PERFECT

COMPETITION 11
CHAPTER
Objectives

After studying this chapter, you will able to

 Define perfect competition
 Explain how price and output are determined in perfect
competition
 Explain why firms sometimes shut down temporarily and
lay off workers
 Explain why firms enter and leave the industry
 Predict the effects of a change in demand and of a
technological advance
 Explain why perfect competition is efficient
Say Cheese!

Dairy farming is a tough competitive business.

Several thousand farms stretching from Vermont to
California are piling up losses and many farmers are
quitting.
Some farms are switching from milk to cheese production.
We study a fiercely competitive market in this chapter.
We explain the changes in price and output as the firms in
perfect competition respond to changes in demand and
technological change.
Competition

Perfect competition is an industry in which:

 Many firms sell identical products to many buyers.
 There are no restrictions to entry into the industry.
 Established firms have no advantages over new ones.
 Sellers and buyers are well informed about prices.
Competition

How Perfect Competition Arises

Perfect competition arises:
 When firm’s minimum efficient scale is small relative to
market demand so there is room for many firms in the
industry.
 And when each firm is perceived to produce a good or
service that has no unique characteristics, so consumers
don’t care which firm they buy from.
Competition

Price Takers
In perfect competition, each firm is a price taker.
A price taker is a firm that cannot influence the price of a
good or service.
No single firm can influence the price—it must “take” the
equilibrium market price.
Each firm’s output is a perfect substitute for the output of
the other firms, so the demand for each firm’s output is
perfectly elastic.
Competition

Economic Profit and Revenue

The goal of each firm is to maximize economic profit,
which equals total revenue minus total cost.
Total cost is the opportunity cost of production, which
includes normal profit.
A firm’s total revenue equals price, P, multiplied by
quantity sold, Q, or P  Q.
Competition

A firm’s marginal revenue is the change in total revenue

that results from a one-unit increase in the quantity sold.
Figure 11.1 illustrates a firm’s revenue curves.
Competition

Figure 11.1(a) shows that market demand and supply

determine the price that the firm must take.
Competition

Figure 11.1(b) shows the demand curve for the firm’s

product, which is also its marginal revenue curve.
Competition

Because in perfect competition the price remains the same

as the quantity sold changes, marginal revenue equals
price.
Competition

Figure 11.1(c) shows the firm’s total revenue curve.

The Firm’s Decisions in Perfect
Competition

A perfectly competitive firm faces two constraints:

 A market constraint summarized by the market price and
the firm’s revenue curves
 A technology constraint summarized by firm’s product
curves and cost curves (like those in Chapter 10).
The Firm’s Decisions in Perfect
Competition

The perfectly competitive firm makes two decisions in

the short run:
 Whether to produce or to shut down.
 If the decision is to produce, what quantity to produce.
A firm’s long-run decisions are:
 Whether to increase or decrease its plant size.
 Whether to stay in the industry or leave it.
The Firm’s Decisions in Perfect
Competition

Profit-Maximizing Output
A perfectly competitive firm chooses the output that
maximizes its economic profit.
One way to find the profit maximizing output is to look at
the firm’s the total revenue and total cost curves.
Figure 11.2 on the next slide looks at these curves along
with the firm’s total profit curve.
The Firm’s Decisions
in Perfect Competition

Part (a) shows the total

revenue, TR, curve.

Part (a) also shows the

total cost curve, TC,
which is like the one in
Chapter 10.
Total revenue minus total
cost is profit (or loss),
shown in part (b).
The Firm’s Decisions
in Perfect Competition

Profit is maximized when

the firm produces 9
sweaters a day.
At low output levels, the
firm incurs an economic
loss—it can’t cover its
fixed costs.
The Firm’s Decisions
in Perfect Competition

At intermediate output
levels, the firm earns an
economic profit.

At high output levels, the

firm again incurs an
economic loss—now it
faces steeply rising costs
because of diminishing
returns.
The Firm’s Decisions in Perfect
Competition

Marginal Analysis
The firm can use marginal analysis to determine the profit-
maximizing output.
Because marginal revenue is constant and marginal cost
eventually increases as output increases, profit is
maximized by producing the output at which marginal
revenue, MR, equals marginal cost, MC.
Figure 11.3 on the next slide shows the marginal analysis
that determines the profit-maximizing output.
The Firm’s Decisions in Perfect
Competition

If MR > MC, economic

profit increases if output
increases.
If MR < MC, economic
profit decreases if output
increases.
If MR = MC, economic
profit decreases if output
changes in either
direction, so economic
profit is maximized.
The Firm’s Decisions in Perfect
Competition

Profits and Losses in the Short Run

Maximum profit is not always a positive economic profit.
To determine whether a firm is earning an economic profit
or incurring an economic loss, we compare the firm’s
average total cost, ATC, at the profit maximizing output
with the market price.
Figure 11.4 on the next slide shows the three possible
profit outcomes.
The Firm’s Decisions in Perfect
Competition

In part (a) price equals ATC and the firm earns zero
economic profit (normal profit).
The Firm’s Decisions in Perfect
Competition

In part (b), price exceeds ATC and the firm earns a

positive economic profit.
The Firm’s Decisions in Perfect
Competition

In part (c) price is less than ATC and the firm incurs an
economic loss—economic profit is negative and the firm
does not even earn normal profit.
The Firm’s Decisions in Perfect
Competition
The Firm’s Short-Run Supply Curve
A perfectly competitive firm’s short run supply curve shows
how the firm’s profit-maximizing output varies as the
market price varies, other things remaining the same.
Because the firm produces the output at which marginal
cost equals marginal revenue, and because marginal
revenue equals price, the firm’s supply curve is linked to
its marginal cost curve.
But there is a price below which the firm produces nothing
and shuts down temporarily.
The Firm’s Decisions in Perfect
Competition

Temporary Plant Shutdown

If price is less than the minimum average variable cost, the
firm shuts down temporarily and incurs a loss equal to total
fixed cost.
This loss is the largest that the firm must bear.
If the firm were to produce just 1 unit of output at price
below average variable cost, it would incur an additional
(and avoidable) loss.
The Firm’s Decisions in Perfect
Competition

The shutdown point is the output and price at which the

firm just covers its total variable cost.
This point is where average variable cost is at its minimum.
It is also the point at which the marginal cost curve crosses
the average variable cost curve.
At the shutdown point, the firm is indifferent between
producing and shutting down temporarily.
It incurs a loss equal to total fixed cost from either action.
The Firm’s Decisions in Perfect
Competition

If the price exceeds minimum average variable cost, the

firm produces the quantity at which marginal cost equals
price.
Price exceeds average variable cost, and the firm covers
all its variable cost and at least part of its fixed cost.
The Firm’s Decisions
in Perfect Competition

Figure 11.5 shows how

the firm’s short-run supply
curve is constructed.
If price equals minimum
average variable cost,
$17 in this example, the
firm is indifferent between
producing nothing and
producing at the
shutdown point, T.
The Firm’s Decisions
in Perfect Competition

If the price is $25, the firm

produces 9 sweaters a
day, the quantity at which
P = MC.
If the price is $31, the firm
produces 10 sweaters a
day, the quantity at which
P = MC.
The blue curve in part (b)
traces the firm’s short-run
supply curve.
The Firm’s Decisions in Perfect
Competition

Short-Run Industry
Supply Curve
The short-run industry
supply curve shows the
quantity supplied by the
industry at each price
when the plant size of
each firm and the number
of firms remain constant.
The Firm’s Decisions in Perfect
Competition

The quantity supplied by

the industry at any given
price is the sum of the
quantities supplied by all
the firms in the industry at
that price.
The Firm’s Decisions in Perfect
Competition

At a price equal to
minimum average variable
cost—the shutdown price
—the industry supply
curve is perfectly elastic
because some firms will
produce the shutdown
quantity and others will
produces zero.
Output, Price, and Profit in Perfect
Competition

Short-Run Equilibrium
Short-run industry supply
and industry demand
determine the market
price and output.
Figure 11.7 shows a short-
run equilibrium at the
intersection of the demand
and supply curves.
Output, Price, and Profit in Perfect
Competition

A Change in Demand
An increase in demand
bring a rightward shift of
the industry demand
curve: the price rises and
the quantity increases.

A decrease in demand
bring a leftward shift of the
industry demand curve:
the price falls and the
quantity decreases.
Output, Price, and Profit in Perfect
Competition

Long-Run Adjustments
In short-run equilibrium, a firm may earn an economic
profit, earn normal profit, or incur an economic loss and
which of these states exists determines the further
decisions the firm makes in the long run.
In the long run, the firm may:
 Enter or exit an industry
 Change its plant size
Output, Price, and Profit in Perfect
Competition

Entry and Exit

New firms enter an industry in which existing firms earn an
economic profit.
Firms exit an industry in which they incur an economic
loss.
Figure 11.8 on the next slide shows the effects of entry
and exit.
Output, Price, and Profit in Perfect
Competition

As new firms enter an

industry, industry supply
increases.
The industry supply curve
shifts rightward.
The price falls, the
quantity increases, and
the economic profit of
each firm decreases.
Output, Price, and Profit in Perfect
Competition

As firms exit an industry,

industry supply decreases.
The industry supply curve
shifts leftward.

The price rises, the

quantity decreases, and
the economic profit of
each firm increases.
Output, Price, and Profit in Perfect
Competition

Changes in Plant Size

Firms change their plant size whenever doing so is
profitable.
If average total cost exceeds the minimum long-run
average cost, firms change their plant size to lower costs
and increase profits.
Figure 11.9 on the next slide shows the effects of changes
in plant size.
Output, Price, and Profit in Perfect
Competition

If the price is $25, firms earn zero economic profit with the
current plant.
Output, Price, and Profit in Perfect
Competition

But if the LRAC curve is sloping downward at the current

output, the firm can increase profit by expanding the plant.
Output, Price, and Profit in Perfect
Competition

As the plant size increases, short-run supply increases,

the price falls, and economic profit decreases.
Output, Price, and Profit in Perfect
Competition
Long-run equilibrium occurs when the firm is producing at
the minimum long-run average cost and earning zero
economic profit.
Output, Price, and Profit in Perfect
Competition

Long-Run Equilibrium
Long-run equilibrium occurs in a competitive industry
when:
 Economic profit is zero, so firms neither enter nor exit
the industry.
 Long-run average cost is at its minimum, so firms don’t
change their plant size.
Changing Tastes and Advancing
Technology

A Permanent Change in Demand

A decrease in demand shifts the demand curve leftward.
The price falls and the quantity decreases.
Changing Tastes and Advancing
Technology

Starting from a position of long-run equilibrium, the fall in

price puts the price below each firm’s minimum average
total cost and firms incur an economic loss.
Changing Tastes and Advancing
Technology

Economic losses induce exit, which decreases short-run

supply and shifts the short-run industry supply curve
leftward.
Changing Tastes and Advancing
Technology

As industry supply decreases, the price rises and the

market quantity continues to decrease.
Changing Tastes and Advancing
Technology

With a rising price, each firm that remains in the industry

increases production in a movement along the firm’s
marginal cost curve (short-run supply curve).
Changing Tastes and Advancing
Technology

A new long-run equilibrium occurs when the price has risen to

equal minimum average total cost so that firms do not incur
economic losses, and firms no longer leave the industry.
Changing Tastes and Advancing
Technology

The main difference between the initial and new long-run

equilibrium is the number of firms in the industry.
Changing Tastes and Advancing
Technology

In the new equilibrium, a smaller number of firms produce

the equilibrium quantity.
Changing Tastes and Advancing
Technology

A permanent increase in demand has the opposite effects

to those just described and shown in Figure 11.9.
An increase in demand shifts the demand curve rightward.
The price rises and the quantity increases.
Economic profit induces entry, which increases short-run
supply and shifts the short-run industry supply curve
rightward.
As industry supply increases, the price falls and the
market quantity continues to increase.
Changing Tastes and Advancing
Technology

With a falling price, each firm decreases production in a

movement along the firm’s marginal cost curve (short-run
supply curve).
A new long-run equilibrium occurs when the price has fallen
to equal minimum average total cost so that firms do not earn
economic profits, and firms no longer enter the industry.
The main difference between the initial and new long-run
equilibrium is the number of firms in the industry. In the new
equilibrium, a larger number of firms produce the equilibrium
quantity.
Changing Tastes and Advancing
Technology

External Economics and Diseconomies

The change in the long-run equilibrium price following a
permanent change in demand depends on external
economies and external diseconomies.
External economies are factors beyond the control of an
individual firm that lower the firm’s costs as the industry
output increases.
External diseconomies are factors beyond the control of a
firm that raise the firm’s costs as industry output increases.
Changing Tastes and Advancing
Technology

In the absence of external economies or external

diseconomies, a firm’s costs remain constant as industry
output changes.
Figure 11.11 illustrates the three possible cases and
shows the long-run industry supply curve, which shows
how the quantity supplied by an industry varies as the
market price varies after all the possible adjustments have
been made, including changes in plant size and the
number of firms in the industry.
Changing Tastes and Advancing
Technology

Figure 11.11(a) shows that

in the absence of external
economies or external
diseconomies, the price
remains constant when
demand increases.
Changing Tastes and Advancing
Technology

Figure 11.11(b) shows that

when external
diseconomies are present,
the price rises when
demand increases.
Changing Tastes and Advancing
Technology

Figure 11.11(c) shows that

when external economies
are present, the price falls
when demand increases.
Changing Tastes and Advancing
Technology

Technological Change
New technologies are constantly discovered that lower
costs.
A new technology enables firms to producer at a lower
average cost and lower marginal cost—firms’ cost curves
shift downward.
Firms that adopt the new technology earn an economic
profit.
Changing Tastes and Advancing
Technology

New-technology firms enter and old-technology firms

either exit or adopt the new technology.
Industry supply increases and the industry supply curve
shifts rightward.
The price falls and the quantity increases.
Eventually, a new long-run equilibrium emerges in which
all the firms use the new technology, the price has fallen to
the minimum average total cost, and each firm earns
normal profit.
Changing Tastes and Advancing
Technology

The adjustment process as old-technology firms exit or

adopt the new technology and new-technology firms enter
can create great changes in local geographic prosperity.
Some regions experience economic decline while others
experience economic growth.
Competition and Efficiency

Efficient Use of Resources

Resources are used efficiently when no one can be made
better off without making someone else worse off.
This situation arises when marginal benefit equals
marginal cost.
Competition and Efficiency

Choices, Equilibrium, and Efficiency

We can describe an efficient use of resources in terms of
the choices of consumers and firms coordinated in market
equilibrium.
We derive a consumer’s demand curve by finding how the
best (most valued by the consumer) budget allocation
changes as the price of a good changes.
So consumers get the most value out of their resources at
all points along their demand curves, which are also their
marginal benefit curves.
Competition and Efficiency

We derive a competitive firm’s supply curve by finding how

the profit-maximizing quantity changes as the price of a
good changes.
So firms get the most value out of their resources at all
points along their supply curves, which are also their
marginal cost curves.
In competitive equilibrium, the quantity demanded equals
the quantity supplied, so marginal benefit equals marginal
cost.
All gains from trade have been realized.
Competition and Efficiency

Competitive equilibrium is efficient only if there are no

external benefits or costs.
External benefits are benefits that accrue to people other
than the buyer of a good.
External costs are costs that are borne not by the
producer of a good or service but by someone else.
Competition and Efficiency

Figure 11.12 illustrates an

efficient allocation of
resources in a perfectly
competitive industry.
In part (a), each firm is
producing at the lowest
possible long run average
total cost at the price P*
and the quantity q*.
Competition and Efficiency

Figure 11.12(b) shows the

market.
Along the demand curve D
= MB the consumer is
efficient.
Along the supply curve S =
MC the producer is
efficient.
Competition and Efficiency

The quantity Q* and price

P* are the competitive
equilibrium values.
So competitive equilibrium
is efficient.
The consumer gains the
consumer surplus,

and the producer gains the

producer surplus.
THE END