Managerial Economics:: Perfect Competition

MANAGERIAL ECONOMICS:
THEORY, APPLICATIONS, AND CASES

W. Bruce Allen | Keith Weigelt | Neil Doherty | Edwin Mansfield
CHAPTER 6
Perfect Competition
OBJECTIVES
• Explain how managers should respond
to different competitive environments
(or market structures) in terms of
pricing and output decisions
OBJECTIVES
• Market Power
• A firm's pricing market power depends on its
competitive environment.
• In perfectly competitive markets, firms have no
market power. They are "price takers." They
make decisions based on the market price, which
they are powerless to influence.
• In markets that are not perfectly competitive
(which describes most markets), most firms
have some degree of market power.
OBJECTIVES
• Strategy in the absence of market
power
• Firms cannot influence price and, because
products are not unique, they cannot
influence demand by advertising or
product differentiation.
• Managers in this environment maximize
profit by minimizing cost, through the
efficient use of resources, and by
determining the quantity to produce.
MARKET STRUCTURE
• Perfect competition: When there are
many firms that are small relative to
the entire market and produce similar
products
• Firms are price takers.
• Products are standardized (identical).
• There are no barriers to entry.
• There is no nonprice competition.
MARKET STRUCTURE
• Imperfect competition
• Firms have some degree of market power
and can determine prices strategically.
• Products may not be standardized.
• Firms employ nonprice competition.
• Product differentiation
• Advertising
• Branding
• Public relations
MARKET STRUCTURE
• Monopolistic competition: When there are many
firms and consumers, just as in perfect
competition; however, each firm produces a
product that is slightly different from the
products produced by the other firms.
• There are no barriers to entry.
• Monopoly: Markets with a single seller
• Barriers to entry prevent competitors from entering the
market.
• Oligopoly: Markets with a few sellers
• There are significant barriers to entry.
MARKET STRUCTURE
• Barriers to entry
• Barriers that determine how easily firms
can enter an industry, depending on the
market structure
MARKET PRICE IN PERFECT
COMPETITION
• Market price is determined by the
intersection of the market demand
curve and the market supply curve.
MARKET PRICE IN PERFECT
COMPETITION
• Example
• Demand: P = 22 - 0.5QD
• Supply: P = 4 + 0.25QS
• Equilibrium: P = $10 and Q = 24
thousand units
• If there are 1,000 firms in the market,
each produces twenty-four units. If one
firm alters output, there will be virtually
no effect on market price, so each firm
faces a nearly horizontal demand curve.
SHIFTS IN SUPPLY AND
DEMAND CURVES
• It is important for managers to
understand the factors that cause
supply and demand curves to shift.
• Advances in technology cause supply to
increase.
• Increasing input prices cause supply to
decrease.
THE OUTPUT DECISION OF A
PERFECTLY COMPETITIVE FIRM
• Profit maximization example
• Market price (P) = $10
• Total revenue (TR) = PQ
• Total cost (TC) = 1 + 2Q +Q2
• Profit () = PQ – TC = 10Q – (1 + 2Q + Q2)
• Table 6.2: Cost and Revenues of a Perfectly
Competitive Firm
• Figure 6.2: Relationship between Total Cost and
Total Revenue of a Perfectly Competitive Firm
• Figure 6.3: Relationship of Profit and Output of a
Perfectly Competitive Firm
• Profit is maximized at the quantity of
output (Q) where marginal revenue
equals marginal cost and marginal
cost is increasing
• /Q = TR/Q – TC/Q = 0
• Marginal revenue (MR) = TR/Q = P
• Marginal cost (MC) = TC/Q
• Profit maximization example continued
• MR = 10
• MC = 2 + 2Q
• MR = MC => Q = 4
• Table 6.3: Marginal Revenue and Marginal
Cost: Perfectly Competitive Firm
• Figure 6.4: Marginal Revenue and
Marginal Cost of a Perfectly Competitive
Firm
SETTING THE MANAGERIAL
COST EQUAL TO THE PRICE
• Shutdown point: When the price
equals the minimum average variable
cost
• If price is greater than average variable
cost, produce a level of output in which
marginal cost is equal to price, even if
this results in negative profit. Profit will
exceed that which would result from
shutting down.
SETTING THE MANAGERIAL
COST EQUAL TO THE PRICE
• Shutdown point: When the price equals the
minimum average variable cost (Continued)
• If price is less than average variable cost, shut
down and produce no output. Negative profit will
be equal to total fixed costs.
• Figure 6.5: Short-Run Average and Marginal
Cost Curves
ANOTHER WAY OF VIEWING THE PRICE
EQUALS MARGINAL COST PROFIT-
MAXIMIZING RULE
• If a firm has one fixed input (say capital)
and one variable input (say labor, L), how
much of its variable input should it utilize?
• Marginal revenue product (MRP): The
amount an additional unit of the variable
input adds to the firm's total revenue
• Marginal revenue product of labor = MRPL
• MRPL = TR/L = (TR/Q)(Q/L) = (MR)(MPL)
ANOTHER WAY OF VIEWING THE PRICE
EQUALS MARGINAL COST PROFIT-
MAXIMIZING RULE
• Marginal expenditure on labor (MEL): The
amount an additional unit of labor adds to
the firm's total costs
• MEL = TC/L = (TC/Q)(Q/L) = (MC)(MPL)
• Profit is maximized when the employment of
the variable input is such that marginal
revenue product is equal to marginal
expenditure.
• Equivalent to MR = MC in terms of output.
PRODUCER SURPLUS IN THE
SHORT RUN
• Producer surplus: The difference between
the market price and the price the producer
is willing to receive for a good or service
(the producer's reservation price)
• A firm's reservation price is the marginal cost of
production above the shutdown point.
• Producer surplus is a firm's variable cost profit:
TR – TVC.
• Producer surplus is the difference between the
market price under perfect competition and a
firm's supply curve.
PRODUCER SURPLUS IN THE
SHORT RUN
• Examples
• Figure 6.6: Producer Surplus and Variable-Cost
Profit
• Figure 6.7: Market Social Welfare (A + B) of a
Perfectly Competitive Price Policy, P*
LONG-RUN EQUILIBRIUM OF A
• Conditions
• Quantity produced is such that profit is
equal to zero and price is equal to
• The lowest point on the long-run average
(total) cost curve and the relevant short-run
total cost curve
• Long-run marginal cost and short-run
marginal cost
LONG-RUN EQUILIBRIUM OF A
• Adjustment to equilibrium
• If firms are earning negative profits, then firms
will exit the industry, market supply will
decrease, and price will rise to the long-run
equilibrium level.
• If firms are earning positive profits, then firms
will enter the industry, market supply will
increase, and price will fall to the long-run
equilibrium level.
THE LONG-RUN ADJUSTMENT PROCESS: A
CONSTANT-COST INDUSTRY
• Constant-cost industry: An industry in

which an increase in output does not
lead to an increase in input prices
• Horizontal long-run supply curve
• Figure 6.9: Long-Run Equilibrium in a
Constant-Cost Industry
THE LONG-RUN ADJUSTMENT PROCESS:
AN INCREASING-COST INDUSTRY
• Increasing-cost industry: An industry in

which an increase in output leads to an
increase in input prices
• Upward-sloping long-run supply curve
• Some industries are decreasing-cost
industries.
• Downward-sloping long-run supply curves
• Figure 6.10: Long-Run Equilibrium in an
Increasing-Cost Industry
HOW A PERFECTLY COMPETITIVE
ECONOMY ALLOCATES RESOURCES
• Example: Demand for corn increases
and demand for rice decreases.
• Short-run equilibrium
• The price of corn will increase, the quantity of
corn produced will increase, and corn
producers will earn positive economic profits.
• The price of rice will decrease, the quantity of
rice produced will decrease, and rice
producers will earn negative economic profits.
HOW A PERFECTLY COMPETITIVE
ECONOMY ALLOCATES RESOURCES
• Example (Continued)
• Long-run equilibrium
• Firms will reallocate resources away from the
production of rice and toward the production of corn.
• The price of corn will decrease from its high, the
quantity of corn produced will increase further, and
corn producers will find that their economic profits
decline to zero.
• The price of rice will increase from its low, the quantity
of rice produced will decrease further, and rice
producers will find that their economic profits rise to
zero.
This concludes the
Lecture PowerPoint
presentation for Chapter 6
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© 2009 W. W. Norton & Company, Inc.

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MANAGERIAL ECONOMICS:

THEORY, APPLICATIONS, AND CASES

• Constant-cost industry: An industry in

• Increasing-cost industry: An industry in

Visit the StudySpace at:

© 2009 W. W. Norton & Company, Inc.

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