Perfect Competition
insignificant
Price taker
homogeneous
complete information
costless
no costs
equal access
barriers to entry/exit
competition
externalities
Objectives
By the end of this lesson you should be able to…
Draw and explain the long run equilibrium diagram
Draw and explain the diagrams illustrating the moves to longrun equilibrium following
Short run abnormal profits
Short run losses
Market Structure
Perfect
Competition
PureMonopoly
Monopolistic Competition
Oligopoly
Duopoly
Monopoly
The further right on the scale, the greater the degreeof monopoly power exercised by the firm.
Many small firms
each of whom produces aninsignificant percentage of totalmarket output and thus exercise nocontrol over the market price
P
Q
O
D
S
P
Q
O
P = D = AR
Price takers…so small and somany – individual firms cannotinfluence price
The firm’s demand curve is perfectly e l a s t i cbecause any firm that raises its prices sees demand fallto zero as consumers, with perfect knowledge, switchto other producers offering an identical product for abetter price
Industry
Firm
Long run equilibrium
P
Q
O
D
S
P
Q
O
P = D = AR = MR
Industry
Firm
P1
Q1
MC
AC
MR=MC
Maximum profits
•Before we look at the market dynamics, lets first understand what the end state looks like…
Long run equilibrium
P
Q
O
D
S
P
Q
O
P = D = AR = MR
Industry
Firm
P1
Q1
MC
AC
MR=MC
Maximum profits
•Before we look at the market dynamics, lets first understand what the end state looks like…
Scenarios
The firm is making
abnormal profits
The firm is making
losses
To get to this end state, there are two possible starting scenarios…
Long run
Equilibrium
Normal profits – that level of profits which isjust sufficient to keep resources employed inmaking a particular product from being used forsome other purpose.
Any profit in excess of that amount is termedAbnormal or Supernormal
What could cause ‘abnormal’profits to occur?
Economies of scale – lower SRAC….
Innovation – better technology
Or….
Major change in fashions….
What does this look like on the 2 split diagram?
SR abnormal profits
What impact would this have onthe market?
Act as a signal for other competitors to enterthe market and produce/sell this product
Increase in Supply….
Scenarios
The firm is making
abnormal profits
The firm is making
losses
To get to this end state, there are two possible starting scenarios…
Long run
Equilibrium
Normal profits – that level of profits which isjust sufficient to keep resources employed inmaking a particular product from being used forsome other purpose.
Any profit in excess of that amount is termedAbnormal or Supernormal
SR abnormal profits
What impact would this have onthe market?
Act as a signal for other competitors to enterthe market and produce/sell this product
Increase in Supply….
Long run equilibrium
So in the Longrun – theabnormalprofitsdisappear andreturn toequilibrium.
Whobenefits fromthis?
Abnormal losses…
Long Run Equilibrium
So in theLong run –theabnormallossesdisappearand returntoequilibrium.
Whobenefits fromthis?
Scenarios
The firm is making
abnormal profits
The firm is making
losses
To get to this end state, there are two possible starting scenarios…
Long run
Equilibrium
New entrants
Firms exit the market
Exam skills
You will always be expected to be able toexplain the effect that abnormal profit orabnormal loss would have on a perfectlycompetitive industry
You need to be able to use both the D&Sand the micro diagrams to do this….
Your tasks
In your notes….
Show a change from abnormalprofit back to equilibrium
Use a step by step logic to your answers….
i.e. a list!
And label diagrams clearly…
Then show the effect of an abnormal lossgoing back to the equilibrium!
Your extension task….
Read article on Coal Industry
Quick questions….
1.Which characteristics of perfect competitiondoes the coal market have?
2.Which characteristics does it not meet?
If facing a loss, a PC firm might prefer toleave the market than take the losses!
Steel – homework….
To complete for next Wednesday’s lesson
Anderton p329
Add these marks to the Q’s – to give you an idea ofquantity required in answers….
Q1 = 4
Q2 = 10
Q3 = 6
The firm in short run SUPPLYequilibrium
•The firm faces constant average and marginal revenue and will choose output at Q1 where MR=MC.
•If the market price were to change, the firm would react by changing output, but always choosing tosupply output at the level at which MR=MC.
•This suggests that the short-run marginal cost curve represents the firm’s short-run supply curve…thequantity of output that the firm would supply at any given price.
P
Q
O
D
S
P
Q
O
P = D = AR = MR
Industry
Firm
P1
Q1
MC
AC
Do not use diagrams
Abnormal profits
If the firm is making abnormalprofits
• If abnormal profits are being made in the short run, firms will enter the industry,
• pushing the supply curve from S1 to Se.
• At Se firms will no longer be attracted into the industry because they will only be able to make normal profits
on their operations.
P
Q
O
P = D = AR = MR
Firm
Q1
MC
AC
P
P
Q
O
D
S1
P1
Pe
Se
Industry
Illustration
P1
•The firm faces constant average and marginal revenue and will choose output at Q1 where MR=MC.
• If the market price were to change, the firm would react by changing output, but always choosing to supplyoutput at the level at which MR=MC.
•This suggests that the short-run marginal cost curve represents the firm’s short-run supply curve…the quantityof output that the firm would supply at any given price.
Abnormal profits
If the firm is making abnormalprofits
If abnormal profits are being made in the short run, firms will enter the industry,pushing the supply curve from S1 to S2. At S2 firms will no longer be attracted intothe industry because they will only be able to make normal profits on theiroperations.
P
Q
O
P = D = AR = MR
Firm
Q1
MC
AC
P
Q
O
D
Se
P
S1
P1
Pe
Industry
How to draw
Short run– abnormal profits
P
Q
O
D
S
P
Q
O
P = D = AR = MR
Industry
Firm
P1
Q1
MC
AC
MR=MC
Maximum profits
Perfect Competition
Diagrammatic representation
Cost/Revenue
Output/Sales
The industry price isdetermined by the demandand supply of the industryas a whole. The firm is avery small supplier withinthe industry and has nocontrol over price. They willsell each extra unit for thesame price. Price therefore= MR and AR
P = MR = AR
MC
The MC is the cost ofproducing additional(marginal) units of output. Itfalls at first (due to the law ofdiminishing returns) then risesas output rises.
AC
The average cost curve is thestandard ‘U’ – shaped curve.MC cuts the AC curve at itslowest point because of themathematical relationshipbetween marginal and averagevalues.
Q1
Given the assumption of profitmaximisation, the firm producesat an output where MC = MR(Q1). This output level is afraction of the total industrysupply.
At this output the firmis making normal profit.This is a long runequilibrium position.
Perfect Competition – Abnormalprofits
Diagrammatic representation
Cost/Revenue
Output/Sales
P = MR = AR
MC
AC
Q1
Now assume a firm makessome form of modification toits product or gains some formof cost advantage (say a newproduction method). Whatwould happen?
AC1
MC1
AC1
Abnormal profit
Q2
Because the model assumesperfect knowledge, the firmgains the advantage for only ashort time before others copythe idea or are attracted to theindustry by the existence ofabnormal profit. If new firmsenter the industry, supply willincrease, price will fall and thefirm will be left making normalprofit once again.
P1 = MR1 = AR1
The lower AC and MC wouldimply that the firm is nowearning abnormal profit(AR>AC) represented by thegrey area.
Average and Marginal costscould be expected to be lowerbut price, in the short run,remains the same.
Plenary – quick on the draw!
By the end of this lesson you should be able to…
Draw and explain the long run equilibrium diagram
Draw and explain the diagrams illustrating the moves to longrun equilibrium following
Short run abnormal profits
Short run losses