Industrial Organization & Perfect Competition

1. Industrial Organization & Perfect Competition

2. Perfectly Competitive Markets Structure Assumptions • Many buyers and sellers • Homogeneous product or output • Note: these first two assumptions imply that the perfectly competitive firm is a price taker. • P(x) = P* = where  is the demand for the individual firm’s output. • Also note that if P(x) is just P*, then mr=P*, too. • “Free” entry and exit • Full and symmetric information

3. Perfectly Competitive Markets • Every demander is a price-taker (no buyer can influence the price). • Every supplier is a price-taker (no seller can influence the price). • The market price is known to all potential buyers and sellers and anyone who wishes to trade at that price can do so.

4. An Example • Jonathan’s farm is perfectly competitive and uses the inputs shown to produce the quantities of apples indicated on the table.

5. Production Detail • Here is some finer detail regarding the apple farm.

6. Factor Prices • Jonathan is a factor price taker. • Use these factor prices to build the cost tables.

7. Costs

8. Finer Cost Details

9. Graph of Jonathan’s Cost Curves • The marginal cost of each ton of apples is shown as the red line. • The average cost is shown as the blue line. • Notice that the marginal cost = average cost at average cost’s minimum.

10. Profit Maximization • Profit () = total revenue(tr) - total cost(tc). • Profit depends on the firm’s output level (x). • So…  (x) = tr(x) - tc(x) • Define • marginal revenue (mr) = tr/x • marginal cost (mc) = tc/x • NOTE: Since we have a perfectly competitive firm P=mr for all levels of production.

11. Profit Maximization • General rules for profit maximization: • If x* maximizes , then • mr = mc at x* • x* is a profit max and not a profit min • at x* it’s worth operating • Reminder: since the firm is perfectly competitive, P=mr for all values of x.

12. Jonathan’s Profit and Loss • Suppose the market price is $600/ton. • The vertical difference between Jonathan’s total revenue and total cost curve is his profit. • The profit maximum occurs at 240 tons/year.

13. Finding Profit Maximizing Points Using The Marginal Cost Curve • Jonathan will supply apples to the market in increasing quantities as the price rises. • The points on the marginal cost curve correspond to profit maximizing quantities at two different market prices. • The quantity supplied at a market price of $600/ton is (about) 240 (black dot). • Consider another market price, P=1,200 and note that x* increases. Marginal Cost of Apples 1,600 mc 1,400 mr when P=1,200 1,200 1,000 Price ($/ton) 800 mr when P=600 600 400 200 0 0 100 200 300 400 Apples (tons/year)

14. Finding the Value of Profit - Case A mc P atc • If market price is P*, then the firm supplies x* where mr=mc. • Total Revenue=OACQ* • Total Cost=OBDQ*Note: use the atc curve to get the value of total costs by multiplying atc by x* • Profit = tr-tc=BACD P* = mr A C B D O x* Quantity

15. Finding the Value of Profit - Case B P mc atc • If market price is P*, then the firm supplies x* where mr=mc. • Total Revenue=OBDQ* • Total Cost=OBDQ* • Profit = tr-tc=0 • Note: economic profit = 0 P* = mr B D O x* Quantity

16. Finding the Value of Profit - Case C P mc atc • If market price is P*, then the firm supplies x* where mr=mc. • Total Revenue=OACQ* • Total Cost=OBDQ*Profit = tr-tc = -ABDCNote: Profits are negative. They are loses. • Should firm continue to operate? Good question. Now need to look at where the average variable cost curve is. Recall: produce at a loss provided tr  vc orp avc • Since P>avc at x*, firm should produce x*. avc D B P* = mr A C O x* Quantity

17. The Firm’s Supply Curve • An individual perfectly competitive firm’s supply curve (the srsfirm) is its marginal cost curve above its average variable cost curve. • For a perfectly competitive firm, choosing the output at which market price equals marginal cost maximizes profits. • Remember, it’s really mr=mc at x*, but since the firm is a price taker, P=mr all the time, so P=mc at x*.

18. Jonathan’s Supply Curve • At the market price indicated on the vertical axis, profit maximizing apple production is given by the marginal cost curve, which is Jonathan’s supply of apples curve. • The supply curve is the the marginal cost curve above average variable cost because profit maximizing behavior means increasing production until marginal cost = market price.

19. Total Costs and Economic Profits • Total costs include fixed costs, variable costs (at market prices) and the opportunity cost of owned factors (such as the owner’s time, land, and equipment owned by the business). • Economic profits are the difference between total revenue from sales and total costs, as defined above.

20. Back to Jonathan’s Farm... • The apple market is competitive. • Jonathan cannot control the price of apples. • Consider, for the moment, a price of say $528/ton now • To profit maximize Jonathan produces until P (=mr) = mc

21. Jonathan’s Economic Profit and Loss • At the market price of $528, the profit maximizing apple production is the highlighted line.

22. Graph of Jonathan’s Revenue and Cost • The vertical difference between Jonathan’s total revenue and total cost curves is his economic profits. • The slope of the total cost line (marginal cost) is equal to the slope of the total revenue line (marginal revenue = market price)

23. Graph of Jonathan’s Economic Profits • The chart at the right shows that Jonathan’s economic profits are maximized at apple production where the market price is equal to the marginal cost (230 tons/year). • Profits are maximized when marginal cost is as close as possible to market price, without exceeding it. • The slope of economic profits = zero at the profit maximum.

24. Accounting Profits • Accounting profits are defined as total sales revenue (the same as total revenue in the economic profits definition) minus operating costs (costs of goods sold + administrative and sales costs for those who know some accounting). • Accounting Profits = Sales Revenue - Accounting Costs

25. Did Jonathan Make Accounting Profits? • The blue line in the table illustrates that Jonathan makes an accounting profit of $40,800 when the apple price is $528/ton.

26. Economic Profits • Economic profits are the difference between total revenue and total costs. • Economic total costs include the opportunity costs of all inputs to the production process–in particular, the opportunity costs of the owner’s time and physical capital (equipment and space).

27. Reconciling Economic and Accounting Profits • The table to the right shows that Jonathan’s economic profits equal his accounting profits minus the opportunity cost of his time. • Thus, when the price of apples is $528/ton and 230 tons/year are sold, economic profits = $27,600

28. Question 1 • At a market price of $440/ton for apples, what is the optimal annual production of apples? • Use the data on your handout to answer this question.

29. Answer 1 • Marginal cost = market price = $440/ton at a production level of 210 tons/year. • This is the profit maximizing level of output when the market price is $440/ton.

30. Question 2 • At a market price of $440/ton for apples, what are Jonathan’s accounting and economic profits?

31. Answer 2 • Total revenue = $440 x 210 = $92,400. • Total costs = $124 x 100 (land) + $8.00 x 7,320 (labor) + $12.00 x 1,100 (proprietor’s time) = $84,160 . • Economic profits = total revenue - total costs = $92,400 - $84,160 = $8,240.

32. Answer 2 (continued) • Total revenue = $440 x 210 = $92,400. • Accounting costs = $124 x 100 (land) + $8.00 x 7,320 (labor) = $70,960. • Accounting profits = total revenue - accounting costs = $92,400 - $70,960 = $21,440. • Economic profits = accounting profits - opportunity cost of owner’s time = $21,440 - $13,200 = $8,240.

33. Question 3 • At a market price of $400/ton for apples, what are Jonathan’s accounting and economic profits?

34. Answer 3 • Optimal production = 200 tons/year. • Total revenue = $400 x 200 = $80,000. • Economic profits = total revenue - total costs = $80,000 - $80,000 = 0. • Accounting profits = total revenue - accounting costs = $80,000 - 66,800 = 13,200.

35. Question 4 • Should Jonathan continue to operate the apple farm if the market price of apples is $400/ton?

36. Answer 4 • Jonathan’s economic profits are zero when the market price of apples is $400/ton ($0.20/pound, about the current price wholesale price for first quality fresh apples). • Jonathan just recovers the opportunity cost of his time ($13,200), so he is indifferent between producing apples and taking a job at $12/hour.

37. Producers Surplus Revisited • Producers surplus measures the gain to the firm from selling all units at the market price. • Producers surplus is the supply-side equivalent of consumers surplus. • Total producers surplus = the area above the marginal cost curve and below the market price = economic profits + fixed costs. • Incremental producers surplus = the difference between the market price and the marginal cost of the given unit of production.

38. Jonathan’s Producers Surplus • Jonathan’s total producers surplus, when the market price is $528,is the sum of his economic profits ($27,600) and his fixed costs ($25,600) = $53,200.

39. Producers Surplus and Economic Profits • Producers surplus is not equal to economic profits. • Producers surplus includes fixed costs. • Economic profits = producers surplus - fixed costs. • Producers surplus = economic profits + fixed costs.

40. The Market Supply Curve • The market supply curve is the sum of the quantities supplied by each seller at each market price. • Market supply, thus reflects the marginal costs of each of the producers in the market. • This is Short Run Market Supply (SRS)

41. Supply Curve for a New York Apple Farm • The data used to construct Jonathan’s supply curve were representative of the typical New York State apple farm. • The supply curve for a single apple farm is shown to the right. • It is the same as the supply curve we have been using, based on the marginal cost curve of a single farm.

42. Market Supply Curve: Horizontal Summation Farm A’s Supply of Apples Farm B’s Supply of Apples 1,600 1,600 1,400 1,400 1,200 1,200 1,000 1,000 Price ($/ton) Price ($/ton) 800 800 600 600 • At a price of $1000/ton, add Farm A’s supply to Farm B’s supply to get market supply (about 560 tons/year). Add over all farms. • The market supply curve is the horizontal summation of the firms’ supply curves. 400 400 200 200 0 0 0 100 200 300 400 0 100 200 300 400 Apples (tons/year) Apples (tons/year)

43. Short Run Equilibrium - Summary • The firm is profit maximizing - no desire at current market price to change the quantity supplied. • Firm is on its short run supply curve • Market Demand = Short run Market Supply • No tendency for market price to change • Note: number of firms fixed, technology given and firm’s capital fixed. • Get: (P*, X*, x*) • Firms can have +/0/- profit.

44. Profit Signal • When profit in the short run is positive there are firms at the margin that want to enter the market and it is assumed that they can. • When profit in the short run is negative there are firms at the margin that want to exit the market and it is assumed that they will.

45. Long Run Equilibrium • All the short run equilibrium properties. • But also…no firms wish to exit the market nor do firms want to enter. • Get: (P*, X*, x*, N*) • Note: For there to be neither entry or exit, need economic profit to be zero. This is a long run equilibrium requirement. Otherwise the number of firms in the market will still be in flux.

46. Long Run Equilibrium Position • Profit max implies that mr=lrmc at x*. • Zero profit implies P=lratc at x*. • Since the firm is perfectly competitive, P=mr at all values of x. • By substitution, P=lratc at x* and P=lratc at x*. • Therefore lrmc=lratc at x*. • This implies that x* is at the minimum of the typical firm’s lratc. x* is at MES. • P* must be the price consistent with the minimum value on the lratc curve. • N* and X* determined by position of market demand.

47. Long Run Equilibrium Picture SRS w/N* lratc A a P* P* mr D X* X x* x market typical firm

48. Steps to Draw The Picture? • Doesn’t matter how you draw it, as long as you draw it correctly in the end. • Draw-a-person test.

49. What’s not ok...

50. Increases in Demand • When demand increases and is expected to remain at the increased level, the short run response is to move along the short run supply curve--higher price and greater quantity supplied. • The long run response is to have entry in the market, movement along the long run supply curve--price returns to the minimum average total cost and quantity supplied increases.