Economics

Perfect Competition

BAHRIA UNIVERSITY KARACHI

ASSIGNMENT PERFECT COMPETION

PREPARED BY

SHAHID BASHIR KHAN

MBA-WEEKEND 2(A) REG # 23027

Prepared By:Shahid Khan

Economics

Perfect Competition

Perfect Competition
The concept of competition is used in two ways in economics. Competition as a process is a rivalry among firms. Competition as the perfectly competitive market structure.

Market structure
Many of the firms decisions depend on the structure of the market in which it operates Market structure describes the important features of a market Market structure describes the features of a market that affect behaviour of firms operating in the market

Firm and Household Decisions

Input and output markets cannot be considered separately or as if they operated independently. Output and input markets are connected because firms and households make simultaneous choices in both arenas, but there are other connections among markets as well. Both input and output markets cannot be considered separately as if there operated independently. While it is important to understand the decisions of individual firms and households and the functioning of individual markets, we now need to add it all up to look at the operation of the system as a whole.

How is Market Structure determined?

Number of suppliers Products degree of uniformity Do firms in the market supply identical products or are there differences across firms? Ease of entry into the market Can new firms enter easily or are they blocked by natural or artificial barriers? Forms of competition among firms

Prepared By:Shahid Khan

Economics

Perfect Competition

Do firms compete only through prices or are advertising and product differences common as well?

Ease of entry and exit into the market Can new firms enter easily or are they blocked by natural or artificial barriers? Knowledge of market/Forms of competition Access to information regarding market How do firms compete? Pricing/advertising/product differences ?

Perfect Competition
Individual participants have no control over the price Price is determined by market supply and demand the perfectly competitive firm is a price taker it must take or accept, the market price Firm is free to produce whatever quantity maximizes profit

Perfectly Competitive Market Structure

Both buyers and sellers are price takers. The number of firms is large. There are no barriers to entry. The firms products are identical. There is complete information. Firms are profit maximizes.

Characteristics of Perfect Competition

Numerous sellers are present in the market, all selling identical products. All buyers and sellers are informed about markets and prices. There is free entry into and exit from the market. No individual seller or buyer can influence market price; instead, price is determined by market supply and demand. Firms in PC have no control over price They are `Price Takers i.e. accept and take the established market price Market price is determined by market demand and market supply Why are individual firms price takers ? Each is small, relative to size of market Buyers are well informed about existing market price charged

Demand
Each firm is so small relative to the market that each has no impact on the market price each farmer is a price taker

Prepared By:Shahid Khan

Economics

Perfect Competition

Because all farmers produce an identical product (?? substitutes exist), anyone who charges more than the market price will sell no wheat (i.e. if price goes to $6, quantity demanded falls to 0) No farmer would sell at a lower price because they can sell all they want at the higher price

Each farmer faces ?? demand at $5. Ed = ??) The demand curve faced by an individual farmer is therefore a horizontal line drawn at the market price.

Market Equilibrium and the Firms Demand Curve in Perfect Competition

Market price of wheat of $5 per bushel is determined in the left panel by the intersection of the market demand curve and the market supply curve. Once the market price is established, farmer can sell all he or she wants at that market price price taker

Short-Run Profit Maximization

How does the perfectly competitive firm maximize its total economic profit earned?

Prepared By:Shahid Khan

Economics

Perfect Competition

The perfectly competitive firm has no control over price, however, what the firm does control is the amount of output produced the question facing the PC firm is :

Two Approaches to Profit Maximisation

TR TC Approach Produce the quantity of output at which TR exceeds TC by the greatest amount Marginal Analysis Approach TR TC Approach Produce the quantity of output at which TR exceeds TC by the greatest amount Marginal Analysis Approach Produce the quantity of output where MR= MC

Revenue & Cost Data for PC Firms

Prepared By:Shahid Khan

Economics

Perfect Competition

Short-Run Profit Maximization

Prepared By:Shahid Khan

Economics

Perfect Competition

At Qty = 12, TR exceeds TC by the greatest amount

The Mc curve is the supply curve. The MC curve intersects the MR curve at point e, At rates of output less than 12 bushels, MR > MC firm can increase profit by expanding output At higher rates of output MC > MR firm can increase profits by reducing output Profit appears in the blue shaded rectangle and equals the price of $5 minus the average cost of $4, or $1 per bushel

Marginal Analysis Approach The PC firm should produce that level of output where MR = MC Marginal revenue ( MR), is the change in total revenue from selling another unit of output. MR = Price in PC Marginal cost (MC), is the change in total cost resulting from producing another unit of output

Revenue & Cost Data for PC Firms

Prepared By:Shahid Khan

Economics

Perfect Competition

Extract of Cost & Revenue Data

Short-Run Profit Maximization

Prepared By:Shahid Khan

Economics

Perfect Competition

MR = MC Approach to Profit Maximisation

Golden rule of profit maximization: Generally, a firm will expand production if MR > MC reduce production if MR < MC Profit maximisation production level occurs where MR = MC If marginal revenue does not equal marginal cost, a firm can increase profit by changing output. The supplier will continue to produce as long as marginal cost is less than marginal revenue. The supplier will cut back on production if marginal cost is greater than marginal revenue.

Prepared By:Shahid Khan

Economics

Perfect Competition

Shutting Down in the Short Run

The shutdown point is the point at which the firm will be better off it shuts down than it will if it stays in business. The firm should shut down if it cannot cover average variable costs. A firm should continue to produce as long as price is greater than average variable cost. If price falls below that point it makes sense to shut down temporarily and save the variable costs. If total revenue is more than total variable cost, the firms best strategy is to temporarily produce at a loss. It is taking less of a loss than it would by shutting down.

The Shutdown Decision

Prepared By:Shahid Khan

10

Economics

Perfect Competition

Normal and abnormal profits

Normal profit- is profit just sufficient to keep that firm in operation. Abnormal profit-profit earned by firms over and above normal profits. Abnormal profits are the main reason why firms enter into market. Firms can easily enter and leave the market due to less barriers

Short run-abnormal profits

This means the higher the existence of abnormal profits more firms will be attracted in the short run. Thus increasing overall market supply in that industry

LONG RUN-NORMAL PROFITS

In the long run there is intense competition due to new entrants of firms This reduces the market price and thus firms face diminishing abnormal profits Due to which some firms may leave the market in the long run and aim at other abnormal profit markets. The long run is therefore where the only firms left are the most efficient ones, making a normal profit. The long run equilibrium is where MC=ATC=AR=MR Thus in perfect competition firms enjoy abnormal profits in the short run and settle down with normal profits in the long run.

Prepared By:Shahid Khan

11

Economics

Perfect Competition

Long Run Equilibrium for the Firm and the Industry

Prepared By:Shahid Khan

12

Economics

Perfect Competition

Social Impact of Perfect Competition

Economic efficiency
Occurs when firms produce at the minimum point on their long-run average cost curves i.e. at the least possible cost

Allocative efficiency
Occurs when consumers pay a price equal to marginal cost Producing the amount of output that consumers value the most

The Efficiency of Perfect Competition

Efficient Allocation of Resources among firms: Perfectly competitive firms have incentives to use the best available technology. With a full knowledge of existing technologies, firms will choose the technology that produces the output they want at the least cost. Each firm uses inputs such that MRPL = PL. The marginal value of each input to each firm is just equal to its market price. (P = MC) The assumption that factor markets are competitive and open, that all firms pay the same prices for inputs, and that all firms maximise profits lead to the conclusion that the allocation of resources among firms is efficient.

Prepared By:Shahid Khan

13

Economics

Perfect Competition

The Key Efficiency Condition: Price Equals Marginal Cost

If PX > MCX, society gains value by producing more X If PX < MCX, society gains value by producing less X

Efficiency in Perfect Competition

Prepared By:Shahid Khan

14