Low Price and Product Competition: A Theoretical Guide
Low Price and Product Competition
Theoretical Support Guide #8
We analyzed the theories of supply and demand separately, establishing the origin and assumptions about demand and supply curves. Now, we use a model under perfect competition to see how it determines product price and quantity within a given market period, both short-term and long-term.
Definition of Perfect Competition
A market is perfectly competitive if:
- A large number of buyers and sellers exist, each too small to affect the product price.
- Production across all firms is homogeneous.
- There is perfect resource mobility.
- Consumers, resource owners, and firms have perfect knowledge of current and future prices and costs.
In perfect competition, the product price is determined solely by the intersection of market demand and supply curves. The firm becomes a “price taker,” selling any quantity at the set market price.
Example 1: In the figure (not included), d represents the demand curve for a representative firm in perfect competition. Note that d is infinitely elastic, a horizontal line at the market equilibrium price of $8 per unit. The firm can sell any quantity at this price.
Determination of Market Price (Within a Given Time)
The market period, or short-term, refers to when product supply is fixed. Production costs don’t affect market price determination, and any product offered can be sold at the prevailing price.
Example 2: In the figure (not included), S is the fixed product supply in the market period. If D is the demand curve, the equilibrium price is $8. If demand shifts to D’, the equilibrium price would be $24.
Short-Term Firm Equilibrium: Total Approach
Total profit equals total revenue (TR) minus total cost (TC). Total profit is maximized when the positive difference between TR and TC is greatest. Equilibrium output maximizes total profit.
Example 3: In Table 1 (not included), quantity multiplied by price gives TR. TR less TC gives total profit, maximized at $1,690 when producing and selling 650 units.
Example 4: The profit-maximizing output can be visualized in a graph (not included) by plotting quantity, TR, TC, and total profit. The TR curve is a straight line because price remains constant at $8. Total profit is maximized at 650 units, where the vertical distance between TR and TC is greatest.
Short-Term Firm Equilibrium: Marginal Approach
The marginal approach uses marginal revenue (MR) and marginal cost (MC). MR is the change in TR per unit change in quantity sold, equal to the slope of the TR curve. In perfect competition, MR equals price (P). The firm maximizes profit when MR (or P) equals MC, and MC is increasing.
Example 5: Table (not included) shows calculations of MR, MC, average cost (AC), and profit per unit. Total profit is maximized at 650 units, where MR = MC and MC is increasing.
Example 6: A graph (not included) illustrates profit maximization. As long as MR exceeds MC, the firm should increase output. Profit is maximized at 650 units, where P = MR = MC and MC is increasing.
Profit or Loss in the Short Term?
If P > AC at optimal output, the firm maximizes profit. If AC > P > AVC, the firm minimizes losses. If P < AVC, the firm minimizes losses by shutting down.
Example 7: A graph and table (not included) illustrate outcomes under different demand curves. The firm maximizes profit, minimizes losses, or shuts down depending on the relationship between price and average costs.
Short-Term Supply Curve
The firm’s short-term supply curve is the upward-sloping portion of its MC curve above the average variable cost (AVC) curve. The industry’s short-term supply curve is the horizontal sum of all firms’ MC curves above their respective AVC curves, assuming constant input prices.
Example 8: Table and graph (not included) show the firm’s and industry’s short-term supply curves.
Long-Term Firm Equilibrium
In the long run, all costs are variable. A firm continues operating only if TR equals or exceeds TC. Long-run equilibrium occurs where P = MR = long-run MC (LMC) and LMC is increasing. If profits exist, new firms enter, driving profits to zero.
Example 9: At a market price of $16, the firm is in long-run equilibrium, producing 700 units and earning a profit.
Example 10: New firms enter, driving the price down to $8, where firms earn zero profit and operate at the minimum point of their long-run average cost (LAC) curve.
Constant-Cost Industry
If input prices remain constant as firms enter, the long-run industry supply curve is horizontal at the minimum LAC. An increase in demand leads to higher prices and profits in the short run, attracting new firms. Entry continues until the price returns to the original level.
Example 11: An increase in demand raises the price to $16. Existing firms earn profits.
Example 12: New firms enter, increasing supply and returning the price to $8. The long-run supply curve is horizontal.
Increasing-Cost Industry
If input prices rise as firms enter, the long-run industry supply curve is upward sloping. Higher output requires higher prices.
Example 13: Similar to Example 11, demand increases and price rises. However, as new firms enter, input prices rise, shifting cost curves upward. The long-run equilibrium price is higher than the original price.
Decreasing-Cost Industry
If input prices fall as firms enter, the long-run industry supply curve is downward sloping. Higher output leads to lower prices.