Perfectly Competitive Markets, Role of Profits, Allocative/Technical Efficiency
Types of Markets
What are the 4 Types of Competitive Models?
Number of competitors significantly affects amount of influence individual firms have on price.
- Perfect Competition: Lots of producers, free entry, product uniformity & consumers can compare prices.
- Monopoly: 1 firm & it has huge influence over the price (within limits the law of demand).
- Monopolistic Competition: Many firms but each have a ‘monopoly’ on their own differentiated product.
- Oligopolies: Very few firms but they all share the market in tandem.
What are the Different Types of Products?
Product can also influence markets. Homogenous products (identical) compete with each other solely based on price. Differentiated products (similar, but not identical) can compete on different traits of the same product, which allows price differences to exist.
What is a ‘Barrier to Entry’?
Any impediment that makes it difficult for a new firm to enter & compete in a market. Free entry markets have no serious impediments, other than cost. Barriers of entry can include high setup costs (ISPs, airlines, oil) or legal barriers (can’t sell a patented good).
Demand in a Perfectly Competitive Market
In a perfectly competitive market:
- You don’t care about your neighbour’s output or price, as it’s just a drop in the bucket.
- All firms are profit-maximization.
- All firms are price-takers (takes whatever price the market sets for them, can’t change it).
What is Total Revenue (TR)?
Total revenue is the total amount received as firms sell their products.
What is Marginal Revenue (MR)?
The change in total revenue as a firm sells one more unit of a good.
For a firm in perfect competition, the marginal revenue is equal to the price received!
What is Average Revenue (AR)?
The average amount received per unit.
For a firm in perfect competition, the average revenue is equal to the price received!
Choosing the Profit-Maximizing Output Level
When is Profit Maximized?
When Marginal Revenue is equal to Marginal Cost. If MR>MC, then increase production to maximize profit. If MR<MC, then decrease production to maximize profit.
In a perfectly competitive market, profit is maximized when P = MC.
At P3, the firm makes profits. (P = MC, P>ATC)
At P2, the firm breaks even. (P = MC = ATC)
At P1, the firm makes a loss. (P=MC, P<ATC)
A Shutdown Decision & Short-Run Equilbrium
At P1, the firm needs to decide if it needs to shut down. A firm should only shut down if variable costs becomes greater than marginal revenue. In competitive markets, if Price > AVC, then firm should not shut down in the short run & should produce at output level where Price = AVC.
Supply in a Competitive Market
How to Find One Firm’s Supply Curve
In perfect competition, the supply curve of an individual firm is the firm’s marginal cost curve above the shutdown point (when MC intersects with short-run AVC).
SRATC = Short-Run Average Total Cost
SRAVC = Short-Run Average Variable Cost
How to Find a Market’s Supply Curve
Add all the individual firms’ supply curves horizontally. Basically, at each price point, add all quantity all firms are going to produce.
An Economist's View of Profits
What are Explicit Costs?
Explicit costs are clearly defined costs that the firm has to directly pay (via checks or cash). When you subtract explicit costs from revenue, you get accounting profits (=Revenue – Explicit Costs).
What are Implicit Costs?
Opportunity costs for a firm. Implicit costs are the profits that could be earned in an alternative business. Potential accounting profits from an alternative business are normal profits.
What is Economic Profit?
Equilibrium in Competitive Markets in Long Run
A firm will enter a market if that market has a positive economic profit. In the long run, all costs are variable & firms can leave/enter. The process to equilibrium in the long run is shown to the left.
Changes to demand or costs in the short run allow existing firms to adjust output. In the long run, firm entries/exits will cause price to adjust to long run equilibrium where economic profits are 0!
The Market in the Long Run
The Long Run Price
- Constant Cost Industry: As industry supply expands, input prices do not change. The cost function is constant. In long run, prices return to original equilibrium & long-run supply curve is perfectly elastic.
- Increasing Cost Industry: As industry supply expands, input prices increase. In long run, prices are above the original equilibrium & long-run supply curve is upward sloping.
- Decreasing Cost Industry: As industry supply expands, input prices decrease. In long run, prices are below the original equilibrium & long-run supply curve is downward sloping.
Long-run Supply Curves after a demand increase.
What is Technical Efficiency?
Average costs, at every possible level of output, are at minimums. The firm would minimize the average cost for its current level of output. The second part of technical efficiency is that the firm is producing a level of output that results in the minimum of all those possible average costs.
What is Allocative Efficiency?
Consumers have maximum satisfaction. Producers produce at a level where Marginal Cost of Good A = Price of Good A. Therefore: