PERFECTLY COMPETITIVE MARKET STRUCTURE AGR 130 Introduction to Agricultural Economics Murray State University Factors of Perfectly Competitive Markets Large number of buyers and sellers Homogenous product Freedom of entry and exit (zero/minimal entry and exit barriers) Perfect Information Perfectly Competitive Markets The key to perfectly competitive markets is that there are a large number of buyers (consumer demand) and a large number of sellers (producer supply), each of who is so small relative to the total market that their individual actions will not affect the market. In perfect competition, both buyers and sellers recognize that the price is something beyond their individual control. Each potential participant in the market can only make a “take-it-or-leave-it” decision at the price dictated by the market Perfectly Competitive Markets In perfect competition, both buyers and sellers recognize that the price is something beyond their individual control. Each potential participant in the market can only make a “take-it-or-leave-it” decision at the price dictated by the market The Perfectly Competitive Firm The basic theory of a perfectly competitive firm assumes that the firm is so small in relation to the market that actions by the firm do not affect the market. This model closely approximated the typical family farm. Conditions of a Perfect Competition The most important characteristic of a perfectly competitive firm is that it is atomistic. Meaning, the perfectly competitive firm is so small relative to the market that any action by the firm will not have a noticeable effect on the market. Example: The typical family farm in the corn-belt is certainly perfectly competitive, for if that farmer decided to halt production or destroy the crop; the impact on the markets for corn would be unnoticeable. Perfect Competition Cont. However, Ocean Spray, the processor of about 80% of the U.S. Cranberry crop, is hardly a perfectly competitive firm. This does not mean that Ocean Spray is not a very competitive company, just that it is a company that does not fit the perfectly competitive model of a firm. Perfect Competition Cont. Another condition of perfect competition is that each firm in the market produces a homogeneous product. That is, each producer’s output cannot be distinguished from that of another producer. Perfect Competition Cont. A third strong assumption about a perfectly competitive firm is that resources (i.e., factors of production such as labor, capital, and land) are free to move in and out of production. That is, if a farmer decides to be a computer technician instead of a farmer, it could be done without any costs involved. Perfect Competition Cont. A fourth assumption of a perfect competition is that all market participants share the same knowledge about the market (buyers and sellers both know what is going on in related markets, and so on). Behavior of a Perfectly Competitive Firm The four characteristics of a perfectly competitive market mean that the perfectly competitive firm is a price taker, not a price maker. A price maker is a market in which the individual producer or consumer is able to establish price. Perfectly Competitive Behavior Cont. Example: A typical farmer is told what the prices are for the inputs he purchases and is told what price he can receive at any given time for his product. The only decision the farmer makes is whether to accept the given price or not. Glory be to the soybean farmer who proudly tells the grain elevator operator that he is going to demand $5.50 per bushel, when the market price is $5.25. Until he accepts the market price, the farmer will never be able to sell his crop. Truly, the farmer is a price taker. Remember: Markets make prices and perfectly competitive firms take prices. Perfectly Competitive Behavior Cont. Example: Ocean Spray The difference between the perfectly competitive firm and Ocean Spray should be clear. Ocean Spray set the price at which it sells frozen concentrated cranberry juice to food wholesalers rather than being dictated by the market. Ocean Spray is at the mercy of the market. If it sets the price too high, consumers will not buy. If consumers do not buy, then wholesalers won’t but it and they will loose the market. Ocean Spray is a price maker rather than a price taker. Accounting Profit vs. Economic Profit In basic economics, it is always assumed that the perfectly competitive firm makes management decisions with the sole objective of maximizing economic profit. For most of us, profit is simply the difference between the receipts of a firm and its expenses. This concept is what most economists call an accounting profit. This is the profit that is typically reported by an accountant. Accounting Profit When reporting accounting profit, the only cost considered are those which payment is actually made. This can be misleading because it may omit some very important costs of production. FARM A Big city lawyer who rents land, hires all machinery services, and hires all labor. FARM B Family Farmer who owns land, own equipment, and uses only own labor. Revenue (400 acres of wheat; 30 bu/acre @ $5/bu $60,000 $60,000 (-) Operating Expenses $30,000 $30,000 (-) Land Rent ($30/acre) $12,000 $.00 (-) Machinery ($20/acre) $8,000 $.00 (-) Hired Labor ($5/acre) $2,000 $.00 (=) Accounting Profit $30,000 $8,000 Accounting Profit In the previous slide the two farms are similar in every respect except that Farm A makes cash payment for some items for which Farm B makes no cash payment. As a result, the accounting profits for Farm B greatly exceed those of Farm A. Notice that the accountant entered zero for labor on Farm B’s account since no cash payment for labor was made. Does this imply that the value of the farmer’s labor is zero? Answer: Of course not! Now we can understand how the accounting profit can be misleading. The labor of Farm B is quite valuable, even if a cash payment for its use is not made. Economic Profit The economist measures value, not payment, in the calculation of Economic Profit. For those productive services for which a cash payment is not made, the economist estimates their value using the concept of opportunity cost. Recall that Opportunity Cost is an estimate of how much payment a resource would receive if that resource were employed in another activity. The economist uses this to estimate the Value in the calculation of the economic profits of a firm. Economic Profit To compute the economic profit of Farm B in the previous slide, it would be necessary to include the opportunity costs of the farmer’s land, labor, and machinery. The opportunity costs of the land would be equal to what the farmer would be paid for the land if he rented it out rather than farming it. The opportunity cost of the farmer’s labor is equal to what the farmer could earn if he were employed in the highest paying alternative employment. Economic Profit The opportunity cost of the farmer’s machinery is what he would have to pay to acquire the same services on a custom hire basis. Custom hire refers to the common practice of one farmer (without machinery) hiring another farmer (with machinery) to perform plowing, planting and harvesting work on a fixed-rate basis. Since each of these three opportunity costs would be roughly equal to the payments made for the factor services by Farm A, the economic profits of the two farms would be similar even though their accounting profits are greatly different. Remember: The economic profit includes the value of all factors of production regardless of whether they are actually paid or not (the term profit will always refer to economic profit).