Principles of Microeconomics

Principles of Microeconomics

Principles of Microeconomics

3. Producer Theroy

Working with the firm's cost function enables us to learn how much of each input the firm should optimally use to produce a given level of output. However, the firm still has to decide how much output it should produce. This decision depends on the type of market the firm is operating in. We begin by analyzing the most common type of market: perfect competition.

In this lecture, we continue to learn about competition, and its implications for the supply curve for different goods. We can use this to construct the market supply curve from firms' supply curves. Now we have all the ingredients for fully understanding the basic supply and demand diagrams that launched our study of economics.


Perfect competition

A perfectly competitive market is a hypothetical market where competition is at its greatest possible level.  Neo-classical economists argued that perfect competition would produce the best possible outcomes for consumers, and society.

Key characteristics

Perfectly competitive markets exhibit the following characteristics:

There is perfect knowledge, with no information failure or time lags in the flow of information.  Knowledge is freely available to all participants, which means that risk-taking is minimal and the role of the entrepreneur is limited.

Given that producers and consumers have perfect knowledge, it is assumed that they make rational decisions to maximise their self interest - consumers look to maximise their utility, and producers look to maximise their profits.

There are no barriers to entry into or exit out of the market.

Firms produce homogeneous, identical, units of output that are not branded.

Each unit of input, such as units of labour, are also homogeneous.

No single firm can influence the market price, or market conditions. The single firm is said to be a price taker, taking its price from the whole industry. The single firm will not increase its price independently given that it will not sell any goods at all. Neither will the rational producer lower price below the market price given that it can sell all it produces at the market price.

There are very many firms in the market - too many to measure. This is a result of having no barriers to entry.

There is no need for government regulation, except to make markets more competitive.

There are assumed to be no externalities, that is no external costs or benefits to third parties not involved in the transaction.

Firms can only make normal profits in the long run, although they can make abnormal (supernormal) profits in the short run.

The firm as price taker

The single firm takes its price from the industry, and is, consequently, referred to as a price taker. The industry is composed of all firms in the industry and the market price is where market demand is equal to market supply. Each single firm must charge this price and cannot diverge from it.

Perfect competition

Equilibrium in perfect competition

In the short run

Under perfect competition, firms can make supernormal profits or losses.

Perfect competition in the short run

In the long run

However, in the long run firms are attracted into the industry if the incumbent firms are making supernormal profits. This is because there are no barriers to entry and because there is perfect knowledge. The effect of this entry into the industry is to shift the industry supply curve to the right, which drives down price until the point where all super-normal profits are exhausted.  If firms are making losses, they will leave the market as there are no exit barriers, and this will shift the industry supply to the left, which raises price and enables those left in the market to derive normal profits.

Perfect competition in the long run

In the long run

The super-normal profit derived by the firm in the short run acts as an incentive for new firms to enter the market, which increases industry supply and market price falls for all firms until only normal profit is made.


The benefits

It can be argued that perfect competition will yield the following benefits:

Because there is perfect knowledge, there is no information failure and knowledge is shared evenly between all participants.

There are no barriers to entry, so existing firms cannot derive any monopoly power.

Only normal profits made, so producers just cover their opportunity cost.

There is no need to spend money on advertising, because there is perfect knowledge and firms can sell all they can produce. In addition, selling unbranded goods makes it hard to construct an effective advertising campaign.

There is maximum possible:

Consumer surplus

Economic welfare

There is maximum allocative and productive efficiency:

Equilibrium will occur where P = MC, hence allocative efficiency.

In the long run equilibrium will occur at output where MC = ATC, which is productive efficiency.

There is also maximum choice for consumers.

Perfect competition and efficiency

How realistic is the model?

Very few markets or industries in the real world are perfectly competitive. For example, how homogeneous is the output of real firms, given that even the smallest of firms working in manufacturing or services try to differentiate their product.

The assumption that producers and consumers act rationally is questioned by behavioural economists, who have become increasingly influential over the last decade. Numerous experiments have demonstrated that decision making often falls well short of what could be described as perfectly rational. Decision making can be biased and subject to rule of thumb ‘guidance’ when consumers and producers are faced with complex situations.

Although unrealistic, it is still a useful model in two respects. Firstly, many primary and commodity markets, such as coffee and tea, exhibit many of the characteristics of perfect competition, such as the number of individual producers that exist, and their inability to influence market price. Secondly, for other markets in manufacturing and services, the model is a useful yardstick by which economists and regulators can evaluate levels of competition that exist in real markets.


Market Models: Pure Competition, Monopolistic Competition, Oligopoly, and Pure Monopoly

A modern economy has many different types of industries. However, an economic analysis of the different firms or industries within an economy is simplified by first segregating them into different models based on the amount of competition within the industry. There are 4 basic market models: pure competition, monopolistic competition, oligopoly, and pure monopoly. Because the competition among the last 3 categories is limited, these market models are often referred to as imperfect competition.

Market Models: Pure Competition, Monopolistic Competition, Oligopoly, Pure Monopoly.

In a purely competitive market, there are large numbers of firms producing a standardized product. Market prices are determined by consumer demand; no supplier has any influence over the market price, and thus, the suppliers are often referred to as price takers. The primary reason why there are many firms is because there is a low barrier of entry into the business. The best examples of a purely competitive market are agricultural products, such as corn, wheat, and soybeans.

Monopolistic competition is much like pure competition in that there are many suppliers and the barriers to entry are rather low. However, the suppliers try to achieve some price advantages by differentiating their products from other similar products. Most consumer goods, such as health and beauty aids, fall into this category. Suppliers try to differentiate their product as being better so that they can justify higher prices or to have a larger market share than the competition. Monopolistic competition is only possible, however, when the differentiation is significant or if the suppliers are able to convince consumers that they are significant by using advertising or other methods that would convince consumers of a product's superiority. For instance, suppliers of toothpaste may try to convince the public that their product makes teeth whiter or helps to prevent cavities or periodontal disease.

An oligopoly is a market dominated by a few suppliers. A high barrier to entry limits the number of suppliers that can compete in the market, so the oligopolistic firms have considerable influence over the market price of their product. However, they must always consider the actions of the other firms in the market when changing prices, because they are certain to respond in a way to neutralize any changes so that they can maintain their market share. Auto manufacturers are a good example of an oligopoly, because the fixed costs of automobile manufacturing are very high, thus limiting the number of firms that can enter into the market.

A pure monopoly has pricing power within the market. There is only one supplier who has significant market power and determines the price of its product. A pure monopoly faces little competition because of high barriers to entry, such as high initial costs, or because the company has acquired significant market influence through network effects, for instance.

One of the best examples of a pure monopoly is the production of operating systems by Microsoft. Because many computer users have standardized on software products that are compatible with Microsoft's Windows operating system, most of the market is effectively locked in, because the cost of using a different operating system, both in terms of acquiring new software that will be compatible with the new operating system and because the learning curve for new software is steep, people are willing to pay Microsoft's high prices for Windows.

Pure Competition Is Best for the Consumer

From the consumer point of view, pure competition is the best type of market, because it gives consumers the greatest consumer surplus. From an economic standpoint, pure competition is also the easiest model to analyze, so this is the first market model that will be covered in depth.



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