Week 3: Economic Models – Perfect Competition

  1. Production and Costs

    2. Two sources of costs – Total costs (TC) = Fixed costs (FC) + variable costs (VC); when there is choice over alternating production methods, TC of producing amount Q is minimum $ it would cost to produce Q. Different production methods can have different FC and VC. (FC different from "lumpy" VC)

    Example – designing a web-page; choice over software packages (free vs. priced packages) and programmer quality (holding end-product quantity & quality constant); consider numbers.

    Returns to scale: definition; example (contd.) – CRS = any level of web-page production can be scaled up or down; IRS = easier to produce twice as many pages than to produce two sets of pages, etc.

    Connection with Marginal costs (MC) and average costs (AC). CRS implies constant MC, IRS implies decreasing MC and DRS implies increasing MC.

    A Numerical Example: Q = K0.5 L0.5 where Q = number of pages, K = number of researcher hours (or server space) and L = number of programmer hours. If K given implies short-run, if not long-run. Wage for researcher = 10/hr and programmer = 50/hr

    SR cost function (K=25) = 250+2Q2

    AC = ..

    LR ,, = 100Q/50.5

    AC = MC = 100/50.5

  2. Perfect Competition - Demand

    3. Appropriate market structure when there are many many firms, and hence each firm has little effect on market price. Implies price-taking behavior.

    Examples – bagel stores, web-design, auctioneers on Ebay, computer retailers online, …

    Examples not – ISPs, Browsers, Catalog merchants, bookstores online, …

    Questions – financial brokerages online, travel agencies, …

    Demand curve implication – horizontal

  3. Profit Maximization and Profits

    4. Profits maximized when MC = price; implication for profits – intra-marginal firms can make profits but need DRS or CRS. Note with IRS, loss.

    Price determination through market supply

    Numerical example (SR cost function) – P = 4Q implying Q = ¼ P is supply curve. Hence aggregate supply curve is N/4 P if there are N firms in the market (e.g., 5P if N = 20)

    If demand curve is 1000 – 5P then market equilibrium is at P = 100 (and aggregate quantity is 50).

    Profits = Revenues – Costs = 2500 – 250 – 1250 = 1000

    Note with CRS (and long-run) no firm optimum possible.

     

  4. Profits and Entry

Profits (abnormal) attract entry. Effect on aggregate supply (and possibly individual supply as well), price decrease and lowering of profits. Downward pressure on profits exacerbated if input costs also go up.

Long-run equilibrium; marginal firm makes zero profit. Implication – if firms identical then no firm makes a profit.

Barriers to entry – large lumpy ("fixed") costs, scarce technologies and other resources, patent protection.

Examples – entry barriers in internet market low; Microsoft, versity.com

Numerical example: with a supply function of Q = ¼ P for every firm, for what value of N (i.e., for how many firms) is profit zero? Is this the long-run equilibrium?