Production | Perfect Competition 1
Market Structure
There are many difierent types of market structure,The main ones are:
1,Perfect Competition,Many small price-taking flrms in an industry with free-entry.
2,Monopoly,One large price-setting flrm in an industry with barriers to entry.
3,Duopoly,Two large price-setting flrms in an industry with barriers to entry.
4,Oligopoly,A small number of large price-setting flrms in an industry with barriers to entry.
5,Monopolistic Competition,A large number of price-setting flrms in an industry with free entry.
The industry of interest dictates appropriate model choice,The models have very difierent properties.
Production | Perfect Competition 2
Perfect Competition
An industry is said to be perfectly competitive if there are a large number of small price-taking flrms which can
enter and leave the industry at will.
In a perfectly competitive market an individual flrm has no impact upon prices.
The demand curve they face is therefore a straight line at the current market price,p?.
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y
p?
Market demand
Firm demand
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If the flrm charges above p? demand is zero,and if it charges below the flrm faces the market demand curve.
Production | Perfect Competition 3
The Supply Decision
The flrm wishes to choose output to maximise proflts,Proflts are given by the following equation:
… = py? c(y) =) maxy … =maxy py? c(y)
The flrm will keep increasing output until proflts start to decline,If ￠…=￠y < 0 the flrm could decrease output to
increase proflt,If ￠…=￠y > 0 an increase in output would increase proflt,Hence the flrm sets y so that ￠…=￠y =0.
Or maximisation can be achieved by setting d…=dy =0 in the standard way.
￠…
￠y =
…0? …
￠y = fp(y
0? y)?(c(y0)? c(y))g=￠y = p? ￠c(y)
￠y =0 =) p =
￠c(y)
￠y
Simply put p = MC(y) at the optimum,The competitive flrm operates at price equals marginal cost.
The supply curve for the flrm is simply the marginal cost curve,Well,not quite.
Production | Perfect Competition 4
The Supply Curve
The flrm’s supply curve is not the whole of the marginal cost curve,There are two exceptions.
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0
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y
p?
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p
y
p?
MC MC
yL yH
AVC
yN
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The flrm would never operate at yL since more proflt could be made at yH,Since MC is downward sloping at yL,
the cost of producing an extra unit is falling (and below p?) and it will always be profltable to produce more.
Moreover,the flrm would never produce at yN,Proflts (excluding flxed costs) are negative since the variable cost
per unit is greater than the price received per unit,The flrm would rather produce nothing at all.
Hence the (short run) supply curve is zero until MC > AVC and then supply is the marginal cost curve.
Production | Perfect Competition 5
Proflts
The diagrams can be used to illustrate the flrms total proflts,The price per unit is p? and the cost per unit is AC.
Hence the area in the box bounded by price above and AC(y?) below is proflt.
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...0
p
y 0 y
ACMC MC
AVC
p
… P
p? p?
y? y?
The flrst graph shows proflt,…,The second shows producer surplus,P.
Producer surplus,the area behind the supply curve,is also given by the area of the box between price and AVC,It
is proflts excluding the flxed costs | revenue minus variable costs.
Production | Perfect Competition 6
Long Run Supply
The long run supply curve is given by the upward sloping part of the long run marginal cost curve.
In the long run all factors are variable | the flrm can shut down if it is unprofltable.
Hence long run supply is long run marginal cost where it is above the long run average cost curve.
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.....0
p
y 0 y
Supply = LRMC
LRAC
p
y?
Short run supply
Long run supply
The long run supply curve is likely to be atter | more elastic | than in the short run,Why?
Production | Perfect Competition 7
Short Run Industry Supply
Industry supply in the short run is given by simply adding up the supply curves for each individual flrm.
S(p)=
nX
i=1
Si(p)
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y
S1 S2 S1 +S2
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Geometrically,just like with demand,the supply functions are summed horizontally.
The intersection with market demand gives p?,Returning to the flrm with this yields short run equilibrium.
Production | Perfect Competition 8
Perfect Competition in the Short Run
In the short run,perfectly competitive flrms can make proflts or losses.
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0
p
y 0 y
AC ACMC MC
p
… > 0
… < 0
p?
p?
y? y?
In the flrst graph,the flrm makes a proflt,…,Average cost lies below average revenue (price).
In the second graph,the flrm makes a loss,Average cost lies above average revenue (price).
Even when making a loss a flrm may wish to produce positive amounts | as long as revenue exceeds variable costs.
Production | Perfect Competition 9
Free Entry
However,a flrm making a loss in the short run will shut down in the long run (and make zero proflts).
Alternatively,if a flrm is making positive proflts,other flrms will enter the market in the long run.
The free entry assumption allows flrms to enter when they see such profltable opportunities.
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SS0
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The graph shows the case when a flrm is making a loss,That flrm (and possibly others) will leave the market in the
long run,decreasing supply from S to S0,Market price rises to p0 from p.
A similar graph could be drawn for flrms entering the market,Price would fall.
Production | Perfect Competition 10
Perfect Competition in the Long Run
Firms making a loss continue to leave causing price to rise until the remaining flrms are making no proflts at all.
In the case when flrms are making a proflt,new flrms continue to enter,forcing market price down until all the
flrms receive zero proflts,The competitive flrm in the long run makes zero proflts,This is illustrated below.
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p
y
ACMC
p?
y?
Notice that (AR =)p? = MC = AC in equilibrium,This implies all kinds of e–ciency,returned to next lecture.
Production | Perfect Competition 11
Industry Supply in the Long Run
In the long run flrms will never operate at p? < minAC,In the long run flrms will enter if p? > minAC.
Suppose there are enough flrms in the market to make the discreteness of flrms unimportant.
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0
p
y
Long run supply =minACp?
The long run supply curve is well approximated by a straight line at p? =minAC.
Production | Perfect Competition 12
Economic Rent
The economic rent paid to a factor is the payment in excess of the minimum required to have that factor supplied.
If there is a flxed supply of some factor (land is a good example) then when price rises above the actual value,other
flrms would like to supply more land but they can’t | there isn’t any left.
The proflts attributable to this factor are called economic rent,Rent is the amount required to drive proflts to zero.
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p
y
MC
AVC
AC
Rent
p?
y?
Rent is the area between AC (average costs including the flxed factor) and AVC (average costs excluding the flxed
factor),Notice this is exactly the producer surplus.
Equilibrium price adjusts causing rent to change until proflts are zero.
Market Structure
There are many difierent types of market structure,The main ones are:
1,Perfect Competition,Many small price-taking flrms in an industry with free-entry.
2,Monopoly,One large price-setting flrm in an industry with barriers to entry.
3,Duopoly,Two large price-setting flrms in an industry with barriers to entry.
4,Oligopoly,A small number of large price-setting flrms in an industry with barriers to entry.
5,Monopolistic Competition,A large number of price-setting flrms in an industry with free entry.
The industry of interest dictates appropriate model choice,The models have very difierent properties.
Production | Perfect Competition 2
Perfect Competition
An industry is said to be perfectly competitive if there are a large number of small price-taking flrms which can
enter and leave the industry at will.
In a perfectly competitive market an individual flrm has no impact upon prices.
The demand curve they face is therefore a straight line at the current market price,p?.
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0
p
y
p?
Market demand
Firm demand
......
.......
.......
.......
.......
If the flrm charges above p? demand is zero,and if it charges below the flrm faces the market demand curve.
Production | Perfect Competition 3
The Supply Decision
The flrm wishes to choose output to maximise proflts,Proflts are given by the following equation:
… = py? c(y) =) maxy … =maxy py? c(y)
The flrm will keep increasing output until proflts start to decline,If ￠…=￠y < 0 the flrm could decrease output to
increase proflt,If ￠…=￠y > 0 an increase in output would increase proflt,Hence the flrm sets y so that ￠…=￠y =0.
Or maximisation can be achieved by setting d…=dy =0 in the standard way.
￠…
￠y =
…0? …
￠y = fp(y
0? y)?(c(y0)? c(y))g=￠y = p? ￠c(y)
￠y =0 =) p =
￠c(y)
￠y
Simply put p = MC(y) at the optimum,The competitive flrm operates at price equals marginal cost.
The supply curve for the flrm is simply the marginal cost curve,Well,not quite.
Production | Perfect Competition 4
The Supply Curve
The flrm’s supply curve is not the whole of the marginal cost curve,There are two exceptions.
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0
p
y
p?
0
p
y
p?
MC MC
yL yH
AVC
yN
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The flrm would never operate at yL since more proflt could be made at yH,Since MC is downward sloping at yL,
the cost of producing an extra unit is falling (and below p?) and it will always be profltable to produce more.
Moreover,the flrm would never produce at yN,Proflts (excluding flxed costs) are negative since the variable cost
per unit is greater than the price received per unit,The flrm would rather produce nothing at all.
Hence the (short run) supply curve is zero until MC > AVC and then supply is the marginal cost curve.
Production | Perfect Competition 5
Proflts
The diagrams can be used to illustrate the flrms total proflts,The price per unit is p? and the cost per unit is AC.
Hence the area in the box bounded by price above and AC(y?) below is proflt.
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......
.
...0
p
y 0 y
ACMC MC
AVC
p
… P
p? p?
y? y?
The flrst graph shows proflt,…,The second shows producer surplus,P.
Producer surplus,the area behind the supply curve,is also given by the area of the box between price and AVC,It
is proflts excluding the flxed costs | revenue minus variable costs.
Production | Perfect Competition 6
Long Run Supply
The long run supply curve is given by the upward sloping part of the long run marginal cost curve.
In the long run all factors are variable | the flrm can shut down if it is unprofltable.
Hence long run supply is long run marginal cost where it is above the long run average cost curve.
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......
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......
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.....0
p
y 0 y
Supply = LRMC
LRAC
p
y?
Short run supply
Long run supply
The long run supply curve is likely to be atter | more elastic | than in the short run,Why?
Production | Perfect Competition 7
Short Run Industry Supply
Industry supply in the short run is given by simply adding up the supply curves for each individual flrm.
S(p)=
nX
i=1
Si(p)
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Geometrically,just like with demand,the supply functions are summed horizontally.
The intersection with market demand gives p?,Returning to the flrm with this yields short run equilibrium.
Production | Perfect Competition 8
Perfect Competition in the Short Run
In the short run,perfectly competitive flrms can make proflts or losses.
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In the flrst graph,the flrm makes a proflt,…,Average cost lies below average revenue (price).
In the second graph,the flrm makes a loss,Average cost lies above average revenue (price).
Even when making a loss a flrm may wish to produce positive amounts | as long as revenue exceeds variable costs.
Production | Perfect Competition 9
Free Entry
However,a flrm making a loss in the short run will shut down in the long run (and make zero proflts).
Alternatively,if a flrm is making positive proflts,other flrms will enter the market in the long run.
The free entry assumption allows flrms to enter when they see such profltable opportunities.
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The graph shows the case when a flrm is making a loss,That flrm (and possibly others) will leave the market in the
long run,decreasing supply from S to S0,Market price rises to p0 from p.
A similar graph could be drawn for flrms entering the market,Price would fall.
Production | Perfect Competition 10
Perfect Competition in the Long Run
Firms making a loss continue to leave causing price to rise until the remaining flrms are making no proflts at all.
In the case when flrms are making a proflt,new flrms continue to enter,forcing market price down until all the
flrms receive zero proflts,The competitive flrm in the long run makes zero proflts,This is illustrated below.
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Notice that (AR =)p? = MC = AC in equilibrium,This implies all kinds of e–ciency,returned to next lecture.
Production | Perfect Competition 11
Industry Supply in the Long Run
In the long run flrms will never operate at p? < minAC,In the long run flrms will enter if p? > minAC.
Suppose there are enough flrms in the market to make the discreteness of flrms unimportant.
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The long run supply curve is well approximated by a straight line at p? =minAC.
Production | Perfect Competition 12
Economic Rent
The economic rent paid to a factor is the payment in excess of the minimum required to have that factor supplied.
If there is a flxed supply of some factor (land is a good example) then when price rises above the actual value,other
flrms would like to supply more land but they can’t | there isn’t any left.
The proflts attributable to this factor are called economic rent,Rent is the amount required to drive proflts to zero.
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Rent is the area between AC (average costs including the flxed factor) and AVC (average costs excluding the flxed
factor),Notice this is exactly the producer surplus.
Equilibrium price adjusts causing rent to change until proflts are zero.
