Over.PC

It is now time to introduce the concept of market structure into our analysis of choice. We should expect the optimal choices of the firm will depend upon the structure of the market and we will now attempt to introduce this into our work. What you will find is that we will be redoing the analysis for each market structure, so do not lose sight of the common core - that the firms are guided by the pursuit of profit. We will also follow the same routine - a few tables followed by a few graphs.

What is unique about the perfect competition model? The uniqueness can be seen in the assumptions that define the market structure. In a perfectly competitive market there are assumed to be a large number of firms selling an identical product in a market where there is perfect information and no barriers to entry.

If you have been to New York City and seen the T-shirt vendors on the streets of the Village and SoHo, you have a sense of what we are talking about in a competitive environment. As you move among the vendors you are struck by the uniformity of the T-shirts and the prices. Nearly all of the vendors have the same T-shirts and they have about the same prices. The fact there are a large number of firms selling the same products means no individual firm has any influence over the price. If one of these vendors decided to raise the price, then consumers, armed with their perfect information about prices, would no longer buy any T-shirts from this vendor.

And what if these vendors were making more income than comparably educated people were making in other businesses or jobs. If this were the case then this would be reflected in the "books" where you would find an economic profit. What you would expect would be a movement of these people into the T-shirt business, as long as there were no barriers to entry. The movement of the new sellers into the market would increase competition and this would tend to drive down prices. In fact, in this perfect world, prices would be driven down to their lowest possible level, a level at which there is no economic profit being made.

Another local example of competition would be the fishing industry. In this industry some high school graduates earn $80,000 plus a year, more than what comparably educated people are getting in other industries. This would show up as economic profits in the fishing industry and we would expect others would move into fishing unless there are some barriers to entry. Left unchecked, the competition would continue until the wages were pushed down to levels comparable to what others with similar skills are making. The economic profit would disappear and there would be no incentive to move resources into this industry. [fishers could believe that above average wages are compensation for the higher level of danger in the industry, but we will talk about that later]. As we will see later, it is precisely this competitive mechanism that has led to the over fishing and the depletion of the fish stocks in local waters.

Now let's attempt to formalize our analysis of perfect competition. In our analysis it will help if you realize you will actually be having two parallel discussions - one about the 'representative' firm and one about the industry which is simply the sum of all of the firms. It is also important to differentiate between the short-run and the long-run. In the short-run the number of sellers is fixed, while in the long-run firms can enter or leave.

As an example, let's return to the tutoring business. We will assume there are a number of tutors all equally productive / effective, and all of the tutors in the industry have the cost structure we saw in our previous unit, and the aggregate of their supply decisions appear in the industry supply curve. The demanders of tutoring services are such that initially the market will produce an equilibrium price at the intersection of the industry supply and demand curves.

Once this price is established in the market, the tutors accept the price and set about the task of determining the level of output that will maximize profit. The decision rule is still the same, choose an output level where MR=MC. It sounds familiar, but there is one significant wrinkle. We now find Marginal Revenue (MR) is a bit different from what we have seen in the past. The difference here is the firm can get ONE price for its output regardless of the level of output. If the firm sells 2 hours of tutoring, the price is no different than if the firm sells 6 hours. In this case the additional revenue from selling an additional unit of output will be equal to the price for all levels of output. In a perfectly competitive world, MR = P.

Below you will find the table containing the cost and revenue figures for Tammy's Tutoring. These are the same numbers as we saw in the last unit, with one small change. As you can see in the table, the price column and the average revenue (AR) column are the same with each entry equaling 1. This table is conveying to the reader the information the price is $1 and it does not change as a result of changes in the level of output. Before you leave this section you should be sure to check out the graphical treatment which is what you would expect to find in traditional textbooks.

Grade	P=MR =AR	TR	TC	AR	AC	MR	MC	Profit
10	1	10	8	1	0.80		0.00	2
22	1	22	13	1	0.59	1	0.42	9
36	1	36	18	1	0.50	1	0.36	18
46	1	46	23	1	0.50	1	0.50	23
54	1	54	28	1	0.52	1	0.63	26
60	1	60	33	1	0.55	1	0.83	27
64	1	64	39	1	0.61	1	1.50	25

For the firm this means we get the unique result that marginal revenue equals the price (MR=P). This is why we have the same numbers in the Price, AR, and MR columns. When you look at the graphical version of the analysis, you will see that the MR curve is horizontal and equal to the price, something you will not see in any other market structure. The firm will choose the output level (Q*) where the MR and P lines intersect.

[Note. If you follow this logic a bit further you realize the procedure that you follow would be the same for all market prices. You would set MC = Price and then find the point on the MC line to determine the profit maximizing output level for the firm. If you then combined all of the points you would have the firm's supply curve. The firm's supply curve would be the MC curve as long as the revenue covered the variable costs of production. This would be true if the price was above the Average Variable Cost. The industry supply curve would simply be the sum of the firm's supply curves.]

What is the profit being earned by the firms? We can demonstrate profit graphically once we recognize that we can calculate total revenues and costs by multiplying the per-unit revenue (P) and per-unit cost (AC) by the level of output (Q). On the graph, P*Q becomes an area, and if the revenue area exceeds the cost area, the firm will be making a profit. In this example the optimal output level will be a grade of 54 and the profit will be $26 ($60-$28). That is the end of the story in the short-run.

The profit maximizing solution reached above is not, however, the end of the story. New entrants will appear, having been attracted by the industry's economic profit. In the case of the tutoring business, more people will realize they can earn more as tutors than as work-study help and move into the tutoring business. As we can see in the market diagram, the result of the entrants will be an outward shift in the supply curve. The outward shift in supply will result in a decline in the market price.

When we shift our attention back to the individual firm, we see the decline in the market price will show up as a lower MR line. The firm is still guided by the same rule (MR=MC), but we will find new firms continue to enter as long as profit is being made. The final market situation appears in the table below. In this simple example, firms continued to enter as long as the price was above $.50, but once the price had been driven to $.50, the maximum profit of the firm had been reduced to 0. At that point we are seeing a long-run equilibrium in the market. At that point we still have MC = MR which tells us that it is the optimal level of output and we have P = AC telling us that the firm is earning zero economic profit. It is these two conditions which define the long-run competitive equilibrium.

Hours	Grade	P=MR=AR	TR	TC	AR	AC	MR	MC	Profit
1	10	0.5	5	8	0.5	0.80		0.00	-3.00
2	22	0.5	11	13	0.5	0.59	0.5	0.42	-2.00
3	36	0.5	18	18	0.5	0.50	0.5	0.36	0.00
4	46	0.5	23	23	0.5	0.50	0.5	0.50	0.00
5	54	0.5	27	28	0.5	0.52	0.5	0.63	-1.00
6	60	0.5	30	33	0.5	0.55	0.5	0.83	-3.00
7	64	0.5	32	39	0.5	0.61	0.5	1.50	-7.00

We can now look at the graphical treatment of optimal output choice for the perfectly competitive firm. We will examine the situation using both the total and marginal approaches.

What is distinctive about the graphical representation of the firm in a perfectly competitive environment is the Total Revenue line. The Total Cost line is the same as we saw earlier, but the Total Revenue line is linear. The straight line is the visual representation of the assumption that price will be unaffected by the level of output. Every time the seller increase output by one unit, revenue increases by the price which does not change.

We can also look at the situation using the average and marginal curves. The distinctive feature here is the horizontal marginal revenue (MR) curve is the same as the average revenue (AR) curve, which is also equal to the price. The optimal choice of the firm is the level of output where MR = MC which occurs at the intersection of the MC and MR lines. This firm, if it were attempting to maximize profit, would operate at an output level of something above 40 points.

At the optimal level of output in the short-run, we find P > AC ($1 > $.5) which means there is a profit being made by the firms in the industry. What happen next in a competitive industry is that new firms move in which increases supply and lowers price. This entry will continue until the price is driven down to the point that economic profit disappears. We can see that in the following diagrams.

The Total Cost line is the same as we saw earlier, but the Total Revenue line remains linear with a lower slope. The straight line is the visual representation of the assumption that price will be unaffected by the level of output. Every time the seller increase output by one unit, revenue increases by the price which does not change. Here, however, the price is lower so the increase in revenue from selling one more unit of output will be lower. Because MR is just the slope of the TR curve and because MR equals the price which is now lower, then the slope has fallen. What we see here is that the only time where costs do not exceed revenues are where the two curves touch each other.

We can also look at the situation using the average and marginal curves. Once again the distinctive feature here is the horizontal marginal revenue (MR) curve that is the same as the average revenue (AR) curve and is also equal to the price. The optimal choice of the firm is the level of output where MR = MC which occurs at the intersection of the MC and MR lines. This firm, if it were attempting to maximize profit, would operate at an output level of something above 40 points.

The difference between the short- and long-run solutions is that in the long-run the MR = P line has been lowered to reflect the impact of additional suppliers on the market price. The intersection of the MR and the MC curves occurs at the minimum point of the AC curve. This gives us the additional equilibrium condition of P = AC so that profit is zero. You see this in the profit diagram below. At each level of output profit is higher in the short-run and in the long-run maximum profit occurs when profit is zero.

Now it is time to look at the behavior of firms in the input market to see what will guide them in their choice of inputs.