ECONOMIC ANALYSIS

Module 5. Concepts of market

Lesson 20
PERFECT COMPETITION

20.1 Introduction

What exactly is perfect competition? A perfectly competitive market is one in which no firm is large enough to affect the market price. Perfect competition is an idealized market of atomistic firms who are price-takers. In fact, while they are easily analyzed, such firms are hard to find.

We begin with an analysis of perfectly competitive firms. If you own such a firm, how much should you produce, if the product sells at `13 per kg? In analyzing the supply behaviour of perfectly competitive firms, we make two observations. First, we will assume that our competitive firm maximizes profits. Second, we observe that perfect competition is a world of atomistic firms who are price-takers.

20.2 Perfect Competition

Perfect competition is the world of price-takers. A perfectly competitive firm sells a homogenous product (one identical to the product sold by the others in the industry.) It is so small relative to its market that it cannot affect the market price; it simply takes the price as given.

Why would a firm want to maximize profits? Profits are like the net earnings or take-home pay of a business. They represent the amount a firm can pay in dividends to the owners, reinvest in new plant and equipment, or employ to make financial investments. All these activities increase the value of the firm to its owners.

Profit maximization requires the firm to manage its internal operations efficiently (prevent waste, encourage worker morale, choose efficient production processes, and so forth) and to make sound decisions in the marketplace (buy the correct quantity of inputs at least cost and choose the optimal level of output).

Fig. 20.1 Demand curve is completely elastic for a perfectly competitive firm

Because competitive firms cannot affect the price, the price for each unit sold is the extra revenue that the firm will earn.

Key points :

1. Under perfect competition, there are many small firms, each producing an identical product and each too small to affect the market price.

2. The perfect competitor faces a completely horizontal demand (or dd) curve.

3. The extra revenue gained from each extra unit sold is therefore the market place.

Given its costs, and desire to maximize profits, how does a competitive firm decide on the amount that it will supply? Assume that the market price for oil is `40 per unit. Suppose selling is 3000 units. This yields total revenue of `40 × 3000 = `120,000, with total cost of `130,000, so the firm incurs a loss of `10,000.

Now you analyze your operations and see that if you sell more oil, the revenue from each unit is `40 while the marginal cost is only `21. Additional units bring in more revenue than they cost. So you raise production to 4000 units. At this output, the firm has revenues of `40 × 4000 = `160,000 and costs of `160,000, so profits are zero.

Flush with your success, you decide to boost output some more, to 5000 units. At this output, the firm has revenues of rupees (40 × 5000) 200,000 and costs of rupees 210,000. Now you’re losing rupees 10,000 again. What went wrong?

When you go back to your accounts, you see that at the output level of 5000, the marginal cost is `60, which is more than the market price of `40, so you are losing `20 (equal to price minus MC) on the last unit produced. Now you see the light: The maximum profit output comes at that output where marginal cost equals price.

The reason underlying this proposition is that the competitive firm can always make additional profit as long as the price is greater than the marginal cost of the last unit. Total profit reaches its peak—is maximized—when there is no longer any extra profit to be earned by selling extra output. At the maximum profit point, the last unit produced brings in an amount of revenue exactly equal to that unit’s cost. What is that extra revenue? It is the price per unit. What is that extra cost? It is the marginal cost.

20.3 Rule for a Firm’s Supply Under Perfect Competition

A firm will maximize profits when it produces at that level where marginal cost equal price:

Marginal cost = price or MC = P

Hence, at a market price of `40, the firm will wish to produce and sell 4000 units. We can find that profit-maximizing amount in Figure 5-2 at the intersection of the price line at `40 and the MC curve at point B.

Fig. 20.2 Firm's supply curve

For a profit-maximizing competitive firm, the upward-sloping marginal cost (MC) curve is the firm’s supply curve. For market price at d ¢ d ¢ , the firm will supply output at the intersection point at A. Explain why intersection points at B and C represent equilibria for prices at d and d ¢ ¢ respectively. The shaded gray region represents the loss from producing at A when price is `40.

In general, then, the firm’s marginal cost curve can be used to find its optimal production schedule: the profit-maximizing output will come where the price intersects the marginal cost curve.

We designed this example so that at the profit-maximizing output the firm has zero profits, with total revenues equal to total costs. Point B is the zero-profit point, the production level at which the firm makes zero economic profits; at the zero profit point, price equals average cost, so revenues just cover costs.

What is the firm chooses the wrong output? Suppose the firm chooses output level A in figure 5-2 when the market price is ` 40. It would be losing money because the last units have marginal cost above price. We can calculate the loss of profit if the firm mistakenly produces at A by the shaded gray triangle in Figure 5-2. This depicts the surplus of MC over price for production between B and A.

A profit-maximizing firm will set its output at that level where marginal cost equals price.General rule for firm supply leaves open one possibility—that the price will be so low that the firm will want to shut down. Isn’t it possible that at the P = MC equilibrium,

For example, suppose the firm were faced with a market price of `35, shown by the horizontal d ¢ ¢ d ¢ ¢ line in Figure 5-2. At that price, MC equals price at point C, a point at which the price is actually less than the average cost of production. Would the firm want to keep producing even through it was incurring a loss?

Surprisingly, the correct answer is yes. The firm should minimize its losses, which is the same thing as maximizing profits. The firm will minimize losses where MR = MC. At this level of output, the firm is covering all of its variable costs and a portion of its fixed costs (Figure 5-3).

Fig. 20.3 Industry and firm supply curve of at shutdown point

Producing at point C would result in a loss of only `20,000, whereas shutting down would involve losing `55,000 (which is the fixed cost). The firm should therefore continue to produce.

To understand this point, remember that a firm must still cover its contractual commitments even when it produces nothing. In the short run, the firm must pay fixed costs such as interest to the bank, rentals on the oil rigs, and directors’ salaries. The balances of the firm’s costs are variable costs, such as those for materials, production workers, and fuel, which would have zero cost at zero production. It will be advantageous to continue operations, with P at least as high as MC, as long as revenue covers variable costs.

The critically low market price at which revenues just equal variable costs (or, equivalently, at which losses exactly equal fixed costs) is called the shutdown point. For prices above the shutdown point, the firm will produce along its marginal cost curve because, even through the firm might be losing money, it would lose more money by shutting down. For prices below the shutdown point, the firm will produce nothing at all because by shutting down the firm will lose only its fixed costs. This gives the shutdown rule:

20.4 Shutdown Rule

The shutdown point comes where revenues just cover variable costs or where losses are equal to fixed costs. When the price falls below average variable costs, the firm will maximize profits (minimize its losses) by shutting down.

Figure 5-3 shows the shutdown and zero-profit points for a firm. The zero-profit point comes where price is equal to AC, while the shutdown point comes where price is equal to AVC. Therefore, the firm’s supply curve is the solid rust line in Figure 5-3. It first goes up the vertical axis to the price corresponding to the shutdown point; next jumps to the shutdown point at M ¢ , where P equals the level of AVC and then continues up the MC curve for prices above the shutdown price.

The analysis of shutdown conditions leads to the surprising conclusion that profit-maximizing firms may in the short run continue to operate even though they are losing money. This condition will hold particularly for firms that are heavily indebted and therefore have high fixed costs (the airlines being a good example). For these firms, as long as losses are less than fixed costs, profits are maximized and losses are minimized when they pay the fixed costs and still continue to operate.

Fig. 20.4 Firm's supply curve travels down the mc curve to the shutdown point

The firm’s supply curve corresponds to its MC curve as long as revenues exceed variable costs. Once price falls below P_s, the shutdown point, losses are greater than fixed costs, and the firm shuts down. Hence the solid rust curve is the firm’s supply curve.

Fig. 20.5 Market structure under perfect competition

In perfectly competitive, total industry demand DD is so vast relative to the efficient scale of a single seller that the market allows viable coexistence of numerous perfect competitors.