MICROECONOMICS

Chapter 5: competitive markets

Perfectly competitive markets
It is an “ideal market” in which a series of assumptions are met that make it work
efficiently:
1- There are a lot of buyers and sellers (firms are price takers).
2- There are no barriers on entering/exiting the market.
3- The good or service is homogeneous.
4- There is perfect information (all economics agents know how the market works,
the prices that are fixed by the different companies, the cost, etc).

In perfectly competitive markets:

• If the price is set above the equilibrium, there will be a surplus situation.
• If the price below the equilibrium, there will be a shortage situation.
Companies will adjust their cost and production functions to reach the equilibrium again.

Profit maximization.
Firms seek to maximize profits.
The economy is alien to morality (is neither, moral or non-moral), in the study of
microeconomics, we assume that firms always tries to maximize profits, regardless of
other factors.
Definition: profit is the difference between total revenue (the value of the output) and
total cost (the cost of the inputs):

To maximize profit, the firm selects the output for which the
difference between revenue (the slope of the revenue curve)
is equal to marginal cost (the slope of the cost curve). This
holds for all firms, whether competitive or not.

Profit maximization condition.

Is maximized at the point at which
an additional increment to output leaves profit unchanged (0):

Where. Is the marginal revenue MR and is the marginal cost

MC. So, we could say that:
Consequences of having a lot of sellers:
Because there are a lot of sellers in the market, each firm in a competitive industry sellers
only a small fraction of the entire industry output, how much the firm decides to sell will
have no effect on the market price of the product (the firm is a price taker).

Because the demand curve facing a competitive firm is horizontal, the general rule for
profit maximization that applies to any firm can be simplified (marginal and average
revenues are constant and equal).

Average revenue AR and marginal revenue MR:

Profit maximization of a perfectly competitive firm:

A perfectly competitive firm should choose its output so that marginal cost equals price:
MC = MR = AR = P

Choosing output in the short

run:
In the short run, a firm operates
with a fixed amount of capital and
must choose the levels of its
variable inputs (labor and
materials) to maximize profit.
Profit is given by the area of
rectangle ABCD.
 • The MR and MC curves cross at an output of q0 as well as q*. At q0, however,
profit is clearly not maximized. An increase in output beyond q0, increases profit
because marginal cost is well below marginal revenue.
• We can thus state the condition for profit maximization as follows: Marginal
revenue equals marginal cost at a point at which the marginal cost curve is
rising.

Output rule: if a firm is producing any output, it should produce at the level at which
marginal revenue equals marginal cost.
When P > ATC, the firm is having a positive profit.

When P = ATC, the firm´s profit is 0.

When AVC < P < ATC, the firm is having a negative profit (loss). But is covering it´s
variables cost (VC).

• The firm is losing money when P < ATC at the profit – maximizing output q*. In
that case, it should shut down and leave the industry.
• Will shutting down always be the best strategy? Not necessarily. The firm might
operate at a loss in the short run because it expects to become profitable again in
the future, when the price of its product increases or the cost of production falls.

When P < AVC, the firm is having a negative profit. It´s not even covering the variable
cost (VC). The firm should shut down.
The short run supply curve:
The firm´s supply curve is the portion of the marginal cost curve for which marginal cost
is greater than average variable cost. In the short run, the firm chooses its output so that
marginal cost Mc is equal to price as long as the firm covers its average variable cost VC.

Choosing output in the long run:

The long-run output of a profit-maximizing competitive firm is the point at which long-
run marginal cost (LMC) equals the price.
The long-run competitive equilibrium:
In competitive markets economic profit becomes zero in the long run (P = LAC = LMC).
In a market with no barriers on entry and exit, a firm enters when it can earn a positive
long-run profit and exits when it faces the prospect of a long-run loss.

The intervention of the public sector:

The public sector (government) could intervene markets for various reasons and apply:
• Maximum prices.
• Minimum prices.
• Imports control.
• Taxes.
• Subsidies.
All government intervention in markets have consequences for the consumer and/or the
producer.
We can measure the gain or loss to consumers and
producers form a government intervention by measuring
the resulting change in consumer and producer surplus.
• Consumer surplus (CS): measures the total net
benefit to consumers.
• Producers surplus (PS): measures the total net
benefit to producers.
• Deadweight loss: Net loss of total (consumer
plus producer) surplus when there is a change in
the market.
Maximum prices:
The price of a good has been regulated to be no higher than
Pmax, which is below the market-clearing price Po
(equilibrium).
• The gain to consumers (sumatorio CS) is the
difference between rectangle A and triangle B, that
is: A – B
• The loss to producers (sumatorio PS) is the sum of
rectangle A and rectangle C, that is: - (A + C).
• Triangles B and C together measure the deadweight
loss from price control, that is: - (B + C).
• A shortage situation is produced.

Minimum prices:
The price of a good has been regulated to be no lower
than Pmin, which is above the market-clearing price Po
(equilibrium).
• The gain to producers (sumatorio PS) is the
difference between rectangle A and triangle C,
that is: A – C.
• The loss to consumers (sumatorio CS) is the sum
of rectangle A and triangle B, that is: - (A + B).
• Triangles B and C together measure the
deadweight loss from price controls, that is: - (B
+ C).
• A surplus situation is produced.

Imports control:
In a free market, the domestic price equals the world price
Pw. A total Qd is consumed, of which Qs is supplied
domestically and the rest imported. When imports are
eliminated (or limited) by the government, the price is
increased to Po.
• The gain to producers (sumatorio PS) is trapezoid
A.
• The loss to consumers (sumatorio CS) is: - (A + B
+ C).
• The deadweight loss is: - (B + C).
Taxes:
Suppose the government imposes a tax of t cents per unit
sold. Assuming that everyone obeys the law, the
government must then receive t cents for every unit sold.
This means that the price the buyer pays must exceed the
net price the seller receives by t cents.
• Pb is the price (including the tax) paid the buyers.
• Ps is the price that sellers receive, less the tax.
• Buyers/consumers lose (sumatorio CS) – (A + B).
• Sellers/producers lose (sumatorio PS) – (D + C).
• The government earns A + D is revenue.
• Deadweight loss is – (B + C).

Subsidies:
A subsidy can be analyzed in much the same way as a tax
in fact, you can think of a subsidy as a negative tax. With
a subsidy, the sellers ‘price (Ps) exceeds the buyers ‘price
(Pb) and the difference between the two is the amount of
the subsidy.
• The effect of a subsidy on the quantity produced
and consumed is just the opposite of the effect of
a tax (the quantity will increase).
• Like a tax, the benefit of a subsidy is split
between buyers and sellers.