Introduction to Revenue Curves: Perfect Competition

We're done learning about cost curves now! Unfortunately, cost is only one of the factors which determines profit. The other factor which determines profit is REVENUE, so for the next three weeks we're going to learning about different types of markets, and different kinds of revenue curves inherent in each of them.

What is a market structure? A market structure is the 'genetic' features of a market that affect firm behavior including:
-The numbers and sizes of the firms involved in the market (are there a whole bunch of firms, like the BC cafe/coffee market, or is there only one firm, like the BC hydroelectric market)
-The types of goods sold in the market (What does the good do? Is it unique to each firm (like artwork) or the same no matter where you buy it from (like coca cola)
-Freedom of firms to enter and exit the market (Can firms enter the market freely, or are their market barriers like licenses or qualification restrictions)

Different Market Structures disperse MARKET POWER in different ways

Market Power: The ability of a single firm to affect the market price. In other words, firms which have a large share of Market power can jack up prices and get away with it.

RIVALRY is the antidote to too much market power. Rivalry (competitive behavior, or competition) deflates the market power of any one firm, so rivalry is inverse related to market power. This is because rival companies can "steal" a firm's customers if that firm tries to jack up the price, so the market power of that firm is lessened.

THIS WEEK: We are learning about perfect competition!

In perfect competition, there is NO MARKET POWER!
Ironically, in markets which are perfectly competitive, there is no competitive behavior. As we will learn, in order for there to be competitive behavior, there needs to be SOME market power.

Here are ALL of the different market types:

Perfect Competition --> No Market Power
Imperfect Competition-> Some Market Power
Oligopoly-----------> Substantial Market Power
Monopoly-----------> Total Market Power

REMEMBER: The each of these market structures, the COST side of the analysis looks IDENTICAL. Only the revenue side changes. Each week, we will study revenues for each structure.

PERFECT COMPETITION: What assumptions can we make about this market structure?

1: Many Sellers (So one firm does not affect the industry's supply curve. In other words, the industry's supply curve is fairly constant. As such, each seller's minimum efficiency scale is quite small relative to the industry's level of output. An example of this would be gasoline stations in Vancouver, or coffee shops in the lower mainland)

2: Each seller is selling a homogenous (identical) product (this is what allows for 'perfect' competition. If one seller raises the price of an IDENTICAL product, consumers will simply obtain that product for a lower price elsewhere. If two gas stations are selling gas for different prices, you're probably going to buy gas from the cheaper station, because THE GAS IS THE SAME PRODUCT NO MATTER WHERE YOU BUY IT FROM)
NOTE: Identical products are very rare (ie: even coffee is not the same at every coffee shop), so perfect competition is very rare. Even arbitrary consumer preferences can turn an identical product into a non-identical product (eg: prefering Husky gas to Shell gas for ethical reasons).
This also gives markets of perfect competition a Horizontal Demand line (perfect elasticity), since an increase in price will simply cause consumers to cease buying the offered product from that firm.

3: Firms can freely enter and exit the market (there are no barriers to entry [BTEs], and startup costs required to enter the industry are reasonable)

In a market of perfect competition, the larger market is composed of MANY MANY small firms, creating the entire market


THE DEMAND CURVE FOR A FIRM in PERFECT COMPETITION
-In perfect competition, firms are 'price takers' (they simply sell products at the market prices as a result of there being many firms which all sell identical products)
-The firm's demand is horizontal
-One firm more or less does not affect industry supply
SO: because demand is horizontal, a firm can sell all it wants to at the going price. If a firm raises prices, however, it loses all of its buyers. If it lowers it prices, and starts a price war, ALL of the other firms in the industry will eventually lower their prices as well, simply creating less profit for all firms within the industry. For this reason, price wars do not usually last very long in perfect competition (because they are bad for ALL firms within that market).

FOR THIS REASON, there is no competitive behavior in perfectly competitive markets: firms cannot raise prices for fear of either losing customers or profit.


As you can see, the industry sets the price, and each firm simply TAKES that price.

SO: Demanded Price = The Firm's selling price = The Average Revenue = The Marginal Revenue

HOW DOES REVENUE WORK?

Revenue is the amount of money firms receive from the sale of goods. In perfect competition, total revenue is a basic function of units sold

TOTAL REVENUE
TR = Quantity of Products sold X fixed price of sold Products
This is the total income of firms
In perfect competition, this is represented graphically by a straight line out from the origin (so it is a linear function)

AVERAGE REVENUE
AR = The total revenue/The quantity of products sold
In other words, this is the 'per unit' income of firms
This is represented graphically as the slope of the ray from the origin to total revenue (so it remains constant throughout the perfect competition revenue function)

MARGINAL REVENUE
MR = Change in total revenue / Change in quantity of products sold
In other words, this is the additional income the firm makes from the last output.
Graphically, this is the slope of the tangent to the total revenue function (so it remains the same throughout the perfect competition revenue function, and is equal to the average revenue)


Seeeee:

Quantity Price TR AR MR
1 $1 $1 $1 $1
2 $1 $2 $1 $1
3 $1 $3 $1 $1
4 $1 $4 $1 $1

Demand = Price = Average Revenue = Marginal Revenue!

Remember: Demand for the ENTIRE industry is downward-sloping, but demand for the INDIVIDUAL FIRM during the short run in a perfectly competitive market is HORIZONTAL!

SO... in a situation of perfect competition, how do firms maximize profits??
Well... there are two rules to follow:

Rule #1: The firms should be breaking even (in other words, the firm must be making more revenue on a daily basis than their average variable costs on a daily basis, or else the firm will LOSE MONEY) (Total fixed costs on the other hand can be paid off slowly over time, so it is not necessary to cover them on a daily basis).

In short: TR must > or = TVC
OR
P must > or = AVC
"You must cover day-to-day costs"

Rule #2: Firms should produce goods up until the point where marginal revenue = marginal costs. In other words, any extra average revenue above the cost of producing each unit gets added to the the total profits for that firm. If you sell cups of coffee for one dollar, as a firm, you'll be making total profits AS LONG AS YOU CAN SELL COFFEE FOR LESS THAN IT COSTS TO MAKE IT. SO, you sell until revenue = costs, and this MAXIMIZES PROFIT. Selling less than this leaves potential total profits unrealized, while selling more than this incurs unnecessary extra costs.


Profit = Total Revenue - Total Costs
Profit Maximization Occurs when the slope of total revenue (aka: the marginal revenue) equals the slope of the total costs (marginal costs)
SO: Profit is maximized when MR = MC

Another way of looking at this is seeing total profits as a bank account. As long as marginal revenues are greater than marginal costs, the bank account is growing. The instant marginal costs become greater than marginal revenues, the bank account starts to shrink.
That's all for today!