A.8 Competitive Markets

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Readings
Baye 6th edition or 7th edition, Chapter 8
BA 445 Lesson A.8 Competitive Markets
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Overview
Overview
BA 445 Lesson A.8 Competitive Markets
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Overview
Competitive Price and Quantity starts with price set to the competition, then
quantity set where marginal cost equals price — provided that production is
better than shutting down.
Efficient Quantity is implied when price and willingness to pay equals marginal
cost. — So, after your market purchases, there is no deal between you and an
electronics supplier that can benefit you both.
Competitive Entry and Exit are determined by profits. Positive profit causes
entry, slightly-negative profit causes exit in the long run, and significantly-negative
profit causes exit in the short run.
BA 445 Lesson A.8 Competitive Markets
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Competitive Price and Quantity
Competitive Price and Quantity
BA 445 Lesson A.8 Competitive Markets
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Competitive Price and Quantity
Overview
Competitive Price and Quantity starts with price set to the
competition, then quantity set where marginal cost equals
price — provided that production is better than shutting
down.
BA 445 Lesson A.8 Competitive Markets
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Competitive Price and Quantity
Perfect Competition Environment
• Many buyers and sellers.
• Homogeneous (perfectly substitutable) products across
sellers.
 Example: USB Thumb Drives from SanDisk or
Kingston.
• Perfect product information for both buyers and sellers.
• Free exit from the industry (from selling) at any time.
• Free entry into the industry (begin selling) in the long
run.
 You can change capital in the long run.
 So free entry means you can enter if you have the
capital.
BA 445 Lesson A.8 Competitive Markets
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Competitive Price and Quantity
Preview of Perfect Competition Implications
What effect did cancer have on the cigarette
industry?
• Demand down, so price, quantity, and profit
down (according to demand-supply analysis).
• But, profit down makes some producers exit.
• As some producers exit, industry supply down.
• As industry supply down, price and profit start
back up.
• Adjustment continues until producers stop
exiting, which means profits back to where
they started.

Remaining producers thus regain profits in the long
run.
BA 445 Lesson A.8 Competitive Markets
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Competitive Price and Quantity
Preview of Perfect Competition Implications
General implications:
• Firms are price takers.
 They each set price P = competitor’s price
 Marginal revenue MR = P (since R = P x Q, with P
constant)
• In the short-run, firms may earn profits or losses
(negative profits).
• Entry (if short-run profits are positive) and exit (if
negative) forces long-run profits to zero.
BA 445 Lesson A.8 Competitive Markets
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Competitive Price and Quantity
Since few producers are perfectly competitive, why
analyze perfect competition?
• Many small businesses are almost perfectly
competitive.
 We could analyze them as monopolistic
competitors, but the predictions would be
almost like perfect competitors.
• Gives an extreme contrast to monopoly.
• Illuminates the danger of competition to managers,
and the importance of product differentiation to
reduce competition.
 Chevron with Techron (an additive for
cleanliness)
 Standard Oil “Put a tiger in your tank”
BA 445 Lesson A.8 Competitive Markets
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Competitive Price and Quantity
Setting Price to Match the Competition
$
$
S
Pe
Df
D
Demand and
Supply for USB
Thumb Drives
QM
Demand for SanDisk
Thumb Drives
(perfectly elastic)
BA 445 Lesson A.8 Competitive Markets
Qf
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Competitive Price and Quantity
Setting Quantity
• General rule, set Q where MC(Q) = MR(Q).
• Since, MR(Q) = constant competitive-equilibrium price
Pe, equate MC(Q) = Pe to set Q.
Calculating Profit
• P = Pe x Q – C(Q) = (Pe – C(Q)/Q) x Q = (Pe – ATC) x Q
BA 445 Lesson A.8 Competitive Markets
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Competitive Price and Quantity
Setting Quantity and Calculating Profit
Profit = (Pe - ATC)  Q > 0
MC
$
ATC
AVC
Pe = MC(Q)
Pe
ATC
Q
BA 445 Lesson A.8 Competitive Markets
Qf
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Competitive Price and Quantity
Setting Quantity and Calculating Profit
Profit = (Pe - ATC)  Q < 0
MC
$
ATC
AVC
ATC
Pe
Pe = MC(Q)
Q
BA 445 Lesson A.8 Competitive Markets
Q
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Competitive Price and Quantity
A Numerical Example
• Given
 Competitor’s Price =$10
2
 C(Q) = 5 + Q
• Optimal Price?
 P = $10
• Optimal Output?
 MR = P = $10 and MC = 2Q
 Set 2Q = 10
 Q = 5 units
• Optimal Profit?
2
 PQ - C(Q) = $(10)(5) - $(5 + 5 ) = $20 > 0
BA 445 Lesson A.8 Competitive Markets
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Efficient Quantity
Efficient Quantity
BA 445 Lesson A.8 Competitive Markets
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Efficient Quantity
Overview
Efficient Quantity is implied when price and willingness to
pay equals marginal cost. — So, after your market
purchases, there is no deal between you and an electronics
supplier that can benefit you both.
BA 445 Lesson A.8 Competitive Markets
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Efficient Quantity
Features of Competitive Equilibrium
• P = MC


That implies output is socially efficient.
Any other output can be changed to make all concerned better
off. For example, suppose P = $2 and MC = $1 for candy.
• P = $2 means there is some consumer willing to buy another
candy for nearly $2.
• MC = $1 means there is a firm that can produce and
distribute another candy for $1.
• All concerned would be better off if the firm produced and
sold another candy for $1.50.
– The consumer gains nearly $.50 surplus; the producer,
$.50 surplus.
– No one else is affected.
BA 445 Lesson A.8 Competitive Markets
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Competitive Entry and Exit
Competitive Entry and Exit
BA 445 Lesson A.8 Competitive Markets
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Competitive Entry and Exit
Overview
Competitive Entry and Exit are determined by profits.
Positive profit causes entry, slightly-negative profit causes
exit in the long run, and significantly-negative profit causes
exit in the short run.
BA 445 Lesson A.8 Competitive Markets
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Competitive Entry and Exit
Shutdown Decision Rule A profit-maximizing firm
should continue to produce in the short run even if profit is
negative as long as its operating loss is less than its sunk
cost, since sunk cost is the loss if shut down.
• Recall the simplifying assumption that FC = sunk cost
• Operating loss P = PQ – TC > -FC, or PQ > TC – FC =
VC.
• P > VC/Q = AVC implies continue to produce in the
Short Run.
• P = VC/Q = AVC implies its does not matter if produce in
the Short Run.
• P < VC/Q = AVC implies immediate shut down in the
Short Run.
BA 445 Lesson A.8 Competitive Markets
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Competitive Entry and Exit
In the Short-Run, should this firm shut down?
P > AVC, so continue producing in the short run.
Slightly-negative profit
MC
$
ATC
AVC
ATC
Pe
Pe = MC(Q)
Q
BA 445 Lesson A.8 Competitive Markets
Q
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Competitive Entry and Exit
In the Short-Run, should this firm shut down?
P < AVC, so immediately shut down in the short run.
Significantly-negative profit
MC
$
ATC
AVC
ATC
Pe
Pe = MC(Q)
Q
BA 445 Lesson A.8 Competitive Markets
Q
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Competitive Entry and Exit
Firm’s Short-Run Supply Curve
Profit maximization MC = P and the shutdown rule imply
the firms short-run (FC > 0) supply is MC above Min AVC.
ATC
MC
$
AVC
P = min AVC
Qf*
BA 445 Lesson A.8 Competitive Markets
Qf
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Competitive Entry and Exit
Short-Run Market Supply Curve
• The number of firms is fixed in the short run (because capital is
fixed).
• The market supply curve is the horizontal summation of each
individual firm’s supply at each price.
P
Firm 1
Market
Firm 2
P
P
S1
S2
SM
15
5
10
18
Q
20
25
Q
BA 445 Lesson A.8 Competitive Markets
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43Q
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Competitive Entry and Exit
Long Run Adjustments if profits are positive
• If the industry is perfectly competitive, not only are firms
price takers but there is free entry into the industry.
 Firms producing perfect substitutes enter the industry
if profits in the industry are positive.
BA 445 Lesson A.8 Competitive Markets
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Competitive Entry and Exit
Effect of Entry on Price
As firms enter, market supply increases and prices
decrease.
$
$
S
Entry S*
Pe
Pe*
Df
Df*
D
QM
Market
Firm
BA 445 Lesson A.8 Competitive Markets
Qf
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Competitive Entry and Exit
Effect of Entry on Firm’s Price, Output, and Profit.
Entry continues until P = PQ – C = 0, meaning P = C/Q =
AC, or P = min AC.
$
MC
AC
Pe
Df
Pe*
Df*
Q L Q f*
BA 445 Lesson A.8 Competitive Markets
Q
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Competitive Entry and Exit
Summary of competitive markets
• Short run profits lead to entry.
• Entry increases market supply, drives down market
price, increases market quantity.
• Lower price means lower quantity supplied by each firm.
• Profit and price adjustment continues until the long run,
where profits are zero.
BA 445 Lesson A.8 Competitive Markets
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Competitive Entry and Exit
Features of Long Run Competitive Equilibrium
P = minimum AC
ATC
MC
$
AVC
P = min AC
Qf*
BA 445 Lesson A.8 Competitive Markets
Qf
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Competitive Entry and Exit
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 445 Lesson A.8 Competitive Markets
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Review Questions
Review Questions
 You should try to answer some of the review
questions (see the online syllabus) 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 Exam 1 and cumulative Final Exam
will contain some similar questions, so you should
eventually consider every review question before taking
your exams.
BA 445 Lesson A.8 Competitive Markets
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BA 445
Managerial Economics
End of Lesson A.8
BA 445 Lesson A.8 Competitive Markets
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