Microeconomics Monday-Perfect Competition and A Single Firm’s Supply

Economics is the study of prices and their effect on markets.  But, it is more than that.  At its core, it’s a study of human behavior.  People behave differently given different incentives.  Over the course of this series, we have seen that one doesn’t even need money to be present for a market to occur.  Markets happen naturally in human interaction because instinctively we know market economies work better for us.

In order to understand the concepts of economics better, it’s important to look at extremes.  Perfect competition is an extreme because all industries evolve toward perfect competition in the long run.  Especially in this day and age of turning virtually all goods and services into a commodity through technological change.

The other types of competition are monopoly, monopolistic competition, and oligopoly.  Those each deserve their own individual blogs.

In perfect competition, there are some assumptions.  First, assume that the market is highly fragmented.  Every participant in the market is a “price taker“.  Think of Farmer Brown.  He has a crop of wheat($ZW_F).  He is forced to sell the wheat at whatever price the market is printing.   Second assumption, products are undifferentiated and every participant has perfect information.  That means there is the “law of one price”.  Third, in the long run there is free entry and exit to the market. Plus, every firm tries to maximize their profit.

Okay?  We model this in three steps.  First, what’s the firm’s decision about production (Q) given a price (P)?  Then look at short run equilibrium and price, and long run equilibrium and price.

When a firm decides how much to produce, they don’t look at gross profits.  They look at marginal revenue.  How much money do they make for producing one more?  The math looks like this: ∆R/∆Q.

The market demand curve looks something like this.

But Farmer Brown’s curve looks like this:

No matter what Farmer Brown does, he is confronted by one price. If he grows less wheat, or more wheat, it doesn’t matter. Same price. He isn’t big enough to influence price by himself.

If the price of a bushel of wheat is $4, and last year Farmer Brown produced 8000 bushels, how much revenue did he generate? (32k) If he sells 10,000 bushels this year, how much revenue does he generate? (40k) Now comes the key question. What is his extra revenue per extra unit sold, or his marginal revenue? 8/2=$4.

What is the marginal revenue for any perfectly competitive firm? It’s the market price of the good.

What is the elasticity of demand for Farmer Brown? It’s flat, or perfectly elastic. This recognizes that Farmer Brown is a price taker.

But what’s key is that there are still constraints on production. There are costs to production. In a perfectly competitive market, firms produce where marginal revenue equal marginal costs. MR=MC. Or, ∆Profit/∆Q=∆TR/∆Q-∆TC/∆Q=MR-MC If MR>MC, profit increases, if MR

Profit is maximized only if Q is set so that MR=MC.

This is important and works for any firm, including monopoly. In perfect competition, MR=P —> so we set Q so MC=P.

What matters for marginal profit? Marginal costs….remember, the variable costs equal the sum of the marginal costs. In general, fixed costs don’t matter-they are sunk. Profit changes incrementally (marginally), as the firm raises or lowers its quantity produced. That has nothing to do with fixed costs.

When you make business decisions, it’s important to figure out which costs are fixed, and which are variable. Ignore the fixed costs in your short term analysis. Fixed costs only matter in the long run for exit or entry into an industry. If max profit

Are fixed costs and sunk costs the same? Not necessarily. It depends. For example, The costs of the research and development team for a product innovation, give management leverage in making decisions. They are regarded as irrecoverable, regardless of the outcome of the research on which decisions to proceed or discontinue the innovation are arrived. The costs are sunk, and shouldn’t enter into your analysis of whether to enter or exit the business.

Fixed costs are necessary to make the business venture succeed while sunk costs are necessary to qualify for the venture. Although a fixed cost may be considered as an irretrievable cost because it has to be incurred regardless of the profit to be realized, it is still not equivalent to sunk costs.

If a project has been evaluated by using fixed costs in the same perspective as the sunk expenses, the analysis and evaluation performed is only an assessment of profitability. But if the project has been evaluated and analyzed by taking into consideration the cost that has to be sunk into a contract or into an extraordinary undertaking, then the decision to enter into that project is partly gauged against risks that said costs can no longer be recovered.

One way to simplify this is to assume all fixed costs are sunk in the short run, and non sunk in the long run. In the short run, the firm must pay all costs even if they produce nothing. In the long run, no costs are sunk since the firm can exit the industry.

The concept of setting MR=MC is a crucial concept in building a toolbox to understand economics. I hope you see why.

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• The Microeconomic Foundations of Macroeconomics
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