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So, returning back to our fundamental principle.
In a perfectly competitive market, no firm realizes economic profits, or rents.
What's interesting is that the existence of economic profits suggests that there's
actually some type of market inefficiencies.
Now for those of you who have studied economics, or for those of you Who've even
just paid attention in the popular business press.
This notion that profits are generated from market inefficiency might seem very
counter intuitive at first. So let me illustrate why this is the case.
So I'd like to take a few minutes here to talk about basically.
Economics 101 in the context of competitive markets.
What we see represented here on the slide is a generic industry here, where we have
supply represented by S, and demand represented by D.
On the horizontal axis, the x axis, we have the quantity demanded within an
industry or quantity sold within an industry.
On the y axis or the vertical axis, we have dollars for example, the price that a
good sells for. Now if you've taken economics you might
remember the classic addage that price is set where supply equals demand.
We see illustrated here, so the price in a given market is set where our supply
curves crosses our demand curve. And that also determines the amount of
quantity of goods sold within that market. The reason we assume the demand curve goes
down, is that for any given price, if you raise that price, fewer people will demand
that product. Or, conversely, if you lower the price,
more people will demand that product. On the flip side, with supply, as you
raise the price you need to provide more, sell more, to justify selling that higher
price. Hence, the just simple curves that we
represent here. Now, this is what we see at the industry
level. What does this mean for a firm?
So here we see two additional curves, MC and AC.
Mc stands for marginal cost, this is the incremental cost to the firm of selling
one additional unit of a good or service. Ac stands for the average cost, the
average cost is the average cost per unit sold.
The reason that we draw the curves in the way that we have is that for the average
cost curve for example, we start with typically some type of fixed cost that you
incur. So consider the following example.
Imagine someone selling t-shirts outside of a sports stadium here at the
university. We have supply and we have demand for
those t-shirts, and we have a market that determines a price and quantity that are
going to be sold and the price that it's going to be sold for.
For an individual t-shirt vendor, they are what we call a price taker.
They don't get to set the price. Now, of course, they have discretion.
They can choose to set the price at whatever level they want, but the market
will not bear that out. So, for example, if they charge more than
the market price, they simply won't sell any futures.
So at the end of the day they are compelled To offer the market price, hence
what we call a price taker. Their average cost curve has the curve as
follows, because they incur some fixed cost in selling t-shirts.
They have to buy a van perhaps, maybe they have to get a table.
They of course have the printing equipment, and the like, to make just that
one t-shirt. So the cost to sell one T-shirt is quite
high, but as they sell more and more of those T-shirts, the average cost per
T-shirt sold comes down. However at some point, they'll reach some
capacity constraint. Perhaps they have to higher another
vendor, maybe another worker to help them sell those T-shirts.
As they reach those capacity constraints and then inquire, incur additional costs,
that will then raise the average cost per unit sold.
A question that before us, for the firm is, how many t-shirts should I bring to
the stadium that I'm trying to sell. What am I likely to sell at the given
market price. How many do I want to sell at the end of
the day. Well, the answer is, in a perfectly
competitive market, you'd want to sell the quantity such that the price equals your
marginal cost. Now how did I come up with this, where did
this come from? Let me take a few minutes here to do a
little calculus. My apologies for those of you not
mathematically inclined. I think this is useful to go through for
those of you who've had some background in calculus just to establish this baseline.
If you haven't, don't worry, we'll come get you back up to speed in a second here.
First let's start with the profit equation very simply, profits equal revenues.
Price times quantity, minus variable cost. The cost for selling that many units.
Minus any fixed costs that are incurred regardless of how many units are sold.
Represented mathematically, we use the Greek symbol pi, to represent profits.
We have our revenues. Once again our price times our quantity
sold. We have our variables cost, which we
represent here as costs as a function of the quality sold, quantity sold there.
And then we have our fixed costs represented by the cf.
Now for those of you who've had some calculus you might remember that if you're
trying to maximize some objective function, trying to maximize profits in
this case. You take the derivative with respect to
the decision variable. In this case the quantity sold and you set
it equal to zero. Well what happens in this case?
The derivative of price times quantity, our revenue part of the equation, equals
price. Our derivative of our cost, our variable
cost part of the equation, we represent very simply as, c prime, q1, which equals.
The derivative of that cost function. The fixed cost function is a fixed
constant and therefore falls out of our of our derivative.
We set that equal to zero and it gives us a decision rule in which we set price
equal to the derivative of variable cost which is, by definition the marginal cost.
Hence again, to maximize profits, a firm who's a price taker sets quantity such
that price equals marginal cost. Now, if you're not mathematically
inclined, if you haven't had calculus, let me show you this visually here.
What the calculus does for us is figure out where on that horizontal axis there,
to put q 1, so as to maximize profits, and if you don't believe me, you can play
around with it on the graph here. Q1 times P1 gives us our revenue,
represented by the green-shaded area. Q1 time AC, where it crosses that line,
gives us our cost. Our average cost per unit times units
sold, gives us our total cost, represented in the red, and our profits are all those
green area that remains there. So let's go back to our t-shirt vendor.
If you're a T-shirt vendor, and you're selling T-shirts outside the stadium.
You're making a hefty profit here. You're doing very well, that's very
exciting for you. But what happens next?
Well, one might expect that others will observe you making good money, selling
T-shirts outside the stadium. And they'll decide, well, they'd like to
sell some T-shirts as well. They'd like to get some of that action.
So how, what happens then to our competitive markets?
Well, the first thing it does is that those coming in to sell T-shirts, entering
the market shift out the supply curve. There are now at any given price more
tshirts, more tshirts being willing to be supplied by the marketplace.
However, our laws of supply and demand still hold true.
Price equals where supply equals demand. So the effect of those entering the market
and shifting out the supply curve is to lower prices and increase aggregate demand
where we see from P1 to P2, and Q1 to Q2. So once again, it shifts out supply,
lowers prices, increases overall demand. But let's see what the effect of this is
on the firm. The firm, once again, is a price taker.
They have to take the market brand price, which is P2.
But they still have the same decision rule, which is the set quantity, such that
price equals marginal cost. As you can see represented by Q2.
P2 times Q2 gives us our revenue. Q2 times AC gives us our cost.
But look what happens. In this example here profits are competed
away. Now to be technically correct again,
economic profits are competed away. It is possible to have accounting profits
in a competitive market. And the reasoning is as follows, as more
and more individuals enter into our T-shirt vending market outside the
stadium, eventually one of them will recognize that if they enter in it will
lower price so far that it really isn't worth their effort to enter in and sell
those T-shirts. In essence, their opportunity cost is high
enough that they choose not to enter into the market.
And this is why we're so clear about economic profits when we talk about the
fundamental principle here. So, in competitive markets, these economic
profits are competed away and you're basically indifferent to the profits you
make from that endeavor versus some other type of investment, of similar risks.
Maybe it's simply investing in some type of mutual fund or other type of investment