Competitive supply ——— Learning outcomes tthe end of this chapter you will be able to: 1 Dstinguish between the short-run and the long-run equilibrium positions of the competitive frm. ¥ Understand the derivation of the supply curve in perfect competition. » Azpreciate why a perfectly competitive environment wil yield an optimum allocation of resources. Having examined the cost structures of the busi- ness, we can now turn to look at how a firm’s price and output policy is determined. In this chapter we consider market behaviour under con- ditions of perfect competition. It should be remembered that the guiding principle of the business is profit maximisation. We can therefore say that the firm will be in equilibrium if it is maximising its profits. . The best profit output and profit in the short run tndet perfect competition the firm is a price- taker i. it has no control over the market price. | qyat.only sell or nor sell at that price (see page | 3). Therefore, in trying to maximise its profits, | aayltt has no pricing decision to make; it can adech008e the output which it thinks most | tiyc8e0us. For example, in a freely competi- WhearatKet @ farmer could choose how much which {© Plant but could not control the price at "shit would be sold when harvested. ptt Profit position for any business in perfect the roi” Ould be where it equated the price of "oduct with its marginal cost (MC). If the cost of producing one more unit (MC) is less than the revenue the producer obtains for selling it, i.e. the price, then profit can be increased by producing and selling that unit. Even when MC is rising, so long as it is less than the price, the firm will go on producing because it is gaining extra profit. It does not matter if the extra profit is only small, it is nevertheless an addition to profit and, if the firm is out to maximise profits, it will wish to receive this. This is illustrated in Figure 21.1, where the most profitable output is OM. If the business produced a sthaller output (OL), then the cost of producing a unit (MC) is less than the rev: enue received from selling it (P). The business could therefore increase its profits by expanding output. The shaded area represents the extra profit available to the producer as output expands. At Price 0 1 MN Q Figure 21.1 Perfect competition in the short =P. al firm produces the output at which MC $a Scanned with CamScanner© section Business economies point E (output OM) there is no more extra profit to be gained. If the firm were to produce a large output (ON), then the cost of producing that unit (MC) would be greater than the revenue from sell- ing it (P) and the producer could increase profits by contracting output back towards OM. Thus the output at which MC = P is an equilibrium posi- tion, i. the one at which the firm will be happy to remain if itis allowed to. Let us look again at our example from Chapter 7 where we considered the apple grower. Suppose that the orchard owner has produced a crop of apples. The grower now has to harvest them and send them to market. Since apples are highly perishable they will continue to be sent to market while the extra cost (MC) incurred in doing so (labour, transport, etc.) is less than the money received for selling them (P). As soon as the cost of getting them to market is greater than the money received for them the grower will cease to do so, even if it means leaving the apples to rot. You will notice in Figure 21.1 that we have not included the AC curve. This is because it is not necessary in the short run to demonstrate how much or how little profit the firm is making to be able to conclude that it is the best profit possible. We have already seen that a firm may produce in the short run, even if it is making a loss, so long as it is covering its variable costs, Therefore we can conclude that so long as price is above AVC a perfectly competitive business will max- imise its profits or (which is the same thing) minimise its losses by producing the output at which MC = P, We shall see in the next chapter that under perfect competition price can be equated with marginal revenue (MR). Thus we could restate the proposi- tion as MC = MR. This then becomes the profit maximisation position for all types of competition. e Common misunderstanding Profits not maximised where MR (or the competiive Price) exceeds MC;a firm could gain more SAbanding its output. Profits fate Output where MC = MR. (In SGePetivon, since P = MR, bo aie = P).At this point all available profit has been MC it wou 22 can be gained, Should MR be less than “ould ay the firm to reduce its level Foutput The long-run equilibrium Although a business might produce at alo the short cun, in the long run all costs muy covered. In order to consider the long-run sus tion we must bring average cost into the pice Before doing this it will be useful if we ly some of the main points established so far, Check that you fully understand them before proceeding any further (a) Under perfect competition there is a freedom of entry and exit to the marker. (b) MC = MR is the profit maximisation output. (c) MC cuts AC at the lowest point of AC. (d) At below normal profit, firms will leave the industry; if profit is above normal new firms will be attracted into the industry. BBince the MC curve cuts the AC curve atthe Towest point on AC it follows that this interse- tion must occur at a level which is higher, lover or equal to price. These three possibilities ar¢ shown on Figure 21.2. In situation (a) the ATC curve dips down below the AR curve and the business is making abnormal profit. Remember that normal profit is included in the costs of firm, Thus any positive gap between ATC 2 AR must be abnormal profit. In the long run th abnormal profit areracts new firms into the ind try and the profit is competed_away. Therefore ( cannot be a long-run positioi Tn situation (b) the ATC is at all points abort AR and therefore there is no output at which business can make a profit. It may remaip business in the short run so long as price (AM) above AVC, but in the long run it will clos down. Therefore (b) cannot be a long-run P° tion either, In situation (c) the ATC is tangential to the a curve, Thus the firm exists making just NO Profit but no abnormal profit. The firm mr therefore continue in this position since itis ™ making enough profit to aeeract other firm © compete that profit away. Hence (c) is the 1on® run equilibrium position of the business operating under conditions of perfect compe! i tion, We may conclude, therefore, char unde! perfect competition the long-run equilibrium for the business is where?) MC=P#ACzAR Scanned with CamScanner® Chapter 21 Compeiive supply M Q © Ounput Jong-run equilibrium of the firm under ere t.2 The’ Perfect competition wedi profits attract new frms to the industry This lowers price and eliminates the abnormal profs. b) The frm i ~angalss andi the long run will leave the industry (¢)The frm is just recovering normal prof Tiss the long-run sgltram where MC = P= AR = AC Te average business is hardly likely to look at se process in this way. Profit maximisation is anved at by practical knowledge of the business snily tial and error. The concepts of marginal on, average revenue, etc., allow us to generalise se principles that are common to all businesses. Although business people may not be familiar sth words like ‘marginal revenue’, they are nev- ‘rheless used to the practice of making small ‘waons in output and price to achieve the best ‘suk. Thus they are using a marginal technique ‘onaximise their profits. Re Tre ttt you are running a business and that ae 's to maximise its profits. Decide tag you would need to be able to do sae he you think such information i Yeu.If you think that some information ‘rat Far dapat; WOUd it till be possible to achieve Drea cue The ig de wil os*Stated the equilibrium of the firm “Sop ula 08 £0 consider the derivation of ~ Te will be recalled that the supply curve shows how supply varies in response to changes in price. No matter how the market price changes, the demand curve always appears to be a horizontal line to the individual firm under perfect competi- tion. Therefore as price goes up or down the firm always tries to equate price with marginal cost in order to maximise its profits. In Figure 21.3 as price increases from OP, to OP, to OP, the firm expands output from OM, to OM, to OM,, This, therefore, shows how the firm varies output in response to changes in price; in other words it is a supply curve. Thus we may conclude that: Under perfect competition the firm's MC curve, above AVC, is its supply curve. Industry supply If we can explain the firm’s supply curve then we explain the industry supply curve since, as we sa ew che beginning of Chapter 8, the industry supply curve is the horizontal summation of indi- vidual firms’ supply curves. A change In supply i ly curve; 21.4 illustrates a shift in the supp! Fear ould be brought about by a change in the com: ait ns of supply. ‘Thus, for example, the lefrwar jtions the supply curve could have been brought shi io esi the ots of production. Scanned with CamScanner