Perfect Competition

Chapter 7

LIPSEY & CHRYSTAL

ECONOMICS 12e
 Learning Outcomes

• The impact of the product market on firms’ prices and output

choices is determined by the nature of the product and the
market structure in which they operate.
• In perfect competition firms produce a homogeneous product
and are price-takers in their output markets.
• All profit-maximising firms choose their output to equate
marginal cost and marginal revenue.
 Learning Outcomes

• Under perfect competition marginal cost will equal the market

price, and so the supply curve of firms is determined by the
marginal cost curve.
• The long-run supply curve of a competitive industry may be
positively sloped, horizontal, or negatively sloped depending on
how input prices are affected by the industry’s expansion.
• Perfect competition maximizes benefits that consumers receive
from the output of the product in question.
 CHAPTER 7: PERFECT COMPETITION

Market Structure and Firm Behaviour

• Competitive behaviour refers to the extent to which individual firms
compete with each other to sell their products.
• Competitive market structure refers to the power that individual firms
have over the market - perfect competition occurring where firms
have no market power and hence no need to react to each other.
Perfectly Competitive Markets
• The theory of perfect competition is based on the following
assumptions: firms sell a homogenous product; customers are well
informed; each firm is a price-taker; the industry can support many
firms, which are free to enter or leave the industry.
 CHAPTER 7: PERFECT COMPETITION

Short-run Equilibrium
• Any firm maximizes profits producing the output where its
marginal cost curve intersects the marginal revenue curve from
below - or by producing nothing if average cost exceeds price at
all outputs.
• A perfectly competitive firm is a quantity-adjuster, facing a
perfectly elastic demand curve at the given market price and
maximizing profits by choosing the output that equates its
marginal cost to price.
• The supply curve of a firm in perfect competition is its marginal
cost curve, and the supply curve of a perfectly competitive
industry is the sum of the marginal cost curves of all its firms.
• The intersection of this curve with the market demand curve for
the industry’s product determines market price.
 CHAPTER 7: PERFECT COMPETITION

Long-run Equilibrium
• Long-run industry equilibrium requires that each individual firm
be producing at the minimum point of its LRAC curve and be
making zero profits.
• The long-run industry supply curve for a perfectly competitive
industry may be [i] positively sloped, if input prices are driven up
by the industry’s expansion; [ii] horizontal, if plants can be
replicated and factor prices remain constant; or [iii] negatively
sloped, if some other industry that is not perfectly competitive
produces an input under conditions of falling long-run costs.
The Allocative Efficiency of Perfect Competition
• Perfect competition produces an optimal allocation of resources
because it maximizes the sum of consumers’ and producers’
surplus by producing equilibrium where marginal cost equals
price.
 The Demand Curve for a Competitive Industry and for One Firm

5 5

4 S
4
Price [£]

Dfirm

Price [£]
3 3

2 2

1 1
D
60
100 200 300 400 10 20 30 40 50
Quantity [millions of tons] Quantity [thousands of tons]
[i] Competitive industry’s demand curve [ii] Competitive firm’s demand curve
The Demand Curve for a Competitive Industry and for One Firm

 The industry’s demand curve is negatively sloped, the firm’s

demand curve is virtually horizontal.
 The competitive industry has output of 200 million tonnes
when the price is £3.
 The individual firm takes that market price as given and
considers producing up to say, 60,000 tonnes.
 The firm’s demand curve in part (ii) is horizontal because any
change in output that this one firm could manage would leave
price virtually unchanged at £3.
 Revenue Concepts for a Price-taking Firm

Quantity sold Price TR = p*q AR = TR/q MR = TR/q

(Units)

(q) (£p) (£) (£) (£)

10 3.00 30.00 3.00

3.00
11 3.00 33.00 3.00
3.00
12 3.00 36.00 3.00
3.00
13 3.00 39.00 3.00
 Revenue Concepts for a Price-taking Firm

 The table shows the calculation of total (TR), average (AR),

and marginal revenue (MR) when market price is £3.00.
 For example when sales rise from 11 to 12 units, revenue
rises form £33 to £36 making marginal revenue equal to £3.
 The table illustrates the general result that when price I fixed
average revenue, marginal revenue, and price are all equal.
 Revenue Curve for a Firm
£ per unit

TR
AR = MP = p
3 £’ 39
30

0 10 0 10 13
Output
Output
[i] Average and marginal revenue [ii] Total revenue
 Revenue Curve for a Firm

 Because price does not change as the firm varies its output,
neither marginal nor average revenue varies with output
-both are equal to price.
 When price is constant, total revenue is a straight line
through the origin whose constant positive slope is the price
per unit.
 The Short-run Equilibrium of a Firm in Perfect Competition

£
per
unit
AVC

Output
 The Short-run Equilibrium of a Firm in Perfect Competition

£ MC
per
unit
AVC

Output
 The Short-run Equilibrium of a Firm in Perfect Competition

£ MC
per
unit
AVC

p=MR=AR

q2 qE q1

Output
The Short-run Equilibrium of a Firm in Perfect Competition

 The firm chooses the output for which p=MC above the level
of AVC.
 When price equals marginal cost, as at output qE, the firm
loses profits if it either increases or decreases its output.
 At any point left of qE, say q2, price is greater than the
marginal cost, and it pays to increase output (as indicated by
the left-hand arrow).
 At any point to the right of qE, say q1, price is less than the
marginal cost, and it pays to reduce output (as indicated by
the right-hand arrow).
 Total Cost and Revenue Curves

TC
TR

0 qE
Output
 Total Cost and Revenue Curves

 At each output the vertical distance between the TR and TC

curves shows by how much total revenue exceeds or falls
short of total cost.
 The gap is largest at output qE which is the profit-maximizing
output.
 The Supply Curve for a Price-taking Firm

MC

5 5
£ per nut

4 4

Price [£]
AVC

3 3

E0
p0
2 2

1 1

Output q0 Quantity
[i] Marginal cost and average variable cost curves [ii] The supply curve
 The Supply Curve for a Price-taking Firm

MC

5 5
£ per nut

4 4

Price [£]
AVC
E1 p1
3 3

E0
p0
2 2

1 1

q0 q1
Output Quantity
[i] Marginal cost and average variable cost curves [ii] The supply curve
 The Supply Curve for a Price-taking Firm

MC

5 5

E2 p2
4 4
£ per nut

Price [£]
AVC
E1 p1
3 3

E0
p0
2 2

1 1

Output q0 q1 q2 Quantity
[i] Marginal cost and average variable cost curves [ii] The supply curve
 The Supply Curve for a Price-taking Firm

MC S
E3 p3
5 5

E2 p2
4 4
£ per nut

Price [£]
AVC
E1 p1
3 3

E0
p0
2 2

1 1

q0 q1 q2 q3
Output Quantity

[i] Marginal cost and average variable cost curves [ii] The supply curve
The Supply Curve for a Price-taking Firm

 For a price-taking firm the supply curve has the same shape
as its MC curve above the level of AVC.
 The point E0, where price, p0, equals AVC is the shutdown
point.
 As price rises from £2 to £3 to £4 to £5, the firm increases its
production from q0 to q1 to q2 to q3 .
 For example at a price of £3, the firm produces output q1 and
earns the contribution to fixed costs shown by the dark blue
shaded rectangle.
 The firm’s supply curve is shown in part (ii). It relates market
price to the quantity the firm will produce and offer for sale.
 It has the same shape as the firm’s MC curve for all prices
above AVC.
Alternative Short-run Equilibrium Positions for a Firm in Perfect Competition

SRATC [i]

£ per unit MC

p1 E

SRAVC

0 q1 Output
Alternative Short-run Equilibrium Positions for a Firm in Perfect Competition

SRATC [ii]

£ per unit
MC

E
p2

0 q2 Output
MC
Alternative Short-run Equilibrium Positions for a Firm in Perfect Competition

SRATC [iii]

MC
£ per unit

E
p3

0 q3
Output
 Alternative Short-run Equilibrium Positions for a Firm in Perfect Competition

£ per unit
£ per unit

SRATC [i] [ii]

MC MC
SRATC

E E
p1 p2
SARVC

0 q1 Output 0 q2 Output
MC
[iii]
£ per unit

SRATC

E
p3

0 q3
Output
Short-run Equilibrium Positions for a Firm in Perfect Competition
(i) The firm is making losses

 The market price is p1. Because this price is below average

total cost, the firm is suffering losses shown by the light blue
area.
 Because price exceeds average variable cost, the firm
continues to produce in the short run.
 Because price is less than ATC, the firm will not replace its
capital as it wears out.
Short-run Equilibrium Positions for a Firm in Perfect Competition
(ii) The firm is just covering all its costs

 The market price is p2.

 The firm is just covering its total costs.
 It will replace its capital as it wears out since its revenue is
covering the full opportunity cost of its capital.
Short-run Equilibrium Positions for a Firm in Perfect Competition

(iii) The firm is making pure profits

 The market price is p3.

 The firm is earning pure (or economic) profits in excess of all
its costs, as shown by the dark blue area.
 The firm will replace its capital as it wears out.
 Consumers’ and Producers’ Surplus

S
Price

E
Consumer surplus Market price
p0
Producers surplus

Total variable cost

0
q0

Quantity
 Consumers’ and Producers’ Surplus

 Consumers’ surplus is the area under the demand curve and above
the market price line.
 The equilibrium price and quantity are p0 and q0.
 The total value that consumers place on q0 units of the product is
given by the sum of the dark yellow, light yellow, and light blue areas.
 The amount that they pay is p0q0, the rectangle that consists of the
light yellow and light blue areas.
 The difference, shown as the dark yellow area, is consumers’
surplus.
 Consumers’ and Producers’ Surplus

 Producers surplus is the area above the supply curve and below the
market price line.
 The receipts of producers from the sale of q0 units are also p0q0.
 The area under the supply curve, the blue-shaded area, is total
variable cost, which is the minimum amount that producers must
receive to induce them to supply the output.
 The difference, shown as the light yellow area, is producers’ surplus.
 The Allocative Efficiency of Perfect Competition

S
Price

E Competitive market price

p0 3

4
2 D

0 q1 q0 q2

Quantity
 The Allocative Efficiency of Perfect Competition

 At the competitive equilibrium E consumers’ surplus is the dark

yellow area above the price line.
 Producers’ surplus is the light yellow area below the price line.
 Reducing the output to q1 but keeping price at p0 lowers
consumers surplus by area 1.
 It lowers producers’ surplus by area 2.
The Allocative Efficiency of Perfect Competition

 Assume that producers are forced to produce output q2 and to

sell it to consumers, who are in turn forced to buy it at price p0.
 Producers’ surplus is reduced by area 3 (the amount by which
variable costs exceed revenue on those units).
 Consumers’ surplus is reduced by area 4 (the amount by which
expenditure exceeds consumers’ satisfactions on those units).
 Only at the competitive output, q0, is the sum of the two
surpluses maximized.
 Short-run and Long-run Equilibrium of a Firm in Perfect Competition

SRATC0
£ per unit

MC0

p0

MC*
c0
SRATC*
LRAC

p*

0 q0
q*
Short-run and Long-run Equilibrium of a Firm in Perfect Competition

 The firm’s existing plant has short-run cost curves SRATC0 and
MC0 while market price is p0.
 The firm produces q0, where MC0 equals price and total costs are
just being covered.
 Although the firm is in short-run equilibrium, it can earn profits by
building a larger plant and so moving downwards along its LRAC
curve.
Short-run and Long-run Equilibrium of a Firm in Perfect Competition

 Thus the firm cannot be in long-run equilibrium at any output

below q*, because average total costs can be reduced by
building a larger plant.
 If all firms do this, industry output will increase and price will
fall until long-run equilibrium is reached at price p*.
 Each firm is then in short-run equilibrium with a plant whose
average cost curve is SRATC* and whose short-run marginal
cost curve, MC*, intersects the price line p at an output of q*.
 Because the LRAC curve lies above p* everywhere except at
q*, the firm has no incentive to move to another point on its
LRAC curve by altering the size of its plant.
 Thus a perfectly competitive firm that is not at the minimum
point on its LRAC curve cannot be in long-run equilibrium.
 Long-run Industry Supply Curves

S0 S0
Price

Price
Quantity S0 Quantity
Price

Quantity
 Long-run Industry Supply Curves

D0 S0 D0 S0
Price

E0
E0

Price
p0 p0

S0
D0
q1 Quantity q1 Quantity
Price

p0 E0

q1 Quantity
 Long-run Industry Supply Curves

D1
D1 S0 D0 S0
D0
E1
Price

E1
E0

Price
p0 E0
p0

S0
q1 Quantity D0 q1
D1 E1 Quantity

E0
Price

p0

q1 Quantity
 Long-run Industry Supply Curves

D1
D1 S0 D0 S0
(ii)
D0 (i) E1
Price

E2
E1 p0
E0 LRS
E2

Price
p0 E0
p0 = p2

LRS

D1 q2
S0
q1 q2 Quantity D0 q1 Quantity
E1

E0 (iii)
Price

p0
E2

p0 LRS

q1 q2 Quantity
 (i) A constant long-run industry supply curve

 The initial curves are at D0 and S0.

 Equilibrium is at E0 with price p0 and quantity q0.
 A rise in demand shifts the demand curve to D1, taking the short-
run equilibrium to E1.
 New firms now enter the industry, shifting the short-run supply
curve outwards.
 Price is pushed down until pure profits are no longer being
earned. At this point the supply curve is S1.
 The new equilibrium is E2 with price at p2 and quantity q2.
 The curves shift so that price returns to its original level, making
the long-run supply curve horizontal.
 (ii) A Rising long-run industry supply curve

 The initial curves are at D0 and S0.

 Equilibrium is at E0 with price p0 and quantity q0.
 A rise in demand shifts the demand curve to D1, taking the short-
run equilibrium to E1.
 New firms now enter the industry, shifting the short-run supply
curve outwards.
 Price is pushed down until pure profits are no longer being earned.
 At this point the supply curve is S1.
 The new equilibrium is E2 with price at p2 and quantity q2.
 Profits are eliminated and entry ceases before price falls to its
original level, giving the LRS curve a positive slope.
 (iii) A falling long-run industry supply curve

 The initial curves are at D0 and S0.

 Equilibrium is at E0 with price p0 and quantity q0.
 A rise in demand shifts the demand curve to D1, taking the short-
run equilibrium to E1.
 New firms now enter the industry, shifting the short-run supply
curve outwards.
 Price is pushed down until pure profits are no longer being
earned. At this point the supply curve is S1.
 The new equilibrium is E2 with price at p2 and quantity q2.
 The price falls below its original level before profits return to
normal, giving the LRS curve a negative slope.