CH.9 Competitive Markets PDF

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31.03.21 CH. 9: COMPETITIVE MARKETS LEARNING OBJECTIVES: 9.1→ distinguish between competitive behaviour and competitive market 9.2→ list the 4 key assumptions of the theory of perfect competition 9.3→ derive a competitive firm’s supply curve → determine whether competitive firms are making profits or losses in the short-run. 9.4 → explain the role played by profits, entry, and exit in determining a competitive industry’s long-run equilibrium. 9.1- MARKET STRUCTURE AND FIRM BEHAVIOUR → market structure: all features of a market that affect the behaviour and performance of firms in that market, such as the number and size of sellers, the extent of knowledge about one another’s actions, the degree of freedom of entry, and the degree of product differentiation. → market power: the ability of a firm to influence the price of its products ➢ COMPETITIVE MARKETS: + A market is said to be competitive when its firms have little to no market power. The more market power the firms have, the less competitive is the market. + Perfectly competitive market: no need for individual firms to compete because none has any power over the market ➢ COMPETITIVE BEHAVIOUR: + Degree in which individual firms actively compete with one another for business. 9.2- THE THEORY OF PERFECT COMPETITION: → perfect competition: A market structure in which all firms in an industry are price takers, and in which there is freedom of entry and exit from the industry. ➢ ASSUMPTIONS OF PERFECTLY COMPETITIVE MARKETS: 1) There are many buyers and many sellers in the market. 2) No market power (can’t control price) 3) The goods offered by the various sellers are the same. (Homogenous goods) 4) Buyers and sellers have full information. 5) Firms can freely enter or exit the market → The first 4 assumptions indicate that the actions of any single buyer or seller in the market have an insignificant effect on the market price. In other words, sellers in this type of market have to sell their product at the market price (i.e, they are price takers= a firm that can alter its output and sales without affecting the market price of its product). ➢ THE DEMAND CURVE FOR A PERFECTLY COMPETITIVE FIRM: → A firm can sell as much output as it could possibly produce at the market price. That means the demand curve facing the individual firm is horizontal (or infinitely elastic) at the ongoing market price. (because variations in the frim’s output have no significant effect on market price)

31.03.21 ➢ TOTAL, AVERAGE, AND MARGINAL REVENUE: → total revenue: total receipts from the sale of a product. Price times quantity. TR= p X Q → average revenue: total revenue divided by quantity sold; this is the market price when all units are sold at the same price AR= TR/Q = (p x Q)/Q = p → marginal revenue: the change in a firm’s total revenue resulting from a change in its sales by one unit. MR= ΔTR / ΔQ → WHEN THE FIRM IS A PRICE TAKER: For a competitive price-taking firm, the market price is the firm’s marginal and average revenue. AR=MR= p

9.3- SHORT-RUN DECISIONS: → The goal of a competitive firm is to maximize profit, which is Profit (π)=TR−TC → To find the optimal point, the firm compares the extra revenue that it receives from selling an extra unit to the extra cost that it has to pay to produce that unit. Note that marginal revenue in a perfectly competitive market is equal to price. (P = MR) → the perfectly competitive firm adjusts its level of output in response to changes in the market-determined price. → Rule 1: A firm should not produce at all if, for all levels of output, total revenue (TR) is less than total variable cost (TVC). Equivalently, the firm should not produce at all if, for all levels of output, the market price (p), is less than the average variable cost (AVC). → Rule 2: if it is worthwhile for the firm to produce at all, the profit-maximizing firm should produce the output at which marginal revenue equals marginal cost. → shut-down price: the price that is equal to the minimum of a firm’s average variable cost. At price below this, a profit-maximizing firm will produce no output. + + + + +

At q1: P > MC → The firm increases production At q2: P > MC → The firm increases production At q3: P < MC → The firm decreases production At q*: P = MC → The profit-maximizing level of output The profit-maximizing condition in a perfectly competitive market is P = MC

31.03.21 At q*, revenue earned on that unit is equal to the cost of that uni However, firms don’t produce at very low prices that is if the price is less than the minimum average variable cost firm decides to shut down. → If P>AVC revenue covers its variable costs and some part of its fixed costs => firm will be better off by producing than shutting down. → If P min AVC → Therefore, we can define the short-run supply function as follows :

31.03.21 ➢ MEASURING THE FIRM’S PROFIT IN THE SHORT RUN:

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Profit (π)=TR−TC = (p x Q) - (Q x TC / Q) = Q(p - AC) ● (p - AC): the distance between p and AC at a given Q is the profit / loss per unit A perfectly competitive firm making an economic profit in the short-run equilibrium:

→ graph 1: if min AVC < P < AFC + If the firm stays in business, the current price covers average variable costs (Q*C) and part of the average fixed cost (CB). So the firm’s loss is the part of the total fixed cost that is not covered (AB). + But if the firm decides to shut down, revenue and variable cost are zero, so the firm’s loss per unit is equal to the average fixed cost (AC).

31.03.21 → graph 2: if p ≤ minAVC + If the firm stays in business, it can barely cover the variable cost (Q*F) and it cannot cover any of the average fixed cost (ED). The loss per unit is greater than or equal to the average fixed cost (FD). + If the firm shuts down, revenue and variable costs are zero. So the loss per unit is equal to the average fixed cost (ED). The firm shuts down if the revenue that it would earn from producing is less than its variable costs of production firm’s shut down point: P = min AV ➢ THE FIRM’S SUPPLY IN THE LONG RUN: ● In the long-run firms do not tolerate any loss. Therefore, if P falls below min AC they stop producing and exit the market. ● Therefore, a firm only continues production in the long run if P≥minAC ● each firm is producing where the average total cost is at a minimum. ● The firm’s long-run supply is

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Notice that one of the assumptions of perfectly competitive markets is free entry and exit for the firms. This assumption plays an important role in the structure of competitive markets in the long run. Refer to the graph below, suppose the market price is set at P2 (P2 > min AC). There is a positive profit in the short run for firms. This motivates new firms to enter the market to earn profit. (Free entry) As more firms enter this market, market supply increases (shifts to the right), and market price falls to P1 where economic profit is zero (P = min AC) Now suppose the market price is set at P3 (P3 < AC) and firms are making a loss. If this situation continues, some firms exit the market (Free exit), market supply decreases and price rises to P1 where economic profit is zero. (P = min AC) → We expect that the price, in the long run, is set at the minimum of AC (P = min AC → q1 and P1) → Long-run profit = Q∗(p−AC)=0

31.03.21 → In long run, perfect competition ensures zero economic profits (normal profits remain positive)....