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Module 4 Part 6

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Sabir Ali
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Module 4 Part 6

Uploaded by

Sabir Ali
Copyright
© © All Rights Reserved
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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Module 4: Part 6

Perfectly Competitive Markets

Main Points:

 We have just finished looking at the cost side of the profit maximization problem.
We now want to refocus our attention on the demand and revenue side.
 TR = P*Q, and the relationship between price and quantity sold is called our
demand curve. Thus, understanding this relationship (demand), is essential
towards our understanding of revenue.
 The key variable that best summarizes this relationship is elasticity: the slope of
demand in percentage terms: it tells us how sales change (in %) when we change
price by 1%.
 So the essential question becomes “what influences the shape of an individual
firm’s demand curve?”
 A key to this answer is the structure of the market that the firm operates in.
 There are two extreme forms of market structure: at one end is perfect
competition: in this case firms face perfectly elastic demand curve (graphically
they are horizontal). At the other extreme is monopoly where the demand curve
for the firm is, by definition, the market demand curve (which is downward
sloping)
 With a flat demand curve the firm has no ability to influence price – they have to
take it as given. We say that perfectly competitive firms have NO market power.
 Monopolists on the other hand DO have market power: they can reduce output in
order to raise their price.
 A key condition for allocative and productive efficiency is that markets must be
perfectly competitive: if they are not then these socially desirable properties will
not hold.

The Most important technical points are:

 PC firms have a perfectly elastic demand curve


 A flat demand curve implies that P = MR
 Since profit max. is where MR = MC, and for PC we have P = MR
then… FOR PC FIRMS P = MC
 P = MC FOR PC FIRMS (I REPEAT!!!)
 In the short run PC firms are allocatively efficient because P =
MC
 In the long run, because of costless entry and exit, economic
profits for a PC firm are 0, and these firms are productively
efficient (because they produce at the minimum of ATC)
What are the characteristics of a perfectly competitive market?

The term “market structure” refers to the set of specific properties that a market has
which will influence the decisions made by firms in that industry.

Essentially, we are moving from the generic problem of “how does any old firm decide
how much to produce?” to “how does a firm in a market characterized in this specific
way decide how much to produce?”

That is, we are introducing characteristics of the market into the decision making process
of a firm.

Let’s first look at the general set of features we will examine:

 Number and size of firms in the industry


 Information structure of industry
 Degree of substitutability of different producers products
 Ease of entry and exit

So all markets in the real world vary in terms of these properties, here are some
examples:

1. Cereal market:
a. A few large firms dominate the market
b. Pretty close to perfect information for buyers and sellers
c. There is product differentiation: they do NOT produce perfect substitutes
d. Entry and exit are likely to be costly
2. Flyer service for woodlake/brandermill
a. Fairly large number of small firms
b. Perfect information
c. Perfect substitutes
d. Very low entry and exit costs
3. market for doctors
a. large number of small firms
b. consumers have very imperfect information regarding quality
c. doctors are not identical
d. entry costs are fairly high, exit costs also.

In these notes we will examine a very specific type of market: perfectly competitive
markets:

Characteristics of a perfectly competitive market:


1. large numbers of small buyers and sellers
2. perfect information
3. perfect substitutes
4. costless entry and exit

So our question is “how do firms make output decisions under these market conditions?”

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