7 Perfect Competition

ECONOMICS 5e
Michael Parkin
CHAPTER
12
Perfect Competition
Learning Objectives
• Define perfect competition

• Explain how price and output are
determined in a competitive industry
• Explain why firms sometimes shut down

temporarily and lay off workers
Copyright © 1998 Addison Wesley Longman, Inc. TM 12-

Learning Objectives (cont.)
• Explain why firms enter and leave an

industry
• Predict the effects of a change in demand

and of a technological advance
• Explain why perfect competition is efficient

Learning Objectives



Perfect Competition
Characteristics of Perfect Competition

• Many firms, each selling an identical product.
• Many buyers.
• No restrictions on entry into the industry.

Perfect Competition
Characteristics of Perfect Competition

• Firms in the industry have no advantage over
potential new entrants.
• Firms and buyers are well informed about
prices of the products of each firm in the
industry.

Perfect Competition
As a result of these characteristics, perfect

competitors are price takers.
Price takers
Firms that cannot influence the price of a good
or service.

Learning Objectives



Economic Profit and Revenue
The firm’s goal is to maximize economic

profit.
Total cost is the opportunity cost - including

normal profit.

Total revenue is the value of a firm’s sales.
• Total revenue = P  Q
Marginal revenue (MR)
• Change in total revenue resulting from a one-unit
increase in quantity sold.
Average revenue (AR)

• Total revenue divided by the quantity sold—revenue per
unit sold.
In perfect competition, Price = MR = AR
Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

Suppose Sidney sells his sweaters

in a perfectly competitive market.

Demand, Price, and Revenue
in Perfect Competition
Quantity Price Marginal Average
sold (P) Total revenue revenue
(Q) (dollars revenue MR  TR / Q (AR = TR/Q
(sweaters per TR = P  Q (dollars per (dollars
per day) sweater) (dollars) additional sweater) per sweater)
8 25
9 25
10 25

8 25 200
9 25 225
10 25 250

8 25 200
25
9 25 225
25
10 25 250

8 25 200 25
25
9 25 225 25
25
10 25 250 25

Sidney’s demand
Sweater market and marginal revenue Sidney’s total revenue
Price (dollars per sweater)
Total revenue (dollar per day)

Price (dollars per sweater) TR
Sidney’s
50 50
demand
S curve
Market
25 MR 225 a
25 demand
curve
D
0 9 20 0 10 20 0 9 20
Quantity (thousands Quantity (sweaters per day) Quantity (sweaters per day)
of sweaters per day)

Learning Objectives



The Firm’s Decisions in
Perfect Competition
A firm’s task is to make the maximum
economic profit possible, given the
constraints it faces.
In order to do so, the firm must make two

decisions in the short-run, and two in the
long-run.

Perfect Competition
Short-run
A time frame in which each firm has a given
plant and the number of firms in the industry is
fixed
Long-run
A time frame in which each firm can change the
size of its plant and decide to enter the industry.

Perfect Competition
In the short-run, the firm must decide:
• Whether to produce or to shut down.
• If the decision is to produce, what quantity to

produce.

Perfect Competition
In the long-run, the firm must decide:
• Whether to increase of decrease its plant size.
• Whether to stay in the industry or leave it.
We will first address the short-run.

Total Revenue, Total Cost,
and Economic Profit
Quantity Total Total Economic
(Q) revenue cost profit
(sweaters (TR) (TC) (TR – TC)
Per day) (dollars) (dollars) (dollars)
0 0
1 25
2 50
3 75
4 100
5 125
6 150
7 175
8 200
9 225
10 250
11 275
12 300
13 325
and Economic Profit
0 0 22
1 25 45
2 50 66
3 75 85
4 100 100
5 125 114
6 150 126
7 175 141
8 200 160
9 225 183
10 250 210
11 275 245
12 300 300
13 325 360
and Economic Profit
0 0 22 -22
1 25 45 -20
2 50 66 -16
3 75 85 -10
4 100 100 0
5 125 114 11
6 150 126 24
7 175 141 24
8 200 160 40
9 225 183 42
10 250 210 40
11 275 245 30
12 300 300 0
13 325 360 -35
and Economic Profit
TC
(dollars per day)
Total revenue & total cost
TR
300 Economic
loss
225
Economic
183 profit =
TR - TC
100
Economic
loss
0 4 9 12
Quantity (sweaters per day)
and Economic Profit
Economic profit/loss
Profit/loss
(dollars per day)
42
Economic Economic
20 loss profit
0 Quantity
4 9 12
(sweaters
-20 per day)
Profit/
-40 Profit loss
maximizing
quantity

Marginal Analysis
Using marginal analysis, a comparison is

made between a units marginal revenue and
marginal cost.

Marginal Analysis
If MR > MC, the extra revenue from selling one

more unit exceeds the extra cost.
• The firm should increase output to increase profit.
If MR < MC, the extra revenue from selling one
more unit is less than the extra cost.
• The firm should decrease output to increase profit.
If MR = MC economic profit is maximized.

Profit-Maximizing Output
Marginal Marginal
revenue cost
Quantity Total (MR) Total (MC) Economic
(Q) revenue (dollars per cost (dollars per profit
(sweaters (TR) additional (TC) additional (TR – TC)
per day) (dollars) sweater) (dollars sweater) (dollars)
7 175
8 200
9 225
10 250
11 275
Marginal Marginal
revenue cost
7 175
25
8 200
25
9 225
25
10 250
25
11 275
Marginal Marginal
revenue cost
7 175 141
25
8 200 160
25
9 225 183
25
10 250 210
25
11 275 245
Marginal Marginal
revenue cost
7 175 141
25 19
8 200 160
25 23
9 225 183
25 27
10 250 210
25 35
11 275 245
Marginal Marginal
revenue cost
7 175 141 34
25 19
8 200 160 40
25 23
9 225 183 42
25 27
10 250 210 40
25 35
11 275 245 30
Marginal revenue & marginal cost
(dollars per day)
Profit-
maximization
MC Loss from
30 point
10th sweater
25 MR
Profit from
9th sweater
20
10
0 8 9 10
The Firm’s Short-Run
Supply Curve
Fixed costs must be paid in the short-run.
Variable-costs can be avoided by laying off

workers and shutting down.
Firms shut down if price falls below the

minimum of average variable cost.

A Firm’s Supply Curve
(dollars per day)
MC = S
31 MR2
25 MR1
Shutdown AVC
point
s
17 MR0
0 7 9 10
A Firm’s Supply Curve
(dollars per day)
S
31
25
s
17
0 7 9 10
Short-Run Industry Supply Curve
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.
It is constructed by summing the quantities
supplied by the individual firms.

Industry Supply Curve
Quantity supplied Quantity supplied

Price by Sidney by industry
(dollars (sweaters (sweaters
per sweater)per day) per day)
a 17 0 or 7 0 to 7,000
b 2 8 8,000
c 25 9 9,000
d 31 10 10,000

Industry Supply Curve
40
S1
30
20
0 6 7 8 9 10
Quantity (thousands of sweaters per day)
Output, Price, and Profit
Industry demand and industry supply
determine the market price and industry
output.
Changes in demand bring changes to

short-run industry equilibrium.

Short-Run Equilibrium
Increase in demand:
price rises and firms
increase production
S
25
Decrease in demand:
20firms
price falls and
decrease production D2
17
D1
D3
0 6 7 8 9 10
Profits and Losses
in the Short-Run
At short-run equilibrium firms may:
• Earn a profit
• Break even
• Incur an economic loss.

Profits and Losses
in the Short-Run
If price equals average total cost a firm
breaks even.
If price exceeds average total cost, a firm

makes an economic profit.
If price is less than average total cost, a firm

incurs an economic loss.

Three Possible Profit Outcomes
in the Short-Run
Price (dollars per chip)
30.00 Normal profit
Break-even
MC ATC
point
25.00
20.00
AR = MR
15.00
0 8 10 Quantity (millions of chips per year)

in the Short-Run
30.00
Economic profit
MC ATC
25.00
Economic AR = MR
Profit
20.33
15.00
0 9 10
Quantity (millions of chips per year)
in the Short-Run
Economic loss
30.00
MC ATC
25.00
20.14
Economic
loss
17.00
AR = MR
0 7 10
Quantity (millions of chips per year)

industry


Long-Run Adjustments
Forces in a competitive industry ensure only

one of these situations is possible in the
long-run.
Competitive industries adjust in two ways:

• Entry and exit
• Changes in plant size
Entry and Exit
The prospect of persistent profit or loss

causes firms to enter or exit an industry.
If firms are making economic profits, other

firms enter the industry.
If firms are making economic losses, some

of the existing firms exit the industry.

Entry and Exit
This entry and exit of firms influence price,

quantity, and economic profit.
Let’s investigate the effects of firms entering or

exiting an industry.

Entry and Exit
Price (dollars per sweater) Entry
increases
supply
S1 S0 S2
23
Exit
20 decreases
supply
17
D1
0 6 7 8 9 10
Entry and Exit
Important Points
As new firms enter an industry, the price falls
and the economic profit of each existing firm
decreases.
As firms leave an industry, the price rises and

the economic loss of each remaining firm
decreases.

Changes in Plant Size
When a firm changes its plant size, it can

lower its costs and increase its economic
profit.
Let’s see how a firm can increase its profit

by increasing its plant size.

Plant Size and
Long-Run Equilibrium
Short-run profit
maximizing point
40
MC0
SRAC0 LRAC
MC1
SRAC1
25 MR0
20 MR1
m
Long-run
14 competitive
equilibrium
6 8
Long-run equilibrium occurs in a competitive

industry when firms are earning normal profit and
economic profit is zero.
Economic profits draw in firms and cause existing
firms to expand.
Economic losses cause firms to leave and cause
existing firms to scale back.

So in long-run equilibrium in a competitive

industry, firms neither enter nor exit the industry
and firms neither expand their scale of operation
nor downsize.


industry


Changing Tastes and
Advancing Technology
Demand has fallen tremendously for
tobacco, trains, TV and radio repair, and
sewing machines.
Demand has increased dramatically for

microwave utensils, paper plates, and flash
memories.

Changing Tastes and
What happens in a competitive

industry when a permanent
change in demand occurs?

A Decrease in Demand
Industry Firm
MC
S1 S0
Price
Price and Cost

ATC
P0 P0 MR0
MR1
P1 P1
D0
D1
Q2 Q1 Q0 Quantity q1 q0 Quantity
0
External Economies
and Diseconomies
External economies
Factors beyond the control of an individual firm
that lower its costs as the industry increases.
External diseconomies
Factors outside the control of a firm that raise
the firm’s costs as industry output increases.

External Economies
and Diseconomies
We will use this information to develop a

long-run industry supply curve.

Long-Run Changes in
Price and Quantity
Constant-cost industry Increasing-cost industry Decreasing-cost industry

Price
Price
Price
S0 S1 S0 S2 S0
Ps Ps LSB Ps S3
P2
P0 LSA P0 P0
P3 LSC
D1 D1 D1
D0 D0 D0
Q0 Qs Q1 Q0 Qs Q2 Q0 Qs Q3
Quantity Quantity Quantity

Changing Tastes and
Technological change
New technology allows firms to produce at lower costs.
This causes their cost curves to shift downward.
Firms adopting the new technology make an economic

profit.
This draws in new technology firms.
Old technology firms disappear, the price falls, and the

quantity produced increases.


industry


Competition and Efficiency
Resources are used efficiently when there is:

• Consumer efficiency
• Producer efficiency
• Exchange efficiency

Consumer efficiency is achieved when it is not possible
for consumers to become better off — to increase
utility — by reallocating their budgets.
• On the household’s demand curve
• External benefits
Producer efficiency occurs when a firm is producing at
any point on its marginal cost curve, or equivalently,
on its supply curve.
• External costs

Exchange efficiency occurs when all the gains

from trade have been realized (i.e. consumer and
producer surplus).

Efficiency of Competition
S
Price
B0 Consumer
surplus Efficient allocation
P *
Producer
surplus
C0
Q0 Q*
Quantity
Efficiency of Perfect
Competition
Perfect competition enables resources to be used
efficiently if there are no external benefits and
external costs.
• External costs and external benefits
• Goods providing external benefits would be underproduced,
while goods providing external costs would be overproduced.
• Monopoly
• Monopoly restricts output below its competitive level to raise
price and increase profit.

7 Perfect Competition

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ECONOMICS 5e

• Define perfect competition

• Explain why firms sometimes shut down

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-

• Explain why firms enter and leave an

• Predict the effects of a change in demand

• Explain why perfect competition is efficient

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-

• Define perfect competition

• Explain why firms sometimes shut down

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-

Characteristics of Perfect Competition

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-

Characteristics of Perfect Competition

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-

As a result of these characteristics, perfect

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-

• Define perfect competition

• Explain why firms sometimes shut down

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-

The firm’s goal is to maximize economic

Total cost is the opportunity cost - including

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-

Average revenue (AR)

In perfect competition, Price = MR = AR

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

Suppose Sidney sells his sweaters

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

Total revenue (dollar per day)

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

• Define perfect competition

• Explain why firms sometimes shut down

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

In order to do so, the firm must make two

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-1

• Whether to produce or to shut down.

• If the decision is to produce, what quantity to

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-2

• Whether to increase of decrease its plant size.

• Whether to stay in the industry or leave it.

We will first address the short-run.

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-2

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-2

Using marginal analysis, a comparison is

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-2

If MR > MC, the extra revenue from selling one

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-2

Variable-costs can be avoided by laying off

Firms shut down if price falls below the

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-3

Short-run industry supply curve

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-3

Quantity supplied Quantity supplied

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-3

Changes in demand bring changes to

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-4

Copyright © 1998 Addison Wesley Longman, Inc. TM 12-4

If price exceeds average total cost, a firm

If price is less than average total cost, a firm