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  1. Overview Overview BA 210 Lesson III.2 Perfect Competition

  2. Lesson overview Chapter 13 Perfect Competition What is Perfect Competition? Finding Profit Maximizing Quantity Exiting an Industry Entering an Industry Long-Run Competitive Equilibrium Summary Review Questions BA 210 Lesson III.2 Perfect Competition

  3. What is Perfect Competition? What is Perfect Competition? BA 210 Lesson III.2 Perfect Competition

  4. What is Perfect Competition? • A price-taking producer is a producer whose actions have no effect on the market price of the good it sells. • Example: Farmer Smith producing apples. • Counter Example: Apple Inc. producing personal computers. • A price-taking consumer is a consumer whose actions have no effect on the market price of the good he buys. • Example: You buying apples, or you buying personal computers. • Counter Example: Microsoft buying the services of computer scientists. • A perfectly competitive market is a market in which all producers and consumers are price-takers. • Example: The apple market. • Counter Example: The personal computer market. • A perfectly competitive industry is an industry in which producers are price-takers. BA 210 Lesson III.2 Perfect Competition

  5. What is Perfect Competition? Two Necessary Conditions for Perfect Competition • For an industry to be perfectly competitive, it must contain many producers, none of whom have a large market share. • A producer’s market share is the fraction of the total industry output accounted for by that producer’s output. • An industry can be perfectly competitive only if consumers regard the products of all producers as equivalent. • A good is a standardized product, also known as a commodity, when consumers regard the products of different producers as the same good. That is, products of different producers are perfect substitutes. BA 210 Lesson III.2 Perfect Competition

  6. What is Perfect Competition? Free Entry and Exit • There is free entry and exit into and from an industry when new producers can easily enter into or leave that industry. • Free entry and exit ensure: • that the number of producers in an industry can adjust to changing market conditions, and, • that producers in an industry cannot artificially keep other firms out. BA 210 Lesson III.2 Perfect Competition

  7. Demand down, so price, quantity, and profit down (according to demand-supply analysis). But, profit down makes some producers quit. As some producers quit, industry supply down. As industry supply down, price and profit start back up. Adjustment continues until producers stop leaving, which means profits have to be back to where they started. Remaining producers thus regain profits in the long run. What is Perfect Competition? Preview of Perfect Competition Implications What effect did cancer have on the cigarette industry? BA 210 Lesson III.2 Perfect Competition

  8. What effect do higher gas prices have on the hybrid-car industry? Demand up, so price, quantity, and profit down (according to demand-supply analysis). But, profit up makes some producers enter the industry. As producers enter, industry supply up. As industry supply up, price and profit start back down. Adjustment continues until producers stop entering, which means profits have to be back to where they started. Producers thus back to original profits in the long run. What is Perfect Competition? BA 210 Lesson III.2 Perfect Competition

  9. What is Perfect Competition? Since few producers are perfectly competitive, why learn about perfect competition? • Many small businesses are almost perfectly competitive. • Gives an extreme environment to compare with monopolies. • Illuminates the danger of competition to producer profits, and the importance of product differentiation to reduce competition and maintain profits. • Chevron with Techron (an additive for cleanliness) • Standard Oil “Put a tiger in your tank” BA 210 Lesson III.2 Perfect Competition

  10. Finding Profit Maximizing Quantity Finding Profit Maximizing Quantity BA 210 Lesson III.2 Perfect Competition

  11. Setting Price to Match the Competition Finding Profit Maximizing Quantity $ $ S Pe Df D QM Qf Market for Apples Farmer Jennifer and Jason’s Tomatoes BA 210 Lesson III.2 Perfect Competition

  12. Production and Profits Finding Profit Maximizing Quantity BA 210 Lesson III.2 Perfect Competition

  13. Finding Profit Maximizing Quantity Using Marginal Analysis to Choose the Profit-Maximizing Quantity of Output • Marginal revenue is the change in total revenue generated by an additional unit of output. BA 210 Lesson III.2 Perfect Competition

  14. Finding Profit Maximizing Quantity The Optimal Output Rule • The optimal output rule says that profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to its marginal revenue. BA 210 Lesson III.2 Perfect Competition

  15. Short-Run Costs for Jennifer and Jason’s Farm Finding Profit Maximizing Quantity BA 210 Lesson III.2 Perfect Competition

  16. Finding Profit Maximizing Quantity Marginal Analysis Leads to Profit-Maximizing Quantity of Output • The price-taking firm’s optimal output rule says that a price-taking firm’s profit is maximized by producing the quantity of output at which the marginal cost of the last unit produced is equal to the market price. • The marginal revenue curve shows how marginal revenue varies as output varies. BA 210 Lesson III.2 Perfect Competition

  17. Finding Profit Maximizing Quantity The Price-Taking Firm’s Profit-Maximizing Quantity of Output Price, cost of bushel MC Optimal point $24 20 E Market price MR = P 18 16 12 8 6 0 1 2 3 4 5 6 7 Quantity of tomatoes (bushels) Profit-maximizing quantity BA 210 Lesson III.2 Perfect Competition

  18. Setting Quantity General rule, set Q where MC(Q) = MR(Q). Since, MR(Q) = constant market price P, equate MC(Q) = P to set Q. Calculating Profit P = P x Q – C(Q) = (P – C(Q)/Q) x Q = (P – ATC) x Q. Finding Profit Maximizing Quantity BA 210 Lesson III.2 Perfect Competition

  19. Exiting an Industry Exiting an Industry BA 210 Lesson III.2 Perfect Competition

  20. Exiting an Industry MC $ ATC AVC Qf Calculating Profit Profit = (Pe - ATC)  Qf* Pe Pe = Df = MR ATC Qf* BA 210 Lesson III.2 Perfect Competition

  21. Exiting an Industry MC $ AVC Loss Qf Should this Firm Sustain Short Run Losses or Shut Down? Profit = (Pe - ATC)  Qf* < 0 ATC ATC Pe = Df = MR Pe Qf* BA 210 Lesson III.2 Perfect Competition

  22. Exiting an Industry Shutdown Decision Rule • A profit-maximizing firm should continue to operate (sustain short-run losses) if its operating loss is less than its fixed costs (really sunk cost), since fixed cost is the loss if shut down. • Operating loss P = PQ – TC > -FC, or PQ > TC – FC = VC. • P > VC/Q = AVC. • Decision rule (if you expect current conditions to persist): • Continue operating as long as P > AVC. • On graph, P > min AVC. • 9/11 made ATA bankrupt years later. • Bankruptcy throughout a recession (not all at once). • Operate or not (it does not matter) if P = min AVC • Immediate shut down if P < AVC. • On graph, P < min AVC. BA 210 Lesson III.2 Perfect Competition

  23. Exiting an Industry MC $ ATC AVC Qf Firm’s Short-Run Supply CurveProfit maximization MC = P and the shutdown rule imply the firms short-run (FC > 0) supply is MC above Min AVC. P min AVC Qf* BA 210 Lesson III.2 Perfect Competition

  24. Exiting an Industry WorldCom files largest bankruptcy ever Nation's No. 2 long-distance company in Chapter 11 -- largest with $107 billion in assets.July 22, 2002: 10:35 AM EDT By Luisa Beltran, CNN/Money staff writerNEW YORK (CNN/Money) - WorldCom, the nation's No. 2 long-distance phone company, filed for Chapter 11 bankruptcy protection late Sunday, nearly one month after it revealed that it had improperly booked $3.8 billion in expenses. WorldCom, crushed by its $41 billion debt load, made its filing in the Southern District of New York. With $107 billion in assets, WorldCom's bankruptcy is the largest in United States history, dwarfing that of Enron Corp. The Houston-based energy trader listed $63.4 billion in assets when it filed Chapter 11 late last year. WorldCom's non-U.S. units were not included in the filing. Bankruptcy had long been expected for WorldCom (P > AVC). BA 210 Lesson III.2 Perfect Competition

  25. Entering an Industry Entering an Industry BA 210 Lesson III.2 Perfect Competition

  26. Entering an Industry S1 S2 SM 25 43 18 20 30 10 Short-Run Market Supply Curve • The number of firms is fixed in the short run (because capital is fixed). • The market or industry supply curve is the horizontal summation of each individual firm’s supply at each price. Market Firm 1 Firm 2 P P P 15 5 Q Q Q BA 210 Lesson III.2 Perfect Competition

  27. Entering an Industry Long Run Adjustments if profits are positive • If firms are price takers but if there were barriers to entry, profits will persist. • If the industry is perfectly competitive, not only are firms price takers but there is free entry into the industry. • Firms producing clones enter the market if profits are positive. • For example, the profitability of the iPhone in 2007 prompted clones to enter the market, including the Samsung Instinct, Sony Xperia, Deeda Pi, LG Voyager, LG Vu, …. • There is now a difference between a short-run equilibrium and a long-run equilibrium. BA 210 Lesson III.2 Perfect Competition

  28. Entering an Industry The Short-Run Market Equilibrium Price, cost of bushel Short-run industry supply curve, S $26 22 E MKT Market price 18 D 14 Shut-down price 10 0 200 300 400 500 600 700 Quantity of tomatoes (bushels) BA 210 Lesson III.2 Perfect Competition

  29. The Long-Run Market Equilibrium (a) Market (b) Individual Firm Price, cost of bushel Price, cost of bushel MC S S S 2 1 3 E $18 $18 MKT E A D 16 16 MKT A T C D B 14.40 Z Break-even price C Y 14 14 MKT C D 0 500 750 1,000 0 3 4 4.5 5 6 Quantity of tomatoes (bushels) Quantity of tomatoes (bushels) BA 210 Lesson III.2 Perfect Competition

  30. The Effect of an Increase in Demand in the Short Run and the Long Run (b) Short-Run and Long-Run Market Response to Increase in Demand (a) Existing Firm Response to New Entrants (a) Existing Firm Response to Increase in Demand Price, cost Price Price, cost Higher industry output from new entrants drive price and profit back down. An increase in demand raises price and profit. Long-run industry supply curve, LRS S S MC 1 2 MC $18 Y A T C A T C Y Y MKT 14 X Z D Z X 2 MKT MKT D 1 0 0 Q Q Q 0 Quantity Quantity Quantity X Y Z Increase in output from new entrants BA 210 Lesson III.2 Perfect Competition

  31. Comparing the Short-Run and Long-Run Industry Supply Curves Short-run industry supply curve, S Price Long-run industry supply curve, LRS The long-run industry supply curve is always perfectly flat – but the short-run industry supply curve has positive slope. Quantity BA 210 Lesson III.2 Perfect Competition

  32. Long-Run Competitive Equilibrium Long-Run Competitive Equilibrium BA 210 Lesson III.2 Perfect Competition

  33. Long-Run Competitive Equilibrium Features of Long Run Competitive Equilibrium • P = MC • The one and only socially-efficient output. • For example, P = $2 and MC = $1 for candy is socially inefficient. • There is some consumer willing to buy another candy for $2. • There is a firm that can produce and distribute another candy for $1. • Society would be better off is we changed plans and the firm produced and sold the extra candy for $1.50. • The consumer gains $.50 surplus; the producer, $.50 surplus. BA 210 Lesson III.2 Perfect Competition

  34. Long-Run Competitive Equilibrium Features of Long Run Competitive Equilibrium • P = minimum AC • Price depends solely on cost. • Why does a Mercedes cost more to consumers than a Honda? • Any long-run difference in price is from a difference in production cost. BA 210 Lesson III.2 Perfect Competition

  35. Summary Summary BA 210 Lesson III.2 Perfect Competition

  36. Summary Summary of exit (shut down) and entry conditions BA 210 Lesson III.2 Perfect Competition

  37. Review Questions • Review Questions • You should try to answer some of the following questions before the next class. • You will not turn in your answers, but students may request to discuss their answers to begin the next class. • Your upcoming cumulative Final Exam will contain some similar questions, so you should eventually consider every review question before taking your exam. BA 210 Lesson III.2 Perfect Competition

  38. Review Questions Follow the link http://faculty.pepperdine.edu/jburke2/ba210/PowerP3/Set9Answers.pdf for review questions for Lesson III.2 BA 210 Lesson III.2 Perfect Competition

  39. BA 210 Introduction to Microeconomics End of Lesson III.2 BA 210 Lesson III.2 Perfect Competition