions
Long Run Equilibrium Conditions
•• Long
Run Supply Curve
Long Run Supply Curve
Chapter Nine

2

Perfectly Competitive Markets

AAperfectly
perfectlycompetitive
competitivemarket
marketconsists
consistsofoffirms
firmsthat
thatproduce
produceidentical
identicalproducts
productsthat
thatsell
sellatat
the
thesame
sameprice.
price.

Each
Eachfirm’s
firm’svolume
volumeofofoutput
outputisisso
sosmall
smallinincomparison
comparisontotothe
theoverall

overallmarket
marketdemand
demandthat
that

Copyright (c)2014 John Wiley & Sons, Inc.

no
nosingle
singlefirm
firmhas
hasan
animpact
impacton
onthe
themarket
marketprice.
price.

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3


Perfectly Competitive Markets - Conditions

A.A. Firms
Firms produce
produce undifferentiated
undifferentiated products

products inin the
the sense
sense that
that
consumers
consumersperceive
perceivethem
themtotobe
beidentical
identical

B.B.Consumers
Consumershave
haveperfect
perfectinformation
informationabout
aboutthe
theprices
pricesall
allsellers
sellers
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ininthe
themarket
marketcharge
charge

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4


Perfectly Competitive Markets - Conditions

C.C. Each
Each buyer’s
buyer’s purchases
purchases are
are soso small
small that
that he/she
he/she has
has an
an
imperceptible
imperceptibleeffect
effecton
onmarket
marketprice.
price.
D.D.Each
Eachseller’s
seller’ssales
salesare
aresososmall
smallthat
thathe/she
he/shehas
hasan

animperceptible
imperceptible
effect
effecton
onmarket
marketprice.
price. Each
Eachseller’s
seller’sinput
inputpurchases
purchasesare
aresososmall
small
that
thathe/she
he/sheperceives
perceivesno
noeffect
effecton
oninput
inputprices
prices
E.E.All
Allfirms
firms(industry
(industryparticipants
participantsand
andnew
newentrants)
entrants)have

haveequal
equal

Chapter Nine

Copyright (c)2014 John Wiley & Sons, Inc.

access
accesstotoresources
resources(technology,
(technology,inputs).
inputs).

5


Implications of Conditions

The Law of One Price: Conditions (a) and (b) imply that there is a single
price at which transactions occur.

Price Takers: Conditions (c) and (d) imply that buyers and
sellers take the price of the product as given when making
their purchase and output decisions.

Copyright (c)2014 John Wiley & Sons, Inc.

Free Entry: Condition (e) implies that all firms have identical
long run cost functions

Chapter Nine

6


The Profit Maximization Hypothesis

Definition:
Definition:Economic
EconomicProfit
Profit
Sales
SalesRevenue
Revenue- -Economic
Economic(Opportunity)
(Opportunity)Cost
Cost
Example:
Example:

Chapter Nine

Copyright (c)2014 John Wiley & Sons, Inc.

•• Revenues:
Revenues:$1M
$1M
•• Costs
Costsofofsupplies
suppliesand

andlabor:
labor:$850,000
$850,000
•• Owner’s
Owner’sbest
bestoutside
outsideoffer:
offer:$200,000
$200,000

7


The Profit Maximization Hypothesis

“Accounting Profit”: $1M - $850,000 = $150,000

“Economic Profit”: $1M - $850,000 - $200,000 = -$50,000

Business “destroys” $50,000 of wealth of owner

Chapter Nine

Copyright (c)2014 John Wiley & Sons, Inc.

•

8

The Profit Maximization Condition

•
•
•

Assuming the firm sells output Q, its economic profit is:

Where

π = TR (Q) − TC (Q)

TR(Q) = Total revenue from selling the quantity Q

⇒ TR (Q) = P × Q

Copyright (c)2014 John Wiley & Sons, Inc.

•

TC(Q) = Total economic cost of producing the quantity Q

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9


The Profit Maximization Condition

•

Since P is taken as given, firm chooses Q to maximize profit.
Marginal Revenue: The rate which TR change with output.

∆TR
MR =
∆Q

Since firm is a price taker, increase in TR from 1 unit change in Q is equal to P

Copyright (c)2014 John Wiley & Sons, Inc.

•
•

∆(TR ) ∆( P * Q)
MR =
=
=P
∆Q
∆Q
Chapter Nine

10


The Profit Maximization Condition
Note:

If P > MC then profit rises if output is increased

If P > MC then profit rises if output is increased
If P < MC then profit falls if output is increased.
If P < MC then profit falls if output is increased.

Copyright (c)2014 John Wiley & Sons, Inc.

Therefore, the profit maximization condition for a price-taking firm is P = MC
Therefore, the profit maximization condition for a price-taking firm is P = MC

Chapter Nine

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Copyright (c)2014 John Wiley & Sons, Inc.

The Profit Maximization Condition

Chapter Nine

12


The Profit Maximization Condition

At profit maximizing point:

1. P = MC = MR
2. MC rising

Copyright (c)2014 John Wiley & Sons, Inc.

“firm demand" = P (sells as much as likes at P)
“firm supply" defined by MC curve? Not quite:

Chapter Nine

13


Short Run Equilibrium
For
Forthe
thefollowing,
following,the
theshort
shortrun
run isisthe
theperiod
periodofoftime
timeininwhich
whichthe
thefirm’s
firm’splant
plantsize
sizeisisfixed
fixedand
andthe
thenumber
numberofof

firms
firmsininthe
theindustry
industryisisfixed.
fixed.

STC(Q)
STC(Q)==SFC
SFC++NSFC
NSFC++TVC(q)
TVC(q)for
forqq>>00

Copyright (c)2014 John Wiley & Sons, Inc.

STC(Q)
STC(Q)==SFC
SFCfor
forqq==00

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14


Short Run Equilibrium
Where:
SFC is the cost of the firm’s fixed input that are unavoidable at q = 0

Output insensitive for q > 0 = Sunk

NSFC is the cost of the firm’s inputs that are avoidable if the firm produces zero (salaries of some
employees, for example)

Copyright (c)2014 John Wiley & Sons, Inc.

Output insensitive for q > 0 = Non-sunk

TFC = SFC + NSFC

TVC(q) are the output sensitive costs (and are non-sunk)

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15


Short Run Supply Curve (SRSC)

Definition: The firm’s Short run supply curve tells us how the profit
maximizing output changes as the market price changes.

Short Run Supply Curve:
NSFC=0

If the firm chooses to produce a positive output, P = SMC defines the short
Copyright (c)2014 John Wiley & Sons, Inc.

run supply curve of the firm. But…

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Shut Down Price
The firm will choose to produce a positive output only if:

π(q) > π(0) …or…

Pq – TVC(q) – TFC > -TFC 

Pq – TVC(q) > 0 

Definition:
Definition: The
Theprice
pricebelow
belowwhich
whichthe
thefirm
firmwould
wouldopt
opttotoproduce
producezero
zeroisiscalled
calledthe
theshut
shutdown
downprice,

price,Ps.
Ps. InInthis
this
case,
case,PsPsisisthe
theminimum
minimumpoint
pointon
onthe
theAVC
AVCcurve.
curve.

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17

Copyright (c)2014 John Wiley & Sons, Inc.

P > AVC(q)


Short Run Supply Function

Therefore, the firm’s short run supply function is defined by:

1. P=SMC, where SMC slopes upward as long as P > Ps
2. 0 where P < Ps

This means that a perfectly competitive firm may choose to operate in the short run even if

Copyright (c)2014 John Wiley & Sons, Inc.

economic profit is negative.

Chapter Nine

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Short Run Supply Curve
NSFC
NSFC==00

SMC
SAC

AVC

Ps

Quantity (units/yr)
Chapter Nine

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Copyright (c)2014 John Wiley & Sons, Inc.

$/yr

Cost Considerations

At prices below SAC but above AVC, profits are negative if the firm produces…but the firm loses less by
producing than by shutting down because of sunk costs.

Example:
Example:

Copyright (c)2014 John Wiley & Sons, Inc.

22
STC(q)
STC(q)==100
100++20q
20q++qq
TFC
TFC ==100
100 (this
(thisisissunk)
sunk)
22
TVC(q)
TVC(q)==20q
20q++qq
AVC(q)
AVC(q)==20
20++qq
SMC(q)
SMC(q)==20
20++2q

2q

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20


Cost Considerations

The minimum level of AVC is the point where AVC = SMC or:

20+q = 20+2q
q=0
AVC minimized at 20

Copyright (c)2014 John Wiley & Sons, Inc.

The firm’s short run supply curve is, then:

P < Ps = 20: qs = 0

P > Ps = 20: P = SMC 
P = 20+2q  qs = 10 + ½P

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SRSC When Some Costs are Sunk and Some are Non-Sunk

TFC = SFC + NSFC, where NSFC > 0

ANSC = AVC + NSFC/Q

Now, the shut down price, Ps is the minimum

Copyright (c)2014 John Wiley & Sons, Inc.

of the ANSC curve.

Chapter Nine

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SRSC When All Costs are Non-Sunk

If the firm chooses to produce a positive output, P = SMC defines the short
run supply curve of the firm. But the firm will choose to produce a positive
output only if:

π(q) > π(0) …or…

Pq – TVC(q) - TFC > 0 

Copyright (c)2014 John Wiley & Sons, Inc.

P > AVC(q) + AFC(q) = SAC(q)

Now, the shut down price, Ps is the minimum of the SAC curve

Chapter Nine

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SRSC When All Costs are Non-Sunk
$/yr

SMC
SAC

Ps

Quantity (units/yr)
Chapter Nine

24

Copyright (c)2014 John Wiley & Sons, Inc.

AVC


SRSC When All Costs are Non-Sunk
STC(q) = F + 20q + q

2

F = 100, all of which is sunk:

Example:

AVC(q) = 20 + q
SMC(q) = 20 + 2q
SAC(q) = 100/q + 20 + q

Copyright (c)2014 John Wiley & Sons, Inc.

SAC = SMC at q = 10

At any P > 40, the firm earns positive economic profit
At any P > 40, the firm earns positive economic profit
At any P < 40, the firm earns negative economic profit.
At any P < 40, the firm earns negative economic profit.

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