Calculations and graphs in Microeconomic. ( perfectly competitive and monopoly firms )

Chapter (14)

Firms in Competitive Markets

In this chapter, we will discuss the general characteristics of a perfectly competitive

market, and the operations of a perfectly competitive firm.

In any economy, there exists a number of market structures, these are:

1. Perfectly competitive market. 2. Monopoly 3. Oligopoly 4. Monopolistic competitive market.

In the chapter, we will discuss the perfectly competitive market, whereas the following 3

chapters will introduce to us the other market structures.

One major difference between perfectly competitive market and all other markets is that

all these markets (other than the perfectly competitive market) are considered imperfectly

competitive markets.

What do perfectly and imperfectly competitive markets mean?

We will start first by listing the major characteristics of a perfectly competitive market.

Characteristics of a perfectly competitive market:

1. Many small sellers that no producer can affect the market price of the product.

2. Many small consumers that no consumer can affect the market price of the product.

3. Homogeneous or standard product supplied by all producers.

4. Any firm operating in this market is a price taker, where firms in this market produce

and sell at the given market price.

5. Barriers to entry to this market are very low and even nonexistent. Hence firms can

enter and leave the industry freely.

From the above characteristics, we can conclude the following definition of a perfectly

competitive market:

A perfectly competitive market is a market where any firm has no control on

determining the price of its product. In other words, it is the market forces (that is

forces of DD and SS) that determines the price of perfectly competitive firms’ products,

and the firms operating in this market accept these market ‘prices; hence we call perfectly

competitive firms as price-takers that is taking the price of their products from the market

and having no control on setting or determining the price of their products.

When a firm has no control on setting the price of its product, its DD curve is a

completely horizontal curve.

On the other side, imperfectly competitive market is a market where the operating firms

have some degree of control on setting the price of their products. The degree of control

determines the degree of imperfection existing in this market. Sine an imperfectly

competitive firm controls the price of its product, then its DD curve is a downward-

sloping curve.

In economics, we identify 3 major imperfectly competitive markets:

1. Monopoly 2. Oligopoly 3. Monopolistic Competitive Market

Objectives, Important Decisions: and Operations of a Perfectly Competitive Firm

To understand the operations of a perfectly competitive firm, we need to recall some

algebraic theorems to understand the below analysis.

1. When we have a horizontal function, its first derivative should be horizontal and coinciding with it.

In Microeconomics, the MR function is the first derivative of the DD curve function.

Since the DD curve of a perfectly competitive firm is a horizontal curve, then its first

derivative – the MR curve- will also be a horizontal curve coinciding with the DD

curve.

2. Graphically, the price of any product lies on the DD curve of the product. 3. TP = TR – TC If we divide the formula by Q –quantity of production and sales-, then we get:

TP = TR – TC

Q Q Q

AP = AR – AC

AP is the profit that the seller gets as he sells one unit of the product.

AR is the revenue that the seller gets as he sells one unit of the product.

As such AR = P.

AC is the cost of producing one unit of the output.

Hence the formula can be written as such: AP = P -AC

Objective of a perfectly competitive firm:

The objective of any business firm is to maximize profits.

TP = TR – TC

Profits are maximum when MR = MC

MR is the additional or extra revenue earned when the firm sells one extra unit of the

output.

MC is the additional or extra revenue incurred when the firm produces 1 extra unit of the

output.

Important Decisions:

Since a perfectly competitive firm is a price taker which implies that it has no control on

setting, determining or changing the price of its product, then the only important decision

that a perfectly competitive firm that is responsible to make in order to achieve its

objective is: HOW MUCH Q SHOULD THE FIRM IN ORDER TO ACHIEVE

MAXIMUM PROFITS?

That is what is the optimal quantity of production and sales (Q) to achieve maximum

profits?

Operations of a perfectly competitive firm:

In a perfectly competitive market:

1. Any firm is a price taker (that is it takes the price that it sells its product at from the market).

2. Any firm has no control on the price of its product, and that is why its DD curve is drawn as completely horizontal curve.

3. Each firm in this market takes the P of its product from the market and sets on the DD curve so that the firm will operate according to it.

4. The MR function is the first derivative of DD curve, that is why it is a horizontal curve coinciding with the DD curve on the graph.

5. For a perfectly competitive market, P = MR = AR 6. The only decision that a perfectly competitive firm makes is that, how much Q

(level of output or production and sales) should it produce to achieve its

maximum-profit objective.

7. Maximum profits are achieved at the point where MR = MC of the firm. At this point, the firm decides its level of Q at which its profits are maximum.

8. Next, if this firm achieves maximum profits at this P and Q, we need to determine how much is this maximum profits?

9. We know that, AP = P – AC (AP = Average profits = profits per unit). If AP are positive (AP > 0), this means that the firm is achieving positive economic profits

at this P and Q, and generally, we advice it to continue its operations at this P

and Q as it is profiting economically.

Situation ONE:

If P > AC

P > AVC then the firm is achieving positive economic profits, we advice the

firm to continue its operations in the market.

With this level of profits, more new firms will be encouraged to enter the market,

hence SS (Sellers) increase and DD remains constant in the market. This is a case of

market surplus, where price tends to decrease to maintain equilibrium.

Again, each firm operating in this market cannot continue to operate at the old P, it

has to decrease its price as determined by the new condition in the market and operate

accordingly to this new less price to achieve its maximum-profit objective,

Accepting the new less price, the firm has to adjust its Q at the point of maximum

profits of MR = MC.

Situation TWO:

If P < AC

P > AVC Then the firm is not covering all its cost’ components (P<AC), in

fact the firm is covering all its variable costs (P>AVC) and part of its fixed costs but

not all of its fixed costs, that is why its P < AC; as such this firm is achieving

negative economic profits (also called economic loss).

Our advice for this firm, in a perfectly competitive market, the rule for operations is this:

If the firm covers its variable costs but part or none of its fixed costs is not covered; we

advice this firm to continue its operations for the meantime because covering fixed costs

needs a period of time (sometimes years) to be completed, however, what is important is

covering variable costs.

So our advice for this firm, that although it is incurring economic loss (negative

economic profits), we advice it to continue its operations in the meantime as long it is

covering its variable costs of production.

Situation THREE:

P < AC

P = AVC at its minimum point (called the shut-down point).

Then this firm, very similar to situation two, is incurring negative economic profits

where it is not covering all its costs of production. This firm is only just covering its

variable costs (P = AVC at its minimum point) but none of its fixed costs ( P <AC).

We say to this firm, as we said in situation two, that although you are incurring

negative economic profits but as you are covering your variable costs, we advice you

to continue your operations in the market, but BE CAREFUL: you are operating at

the verge of shutting down and exiting from the market. You are operating at the

critical Shutdown point, if price decreases any further, you should shut down and exit

from the market immediately.

Situation FOUR:

P < AC

& P < AVC then this firm is incurring negative economic profits and the firm is

not covering any of its costs of production. We, immediately, advice this firm to shut

down and exit from the market.

Situation FIVE:

Finally this exit and entry of firms continues to happen until a state of long-run

equilibrium is attained where at this point:

P = AC at its minimum point (cost-efficient point or break-even point)

& P>AVC

At this point, the firm is covering all its costs (P = AC at its minimum point) but

economic profits are ZERO – called normal profits- (AP= P – AC = 0).

When firms operate at this point, it is said that the market is maintained in a state of long-

run equilibrium where no more firms will either enter or exit from the market because the

reason of positive profits no longer exists to attract new firms to enter the market. But

what about the existing firms operating in the market? They are in the best position of

producing and selling in the market, and this is what is meant by long-run equilibrium to

operating firms.

To conclude: So in the short-run, it is the forces of competition that tend to push firms into this market

towards zero-profit long-run state.

The firms that are profitable attract new firms to enter the market thereby driving down

prices and reducing profits.

By contrast, those firms which are suffering losses tend to quit or exit from the market.

The long-run equilibrium is one with no pure positive economic profits but only ZERO

Economic Profits or in other words NORMAL PROFITS.