Tuesday, October 21, 2014

Perfect Competition 1

Perfect Competition

Mjmfoodie - Perfect Comp. - Video

I wanted to post some new graphs that I created to push me to do some new blog posts.
Comments always welcome. :)

Obviously this is a perfect competition graph,,,

Firms in a perfectly competitive market are consider price-takers meaning that in this industry they can't manipulate the price of their goods. They can't do this because the market is saturated with firms all selling identical products. (Hint - perfect competition doesn't really exist) The closest markets are agricultural markets and they are often subsidized by their governments for various reasons: security (America & corn), patriotic bromides (Japan & rice), environmental (America and corn/ethanol) or tradition (America and sugar).

Profit - often students of economics don't quite get the references to a firm earning profits.

  • @ P1 the market is in short-run and long-run equilibrium, this means that the firm is earning a normal profit and all of its explicit and implicit costs are being covered. (Implicit in that the entrepreneur is earning enough profit to allow him to stay in this industry,,, more than his next best alternative) The AP exam uses normal profit and zero economic profit interchangeably.  They mean the same thing, (zero economic profit = normal profit)Notice that at P1 the firm is at a break even, meaning that all revenues are covering all costs. 
  • @P3 the price has risen above the firms ATC's (Average Total Costs). This price rise allows the firm to make Abnormal/Super/Positive Economic Profit, you must know that all of these terms when used,,, imply that the price has risen above where MC intersects with the ATC curve. When firms are makingAbnormal/Super/Positive Economic Profit, then we can expect other entrepreneurs/firms to rush into the industry to try and capture these profits. As more and more of these firms rush into this industry,,, the increase in supply causes prices to fall,,, falling prices causes inefficient firms to leave the market until we return to the previous level of equilibrium at P1, where P=minATC or Long-Run Equilibrium.
Lets look at it on a graph.

Notice that at P3 firms are making super/abnormal/positive economic profits. 

  • As more firms enter the market and increase supply, P3 to P1 (right shift) the price drops and inefficient firms exit the market.
  • Know that a perfectly competitive firm always produces to Maximize Profit, where MR = MC.
Why you ask?,,,, well.

MC = MR -  the firm’s total profits are maximized or losses are minimized - there is no reason to change the level of output, if it does it will be decreasing profits or increasing losses.

MR>MC - revenues are rising faster than costs so it pays the firm to increase output as in this way it will increase profits or decrease losses. There is money on the table. If the marginal unit is sold then more revenue will be collected. If more profit can be collected then the firm has not maxed profit. ** Ok, to often, this is very confusing to students,,, why? don't we want MR to be more than MC. NO,,, you want your revenues to be more than costs, but not your Marginal Revenues to be greater than your Marginal Costs... Explain,, you say,,

First, recognize that the word marginal here means either to sell or not sell one more unit. Would it increase our profit if we sold one more unit or would it decrease our profits. MR>MC, simply means that by selling that (one more unit)  or (more units) profits will be increased. {Lets use as an example the selling of a 3 million dollar plane. If your costs are 2 million and you sell the plane for 3 million, you have just increased the firms profits by 1 million dollars. If you had not sold the plane you would have cost the firm a million dollars in unrealized profit. If you can make one penny on a marginal sell,,(by selling one more) then you aren't at max profit until you make the sell}. Simple,, yes..

MC>MR - costs are rising faster than revenues, so it pays to decrease output as in this way the firm will increase profits or decrease losses.

Mjmfoodie - Profit Max - Video

What if the Price drops to P2?

  • @P2, the firm is now suffering some losses. At this price the firm will produce a quantity equal to Q2. Still at (MR = MC) to profit maximize. They are making losses but they are still covering some of their fixed cost. Why shouldn't they exit the market if they are making losses. Well, if they did exit the market they would still have to pay for all of their fixed costs. By staying in the market they can at least pay for some of their fixed costs. 
  • Remember that fixed costs are = to ATC - AVC. That rectangle that that includes LOSS & Area of fixed costs being Paid,,, is equal to all of the fixed costs. (ATC-AVC= AFC.)

What if the Price drops to P4?

  • Shut-Down is when price drops below the AVC. Once the price drops below P4, then the firm is not able to even pay its VC (workers) and to stay in business would be costing it money. Exit the Industry.

What if Demand Shifts lowering or raising price. If you understand the right sided graph it's easy to plug in the Demand Shift.

Points to Remember:

  • Break-Even - P=minATC
  • Profit Max - MR=MC
  • Shut-Down - P<AVC
  • A firm's MC curve above the AVC is its Supply Curve
  • Price will equal MC (Allocative Efficiency) - Allocative Efficiency exists when just the right amount, from society's point of view, is being produced. It requires that for the last unit produced, price is equal to its marginal cost (MC) or, more generally, that MSB=MSC.
  • Price will equal minimum ATC (Productive Efficiency) - When production takes place with a minimum average costs, implying that production takes place with minimal resource waste.
  • Perfectly Competitive industries are the most efficient type of Market Structure