Chapter 9: Market Structures, Perfect Competition, Monopoly, and Things Between

\ ## __**Perfect competition (characteristics)**__ ### **1. Many small independent producers and consumers** * All firms are too small to influence market in any way, hence there are multiple producers in the market * This means that no 1 firm can drive up or down the prices of the products in the market by influencing the output * Consumers on the other end can also not influence the prices by consuming more or less ### **2.** **Firms produce a standardized product** * All firms in the market produce almost the same product ### **3. No barriers to entry or exit** * No significant obstacles to the entry of new firms into, or the exit of existing firms out of, this industry ### 4. **Firms are “price takers”** * Since none of the firms can influence the prices, they go along with the prices which are set by the market and produce how much they want * Any firm which tries to increase the price even by a dollar would end up losing customers, due to as mentioned earlier about the production of standardized products * Consumers would not prefer buying expensive products if they can get it cheaper elsewhere \ ### __**Demand for the firm**__  * Since each firm’s output is such a small share of the total market supply, the demand for each firm’s output is perfectly elastic * They simply produce as much as they can at the going price hence a horizontal demand curve * Keep in mind that the horizontal demand curve is of individual producers, not the market demand curve ### __Profit Maximization__ * Maximizing economic profit is highest possible difference between total revenue and total economic cost * Any opportunity is seized where even if one extra dollar is being earned * If the maximum profit possible is actually zero, or even negative dollars, they accept this short-run outcome \ ## __**Methods to maximize profits**__ ### 1. **The Method of “Totals’’** * Since prices can’t be altered, firms look to manipulate the output. * Imagine a carrot farmer operating in a perfectly competitive market, sales carrots for $11 | ]]Daily bushels of carrots (q)]] | ]]Price (P)]] | ]]Total revenue]] | ]]Total cost]] | ]]Profit]] | |----|----|----|----|----| | 0 | $11 | $0 | $16 | -$16 | | 1 | $11 | $11 | $22 | -$11 | | 2 | $11 | $22 | $27.50 | -$5.50 | | 3 | $11 | $33 | $34 | -$1 | | 4 | $11 | $44 | $42 | $2 | | 5 | $11 | $55 | $53 | $2 | | 6 | $11 | $66 | $65 | $1 | \ * As noticeable from the chart, total cost increases with increased production * Logically, the carrot farmer would grow 5 bushels of carrots to generate more economic profit * When there are two quantities that produce the same amount of profit, like 4 and 5 bushels, we select the larger of the two quantities ### 2. **The Method of “Marginal”** * Only decision to be made by perfectly competitive firm is to choose the optimal level of output. ### __Decisions are as follows__ 1\. Choose the level of output where MR = MC | ]]Daily bushels of carrots (q)]] | ]]Price (P)]] | ]]Total revenue]] | ]]Total cost]] | ]]Profit]] | ]]Marginal revenue]] | ]]Marginal cost]] | |----|----|----|----|----|----|----| | 0 | $11 | $0 | $16 | -$16 | | | | 1 | $11 | $11 | $22 | -$11 | $11 | $6 | | 2 | $11 | $22 | $27.50 | -$5.50 | $11 | $5.50 | | 3 | $11 | $33 | $34 | -$1 | $11 | $6.50 | | 4 | $11 | $44 | $42 | $2 | $11 | $8 | | 5 | $11 | $55 | $53 | $2 | $11 | $11 | | 6 | $11 | $66 | $65 | $1 | $11 | $12 | 2. Since MR=MC at 5 bushels of carrot, the farmer would grow that level 3. Price = Marginal revenue in perfectly competitive market structures  4. This is because Farmers can sell as much as they want at the market price hence earn the same amount of marginal revenue 5. Price is also equivalent to average revenue (AR), or total revenue per unit ### __**Short-run profit and loss**__ * Profit = *q*e x (P-ATC) * The term (P - ATC) is the per-unit difference between what the firms receives from the sale of each unit and the average cost of producing it, or profit per unit * Multiply this per-unit profit by the number of units (qe) produced, you have total profit | ]]Daily bushels of carrots (q)]] | ]]Price (P)]] | ]]Total cost]] | ]]Average total cost]] | ]](P-ATC)]] | ]]Profit]] | |----|----|----|----|----|----| | 0 | $11 | $16 | $16 | | -$16 | | 1 | $11 | $22 | $22 | -$11 | -$11 | | 2 | $11 | $27.50 | $27.50 | -$2.75 | -$5.50 | | 3 | $11 | $34 | $34 | -$.33 | -$1 | | 4 | $11 | $42 | $42 | $.50 | $2 | | 5 | $11 | $53 | $53 | $.40 | $2 | | 6 | $11 | $65 | $65 | $.17 | $1 |  ### __**Profit rectangles and flying monkeys**__ * Never leave this level of output (qe)or bad things happen * We have positive economic profits of $2 if we produce at qe ### __**Short-run losses**__ | ]]Daily bushels of carrots (q)]] | ]]Price (P)]] | ]]Total revenue]] | ]]Total cost]] | ]]profit]] | ]]Marginal revenue]] | ]]marginal cost]] | |----|----|----|----|----|----|----| | 0 | $6.50 | $0 | $16 | -$16 | | | | 1 | $6.50 | $6.50 | $22 | -$15.50 | $6.50 | $6 | | 2 | $6.50 | $13 | $27.50 | -$14.50 | $6.50 | $5.5 | | 3 | $6.50 | $19.50 | $34 | -$14.50 | $6.50 | $6.5 | | 4 | $6.50 | $26 | $42 | -$16 | $6.50 | $8 | | 5 | $6.50 | $32.50 | $53 | -$20.50 | $6.50 | $11 | | 6 | $6.50 | $39 | $65 | -$26 | $6.50 | $12 | * MR=MC at 3 bushels now, however the carrot farmer would now face economic losses instead * At this point however, the farmer is able to minimize losses the most at this level  * This becomes the loss minimizing level for him ### __When finding the profit/loss rectangle, it is important to remember the following:__ 1. Find qe where P = MR = MC. Once you have found qe, never leave it 2. Find ATC vertically at qe. If you move downward, π > 0. If you move upward, π < 0 3. Move horizontally from ATC to the y-axis to complete the rectangle, and clearly label it as positive or negative ### __**Decision to shut down**__ * If firms are incurring losses, they must decide whether it is economically rational to operate at all * Decision to shut down, or produce zero, in the short run is sometimes the optimal strategy ### __2 things happen when firms produce output > 0__ 1. Total revenue is generated 2. Total variable cost is incurred (fixed cost is incurred irrespective of output) 1. If the firm is able to at least meet its total variable cost irrespective of fixed cost, it continues to operate under losses 2. However if the situation is dire and they are unable to cover their TVC, the firms best choice if to shutdown operation 3. This strategy would prevent firms from incurring more losses and only take the fixed cost as their losses 4. If TR ≥ TVC, the firm produces qe where MR = MC. 5. If TR < TVC, the firm shuts down and q = 0 ### __**The shutdown point**__  * If P ≥ AVC, the firm produces qe where MR = MC. * If P < AVC, the firm shuts down and q = 0 * PH is the highest price. At qh, the firm earns enough total revenue to cover all costs (π > 0) * PM is the middle price. At qm, the firm’s TR exceeds TVC but only covers part of the TFC. π < 0. * PD is the shutdown price. At qd, the firm’s TR just covers TVC and the firm is at the shutdown point. If price falls any lower, the firm does not produce. * PL is the lowest price. At q1, the firm’s TR cannot even cover TVC, and so the firm shuts down, producing q = 0. π = -TFC ### __**Short-run supply**__ * If price increases, quantity supplied increases * If price decreases, quantity supplied decreases * When the price falls below the shutdown point (minimum of AVC) and the firm quickly decides to produce nothing * The MC curve above the shutdown point serves as the supply curve for each perfectly competitive firm. * The market supply curve is therefore the horizontal sum of all of the MC curves: S = S MC ### __**Long-run adjustment**__ * Firms enter and leave a perfectly competitive market based on the level of profits being made or the incurring of losses ### __**Short-run positive profits**__  * Since the market price is above ATC, the firms in the market are earning a short term profit * In the long run however, seeing the success of the firms in the market, more firms join in * As more firms join in, the supply gradually increases because of which the market price comes down * As the market price comes down, firms already in the market begin to make less and less profit until there is no profit at all * At the point where P = MR = MC = ATC, each carrot farmer is now breaking even with π = 0 * This breakeven point is described as the long-run equilibrium * Market quantity increases and Individual producer output falls.  ### __**What’s so great about breaking even?**__ * Economic profit subtracts the next best opportunity costs of your resources from total revenue * Accounting profit is simply total cost – total revenue * You are making a fair rate of return on your invested resources and you have no incentive to take them elsewhere ### __**Short-run losses**__  * Since market price is below ATC, the firms in the market incur losses * In the long run, when firms continue to incur losses, most of them would begin to leave the market * As more firms leave, the supply would automatically cut short, raising the market price * Overtime, losses would be reduced further leading to breaking even point eventually * At the point where PLR = MR = MC = ATC, each remaining carrot farmer is now breaking even with π = 0 * Market quantity decreases and Individual producer output rises.  ### __**Conclusion**__ * All the assumptions made up till now rely on one more assumption which is that it’s a constant cost industry * When new firms enter markets, the demand for key resources increases which in return increases the cost that would be incurred to employ these * The cost curves for firms in the industry start to shift upward and this is known as increasing cost industry * Entry of new firms drives down the price of the output and increases the cost curves, so the profit is eliminated more quickly than with our constant cost industry * Fewer firms eventually enter and the new long-run price is higher than it is in a constant cost industry * A decreasing cost industry is one in which the entry of new firms decreases the price of key resources and causes the cost curves to shift downward * The entry of new firms lowers the price of the output and decreases the cost curves, it takes longer for the profit to be eliminated than in our constant cost industry * More firms can eventually enter this market, and the new long-run price is lower than it would be in a constant cost industry | ]]When the short run]] | ]]The firm produces where]] | ]]Short-run economic profit are]] | ]]In the long run]] | ]]The long-run outcome is]] | |----|----|----|----|----| | P>ATC | MR=MC | + | Firms enter | Plr = MR = MC = ATC and profit =0 | | P=ATC | MR=MC | zero, breakeven | no entry/exit | Plr = MR = MC = ATC and profit =0 | | AVC < P < ATC | MR=MC | - (0