Determination of price in short and long run
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This document discusses the principles of perfect competition, emphasizing assumptions such as numerous firms producing identical products, firms being price takers, and no barriers to entry. It outlines the dynamics of supply response in the short run and long run, explaining how firms can adjust output and how new firms can enter or exit the market based on economic profits. Additionally, it analyzes the effects of changing technology and taxation on market pricing and firm profitability.
Determination of price in short and long run
- 1. Perfect Competition • A perfectly competitive industry is one that obeys the following assumptions: – there are a large number of firms, each producing the same homogeneous product – each firm attempts to maximize profit – each firm is a price taker • its actions have no effect on the market price – information is perfect – transactions are costless
- 2. Timing of the Supply Response • In the analysis of competitive pricing, the time period under consideration is important – very short run • no supply response (quantity supplied is fixed) – short run • existing firms can alter their quantity supplied, but no new firms can enter the industry – long run • new firms may enter an industry
- 3. Pricing in the Very Short Run • In the very short run (or market period), there is no supply response to changing market conditions – price acts only as a device to ration demand • price will adjust to clear the market – the supply curve is a vertical line
- 4. Pricing in the Very Short Run Quantity Price S D D’ Q* P1 P2 When quantity is fixed in the very short run, price will rise from P1 to P2 when the demand rises from D to D’
- 5. Short-Run Price Determination • The number of firms in an industry is fixed • These firms are able to adjust the quantity they are producing – they can do this by altering the levels of the variable inputs they employ
- 6. Long-Run Analysis • In the long run, a firm may adapt all of its inputs to fit market conditions – profit-maximization for a price-taking firm implies that P is equal to long-run MC • Firms can also enter and exit an industry in the long run – perfect competition assumes that there are no special costs of entering or exiting an industry
- 7. Long-Run Analysis • New firms will be lured into any market for which economic profits are greater than zero – entry of firms will cause the short-run market supply curve to shift outward – market price and profits will fall – the process will continue until economic profits are zero
- 8. Long-Run Analysis • Existing firms will leave any industry for which economic profits are negative – exit of firms will cause the short-run market supply curve to shift inward – market price will rise and losses will fall – the process will continue until economic profits are zero
- 9. The Effect of changing technology q1 Output Output SRATC1 MC AVC1 P0 q3 The expansion in capacity and fall in price will continue until price is equal to the average total cost of the new plants. At this price old plants will not covering their long run costs. As well as price exceeds their average variable cost, however they will continue in production. E1 MC SRATC2 AVC2 E2 q2 Output MC SRATC3 AVC3 P0 P0 Plant 3Plant 1 Plant 2
- 10. The Effect of changing tax q1 Output Output SRATC1 MC AVC1 P0 q3 E1 MC SRATC2 AVC2 E2 q2 Output MC SRATC3 AVC3 P0 P0 Plant 3Plant 1 Plant 2 The change in tax affects the price. On increase in tax it will be included in the cost at same price, so the profit will be minimize.
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