Study Notes on Competitive Markets

Competitive Markets

Overview

  • Focus on Chapter 8 of Perloff's "Microeconomics".

  • Key topics include:

    • Perfect Competition

    • Profit Maximization

    • Competition in the Short Run

    • Competition in the Long Run

Market Structure

  • Market Structure influences firm decisions:

    • Factors Firms Consider:

    • Market Demand

    • Behavior of Other Firms

    • Key Components of Market Structure:

    • Number of Firms in the Market

    • Ease of Entry and Exit for Firms

    • Ability of Firms to Differentiate Products

Price Taking

  • Definition of Competitive Market Structure:

    • Presence of many firms producing identical products.

    • Easy market entry and exit.

  • Price Taker:

    • A firm that cannot significantly influence market price for its output or input prices.

    • The demand curve faced by a price taker is horizontal at the market price.

Characteristics of Perfectly Competitive Markets

  • Five core characteristics that result in firms being price takers:

    1. Many small buyers and sellers.

    2. All firms produce identical products.

    3. Full information available to buyers and sellers regarding prices and product characteristics.

    4. Negligible transaction costs.

    5. Freedom for firms to enter and exit the market with ease.

Deviations from Perfect Competition

  • Many markets are competitive but do not exhibit all perfect competition characteristics.

  • Definition of Competitive Markets:

    • All markets where no buyer/seller can significantly impact market price (price takers) even if imperfect.

Importance of Studying Perfect Competition

  • Many markets resemble competitive markets (e.g., agriculture, stock exchanges).

  • Perfect competition serves as a benchmark for evaluating real-world market conditions.

Profit

  • Definition of Economic Profit:

    • Economic profit = Revenue - Economic cost

    • Negative profit indicates a loss.

  • Economic Costs:

    • Include both explicit and implicit costs (opportunity costs).

  • Profit Maximization Formula:


    • 6π = R - C; where π < 0 indicates a loss.

Decisions for Maximizing Profit

  • Firms face two core decisions for profit maximization:

    1. Output Decision:

    • Determine output level that maximizes profit or minimizes loss.

    1. Shutdown Decision:

    • Decide between production and shutdown (produce no output).

  • Profit Function:


    • 6π(q) = R(q) - C(q).

Rules for Maximizing Profit

Output Decision Rules (1 of 2)

  1. Output Rule 1:

    • Firm sets output where profit is maximized.

  2. Output Rule 2:

    • Firm sets output where marginal profit is zero.

  3. Output Rule 3:

    • Firm sets output where marginal revenue equals marginal cost:

      • MR(q)=MC(q)MR(q) = MC(q)

Output Decision Rules (2 of 2)

  • Marginal Revenue (MR):

    • Change in revenue from selling one more unit:

    • MR=racβRβqMR = rac{\beta R}{\beta q}

  • Marginal Profit:

    • Change in profit from selling one more unit:

    • MarginalootnoteProfit(q)=MR(q)−MC(q)Marginal ootnote{Profit}(q) = MR(q) - MC(q)

Shutdown Decision Rules

Shutdown Rule (1 of 2)

  1. Shutdown Rule 1:

    • Firm shuts down if it can reduce loss by doing so.

    • Example:

      • Revenue (R) = $2000

      • Variable Costs (VC) = $1000

      • Fixed Costs (FC) = $3000

      hereforeextLoss:extProfit=R−VC−FC=2000−1000−3000=−2000herefore ext{Loss: } ext{Profit} = R - VC - FC = 2000 - 1000 - 3000 = -2000

      • Shutting down yields a loss of $3000 (fixed costs); thus, operation recommended.

  2. Shutdown Rule 2:

    • Firm should only shut down if revenue is less than avoidable cost.

    • Avoidable costs:

      • Costs that vary with production; some fixed costs can be.

    • Long run: all costs are generally avoidable; shutdown if any loss exists.

Short-Run Output Decision

  • For a competitive firm, marginal revenue equals market price:

    • MR=p=MC(q)MR = p = MC(q)

How a Competitive Firm Maximizes Profit

  • Maximum profit occurs when market price (MR) equals marginal cost (MC) curve.

  • Profit-maximizing condition illustrated graphically with given data on costs, revenue, and output levels.

Short-Run Shutdown Decision

  • Condition:

    • Firm shuts down if revenue is below avoidable variable costs:

    • In average terms:

      • R(q)<pimesAVC(q)R(q) < p imes AVC(q)

Supply Curves in Short Run

Short-Run Firm Supply Curve

  • Supply curve coincides with marginal cost curve above minimum average variable cost.

Short-Run Market Supply Curve

  • In short run, maximum number of firms stays constant due to market entry time.

  • Identical firms produce identical individual supply curves leading to market supply being n times an individual firm’s supply.

Short-Run Market Supply with Identical Firms

  • As the number of identical firms expands, market supply curve flattens at average variable costs.

Short-Run Market Supply with Different Firms

  • Variations in individual firms' marginal costs and average variable costs affects shorter run supply curves, which relate market prices to output.

  • Flatter market supply curves when all firms produce at a given price.

Short-Run Competitive Equilibrium

  • Equilibrium demonstrated through intersection of firm and market supply curves alongside demand curves in a hypothetical lime market with specific price and output data.

Long-Run Competitive Profit Maximization

Profit Maximization (1 of 2)

  • Long-run model parallels short-run profit max rules:

  • Firm must find quantity to maximize long-run profit, where long-run marginal profit equals zero and marginal revenue equals long-run marginal cost.

Profit Maximization (2 of 2)

  • Decisions on production or shutdown remain while considering variable costs in the long-run for decision-making.

Long-Run Firm Supply Curve

  • Long-run supply curve aligned with long-run marginal cost above minimum average cost.

Long-Run Market Supply Curve

  • Constructed from the horizontal summation of individual firm supply curves in both short- and long-run scenarios.

  • Variability in firm numbers affects supply responses.

Entry and Exit Dynamics

  • Key factors influence entry and exit in free markets:

    • Market entry when profit exists and exit when long-run loss mandates it.

  • Zero long-run profits create indifference towards remaining or vacating market.

Long-Run Market Supply Characteristics

Identical Firms and Free Entry

  • Long-run supply curve remains flat at minimum long-run average cost due to homogeneity of firms and constant input prices.

Limited Entry Impacts

  • Upward slope in market supply curves occurs when market entry is constrained by resources or regulatory limits.

Differentiated Cost Functions

  • Variability in firms' cost structures produces upward-sloping supply due to heterogeneous entry barriers amongst customers.

Application Example: Cotton Market

  • Data presentation outlining the long-run upward sloping supply curve for cotton production based on national outputs represented graphically.