Perfect Competition

Chapter 12

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Main ideas
After studying this chapter, you will be able to:

• Define perfect competition

• Explain how a firm makes its output decision
• Explain how price and output are determined in a perfectly competitive market
• Explain why firms enter and leave a competitive market
• Predict the effects of a technological change in competitive market
• Explain why perfect competition is efficient

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What Is Perfect Competition?
Perfectly competitive market
• Many firms sell identical products to many buyers
• No restrictions on entry or exit
• Established firms have no advantage over new ones
• Sellers and buyers are well informed about prices
How perfect competition arises
• Minimum efficient scale of a single producer is small relative to the market demand
for the good or service
Price takers

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What Is Perfect Competition?
Economic profit and revenue
• Firm’s goal: maximise profit, where Profit = TR – TC
• TR = P x Q
• TC = opportunity cost of production
• MR = ∆TR / ∆Q
• In perfect competition MR = P

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What Is Perfect Competition?
• Firm can sell any quantity it chooses at the market price (D = P = MR)

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What Is Perfect Competition?
The firm’s decisions
• To achieve maximum profit, a firm must decide:
1. How to produce at minimum cost
2. What quantity to produce
3. Whether to enter or exit a market
Answer to Q1 (from chapter 11)
• Operate on LRAC curve

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The Firm’s Output Decision
1. What quantity to produce

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The Firm’s Output Decision
2. What quantity to produce
• Profit-maximising Q where MR (= D = P) = MC

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The Firm’s Output Decision
2. What quantity to produce
• Profit-maximising Q where MR (= D = P) = MC

Shutdown decision:
Profit-maximising Q where MR = MC
But what if P < ATC ?
Loss comparisons:
Economic loss = TFC + TVC – TR
= TFC + (AVC x Q) – (P x Q)
= TFC + (AVC – P) x Q
Shut down if: TVC > TR or if AVC > P
Shutdown point:
Where AVC is at minimum

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The Firm’s Output Decision
2. What quantity to produce
The firm’s supply curve:
• Derived from MC and AVC curves

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Output, Price, and Profit in the Short Run
Market supply in the short run
• Short-run market supply curve shows quantity supplied by all firms in the market at
each price
Short-run equilibrium
• Where market D = market S
Change in demand
• Brings changes to short-run market
equilibrium
Profits and losses in the short run
• Profit per Q = P – ATC
• Economic profit = (P – ATC) x Q

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Output, Price, and Profit in the Short Run
Three possible short-run outcomes

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Output, Price, and Profit in the Long Run
3. Whether to enter or exit the market
• In the long run firms can enter or exit the market
• New firms enter when existing firms are making permanent profit – market P ↓ and
economic profit ↓
• Firms leave when they are making permanent losses – market P ↑ and economic
profit ↑

Long-run equilibrium
• When economic profits and losses are eliminated
• Entry and exit have stopped

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Output, Price, and Profit in the Long Run
3. Whether to enter or exit the market

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Changing Demand and Supply due to
Advancing Technology
Decrease in demand

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Changing Demand and Supply due to
Advancing Technology
Increase in demand

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Changing Demand and Supply due to
Advancing Technology
Falling production costs
• Increase in supply

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Competition and Efficiency
Efficient Use of Resources
• When MSC = MSB
Choices, Equilibrium, and Efficiency
Choices
• Consumers allocate their budgets to get the most value possible out of them
Equilibrium and Efficiency
• Competitive equilibrium achieves efficient outcome:
• P = MSB for consumers, and P = MSC for producers

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Competition and Efficiency

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