Competition Manual
Purpose of the Module
This module is designed to allow the user to practice running a firm in a competitive market. You will have to respond to a fluctuating market price, and try to maximize short run profit for the firm. You can either select different market prices or let the computer randomly select different market prices for your firm. The firm then tries to maximize profits given the chosen market price. In order to do a good job you will have to figure out how the firm’s costs change as its level of production changes, how its revenues change as its production changes, and how profits or losses are affected by cost and revenue changes.
No real world firms operate in competitive markets, but the principles governing successful profit maximization that apply in competitive markets also apply in the kinds of markets that firms do operate in. There are differences in the details of how the principles are applied, but if you master the reasoning required by this module, applying it to other, more realistic, situations should not be too difficult. The most important aspect of that reasoning is marginal analysis. You do not start out by thinking about whether you should do everything or nothing. That question may come up eventually, but the more important questions are “Should I produce the next unit?” and “Should I have produced the previous unit?” As long as you keep getting an affirmative answers to these questions, you will continue to raise profits or lower losses.
Throughout the module, you will be focusing on the desirability of making small changes in the amount of output, and evaluating whether or not those small changes increase the firm’s profits or reduce its losses. This incremental analysis is the “marginal” analysis that will guide the firm towards maximizing total economic profits or minimizing total economic losses.
The Module
This module features a firm in a competitive market. To understand the firm’s problems you need to understand how that kind of market works. First, some definitions of terms that are important in understanding the model are provided. Then an explanation of the competitive market and how it functions, and a discussion of how an individual firm fits into such markets are provided.
Price (P)
At a given moment of time the market price is the dollar amount that will be paid in the market for one unit of the product. Every unit sold will be sold at this price regardless of which firm sold it, or who bought it. In the real world, the firm’s price in a competitive market is determined by the market demand and supply for the product. Each purely competitive firm “takes”, or accepts, the price that is determined by the market, or industry, and then chooses the quantity it will offer for sale so as to maximize total economic profits or minimize total economic losses. Economic profit differs from accounting measures of profit since economic profit is what is left after subtracting all opportunity costs from revenues, while accounting profit only subtracts “explicit costs” which are generally less than opportunity costs.
Shut Down Price (PSD)
The “shut down price” for a purely competitive firm is the price at which it looses exactly the same amount of money as if it shut down completely (losing the value of fixed cost). Any price lower than this is a price at which the firm is better off shutting down than operating (it will lose less shutting down than producing where marginal revenue equals marginal cost). Any price higher than this and the firm is better off operating than shutting down in the short run, even if it is making a loss. The shut down price is at the lowest, or minimum, point on the average variable cost (AVC) curve, or PSD = min AVC.
Break Even Price (PBE)
The “break even price” for the purely competitive firm is the lowest price at which the firm can operate and not lose money. Any price lower than this is a price at which, even if the firm operates in the best possible way, it will still make economic losses. A price higher than this is one at which the firm can make a positive economic profit as long as it makes good decisions. The break-even price is at the lowest, or minimum, point on the average total cost (ATC) curve, or PBE = min ATC. Note that at the break even price the firm may be making “normal profits”, or the payment to the entrepreneur. Economists count “normal profits” as part of the total costs of production since they are compensation to the entrepreneur to cover the opportunity costs of risk, time and effort put into the business.
Average Total Cost (ATC)
The average total cost of the product is the firm’s total cost (all costs regardless of type) divided by the total number of units of the product produced, or ATC = TC/Q. This is often referred to as per unit cost, or cost per unit. Average total cost is comprised of of average fixed and average variable costs, or AFC + AVC = ATC.
Average Fixed Cost (AFC)
The average fixed cost of the product is the firm’s total fixed cost divided by the total number of units of the product produced, or AFC = TFC/Q. This is a per unit cost. Average fixed cost is one of two types of cost that the firm has in the short run. In the short run, the fixed costs represent the firm’s costs that do not vary as the firm changes its output. These costs exist even if the firm shuts down, or produced nothing. Examples of fixed costs are “overhead costs” such as insurance, salaries to top management, licenses, etc. The average fixed cost is the difference between the firm’s average total cost and average variable cost, or AFC = ATC – AVC.
Average Variable Cost (AVC)
The average variable cost of the product is the firm’s total variable cost divided by the total number of units of the product produced, or TVC/Q. This is a per unit cost. Average variable cost is distinguished from average total cost in the short run by the presence of fixed costs, or ATC – AVC = AFC. Examples of variable costs would include materials, energy, labor, etc.
Marginal Cost (MC)
The firm’s marginal cost is the additional cost of producing an additional unit of the same product. In this module, marginal cost falls and then rises as the level of production increases. The reason for this pattern in marginal cost is that the firm experiences increasing returns to production initially (higher additional output per each additional unit of input), but as production continues to grow, diminishing returns to production occur (lower additional output per each additional unit of input).
Diminishing returns occur in the short run due to use of variable resources in combination with at least one fixed factor of production. As output increases, the fixed factor cannot increase to accommodate the addition of variable resources to increase production. As a result, the additional output grows by less and less. Imagine increasing the application of seeds, water and fertilizer (the variable resources) to a fixed plot of land. Initially, the use of additional variable resources will produce greater and greater additions to crop yield. Sooner or later, however, the fixed amount of land will limit those increasing returns and, at some level of output, adding more variable resources will produce smaller and smaller additions to crop yield. The U-shape of the MC reflects such increasing then decreasing returns.
If you have information about total cost at one level of production and total cost at another level of production, you can determine marginal cost. You could subtract one total cost from the other (TC0 – TC1) and divide by the change in amount produced (Q0 – Q1). The result of this calculation is (on average) what marginal cost is like in that range of production. However, in the module MC will be calculated for you.
Profit Margin (or Per Unit Profit)
This is the profit the firm makes on each unit it sells at the current level of production. It is the price of the product, or the firm’s average revenue (AR) minus the firm’s per unit cost, or average total cost (ATC). Thus per unit profit is P – ATC, or AR – ATC.
Total (Economic) Profit
The firm’s total profit is its total revenue (TR) (price per unit multiplied by the total amount produced, or P X Q) minus its total cost (TC). In economics, the total costs include all of the firm’s opportunity costs. The profit that remains after subtracting TC from TR is the total “economic profit”. This “economic profit” is what the firm is earning over and above what it could get using the same resources in some other way.
Equity
A firm’s equity is a measure of the value of the firm to its owners. If a firm makes a profit and does not pay it out as dividend income to the owners, the profit is added to the firm’s equity. If it makes a loss, that amount is subtracted from equity. A firm that has a zero or negative equity is a firm likely to find itself in bankruptcy court.
The Purely Competitive Market
In the pure sense, there are no real world markets that are purely competitive. There can’t be because purely competitive markets require: an infinite number of buyers; an infinite number of sellers; all firms selling an identical product and all buyers know that; free information about the price charged by all sellers; and firms have no costs of entering or exiting the market. Not one of these requirements is completely fulfilled by any actual market. The purely competitive model is useful, however, in spite of the lack of realism in its assumptions because it is relatively easy to use, and its predictions are good enough in most situations in most markets to be useful.
As a result of its assumptions, purely competitive markets can be described in terms of market analysis. On one side of the market, there is the supply of a good, and if technology, expectations, taxes, and resource costs are held constant, a rise in price leads to an increase in the quantity supplied (aka the “Law of Supply”). On the other side of the market, there is the demand, and if consumers’ preferences, incomes, expectations and the prices of other goods are constant, a higher the price will result in a lower quantity demanded (aka the “Law of Demand”).
The equilibrium market price and quantity (PE and QE in Figure 1) are determined by the intersection of the industry’s demand and supply.
Figure 1 Equilibrium in a Purely Competitive Market
Price
PE
0 QE Quantity
If the price rises above PE, there will be a surplus of the good in the market -- a large quantity offered by suppliers compared to a smaller quantity demanded. When the market has a surplus the market price drops, and continues dropping until it reaches PE. If the price is lower than PE, there is a shortage, a larger quantity demanded than supplied. When there is a shortage, price rises until it reaches PE. In this module, the market price is assumed to always be PE. That is, any market disturbances that result in a price above or below PE are adjusted to so quickly that you never see them, the price you see is always the price at which short run supply equals demand.
The equilibrium price determined in the purely competitive market, or industry, is the price that all of the purely competitive firms will sell at. Each purely competitive firm is thus a “price taker” in the sense that the firm does not select its own price, but, rather, “takes” the price from the industry’s market price determination. Figure 2 shows this connection between short run equilibrium in the purely competitive industry and the price that a representative firm will sell its units at.
Figure 2 Equilibrium in a Purely Competitive Industry and Representative Firm
Industry Firm
Price Price
Supply
PE P
Demand
0 QE Quantity 0 Quantity
Long Run Market Equilibrium
The short run equilibrium price for the market, PEin Figure 2, might offer the firms in the market a higher profit than they could make using their resources in any other way. If that happens, more firms put more resources into this market, supply increases (the supply curve in Figure 2shifts to the right -- at every price a larger quantity is supplied). This is also referred to as “entry of firms” and constitutes the form of long run adjustment that results from the presence of short run economic profits. The result of this type of long run adjustment is that is a new equilibrium price will be determined, and it will be lower than the old equilibrium price. This long run adjustment process will continue until the market price falls to the point where profits are no better than the resources could have produced elsewhere. In other words, “economic profits” are zero, and “normal profits” are the profits that the firms’ resources could have produced elsewhere. Thus, all purely competitive firms in the industry in the long run would “breakeven”.
The short run equilibrium price could also have been so low that resources used in this industry brought less profit than they would have offered if used elsewhere. This would mean that there were zero “economic profits”, and less than “normal profits” for the firm. In that case the firms would begin removing resources from this market, supply would shift to the left (“exit of firms”), and price would rise until profits were no worse in this market than they could have been elsewhere. This means that “economic profits” would be zero, and “normal profits” would be what the firms’ resources could have produced elsewhere. Again, all purely competitive firms in the industry in the long run would “breakeven”.
In the case of constant cost industries, the long run equilibrium price is the same regardless of any shifts in demand. Such is the case in this module. There is a competitive force moving any initial price toward the one and only long run equilibrium price.
If unit costs are constant for the firms and industry in the long run, there is a particular relationship between long and short run average costs. The long run average cost curve is a horizontal line (and is equal to long run marginal cost). Every point on the long run average cost line corresponds to the minimum point on a short run average cost curve. In the Figure 3, if a firm has a short run fixed cost of $100, then its unit cost is higher than it could be in the long run if it produces less than Q1 or if it produces more than Q1. This relationship is shown by ATC1 and the long run AC line. It has the same unit cost in both short and long run if it produces exactly Q1. If the firm had a fixed cost of $200 the relationship between long and short run costs is shown by the relationship between long run AC and ATC2. The Average Variable Costs for each short run are also shown in the figure.
Figure 3 Short Run and Long Run Cost for the Purely Competitive Firm
Figure 4 Long Run Equilibrium in A Constant-Cost Industry
Price
PLR = SLR
QLR
In Figure 4, PLR is the long run equilibrium price and QLR is the long run equilibrium industry output. The long run equilibrium is where long run supply (SLR) equals demand, just as short run equilibrium is where short run supply equals demand. In the case of the “constant cost” industry, the long run supply line represents both the long run marginal costs and average costs for the industry. As a result, the long run equilibrium price is equal to the cost per unit of producing the product. Since economic profit per unit produced is the difference between price per unit and average cost, and since price and unit costs are the same, economic profit per unit is zero, and therefore total economic profit for the industry is zero. In the Figure 4, the industry is also in short run equilibrium with short run demand equal to short run supply (SSR).
If you let the computer generate prices for you while running this module the “Set the Market Price Automatically” option), the long run adjustment described above will take place with each short run equilibrium price getting closer to the long run equilibrium than the previous one. To keep the module interesting, the module allows the price to “overshoot” so while the previous price was above the long run equilibrium the next one might be below the long run equilibrium -- but closer to it. Real markets do overshoot and adjust to such overshoots in this manner. You can compare the short run firm results with the long run industry equilibrium by viewing the “Industry Graph” in the module.
The Purely Competitive Firm
An individual firm in this type of market is so small, compared to the total size of the market, that it has no ability to set its price independently. If the firm tries to charge a price higher than the one that is prevailing in the market, customers will not buy from it because everyone knows via free price information that the other firms are charging less. The firm could charge less than the market price, but why would it do that -- it can sell all it is willing to produce at the equilibrium price, PE. In effect, the firm sees its demand as a horizontal line at the value PE. (See Figure 5).