Eca iii – the price system perfect competition
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1. The document discusses the theory of perfect competition and the basic model of the firm. It covers the assumptions of perfect competition including numerous buyers and sellers and a homogeneous product. 2. Under perfect competition, each firm is a price taker and will produce at the market price to maximize profits where marginal revenue equals marginal cost. In the short run, a firm can experience normal profits, losses, or abnormal profits but only normal profits can persist in the long run. 3. In the long run under perfect competition with constant costs, if demand increases, price will also increase but will eventually return to the original level as more firms enter the market and supply increases.
![I. GENERAL INTRODUCTION
Perfect Monopolistic Monopolistic
Oligopoly
Competition Competition Competition
∞
Number
6 – [∞-1] 2 or 3 - 5 1
of Firms
Homogeneous Heterogeneous
Nature of
Homogeneous ↓ ↓ Heterogeneous
Product
Heterogeneous Homogeneous
Perfectly
Perfectly
Imperfect Competition Non -
Competitive
Competitive](https://image.slidesharecdn.com/ecaiiithepricesystem-perfectcompetition-130329202120-phpapp02/85/Eca-iii-the-price-system-perfect-competition-5-320.jpg)
![II. PERFECT COMPETITION
C. Equilibrium (Short Run) [Price Takers]
Equilibrium Output: oq*
Equilibrium Price: op*
Equilibrium Profits: ∏ = TR - TC](https://image.slidesharecdn.com/ecaiiithepricesystem-perfectcompetition-130329202120-phpapp02/85/Eca-iii-the-price-system-perfect-competition-12-320.jpg)
![II. PERFECT COMPETITION
A. Start at equilibrium (S/T) [E1 & e1]
At Q1 (Industry) q1 (Firm) charging
P1 (for both the industry and the firm)
B. Something happens to the change (↑) Demands (into L/T) and D1
shifts to D2, resulting in new equilibrium point (at E2 & e2)
Price has increased (P1 to P2), therefore the firms demand curve
↑s to D2 = AR2 & the firms equilibrium point is now at e2 (at q2
and P2)
C. This results in abnormal profit because AR > AC at P2,q2.
This causes more firms to enter the market and supply curve shifts
to S2.](https://image.slidesharecdn.com/ecaiiithepricesystem-perfectcompetition-130329202120-phpapp02/85/Eca-iii-the-price-system-perfect-competition-19-320.jpg)
Eca iii – the price system perfect competition
- 1. ECA III – THE PRICE SYSTEM LECTURE: V PERFECT COMPETITION
- 2. I. GENERAL INTRODUCTION A. Market Structure Theory 1. When the theory of “Micro Economics” was originally introduced (1881) there were only two alternative positions for a firm: • Perfect Competition • Monopoly 2. These Market Structures Theoretical &/or Philosophical counterparts 3. If fairness reigned, the market was “Good” & hence competitive (Perfectly)
- 3. I. GENERAL INTRODUCTION According to general precepts of our economic system {Capitalism}, the most efficient allocation of scarce resources is the Perfectly {Unrestricted – Governmentally; Geographically} Competitive Market. 4. If these (above) conditions were not met; the market would be Imperfect (& therefore at the time) Monopolistic, i.e. “BAD” – There are definite political & indeed physichological overtones (i.e. Control) present
- 4. I. GENERAL INTRODUCTION 5. At that time, from a purely economical perspective, the distinction between the two markets was the # of firms – Perfect Competition :∞ – Monopoly :1 6. As time progressed markets developed beyond these two markets. • Early 1900’s: Oligopoly • 1930’s: Monopolistic Competition 7. Once these markets evolved. It became problematic to try and distinguish all of these new markets from those already established
- 5. I. GENERAL INTRODUCTION Perfect Monopolistic Monopolistic Oligopoly Competition Competition Competition ∞ Number 6 – [∞-1] 2 or 3 - 5 1 of Firms Homogeneous Heterogeneous Nature of Homogeneous ↓ ↓ Heterogeneous Product Heterogeneous Homogeneous Perfectly Perfectly Imperfect Competition Non - Competitive Competitive
- 6. II. BASIC MODEL OF THE FIRM (REV. & COST) A. Motivations for the firm – Profit – Stock Price Maximization – “Green” • Environmentally Friendly • Produce Products to help other firms (Air Filters; Sewage Treatment Plants) – Social Conscience – Maximize Market Share (Product Markets) B. Here, we focus on Profit Vs Accounting Profit
- 7. II. BASIC MODEL OF THE FIRM (REV. & COST) C. Economic Profit Vs Accounting Profit – Economic Cost: Value of all resources used in production (Opportunity Cost) – Explicit Cost: Out of pocket cost (Specific Payment) – Implicit Cost: Foregone Opportunities – Economic Profit: (Total Rev.) – (Total Economic Cost) Example Total Revenue Merchandise Sold - Explicit Costs Wages Rent Taxes Accounting Profit - Implicit Costs Owners Wages (ie. % of Profit), Act. Yield Economic Profit
- 8. II. BASIC MODEL OF THE FIRM (REV. & COST) Profit Maximization 1. Total Revenue (TR) = Price x Quantity Total Revenue 2. Average Revenue (AR) = Output Quantity Change in Total Revenue 3. Marginal Revenue (MR) = Change in Quantity Change in Total Cost 4. Marginal Cost (MC) = Change in Quanity Relative Positions: MR > MC → ↑ Output MR < MC → ↓ Output MR = MC → Equilibrium
- 9. II. BASIC MODEL OF THE FIRM (REV. & COST) Graphically General Model MC R A E AC C T Demand = Average Revenue O Q Output Marginal Revenue
- 10. II. BASIC MODEL OF THE FIRM (REV. & COST) Total Revenue: OQRA Total Cost: OQTC Abnormality or Economic Profit: Because AR > AC at Equilibrium & is specifically determined ∏ = TR – TC ∏ = OQRA - OQTC ∏ = CTRA
- 11. II. PERFECT COMPETITION A. Basic Logic 1. Demand establishes Revenues (TR = P X Q) 2. Production & Cost establish Supply 3. Profit Maximization at MARGINAL REVENUE = MARGINAL COST B. Assumptions 1. Markets are unrestricted (i.e. Open Exit & Open Entry) 2. Infinite number of Buyers & Sellers 3. Homogeneous Product 4. Free Mobility of Factors 5. Perfect Price Knowledge
- 12. II. PERFECT COMPETITION C. Equilibrium (Short Run) [Price Takers] Equilibrium Output: oq* Equilibrium Price: op* Equilibrium Profits: ∏ = TR - TC
- 13. II. PERFECT COMPETITION D. Conclusions: 1. Demand Curve for the firm is Infinitely Elastic (i.e. Flat) at The Market Price (p*) A. Firms are called Price Takers B. The only decision they make is what quantity to produce at p* C. If the firm ↑ P : No Sales D. If the firm ↓ P : Needless loss of Revenues
- 14. II. PERFECT COMPETITION 2. Three (Statistically) possible S/T Alternatives MC P Normal Profits: AR = AC Profit Earned (What Kind?) AC (Where?) P* AR=MR O q* q
- 15. II. PERFECT COMPETITION MC P Abnormal: AR > AC (Economic) Profit Earned AC (Not Possible) P* AR=MR (Why Not?) O q* q Any attempt by the Firm to lower costs will be copied immediately, so that there is no advantage to do it in the first place.
- 16. II. PERFECT COMPETITION MC P AC Loss Incurred Loss P* E AR=MR O q* q 3. The two decisions that the firm must make – How much to produce @ P*? – Shut Down or Stay Open? 4. On the surface it appears that if the firm is incurring a loss, it should always & immediately shut down, not necessarily true.
- 17. II. PERFECT COMPETITION 5. Total Costs = Fixed Cost + Variable Costs – Variable costs = F (Output) VC = O Output = O – Fixed Costs = F (Time) Even if Output = O FC = “+” (Must be paid, even if output=O 6. Therefore, a perfectly competitive firm will continue to produce, even if there is a loss, as long as The Operating Loss < The shutdown Loss. 7. This usually occurs at TR > TVC Price←Average Revenue > Average Variable Cost or Total Revenue > Total Variable Cost
- 18. II. PERFECT COMPETITION E. Equilibrium (Long Run) 3 Possibilities – Constant/Increasing/Decreasing 1. CONSTANT COSTS
- 19. II. PERFECT COMPETITION A. Start at equilibrium (S/T) [E1 & e1] At Q1 (Industry) q1 (Firm) charging P1 (for both the industry and the firm) B. Something happens to the change (↑) Demands (into L/T) and D1 shifts to D2, resulting in new equilibrium point (at E2 & e2) Price has increased (P1 to P2), therefore the firms demand curve ↑s to D2 = AR2 & the firms equilibrium point is now at e2 (at q2 and P2) C. This results in abnormal profit because AR > AC at P2,q2. This causes more firms to enter the market and supply curve shifts to S2.
- 20. II. PERFECT COMPETITION D. This results in a new equilibrium point at E3 (at Q3, P1) E. Abnormal Profits have been eliminated and system reestablishes equilibrium at e1 (for the firm) Q: If the firms quantity ends at q1, how is it possible for the industry to be producing at Q3? Conclusion: For perfect competition (L/T) with constant cost If demand ↑ with constant costs, P ↑ and then returns to its original level
- 21. II. PERFECT COMPETITION 2. INCREASING COSTS
- 22. II. PERFECT COMPETITION A. Start at equilibrium (S/T) (at e,E1) Q: What is original output and price for industry and firm? B. Demand into L/T ↑’s (D1 → D2) intersecting original supply curve at E2. This causes an increase in the market price which is carried over to each firm. C. The firm is now earning abnormal (or economic) profits, which causes more firms to enter the industry D. Since more firms are entering the industry this causes two things to occur simultaneously. 1. Since Factors are limited, this causes a “Bidding War” which increases the firms cost (AC1 → AC2 & MC1 → MC2)
- 23. II. PERFECT COMPETITION 2. This causes the market supply curve to shift to S2 3. L/T Equilibrium is reestablished at (e3,E3) 4. S* represents the L/T Market supply curve for increasing cost industries Conclusion: Perfect Competition (L/T) with the increasing cost. As Demand in the ling term increases (with increasing cost industries), Price ↑&↓ but not to its original level.