Perfect+competition+-+Interpretation+of+the+long-run+supply+curve+(perfect++competition)

//By Danny van der Steeg//
 * Perfect competition - Interpretation of the long-run supply curve**

__**Introduction**__ Markets can be categorized into four basic categories, based on the degree of competition in the markets. The four categories are:

• Perfect competition; • Monopoly; • Monopolistic competition; • Oligopoly.

The market structure “perfect competition” is the most competitive structure out of the above-mentioned structures. The topic of this paper is perfect competition.

__**Definition**__ Perfect competition is a market structure in which price competition is so intense that maximum efficiency in the allocation of resources is obtained (McKenzie and Lee, 2006).

A market can be classified as a market with perfect competition if certain key conditions are met (Baye 2006):

1. There are many buyers and sellers in the market, each of which is “small” relative to the market; 2. Each firm in the market produces a homogeneous (identical) product; 3. Buyers and sellers have perfect information; 4. There are no transaction costs; 5. There is free entry into and exit from the market.

Every key condition has its own implications. The fact that (1) there are many buyers and sellers in the market, each of which is small relative to the market, implies that a single firm has very limited influence on the market. The fact that (2) each firm in the market produces a homogeneous product implies that consumers view the products of all firms as perfect substitutes. The fact that (3) buyers and sellers have perfect information implies that the market is transparent and that consumers know the quality and price of each firm’s product. The fact that (4) there are no transaction costs implies that if a firm charges a higher price than other firms, consumers will purchase products from firms charging a lower price. The fact that (5) there is free entry into and exit from the market implies that firms are free to enter or leave the market if they expect to make economic profits or expect losses.

The conclusion drawn from these five key conditions is that, in a perfectly competitive market, no single firm can influence the price of a product and all firms must charge the same price for a product. This price is determined by the interaction of all buyers and sellers in the market and is also known as the equilibrium price.

Although perfect competition is a hypothetical market structure of “an idealized situation that is seldom, if ever, achieved in real life” (McKenzie and Lee, 2006), it is often used in economics. This theoretical market form is utilized to simplify calculations and increase understanding of market reactions. It is also well suited for graphic analysis.

__**Market demand curve VS firm demand curve**__ In a perfectly competitive market, individual firms do not have any influence on the market price and price is determined by the intersection of market supply and demand curves, other wise known as the equilibrium point. Individual firms are forced to charge the equilibrium price of the market or consumers will purchase the product from the numerous other firms in the market charging a lower price (keep in mind the key conditions of perfect competition). Therefore an individual firm demand curve is equal to the equilibrium price of the market. Below is a graphic representation of this relationship.


 * Graph 1**

As is shown in the graphs above, the difference between the market demand curve (on the left) and the firm's demand curve (on the right) is that the market demand curve slopes downward (D), while the perfectly competitive firm's demand curve is a horizontal line (Df = Pe). The individual firm’s demand curve is a horizontal line equal to the equilibrium price of the entire market. A horizontal demand curve means that the own price elasticity of demand is infinite in absolute value; the demand curve is perfectly elastic. This horizontal line implies that if any individual firm charged a price slightly above market price, it would not sell any products. This makes the individual firm a price taker.

A strategy often used to increase market share is, to offer your firm’s product at a lower price than your competitors. In a perfectly competitive market, firms do not have an incentive to decrease their product price. As is discussed later on in this paper, perfectly competitive firms make zero economic profit. If a firm would decrease their price, they would make negative economic profit. This would mean that it would be more profitable for the firm to utilize their recources elsewhere. This will result in exit from the market. Another reason for firms not to lower their prices, is that "at the going market price the individual firm can sell all it wishes" (McKenzie and Lee, 2006).

__**Short-run VS long-run**__ The difference between short-run and long-run decisions is that in the short run, choices in making input decisions are limited due to certain fixed factors of production. In the long-run there are no fixed factors of production. The short run is defined as “the time frame in which there are fixed factors of production” and the long run is defined as “the time fame over which the manager can adjust all factors of production” (Baye, 2006).

The firm’s short-run supply curve is beyond the scope of this paper and therefore only the long-run supply curve is discussed.

__**Long-run supply curve**__ //Before continuing to discuss the long-run supply curve it useful to review certain economic definitions. See the glossary for the following: accounting profits, economic profits, application of accounting and economic profits, marginal cost, average cost of production and marginal revenue.//

In a perfectly competitive market, no individual firm has influence on the market price; hence long-run (supply) decisions for an individual firm are mainly related to the entry into the market by other firms or exit from the market by firms and the optimal level of output.

//Exit and entry// Entry into the market by other firms in the long-run can be expected if firms earn short-run economic profits. Profits provide incentives for other firms to enter the market and existing firms to expand (McKenzie and Lee, 2006). Exit from the market by firms can be expected if firms incur short-run losses. This means that in the long run a firm is not covering their opportunity costs. In other words, their resources can be more profitable elsewhere. Entry and exit have differential effects on the market supply curve.

Entry increases the amount supplied in the market causing the supply curve to shift to the right. This shift to the right in turn lowers the equilibrium price. Exit decreases the amount supplied in the market causing the supply curve to shift to the left. This shift to the left in run raises the equilibrium price. Whenever there is economic profit to be earned, firms will enter the market. As firms enter the market, supply is increased, which decreases the equilibrium price. As price is decreases, profitability of the firms decreases. If profitability for some firms decrease below the point that opportunity cost is covered, firms will exit the market. As firms exit the market, supply decreases, which in turn increases the equilibrium price (Rosefielde, 2002).

The effects of entry and exit are graphically represented below:


 * Graph 2**

As is shown in graph 2, when additional firms enter the market, the supply increases to S1 and the equilibrium price decreases to P1. When firms exit the market, the supply decreasesto S2 and the equilibruim price increases to P2.

//Optimal level of output// The long-run supply curve is determined by the long-run competitive equilibrium. The process described in exit and entry continues until the market price as at the level where all firms earn zero economic profits and the long-run competitive equilibrium is reached.

The optimal level of output is the point where price equals the minimum of average costs of production and where price equals marginal cost. As mentioned before, this point is known as the long-run competitive equilibrium. At this point, each firm’s profits are exactly enough to cover the average costs of production and economic profits are zero.

The two conditions long-run competitive equilibrium has to fulfill are:

• P = MC • P = minimum AC

Below is a graphic representation of this relationship.

As is shown in graph 3, the long-run competitive equilibrium (Pe) is where price equals the minimum average costs (AC) and where price equals marginal cost (MC).
 * Graph 3**

__**Real world-application**__ As mentioned before, perfect competition is a hypothetical market structure that is seldom, if ever, achieved in real life. The markets for agriculture and computer chips are often used as examples of real-world markets that come close to perfect competition.

Below, the most commonly used example of perfect competition, agriculture, will be used to apply the concept of perfect competition. Let's narrow it down and focus on the product "apples".Keep in mind that perfect competition is more of a conceptual topic, which does not suit well for numerical examples. First of all, lets check if the market for apples fulfills the five conditions of a perfectly competitive market. As a reminder, these are the five key conditions:

1. There are many buyers and sellers in the market, each of which is “small” relative to the market; 2. Each firm in the market produces a homogeneous product; 3. Buyers and sellers have perfect information; 4. There are no transaction costs; 5. There is free entry into and exit from the market.

The market for apples does have numerous suppliers and each of them is small relative to the market, which gives the individual farmer no influence on the market price. Farmer A’s apple is (almost) identical to farmer B’s apple and therefore in the eyes of the consumer, apples are (almost) perfectly substitutes. Buyers and sellers have perfect information, because it is relatively simple to determine the quality and price of each apple. There are no transaction costs related to buying farmer A’s apples or farmer B’s apples. Lastly, everyone is free to enter the market of apples to start selling apples and everyone is free to exit the market if they make losses.

As can be concluded from the paragraph above, the market for apples is perfectly competitive.

Let’s continue with determining the price for farmer B, who sells apples. If the market demand and supply curves intersect at, for example, a price of 1 US dollar, then this would result in the equilibrium price of 1 US dollar. Farmer A, along with all the other farmers, sells his apples for 1 US dollar. Farmer B decides to charge 1.50 US dollar per apple. Farmer B will sell no apples, because in a perfectly competitive market farmer B is not a price setter and therefore has no influence on the market price. Consumers also have perfect information, which means they know that there are nearly identical cheaper than 1.50 US dollar apples out there, which they can purchase at no extra costs.

See the graph below for a graphical representation of the above described situation. As becomes clear, farmer B's price is above the equilibrium price and will therefore not sell any apples. This situation makes clear that every firm in a perfectly competitive market has to charge the market equilibrium price.


 * Graph 4**

Now let’s see what happens if several farmer decide to exit the market (remember there is free entry into en exit from the market). Imagine that farmers K to Q decide to leave the market. One reason could be that they are making negative economic profit, which means that they can utilize more profitably their resources elsewhere. The exit from the market by these farmers reduces the amount of apples supplied in the market. As experienced economists we instinctively know that a reduction in the amount supplied results in an increase in the equilibrium price (the market supply curve and the market demand curve intersect at a higher price, see graph 2 for a graphical representation). The higher equilibrium price means that the remaining firms make more economic profit. The possibility of making economic profit attracts new capitalist farmers who start growing apples and selling them on the market. This entry into the market increases the supply of applies on the market, which decreases the equilibrium price (the market demand curve and the market supply curve intersect at a lower price, see graph 2 for a graphical representation of this). This process of entry and exit will continue until farmers make zero economic profit. The reason for this is that at zero economic profit, farmers cover their average costs. If they did not cover their average costs their resources could be utilized elsewhere more profitable.

Now let's continue to determine the optimal level of output. For simplicity reasons, the marginal costs and average costs of farmer B are provided and graphed into graph 5.

As discussed earlier, the two conditions long-run competitive equilibrium has to fulfill are:

• P = MC • P = minimum AC

At the point indicated by a red dot, the price is equal to the marginal cost and the average costs is at its minimum. The optimal level of output would be 3.5 thousand apples.


 * Graph 5**

__**Glossary**__

//Accounting profits// Accounting profits is the total amount of money taken in from sales (total revenue, or price times quantity sold) minus the dollar cost of producing goods or services (Baye, 2006).

//Economic profits// Economic profits are the difference between the total revenue and the total opportunity cost of producing the firm’s goods or services. The opportunity cost of using a resource includes both the explicit (accounting) cost of the resource and the implicit cost of giving up the next-best alternative use of the resource (Baye, 2006).

//Application of accounting and economic profits// Often accounting profits and economic profits are unclear; therefore it wise to provide an example to clarify the difference.

Suppose you are working as a manager at a local factory for 10 years earning 45,000 dollars a year. You feel as if you have not reached your maximum potential yet and you decide to pursue a full time Master of Business Administration at a certain Mid-West university. In order to pursue this degree you have to give up your current job and to cover (some) of your expenses, you decide to accept a graduate assistantship position, which exempts you from paying tuition and other fees ($25,000). You will be earning 1,000 dollars a month ($12,000 a year) in this position. You’re monthly expenses are 900 dollars a month (food, books, mortgage, car payments, etc.) ($10,800 a year).

Your accounting profits are: $12,000 - $10,800 = $1200 a year. Your economic profits are: $12,000 - $10,800 - $45,000 + $25,000 = -$18,800.

//Marginal cost// The change in total benefits arising from a change in the managerial control variable, Q.

//Average cost of production// Average cost of production is your fixed costs plus your variable costs divided by the number of units of output.

//Marginal revenue// Marginal revenue is the added revenue an additional unit of output will bring to a firm.

//Perfectly elastic demand// Demand is perfectly elastic if the own price elasticity is infinite in absolute value.

//Perfect substitutes// Perfect substitutes exist for goods produced by an individual firm engaged in perfect competition. The product produced by other firms is a perfect substitute for the product produced by a single firm.

//Short run// The time frame in which there are fixed factors of production.

//Long run// The time fame over which the manager can adjust all factors of production.

__**Questions**__

In order for firms in a perfectly competitive market to earn zero economic profits: I. P = minimum AC II. P = maximum TC III. P = MC
 * //Question 1//**

a) I b) I, II c) II, III d) I, III

//Answer//
 * A** → at P equals MC and P equals minimum AC economic profits are zero. At this point profits are just enough to cover the average costs of production.

When in a perfectly competitive market short-run economic profits are to be made, additional firms enter the market. What are the consequences for the supply curve and equilibrium price?
 * //Question 2//**

a) Supply curve shifts to the right and equilibrium price decreases. b) Supply curve shifts to the left and equilibrium price increases. c) Supply curve shifts to the right and equilibrium price remains the same. d) Supply curve shifts to the left and equilibrium price decreases.

//Answer//
 * A** → supply curve shifts to the left and equilibrium price decreases. As more firms enter the market, supply increases (supply shifts to the left) putting a downward pressure on the equilibrium price (equilibrium price decreases).

The horizontal demand curve of a single firm in a perfectly competitive market:
 * //Question 3//**

a) is related to the point where MC and the supply curve intersect. b) represents that a single firm will sell any quantity at any price (the line is infinite). c) represent the fact that a firms demand curve is perfectly elastic. d) implies that the firm is a price setter.

//Answer//
 * C** → a horizontal demand curve means that the firms demand curve is perfectly elastic. The firm can only charge this price and not a price slightly higher.

In order for firms not to exit a perfectly competitive market,:
 * //Question 4//**

a) they have to cover their accounting costs. b) they have to cover their average costs. c) they have to cover their total costs. d) they have to cover their overhead.

//Answer//
 * B** → in order for firms not to exit the market, they have to cover their average costs of production.

If firm A increases their price above market price in a perfectly competitive market, the following will occur:
 * //Question 5//**

a) firm A will not sell any products. b) consumers will purchase more products from firm A, because in a perfectly competitive market “normal goods” are involved. c) additional firms will enter the market, because more economic profit is to be made. d) existing firms will increase their price to match firm A, because firm A is a price setter.

//Answer//
 * A** → Firm A will not sell any products. In a perfectly competitive market, every firm is a price taker and must charge the market price or else it will sell no products.

__**References**__

• Baye, Michael R., Managerial Economics and Business Strategy, 2006 • McKenzie, Richard B. and Dwight R. Lee, Microeconomics for MBAs: The Economic Way of Thinking for Managers, 2006 • Bernheim, B. Douglas and Michael D. Whinston, Microeconomics, 2007 • Rosenfielde, Steven, Comparative Economic Systems: Culture, Wealth, And power in the 21st Century, 2002 • Greenfield, Levenson, Hamovitch and Rotwein, Theory for Economic Efficiency, 1979