Managerial Economics

Perfectly competitive markets

Price-taker firms
Supply schedule
Market equilibrium in short and long term

BM - Term 1

Sumit Sarkar, XLRI Jamshedpur

 Perfect Competition
 Very large number of buyers and sellers
 HHI = (1/N)+N σ2 = 0 As N→∞ and σ→0
 Market power of each firm is zero
Lerner Index = [(P – MC)/P] = 0
 Firms are equal in size
 Sellers selling homogenous products
 Firms use same technology and hence their cost
structure is same
 Price is determined by the market forces and the
agents act as price takers
 Free entry and exit
Sumit Sarkar, XLRI
HHI

 σ2 = (1/N) ∑ (si - μ)2

 Nσ2 = ∑ [si – (1/N)]2 = ∑ si2 - (2/N) ∑ si +N(1/N)2

 Nσ2 +(1/N) = ∑ si2 = HHI

 Definitions: Revenue, contribution and profit

Revenue[R] = Quantity Sold [x] . Price [P]

Cost [C] = Var.Cost [c(x)] + Fixed Cost [F]

Contribution [] = Revenue [R] – Var.Cost [c(x)]

= P.x – c(x)

Profit [] = Contribution [] – Fixed Cost [F]

= P.x – c(x) – F

Sumit Sarkar, XLRI

 Revenue and cost function

Rs. C = c(x) + F
R = P.x

Sumit Sarkar, XLRI

 Rs. C = c(x) + F
R = P.x

x
 in Rs.
Break-even
Profit
point
maximized

x* x
Profit
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function
 Profit maximizing condition for a price taker
firm

Profit function:
 = P.x – c(x) – F
First order condition:
P = (MR) = dc(x)/dx = MC
Second order condition:
d2c(x)/dx2 > 0

Profit is maximized when the MC is equal to the

market price and the MC is increasing.

Sumit Sarkar, XLRI

 Why competitive firm’s profit is max at P=MC

P
MC
MR MC

P* a MR0

x0 x* x

Sumit Sarkar, XLRI

 The supply curve of a firm
Supply curve
AC, MC AC
MC
AVC

P1
P2
P3 Shut-down
P4 point

AFC
x4 x2 x1 X
x3
Sumit Sarkar, XLRI
Understanding market forces

Sumit Sarkar, XLRI

Excess supply

At price $20 Price ($)

consumers demand
80 units, but
S
producers want to
supply 280 units. 20
The demand
and the
So, if the price is at
supply
$20, there will be schedules
200 units unsold in are put in the
the market. D same graph.

80 280 X
Price must fall.

Sumit Sarkar, XLRI

Excess demand

At price $10 Price ($)

consumers demand
200 units, but
producers want to S
supply 100 units.

So, if the price is at

$20, there will be 10
excess demand of
100 units. D

Price must rise. 100 200 X

Sumit Sarkar, XLRI

Market Equilibrium

Price must be Price ($)

something between
$10 and $20.
S
20
At price $14, the
consumers 14
demand 160 unit 10
and the producers
want to supply D
160 units.
160 X
Market clears

Sumit Sarkar, XLRI

 Case: Global Crude Oil Market

 Who demands?
◦ The world

 Who supplies?
◦ 80% of the supply comes
from 12 countries.

 Not perfect competition

◦ Purpose is to understand the
role of market forces.

Sumit Sarkar, XLRI

 Demand side issues
 Growth of the
transportation sector.
 Increased volumes of Global consumption by type
trade (↑ demand for
Motor Gasoline
bunker fuel).
Jet Fuel
 Industrialization (↑
demand for fuel oil). 18% 25% Kerosene

10%
 Population growth and 6%
Distillate Fuel Oil

change in lifestyle (↑ 10% 29% 1%

Residual Fuel Oil

demand for heating oil Liquefied Petro-

and LPG). leum Gases

Other Products

Sumit Sarkar, XLRI

 Demand side effect on price

 Increase in demand
shifts the demand
schedule from D1
to D2
 Supply being very
inelastic price will
increase sharply.
 Not much change in
equilibrium output.
 This explains
general increasing
trend of oil price.

Sumit Sarkar, XLRI

 Supply side effect on price

 Short run supply

contraction shifts
the supply schedule
from S1 to S2
 Demand being very
inelastic price will
increase sharply.
 Not much change in
equilibrium output.
 Explains the short
term spikes in price
trend.

Sumit Sarkar, XLRI

Demand shock during the financial
crisis – effect on price

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Supply response

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Supply response to demand shock and
effect on price
Initially price was
Price (P) S2
P0
S1
Demand reduces to
D2
Price reduces to P1.
Equilibrium qty P00
reduces to Q1 P2
Supply gets adjusted P1
As supply is D1
D2
contracted price
increases. Q2 Q00
Q Quantity (X)
Q1

Sumit Sarkar, XLRI

Why oil price dropped since 2014?
• Reduced demand?
◦ No. Demand increased.
◦ Average daily demand increased by approximately 2 million
barrels per day in 2014 as compared to previous year.
• Supply side explanation
◦ Supply increased.
◦ US production increased steadily since 2008.
 Horizontal drilling in North Dakota and Texas
◦ OPEC could not reduce supply.

Sumit Sarkar, XLRI

Supply trend

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Increase in supply results in price fall

Supply schedule Price (P)

shifts right. The new
supply schedule is S1
S

Price falls from P0 S1

to P1 P0

P1
Q1 quantity is D
demanded and
sold. Q0 Q1 Quantity (X)

Sumit Sarkar, XLRI

 Short term equilibrium in Perfect Competition

P MC
S0 MC AC
MR

A a MR0
P0

D
X x0 x
X0
Market Firm

Sumit Sarkar, XLRI

 Long term equilibrium (from profit in short
term equilibrium)

P MC
S0 MC
MR
S1 AC

A a MR0
P0
B
P1 MR1
b
D
X x1 x0 x
X0 X1
Market Firm

Sumit Sarkar, XLRI

 Long term equilibrium (from loss in short
term equilibrium)

P MC
MR MC
S1 AC
S0
AVC

B b
P1 MR1
P0 A MR0
a
D
X x0x1 x
X1 X0
Market Firm

Sumit Sarkar, XLRI

 Long term dynamics – disturbance from the
demand side

P MC
S0 MR MC
AC
B S1
b MR1
P1
A C
P0 MR0
a
D1
D0
X x
X0 X1 X2 x0 x1
Market Firm

Sumit Sarkar, XLRI

 Long term dynamics– disturbance from the
supply side

P S0 MC MC
AC
S1 MR MC1
S2
AC1
A a MR0
P0 B b
P1 MR1
P2 C
c MR2
D0

X x
X0X1 X2 x0 x1
Market Firm

Sumit Sarkar, XLRI

Reading
• Besanko & Braeutigam. Ch. 2 (Sec. 2.1)
Ch. 8 (Sec. 8.2)
Ch. 9 (Sec 9.1, 9.2, 9.3 and
9.4)

Sumit Sarkar, XLRI

Understanding Perfectly Competitive Market – The
case of Sub-Zero
 Demand side
 For each buyer (total 300 buyers)
 Max: U = x1/3y2/3 Sub. To: 9000 = px.x + pyy

 Each buyer’s demand

 Market demand
Understanding Perfectly Competitive Market – The
case of Sub-Zero
 Supply side
 Finding supply by each supplier (total 100 buyers)
 Prod. Fn x = 3K1/2L1/2 Fixed K: K0 = 1
 L-requirement Other costs: Power = 410 ut / day

 Factor prices: w = 180 / day; r = 2000 / day; e = 5 / ut

 VC FC

 MC
Profit maximization and market supply

 For profit maximization px = MC

 Each supplier’s supply:

 Market supply
Market equilibrium

XS
px

XD