Production Quantity and Market Setting
With the Producer Theory, firms will only be able to minimise production cost. To maximise profit, firms also need to know the quantity to produce, which will determine the revenue. This quantity is determined by the market setting,which are the conditions imposed by the market on all the firms.
To aid in simplifying analysis and improving understanding, the first market setting that any course will visit is the Perfect Competition setting.
Perfect Competition Setting
In such a setting, all firms are price-takers for both inputs and outputs of the market.
A perfectly competitive market exists when the following conditions are met:
- Firms are producing identical products
- Consumers have full information of all prices in the market
- Low transactions cost that does not affect prices of products
- Free entry and exit of firms in the market with no barriers
In such a setting, the demand of the market as a whole is downward sloping. However, the demand facing individual firms, called Residual Demand, is perfectly elastic, therefore a horizontal line. Residual demand is the demand for an individual firm left over from the supply of all other firms.
The supply of the market in the short run is a summation of all the supply curves of individual firms. In the long run, supply of the market is perfectly elastic, which is a horizontal line.
Short Run Profit Maximisation
Recall that profit = revenue – cost. Cost in economics refers to opportunity cost, unlike accounting cost which refers to the cash flow. In the short run, profit is maximised when:
- Marginal Revenue MR = Marginal Cost MC
At this point where MR = MC, marginal profit is zero. Beyond that point of sales and production, total profit gained by the firm will start to decrease. Similarly producing at any points below that will result in less total profit.
And since revenue = price * quantity produced, at the point of profit maximisation:
- Price P = MR = MC
In perfect competition setting, firms are price-takers, therefore the market price determines the quantity produced.
Aside from deciding the quantity to produce based on the market price, firms must also decide whether they want to stay in business or not. When the shutdown condition is met, firms will choose to shutdown instead of sustaining further losses. The condition for shutdown is for firms to lose more than the fixed costs. In other words, even if firms are making losses, they will stay in business as long as revenue is at least equal to variable cost:
- PQ > VC
- or equivalently, P > AVC
Firms are willing to do this only in the short run as this is an interim arrangement. In the long run, no firms will be willing to sustain losses.
Therefore, since the firms follows a two step process to make decision in the short run, which is 1) Using P = MC to determine quantity and 2) Using P > AVC to determine whether to stay in business, the short run supply curve of an individual firm is equal to the MC curve that lies above the point where P = AVC.
Short Run Market Equilibrium
How is the market price determined? That depends on the market equilibrium, which is determined in the following steps:
- The cost function of each individual firms determine the individual supply curve, based on MC curve
- The summation of all individual supply curves determines the market supply curve
- The intersection of market supply and market demand determines the equilibrium price and quantity
- Based on this price, each firm will decide how much to produce, or whether to shutdown.
Long Run Market Equilibrium
In the long run, there is no shutdown condition, as no firms will be willing to sustain losses. They will just exit the market if no profit can be made. This is only possible because firms can freely enter or exit the market.
Therefore, in the long run all firms make zero profit or normal profit. This is because if there is profit to be made, it will attract more firms into the market. With more firms, market supply increases, bringing price down. When P = ATC, all firms will be making zero profit. Conversely, if firms suffer losses, P < ATC, some firms will exit and once again the market will reach equilibrium at P = ATC.
The market supply curve in the long run is a horizontal line, with all firms producing at
- P = MC = ATC
The point of production where MC = ATC is also the point of minimum cost. This makes sense as any firms not producing at the lowest cost possible will be driven to exit the market for making losses under perfect competition.
It is interesting that in the long run, only the cost function of the firms is required to determine the market price.
Perfect Competition in Reality
Perfectly competitive market does not exist in reality because the long run supply curve is upward sloping for three simple reasons.
- Barriers to Entry or Exit
This can be due to high sunk cost required to enter the market, which will deter other players from entering once the first few firms had established themselves. It can also be due to licensing or patents, that prevents entry or exit in a certain industry.
- Firms are not identical
Even when firms are creating the same product, they have different cost functions. Those with lower cost of production will be able to sustain in the market with low demand, or a market of lower supply. The current collapse in oil price is affecting US shale oil company in the same way, because shale oil production is more costly as compared to traditional producers in the market.
- Input prices may increase as market expands
If the inputs of production have upward sloping supply curve, for firms to increase production, their cost will increase, changing the cost function itself.
(Reference: MIT OCW Principles of Microeconomics)