Lecture 11 market structure- perfect competition

Chapter 8

Profit Maximization and
Competitive Supply

Staples and Office Depot Merger

 1997, Staples and Office Depot wanted
to merge

 FTC analyzed the effect of proposed
merger on consumers.

 What would the decision be based on?

©2005 Pearson Education, Inc.

Coca Cola Inc.


Coca Cola Inc.

 Coca Cola is reviewing price of Coke.

 What should it expect revenue to be if it
increased its price?


MARKET STRUCTURE

©2005 Pearson Education, Inc. Chapter 8 5

MARKET STRUCTURE

 What determines concentration in a
market?

 Number of firms?

 Number of firms is a good indicator if
firms are homogeneous


SEARCH ENGINES:

 : 64.1%

: 18.0%

: 13.6%


SODA COMPANIES


 : 41.2% : 15.4%

 : 33.6%


Satellite TV Providers


MEASURING MARKET
CONCENTRATION


CONCENTRATION INDEX

 Measure ability of firms to raise price
above competitive level.

 Higher concentration index, greater likely
hood to collude


CONCENTRATION RATIO

 m- Firm Concentration Ratio

Sum total of share of total industry sales
accounted by m largest firms


m-Firm Concentration Ratio
Firm Industry X Industry Y
1 20 60
2 20 10
3 20 5
4 20 5
5 20 5
Total 100 85


% of total industry o/p X

Y
80

60

1 4 Number of
Firms

INDUSTRY CLASSIFICATION

 US Bureau of Census has a
classification of industries : Standard
Industrial Classification

 Number classification where each
succeeding number represents a finer
classification


INDIAN INDUSTRY
CLASSIFICATION

 National Sample Survey Organization
classifies industries in India in a similar
fashion.

 National Industrial Classification

 5 Digit Index


National Industry Classification
 Section: e.g. Section C: Manufacturing
 Division: e.g. 13, Manufacturing textiles
 Group: e.g. 131, Spinning, weaving and
finishing of textiles
 Class: e.g. 1311, Preparation and Spinning
of textiles
 Sub-Class: e.g. 13111 Preparation and
spinning of cotton fibre including blended
cotton

1 20 60
2 20 10
3 20 5
4 20 5
5 20 5
Total 100 85


Herfindahl and Hirschman Index

 Weighted average of market shares of
firms
N 2
HHI i 1 Si

 An industry with only one firm will have
HHI index of 10,000
 As number of firms increases HHI
decreases


1 20 60
2 20 10
3 20 5
4 20 5
5 20 5
Total 100 85


Herfindahl and Hirschman Index

 HHI for Industry X= 2,000

 HHI for Industry Y = 3,850


TYPES OF MARKET
STRUCTURE


TYPES OF MARKET
STRUCTURE

 PERFECT COMPETITION

 MONOPOLY
 OLIGOPOLY


PERFECT COMPETITION


ASSUMPTIONS OF PERFECT
COMPETITION
1. Price taking

2. Product homogeneity

3. Free entry and exit


Perfectly Competitive Markets

1. Price Taking
 The individual firm sells a very small share
of the total market output and, therefore,
cannot influence market price
 Each firm takes market price as given –
price taker
 The individual consumer buys too small a
share of industry output to have any impact
on market price


2. Product Homogeneity
 The products of all firms are perfect
substitutes
 Product quality is relatively similar as well
as other product characteristics
 Agricultural products, oil, copper, iron,
lumber
 Heterogeneous products, such as brand
names, can charge higher prices because
they are perceived as better


3. Free Entry and Exit
 When there are no special costs that make
it difficult for a firm to enter (or exit) an
industry
 Buyers can easily switch from one supplier
to another
 Suppliers can easily enter or exit a market
 Pharmaceutical companies are not perfectly
competitive because of the large costs of R&D
required


When are Markets Competitive?
 Few real products are perfectly
competitive
 Many markets are, however, highly
competitive
They face relatively low entry and exit costs
Highly elastic demand curves
 No rule of thumb to determine whether a
market is close to perfectly competitive
Depends on how they behave in situations


Do firms maximize profits?
Managers in firms may be concerned with
other objectives

 Revenue maximization
 Revenue growth
 Dividend maximization
 Short-run profit maximization (due to bonus or
promotion incentive)
 Could be at expense of long run profits


Profit Maximization

 Implications of non-profit objective
Over the long run, investors would not
support the company
Without profits, survival is unlikely in
competitive industries
 Managers have constrained freedom to
pursue goals other than long-run profit
maximization


OPTIMAL OUTPUT


Marginal Revenue, Marginal
Cost, and Profit Maximization

 We can study profit maximizing output for
any firm, whether perfectly competitive or
not
Profit ( ) = Total Revenue - Total Cost
If q is output of the firm, then total revenue is
price of the good times quantity
Total Revenue (R) = Pq



 Costs of production depends on output
Total Cost (C) = C(q)
 Profit for the firm, , is difference
between revenue and costs

( q ) R( q ) C ( q )



 Firm selects output to maximize the
difference between revenue and cost
 We can graph the total revenue and total
cost curves to show maximizing profits
for the firm
 Distance between revenues and costs
show profits


Profit Maximization – Short Run
Profits are maximized where MR (slope
Cost, at A) and MC (slope at B) are equal
Revenue,
Profit Profits are
C(q)
($s per maximized
year) where R(q) –
A C(q) is
R(q) maximized

B

0 Output
q0 q*
(q)


 Slope of the revenue curve is the marginal
revenue
 Change in revenue resulting from a one-unit increase
in output

 Slope of the total cost curve is marginal cost
 Additional cost of producing an additional unit of
output


 Profit is negative to begin with, since revenue is
not large enough to cover fixed and variable
costs
 As output rises, revenue rises faster than costs
increasing profit

 Profit increases until it is maxed at q*

 Profit is maximized where MR = MC or where
slopes of the R(q) and C(q) curves are equal



 Profit is maximized at the point at which
an additional increment to output leaves
profit unchanged
R C
R C
0
q q q
MR MC 0
MR MC

The Competitive Firm
Price
$ per Firm Price Industry
bushel $ per
bushel

S

$4 d $4

D

Output Output
100 200 (bushels) 100 (millions
of bushels)


 Demand curve faced by an individual firm
is a horizontal line
Firm’s sales have no effect on market price

 Demand curve faced by whole market is
downward sloping
Shows amount of goods all consumers will
purchase at different prices



 The competitive firm’s demand
Individual producer sells all units for $4
regardless of that producer’s level of output
MR = P with the horizontal demand curve
For a perfectly competitive firm, profit
maximizing output occurs when

MC(q) MR P AR


SHORT RUN OPTIMAL
OUTPUT


Choosing Output: Short Run

 In the short run, capital is fixed and firm
must choose levels of variable inputs to
maximize profits

 We can look at the graph of MR, MC,
ATC and AVC to determine profits


A Competitive Firm
Price MC
Lost Profit
50 Lost Profit for q2>q*
for q2>q*
A
40 AR=MR=P
ATC

30 AVC

20 q1 : MR > MC
q2: MC > MR
q*: MC = MR
10

0 1 2 3 4 5 6 7 8 9 10 11
q1 q* q2 Output


Choosing Output: Short Run

 The point where MR = MC, the profit
maximizing output is chosen

MR = MC at quantity, q*, of 8
At a quantity less than 8, MR > MC, so more
profit can be gained by increasing output
At a quantity greater than 8, MC > MR,
increasing output will decrease profits


A Competitive Firm – Positive
Profits
Price MC
Total
50 Profit =
ABCD
D A
40 AR=MR=P
ATC

30 C AVC Profits are
Profit per B
determined
unit = P-
AC(q) = A by output per
to B 20 unit times
quantity
10

0 1 2 3 4 5 6 7 8 9 10 11
q1 q* q2 Output


PROFITS AND LOSSES



 A firm does not have to make profits
 It is possible a firm will incur losses if the
P < AC for the profit maximizing quantity

Still measured by profit per unit times
quantity
Profit per unit is negative (P – AC < 0)


A Competitive Firm – Losses
MC ATC
Price

B
C

D P = MR
A
Atq *:MR =
MC and P < AVC
ATC
Losses =
(P- AC) x q*
or ABCD

q* Output

Choosing Output in the Short
Run

 Summary of Production Decisions

Profit is maximized when MC = MR
If P > ATC the firm is making profits
If P < ATC the firm is making losses


SHUTDOWN OUTPUT


Short Run Production

 Why would a firm produce at a loss?
Might think price will increase in near future
Shutting down and starting up could be
costly
 Firm has two choices in short run
Continue producing
Shut down temporarily
Will compare profitability of both choices


Short Run Production

 When should the firm shut down?

If AVC < P < ATC, the firm should continue
producing in the short run
 Can cover all of its variable costs and some of
its fixed costs
If AVC > P < ATC, the firm should shut down
 Cannot cover its variable costs or any of its
fixed costs


A Competitive Firm – Losses
Price MC ATC
Losses
B
C

D P = MR
A
P < ATC but
AVC so AVC
firm will
continue to F
produce in E
short run

q* Output

SHORT RUN SUPPLY CURVE


Competitive Firm – Short Run
Supply

 Supply curve tells how much output will
be produced at different prices
 Competitive firms determine quantity to
produce where P = MC
Firm shuts down when P < AVC
 Competitive firms’ supply curve is portion
of the marginal cost curve above the
AVC curve


A Competitive Firm’s
Short-Run Supply Curve
Price
($ per The firm chooses the Supply is MC
unit) output level where P = MR = MC, above AVC
as long as P > AVC.

MC S
P2 ATC

P1 AVC

P = AVC

q1 q2 Output



 Supply is upward sloping due to
diminishing returns


CHANGE IN COSTS AND
SUPPLY CURVE



 Over time, prices of product and inputs
can change
 How does the firm’s output change in
response to a change in the price of an
input?
We can show an increase in marginal costs
and the change in the firm’s output decisions


The Response of a Firm to
a Change in Input Price
Price
($ per MC2 Input cost increases
unit) and MC shifts to MC2
Savings to the firm and q falls to q2.
from reducing output
MC1

$5

q2 q1 Output


MARKET SUPPLY CURVE


Short-Run Market Supply Curve

 Shows the amount of product the whole
market will produce at given prices
 Is the sum of all the individual producers
in the market
 We can show graphically how we can
sum the supply curves of individual
producers


Industry Supply in the Short
Run
The short-run S
$ per industry supply curve
unit is the horizontal
summation of the supply
curves of the firms.
P3

P2

P1

Q
2 4 5 7 8 10 15 21


ELASTICITY OF SUPPLY


Elasticity of Market Supply

 Elasticity of Market Supply
Measures the sensitivity of industry output to
market price
The percentage change in quantity supplied,
Q, in response to 1-percent change in price

Es ( Q / Q ) /( P / P )


Elasticity of Market Supply
 When MC increases rapidly in response to
increases in output, elasticity is low
 When MC increases slowly, supply is relatively
elastic
 Perfectly inelastic short-run supply arises
when the industry’s plant and equipment are so
fully utilized that new plants must be built to
achieve greater output
 Perfectly elastic short-run supply arises when
marginal costs are constant


PRODUCER SURPLUS


Producer Surplus in the Short
Run
 Price is greater than MC on all but the last unit
of output
 Therefore, surplus is earned on all but the last
unit
 The producer surplus is the sum over all units
produced of the difference between the market
price of the good and the marginal cost of
production
 Area above supply curve to the market price


Producer Surplus for a Firm
Price
($ per
unit of Producer MC AVC
output) Surplus

B
A P

At q* MC = MR.
Between 0 and q,
MR > MC for all units.

Producer surplus
is area above MC
to the price

q* Output

The Short-Run Market Supply
Curve
 Sum of MC from 0 to q*, it is the sum of
the total variable cost of producing q*
 Producer Surplus can be defined as the
difference between the firm’s revenue
and its total variable cost
 We can show this graphically by the
rectangle ABCD
Revenue (0ABq*) minus variable cost
(0DCq*)


Producer Surplus for a Firm
Price
($ per Producer MC AVC
unit of Surplus
output)
B
A P

Producer surplus
is also ABCD =
Revenue minus
D variable costs
C

q* Output

Producer Surplus Versus Profit

 Profit is revenue minus total cost (not just
variable cost)
 When fixed cost is positive, producer
surplus is greater than profit

Producer Surplus PS R - VC

Profit R - VC - FC

Producer Surplus Versus Profit

 Costs of production determine magnitude
of producer surplus
Higher cost firms have less producer surplus
Lower cost firms have more producer surplus
Adding up surplus for all producers in the
market given total market producer surplus
Area below market price and above supply
curve


Producer Surplus for a Market
Price S
($ per
unit of
output)

Market producer surplus is
P* the difference between P*
and S from 0 to Q*.

Producer
Surplus D

Q* Output


LONG RUN OUTPUT
DECISIONS


Choosing Output in the Long
Run

 In short run, one or more inputs are fixed
Depending on the time, it may limit the
flexibility of the firm
 In the long run, a firm can alter all its
inputs, including the size of the plant
 We assume free entry and free exit
No legal restrictions or extra costs


Output Choice in the Long Run
Price
LMC
LAC
SMC
SAC
D A
$40 P = MR
C
B

$30
In the short run, the
firm is faced with fixed
inputs. P = $40 > ATC.
Profit is equal to ABCD.

q1 q2 q3 Output


Run
 In the short run, a firm faces a horizontal
demand curve
 Take market price as given
 The short-run average cost curve (SAC) and
short-run marginal cost curve (SMC) are low
enough for firm to make positive profits (ABCD)
 The long-run average cost curve (LRAC)
 Economies of scale to q2
 Diseconomies of scale after q2


Output Choice in the Long Run
In the long run, the plant size will be
Price increased and output increased to q3.
Long-run profit, EFGD > short run LMC
profit ABCD.
LAC
SMC
SAC
D A
$40 P = MR
C
B
G F
$30

Output
q1 q2 q3


Long-Run Competitive
Equilibrium

 For long run equilibrium, firms must have
no desire to enter or leave the industry

 We can relate economic profit to the
incentive to enter and exit the market


Equilibrium

 Zero-Profit
A firm is earning a normal return on its
investment
Doing as well as it could by investing its
money elsewhere
Normal return is firm’s opportunity cost of
using money to buy capital instead of
investing elsewhere
Competitive market long run equilibrium


Equilibrium

 Entry and Exit
The long-run response to short-run profits is
to increase output and profits
Profits will attract other producers
More producers increase industry supply,
which lowers the market price
This continues until there are no more profits
to be gained in the market – zero economic
profits


Equilibrium – Profits
•Profit attracts firms
•Supply increases until profit = 0
$ per Firm $ per Industry
unit of unit of S1
output output

LMC
$40 P1
LAC S2

$30 P2

D

q2 Output Q1 Q2 Output


Equilibrium – Losses
•Losses cause firms to leave
•Supply decreases until profit = 0
$ per Firm $ per Industry
unit of LMC unit of S2
output output
LAC

$30 P2
S1

$20 P1

D

q2 Output Q2 Q1 Output


Equilibrium

1. All firms in industry are maximizing
profits
 MR = MC
2. No firm has incentive to enter or exit
industry
 Earning zero economic profits
3. Market is in equilibrium
 QD = Q S


Run

 Economic Rent
The difference between what firms are willing
to pay for an input less the minimum amount
necessary to obtain it
When some have accounting profits that are
larger than others, they still earn zero
economic profits because of the willingness
of other firms to use the factors of production
that are in limited supply


Run

 An Example
Two firms A & B that both own their land
A is located on a river which lowers A’s
shipping cost by $10,000 compared to B
The demand for A’s river location will
increase the price of A’s land to $10,000 =
economic rent
Although economic rent has increased,
economic profit has become zero


Firms Earn Zero Profit in
Long-Run Equilibrium
Ticket
Price A baseball team
in a moderate-sized city
sells enough
tickets so that price
LMC LAC is equal to marginal
and average cost
(profit = 0).

$7

Season Tickets
Sales (millions)
1.0

Ticket
Price

Economic Rent LMC LAC

$10

$7.20
A team with the same
cost in a larger city
sells tickets for $10.

Season Tickets
Sales (millions)
1.3


 With a fixed input such as a unique
location, the difference between the cost
of production (LAC = 7) and price ($10) is
the value or opportunity cost of the input
(location) and represents the economic
rent from the input



 If the opportunity cost of the input (rent) is
not taken into consideration, it may
appear that economic profits exist in the
long run


Lecture 11 market structure- perfect competition

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