Perfect Competition and Long Run Production

OVER THE LONG RUN, FIRMS CAN ENTER AND EXIT DIFFERENT PERFECTLY COMPETITIVE INDUSTRIES (This is one of the defining traits of a perfectly competitive market structure. Remember, we assume in perfectly competitive markets that there are no barriers to entry, and that startup costs are relatively inexpensive).

The difference between the long run and the short run in perfect competition is the free entry and exit of different firms. There are three different short run scenarios which can predict the long-run movement of firms into and out of industries.

1: Economic Profits- New firms and capital enter the industry
2: Normal Profits- Firms neither exit nor enter the industry
3: Economic Loss- Firms and capital exit the industry

ENTRY INDUCING PRICE:

1: Firms could be making economic profit at the equilibrium price for S0.
2: This economic profit signals other firms to enter the industry to try and take some of that industry-profit for themselves. This increases the industry supply from S0 to S1
3: Due to supply shifting to the right, the industry equilibrium price decreases.
4: This decrease in price lowers the economic profits of each individual firm, and each individual firm must produce less in order for marginal costs to equal marginal revenue (the price). As industry output rises, individual firm output falls
5: This cycle continues until each firm is only making normal profit. After this point, no new firms will enter the industry, because there is no profit-incentive for them to do so.


Let's go over this again:
FIRST- In the short run, an industry sees economic profits
THEN- In the long run, this will adjust to only normal profits. Why?
-In the long run, economic profits act as a signal for new firms to enter the industry
-As new firms enter the industry, industry supply increases
-As such, the price for each individual firm is pushed down to the short-run-average-cost minimum (the lowest price each firm can charge without making an economic loss)
BUT REMEMBER- The Long Run Average Cost for any quantity of production is even lower than the minimum short run average cost for firms. So:
-Firms can lower their costs even further by changing their amount of capital (ie: office space or factory size)
-Economic profits would thus rise, due to decreased costs over the long run
-These economic profits signal more firms to enter the industry, and the cycle repeats itself

THE MORAL OF THE STORY: Firms will continue to increase output, and change their capital investment until they reach the minimum efficiency scale (the minimum quantity of production where the long run average cost is minimized). THIS IS LONG RUN EQUILIBRIUM IN PERFECT COMPETITION

EQUILIBRIUM:

There are 3 conditions for long run equilibrium in a perfectly competitive market.
1: Price must equal marginal costs for each firm (so each firm must be maximizing profits)
2: Price must be equal to minimum short run average cost. This ensures the each firm is only making normal profits.
3: Price must be equal to the minimum long run average cost. This ensures that firms cannot make further economic profits by increasing scale.

If this condition is met, no firms will enter or exit the industry in the long run (due to stable, normal economic profit), so industry supply will not change (STABILITY = EQUILIBRIUM).

LONG RUN SUPPLY: This is the supply curve when firms are no longer entering or exiting the industry (the supply when individual firms are making zero economic profits)
-This is caused by shifts in the long run average cost as the industry size changes
-DO NOT confuse this with short run supply
-"Decreasing cost industry" refers to an industry in which costs are decreasing over the long run
-"Decreasing costs" just refers an an individual firm facing decreasing costs over the short run

THIS IS HOW WE DERIVE LONG RUN SUPPLY:

-Start off with an autonomous increase in industry demand.
-This increases the price of the good over the short run
-Individual firms will make higher economic profits due to this increased price
-Economic profits signals more firms to enter
-Supply increases in the long run due to more firms entering
-LONG RUN SUPPLY IS A LINE CONNECTING ALL POINTS OF DEMAND-INDUCED SHIFTS IN SHORT RUN SUPPLY (so it only includes supply over the log run at points when there is no net entry or exit into firms)

AN INCREASING COST INDUSTRY: This is where long run supply is rising
-Division of labour, bulk discounts and the spreading of overhead occur in these industries
-Input prices rise as quantity increases
-This causes the cost curves to shift up
-The increases the price at which all firms will make zero economic profits

A CONSTANT COST INDUSTRY: This is where long run supply is constant, and horizontal
-Input prices are constant, and the long run average cost for firms does not rise or fall

A DECREASING COST INDUSTRY: This is where long run supply is falling
-Alienation of labour and middle management mush occur in these industries
-New entrants to the industry make it cost effective for suppliers
-Input prices fall as quantity increases

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LONG RUN MISCONCEPTIONS:

TECHNOLOGICAL CHANGE: We assume the technologies change and improve continuously for all firms. One might assume from this that all firms in perfect competition have the same cost curves. In reality, new firms can enter the industry with lower cost curves due to improved technology (ie: a new wool sweater factory will have more efficient equipment, and therefore lower long run average costs than an existing, older factory)

THERE ARE THREE CHARACTERISTICS FOR INDUSTRIES WITH CONTINUOUS TECHNOLOGICAL IMPROVEMENTS

1: Older firms with higher cost will continue to exist... for a while anyways
-As witnessed, new firms usually enter with improved technologies and lower average costs
-These new firms increase industry supply and push price down to a new average cost minimum
-Preexisting firms are stuck with higher production costs, and must produce at a lower marginal revenue rate (think GM after the more advanced Japanese car manufacturers entered the market)
-This may cause older firms to make an economic loss on production
-The older firms should continue to operate at an economic loss, however, as long as the price remains higher than their average variable costs (so they can cover their daily costs). Although this may not be the most efficient use of capital, this will still generate some accounting profits.

MISCONCEPTION: We should eliminate the use of older, higher cost plants as new technology exists.
THE TRUTH: Many different plants with different cost and different levels of technological advancement can exist in any industry and still continue to produce.

2: Price is eventually determined by the minimum average cost of production for new plants
-New firms with the latest technology have lower average costs than pre-existing firms, and will make comparative economic profits
-As more firms enter the industry due to economic profits, the price is bid down to the minimum average cost for the new firms (so at equilibrium, even the new firms are only making economic profit)

3: Old plants are shut down when they become economically obsolete
-Once price is lower than average variable costs for older firms, the plant should be shut down, because continuing production costs more than the product will sell for
MISCONCEPTION: Plants that can still produce products should not be shut down until they are physically obsolete (until the equipment no longer works)
THE TRUTH: Some plants are perfectly well equipped to continue to production, but it would be illogical for any firm to continue to produce goods with these plants, because the goods they could produce would sell for a price lower than the cost of making them.



DECLINING INDUSTRIES: Industries where the long run equilibrium is disturbed to a trend of decreasing consumer demand (think horseshoes and buggy whip industries, or the decline in demand for glass beverage containers following the rise of plastic)

The Response of Firms: Firms generally try to cut costs by forgoing necessary upgrades and equipment maintenance. This leads to further long run economic losses, which leads to further cost cutting measures (it's a slow and vicious cycle).

Government's role in failing industries:
MISCONCEPTION: The government should subsidize failing industries in order to save people's jobs (voters prefer to be employed than unemployed).
THE TRUTH: By subsidizing failing industries, the government is just delaying the inevitable (the industry will eventually become obsolete, and involved firms will go under). A better approach would be for the government to encourage workers to find new jobs with subsidized retraining and temporary income support.

THAT'S ALL!!!!!! =D

Short Run Decisions in Perfect Competition

REMEMBER:
-Demand in perfect competition is constant for individual firms (it does not change with quantity produced), and demand is equal to price, average revenue, and marginal revenue.
-Supply is equal to the marginal cost curve above the average variable cost curve.

We're going to look at some different scenarios for firms in perfect competition in the short run. For each of these, we try to calculate economic profit. Here's how:

-First, we find out which quantity will allow Marginal Revenues is equal to Marginal Costs
-Next we calculate total revenue, which is the price X the quantity exchanged
-Next we calculate the total cost, which is the average cost for this quantity X the quantity exchanged
-Finally we determine economic profit by subtracting the total costs from the total revenue. The remaining money is economic profit!

SCENARIO ONE: ECONOMIC PROFIT

Here, marginal revenue = marginal costs at a point where the average revenue (price) is greater than the average costs. Because of this, revenue will exceed costs, thus creating positive economic profit in the short run. NOTE: This usually signals firms to enter the industry, which occurs over the long run.

SCENARIO TWO: NORMAL PROFIT

Here, marginal revenue = marginal costs at a point where the average revenue (price) is just equal to average costs. Because of this, revenue will equal costs, thus creating zero economic profit (aka: normal profit). In a normal profit scenario, firms are making the same amount of accounting profits in this industry that they would anywhere else. There is no incentive for firms to enter or leave the industry.

SCENARIO THREE: ECONOMIC LOSS

Here. marginal revenue = marginal costs at a point where the average revenue (price) is lower than average costs. As a result, firms in this scenario will take an economic loss on production (they could still be making accounting profits on their business, but that money would make more profits if invested elsewhere). In the long run, economic losses act as a signal for firms to leave a business. However, firms which are operating at an economic loss should not necessarily exit the industry. As long as they continue to cover daily operating costs, they are 'breaking even' in an accounting sense, and should continue to produce.

SCENARIO FOUR: SHUT DOWN POINT

Here, total revenue is much lower than total costs (negative economic profit). Average revenue JUST equal average variable costs, which means that this firm can JUST cover daily expenses (zero accounting profit). Any point below this, and the firm will be operating at a loss, and should shut down.

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SHORT RUN SUPPLY CURVES:
-a supply curve shows a firm's willingness to produce at any given price.

remember:
-a demand curve is derived using the principles of total utility maximization, so when price increases, quantity demanded decreases
-a supply curve is derived using the principles of profit maximization, so when the price increases, quantity supplied increases.

THE MARGINAL COST ABOVE THE AVERAGE VARIABLE COST CURVE IS THE SHORT RUN SUPPLY CURVE FOR FIRMS IN PERFECT COMPETITION! As the price increases, marginal costs will = marginal revenue at a greater quantity of production.


INDUSTRY SUPPLY IN THE SHORT RUN FOR PERFECT COMPETITION
Industry supply for the short run is just the horizontal sum of each individual firm's supply curves (aka their marginal cost curve above average variable cost)
-It is the short run, because the cost curves are holding capital constant (so individual firms cannot change their scale of production)

CONDITIONS FOR SHORT RUN INDUSTRY EQUILIBRIUM:
1-The demand and supply must be equal for the industry
2-Each firms must be maximizing profits (minimizing losses)
3-This does not necessarily mean that all of the firms will be making economic profit. If there are too many firms in the industry, in the short run, all of the firms may be making economic losses while operating at maximum profit

THATS ALL FOR NOW

Introduction to Revenue Curves: Perfect Competition

We're done learning about cost curves now! Unfortunately, cost is only one of the factors which determines profit. The other factor which determines profit is REVENUE, so for the next three weeks we're going to learning about different types of markets, and different kinds of revenue curves inherent in each of them.

What is a market structure? A market structure is the 'genetic' features of a market that affect firm behavior including:
-The numbers and sizes of the firms involved in the market (are there a whole bunch of firms, like the BC cafe/coffee market, or is there only one firm, like the BC hydroelectric market)
-The types of goods sold in the market (What does the good do? Is it unique to each firm (like artwork) or the same no matter where you buy it from (like coca cola)
-Freedom of firms to enter and exit the market (Can firms enter the market freely, or are their market barriers like licenses or qualification restrictions)

Different Market Structures disperse MARKET POWER in different ways

Market Power: The ability of a single firm to affect the market price. In other words, firms which have a large share of Market power can jack up prices and get away with it.

RIVALRY is the antidote to too much market power. Rivalry (competitive behavior, or competition) deflates the market power of any one firm, so rivalry is inverse related to market power. This is because rival companies can "steal" a firm's customers if that firm tries to jack up the price, so the market power of that firm is lessened.

THIS WEEK: We are learning about perfect competition!

In perfect competition, there is NO MARKET POWER!
Ironically, in markets which are perfectly competitive, there is no competitive behavior. As we will learn, in order for there to be competitive behavior, there needs to be SOME market power.

Here are ALL of the different market types:

Perfect Competition --> No Market Power
Imperfect Competition-> Some Market Power
Oligopoly-----------> Substantial Market Power
Monopoly-----------> Total Market Power

REMEMBER: The each of these market structures, the COST side of the analysis looks IDENTICAL. Only the revenue side changes. Each week, we will study revenues for each structure.

PERFECT COMPETITION: What assumptions can we make about this market structure?

1: Many Sellers (So one firm does not affect the industry's supply curve. In other words, the industry's supply curve is fairly constant. As such, each seller's minimum efficiency scale is quite small relative to the industry's level of output. An example of this would be gasoline stations in Vancouver, or coffee shops in the lower mainland)

2: Each seller is selling a homogenous (identical) product (this is what allows for 'perfect' competition. If one seller raises the price of an IDENTICAL product, consumers will simply obtain that product for a lower price elsewhere. If two gas stations are selling gas for different prices, you're probably going to buy gas from the cheaper station, because THE GAS IS THE SAME PRODUCT NO MATTER WHERE YOU BUY IT FROM)
NOTE: Identical products are very rare (ie: even coffee is not the same at every coffee shop), so perfect competition is very rare. Even arbitrary consumer preferences can turn an identical product into a non-identical product (eg: prefering Husky gas to Shell gas for ethical reasons).
This also gives markets of perfect competition a Horizontal Demand line (perfect elasticity), since an increase in price will simply cause consumers to cease buying the offered product from that firm.

3: Firms can freely enter and exit the market (there are no barriers to entry [BTEs], and startup costs required to enter the industry are reasonable)

In a market of perfect competition, the larger market is composed of MANY MANY small firms, creating the entire market


THE DEMAND CURVE FOR A FIRM in PERFECT COMPETITION
-In perfect competition, firms are 'price takers' (they simply sell products at the market prices as a result of there being many firms which all sell identical products)
-The firm's demand is horizontal
-One firm more or less does not affect industry supply
SO: because demand is horizontal, a firm can sell all it wants to at the going price. If a firm raises prices, however, it loses all of its buyers. If it lowers it prices, and starts a price war, ALL of the other firms in the industry will eventually lower their prices as well, simply creating less profit for all firms within the industry. For this reason, price wars do not usually last very long in perfect competition (because they are bad for ALL firms within that market).

FOR THIS REASON, there is no competitive behavior in perfectly competitive markets: firms cannot raise prices for fear of either losing customers or profit.


As you can see, the industry sets the price, and each firm simply TAKES that price.

SO: Demanded Price = The Firm's selling price = The Average Revenue = The Marginal Revenue

HOW DOES REVENUE WORK?

Revenue is the amount of money firms receive from the sale of goods. In perfect competition, total revenue is a basic function of units sold

TOTAL REVENUE
TR = Quantity of Products sold X fixed price of sold Products
This is the total income of firms
In perfect competition, this is represented graphically by a straight line out from the origin (so it is a linear function)

AVERAGE REVENUE
AR = The total revenue/The quantity of products sold
In other words, this is the 'per unit' income of firms
This is represented graphically as the slope of the ray from the origin to total revenue (so it remains constant throughout the perfect competition revenue function)

MARGINAL REVENUE
MR = Change in total revenue / Change in quantity of products sold
In other words, this is the additional income the firm makes from the last output.
Graphically, this is the slope of the tangent to the total revenue function (so it remains the same throughout the perfect competition revenue function, and is equal to the average revenue)


Seeeee:

Quantity Price TR AR MR
1 $1 $1 $1 $1
2 $1 $2 $1 $1
3 $1 $3 $1 $1
4 $1 $4 $1 $1

Demand = Price = Average Revenue = Marginal Revenue!

Remember: Demand for the ENTIRE industry is downward-sloping, but demand for the INDIVIDUAL FIRM during the short run in a perfectly competitive market is HORIZONTAL!

SO... in a situation of perfect competition, how do firms maximize profits??
Well... there are two rules to follow:

Rule #1: The firms should be breaking even (in other words, the firm must be making more revenue on a daily basis than their average variable costs on a daily basis, or else the firm will LOSE MONEY) (Total fixed costs on the other hand can be paid off slowly over time, so it is not necessary to cover them on a daily basis).

In short: TR must > or = TVC
OR
P must > or = AVC
"You must cover day-to-day costs"

Rule #2: Firms should produce goods up until the point where marginal revenue = marginal costs. In other words, any extra average revenue above the cost of producing each unit gets added to the the total profits for that firm. If you sell cups of coffee for one dollar, as a firm, you'll be making total profits AS LONG AS YOU CAN SELL COFFEE FOR LESS THAN IT COSTS TO MAKE IT. SO, you sell until revenue = costs, and this MAXIMIZES PROFIT. Selling less than this leaves potential total profits unrealized, while selling more than this incurs unnecessary extra costs.


Profit = Total Revenue - Total Costs
Profit Maximization Occurs when the slope of total revenue (aka: the marginal revenue) equals the slope of the total costs (marginal costs)
SO: Profit is maximized when MR = MC

Another way of looking at this is seeing total profits as a bank account. As long as marginal revenues are greater than marginal costs, the bank account is growing. The instant marginal costs become greater than marginal revenues, the bank account starts to shrink.
That's all for today!