Perfect Competition

Chapter 11

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Laugher Curve
Q. How many economists does it take to screw in a light bulb? A. Eight. One to screw it in and seven to hold everything else constant.

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Perfect Competition


The concept of competition is used in two ways in economics.

Competition as a process is a rivalry among firms.  Competition as the perfectly competitive market structure.


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A Perfectly Competitive Market



A perfectly competitive market is one in which economic forces operate unimpeded.

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A Perfectly Competitive Market



A perfectly competitive market must meet the following requirements:

Both buyers and sellers are price takers.  The number of firms is large.  There are no barriers to entry.  The firms products are identical.  There is complete information.  Firms are profit maximizers.


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The Necessary Conditions for Perfect Competition



Both buyers and sellers are price takers.

A price taker is a firm or individual who takes the market price as given.  In most markets, households are price takers they accept the price offered in stores.


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The Necessary Conditions for Perfect Competition



Both buyers and sellers are price takers.

The retailer is not perfectly competitive.  A retail store is not a price taker but a price maker.


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The Necessary Conditions for Perfect Competition



The number of firms is large.

arge means that what one firm does has no bearing on what other firms do.  Any one firm's output is minuscule when compared with the total market.


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The Necessary Conditions for Perfect Competition



There are no barriers to entry.

Barriers to entry are social, political, or economic impediments that prevent other firms from entering the market.  Barriers sometimes take the form of patents granted to produce a certain good.


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The Necessary Conditions for Perfect Competition



There are no barriers to entry.

Technology may prevent some firms from entering the market.  Social forces such as bankers only lending to certain people may create barriers.


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The Necessary Conditions for Perfect Competition



The firms' products are identical.



This requirement means that each firm's output is indistinguishable from any competitor's product.

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The Necessary Conditions for Perfect Competition



There is complete information.

Firms and consumers know all there is to know about the market prices, products, and available technology.  Any technological breakthrough would be instantly known to all in the market.


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The Necessary Conditions for Perfect Competition



Firms are profit maximizers.

The goal of all firms in a perfectly competitive market is profit and only profit.  The only compensation firm owners receive is profit, not salaries.


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The Definition of Supply and Perfect Competition



If all the necessary conditions for perfect competition exist, we can talk formally about the supply of a produced good.

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The Definition of Supply and Perfect Competition



Supply is a schedule of quantities of goods that will be offered to the market at various prices.

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The Definition of Supply and Perfect Competition



When a firm operates in a perfectly competitive market, its supply curve is that portion of its short-run marginal cost curve above average variable cost.

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Demand Curves for the Firm and the Industry

The demand curves facing the firm is different from the industry demand curve.  A perfectly competitive firms demand schedule is perfectly elastic even though the demand curve for the market is downward sloping.


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Demand Curves for the Firm and the Industry



Individual firms will increase their output in response to an increase in demand even though that will cause the price to fall thus making all firms collectively worse off.

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Market Demand Versus Individual Firm Demand Curve

Price $10 8 6 4 2 0
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Market Market supply

Firm Price $10 8 6 4 2 0 10 20 30 Quantity Individual firm demand

Market demand 1,000 3,000 Quantity

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ProfitProfit-Maximizing Level of Output

The goal of the firm is to maximize profits.  Profit is the difference between total revenue and total cost.


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ProfitProfit-Maximizing Level of Output

What happens to profit in response to a change in output is determined by marginal revenue (MR) and marginal cost (MC).  A firm maximizes profit when MC = MR.


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ProfitProfit-Maximizing Level of Output

Marginal revenue (MR) the change in total revenue associated with a change in quantity.  Marginal cost (MC) the change in total cost associated with a change in quantity.


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Marginal Revenue
A perfect competitor accepts the market price as given.  As a result, marginal revenue equals price (MR = P).


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Marginal Cost
Initially, marginal cost falls and then begins to rise.  Marginal concepts are best defined between the numbers.


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Profit Maximization: MC = MR


To maximize profits, a firm should produce where marginal cost equals marginal revenue.

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How to Maximize Profit

If marginal revenue does not equal marginal cost, a firm can increase profit by changing output.  The supplier will continue to produce as long as marginal cost is less than marginal revenue.


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How to Maximize Profit

The supplier will cut back on production if marginal cost is greater than marginal revenue.  Thus, the profit-maximizing condition of a competitive firm is MC = MR = P.


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Marginal Cost, Marginal Revenue, and Price

Price = MR Quantity Produced Marginal Cost Costs

MC

$35.00 35.00 35.00 35.00 35.00 35.00 35.00 35.00 35.00 35.00 35.00
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0 1 2 3 4 5 6 7 8 9 10

60 50 40 30 20 10 0 1 2 3 4 5 6 7 8 9 10 Quantity A A C B P = D = MR

$28.00 20.00 16.00 14.00 12.00 17.00 22.00 30.00 40.00 54.00 68.00

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The Marginal Cost Curve Is the Supply Curve



The marginal cost curve is the firm's supply curve above the point where price exceeds average variable cost.

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The Marginal Cost Curve Is the Supply Curve

The MC curve tells the competitive firm how much it should produce at a given price.  The firm can do no better than produce the quantity at which marginal cost equals marginal revenue which in turn equals price.

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The Marginal Cost Curve Is the Firms Supply Curve

$70 60 Cost, Price 50 40 30 20 10 0
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Marginal cost C

A B

9 10 Quantity

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Firms Maximize Total Profit



Firms seek to maximize total profit, not profit per unit.

Firms do not care about profit per unit.  As long as increasing output increases total profits, a profit-maximizing firm should produce more.


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Profit Maximization Using Total Revenue and Total Cost

Profit is maximized where the vertical distance between total revenue and total cost is greatest.  At that output, MR (the slope of the total revenue curve) and MC (the slope of the total cost curve) are equal.


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Profit Determination Using Total Cost and Revenue Curves

TC Loss $385 350 315 Maximum profit =$81 280 245 210 $130 175 140 105 Profit =$45 70 Loss 35 0 Total cost, revenue TR Profit

1 2 3 4 5 6 7 8 9

Quantity

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Total Profit at the ProfitProfitMaximizing Level of Output

The P = MR = MC condition tells us how much output a competitive firm should produce to maximize profit.  It does not tell us how much profit the firm makes.


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Determining Profit and Loss From a Table of Costs

Profit can be calculated from a table of costs and revenues.  Profit is determined by total revenue minus total cost.


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Costs Relevant to a Firm

35.00 35.00 35.00 35.00 35.00 35.00
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Profit Maximization for a Competitive Firm

Profit TR-TC

Marginal Average Total P = MR Output Total Cost Cost Total Cost Revenue

0 1 2 3 4 5 6

40.00 68.00 88.00 104.00 118.00 130.00 147.00

28.00 20.00 16.00 14.00 12.00 17.00

68.00 44.00 34.67 29.50 26.00 24.50

0 35.00 70.00 105.00 140.00 175.00 210.00

40.00 33.00 18.00 1.00 22.00 45.00 63.00

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Costs Relevant to a Firm

35.00 35.00 35.00 35.00 35.00 35.00 35.00
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Profit Maximization for a Competitive Firm

Profit TR-TC

Marginal Average Total P = MR Output Total Cost Cost Total Cost Revenue

4 5 6 7 8 9 10

118.00 130.00 147.00 169.00 199.00 239.00 293.00

14.00 12.00 17.00 22.00 30.00 40.00 54.00

29.50 26.00 24.50 24.14 24.88 26.56 29.30

140.00 175.00 210.00 245.00 280.00 315.00 350.00

22.00 45.00 63.00 76.00 81.00 76.00 57.00

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Determining Profit and Loss From a Graph



Find output where MC = MR.



The intersection of MC = MR (P) determines the quantity the firm will produce if it wishes to maximize profits.

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Determining Profit and Loss From a Graph



Find profit per unit where MC = MR.

Drop a line down from where MC equals MR, and then to the ATC curve.  This is the profit per unit.  Extend a line back to the vertical axis to identify total profit.


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Determining Profit and Loss From a Graph

The firm makes a profit when the ATC curve is below the MR curve.  The firm incurs a loss when the ATC curve is above the MR curve.


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Determining Profit and Loss From a Graph



Zero profit or loss where MC=MR.

Firms can earn zero profit or even a loss where MC = MR.  Even though economic profit is zero, all resources, including entrepreneurs, are being paid their opportunity costs.


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Determining Profits Graphically

MC MC MC Price Price Price 65 65 65 60 60 60 55 55 55 ATC 50 50 50 ATC 45 45 45 40 40 D A P = MR 40 Loss P = MR 35 35 35 P = MR 30 30 30 Profit B ATC AVC 25 25 25 C AVC AVC E 20 20 20 15 15 15 10 10 10 5 5 5 0 0 0 1 2 3 4 5 6 7 8 910 12 1 2 3 4 5 6 7 8 9 10 12 1 2 3 4 5 6 7 8 9 10 12 Quantity Quantity Quantity (b) Zero profit case (a) Profit case (c) Loss case
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The Shutdown Point



The firm will shut down if it cannot cover average variable costs.
A firm should continue to produce as long as price is greater than average variable cost.  If price falls below that point it makes sense to shut down temporarily and save the variable costs.


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The Shutdown Point



The shutdown point is the point at which the firm will be better off it it shuts down than it will if it stays in business.

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The Shutdown Point

If total revenue is more than total variable cost, the firms best strategy is to temporarily produce at a loss.  It is taking less of a loss than it would by shutting down.


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The Shutdown Decision

MC Price 60 50 40 30 20 $17.80 10 0 2 4 6 A Loss P = MR AVC ATC

Quantity

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Short-Run Market Supply and ShortDemand

While the firm's demand curve is perfectly elastic, the industry's is downward sloping.  For the industry's supply curve we use a market supply curve.


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Short-Run Market Supply and ShortDemand



The market supply curve is the horizontal sum of all the firms' marginal cost curves, taking account of any changes in input prices that might occur.

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Long-Run Competitive LongEquilibrium



Profits and losses are inconsistent with long-run equilibrium.

Profits create incentives for new firms to enter, output will increase, and the price will fall until zero profits are made.  The existence of losses will cause firms to leave the industry.


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Long-Run Competitive LongEquilibrium

Only at zero profit will entry and exit stop.  The zero profit condition defines the longrun equilibrium of a competitive industry.


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Long-Run Competitive LongEquilibrium

MC

Price 60 50 40 30 20 10 0
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SRATC P = MR

LRATC

Quantity

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Long-Run Competitive LongEquilibrium

Zero profit does not mean that the entrepreneur does not get anything for his efforts.  Normal profit the amount the owners of business would have received in the nextbest alternative.


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Long-Run Competitive LongEquilibrium

Normal profits are included as a cost and are not included in economic profit.  Economic profits are profits above normal profits.


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Long-Run Competitive LongEquilibrium

Firms with super-efficient workers or machines will find that the price of these specialized inputs will rise.  Rent is the income received by those specialized factors of production.


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Long-Run Competitive LongEquilibrium

The zero profit condition makes the analysis of competitive markets applicable to the real world.  To determine whether markets are competitive, many economist focus on whether barriers to entry exist.


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Adjustment from the Long Run to the Short Run



Industry supply and demand curves come together to lead to long-run equilibrium.

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An Increase in Demand


An increase in demand leads to higher prices and higher profits.

Existing firms increase output.  New firms enter the market, increasing output still more.  Price falls until all profit is competed away.


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An Increase in Demand


If input prices remain constant, the new equilibrium will be at the original price but with a higher output.

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An Increase in Demand


The original firms return to their original output but since there are more firms in the market, the total market output increases.

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An Increase in Demand
In the short run, the price does more of the adjusting.  In the long run, more of the adjustment is done by quantity.


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Market Response to an Increase in Demand

Price Market S0SR $9 7 A D1 D0 0
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Price S1SR

Firm

MC AC

B C

SLR

$9 Profit 7

B A

700

8401,200 Quantity

1012 Quantity

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Long-Run Market Supply LongIn the long run firms earn zero profits.  If the long-run industry supply curve is perfectly elastic, the market is a constantcost industry.


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Long-Run Market Supply Long

Two other possibilities exist:

Increasing-cost industry factor prices rise as new firms enter the market and existing firms expand capacity.  Decreasing-cost industry factor prices fall as industry output expands.


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An Increasing-Cost Industry Increasing

If inputs are specialized, factor prices are likely to rise when the increase in the industry-wide demand for inputs to production increases.

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An Increasing-Cost Industry Increasing

This rise in factor costs would force costs up for each firm in the industry and increases the price at which firms earn zero profit.

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An Increasing-Cost Industry Increasing

Therefore, in increasing-cost industries, the long-run supply curve is upward sloping.

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A Decreasing-Cost Industry Decreasing

If input prices decline when industry output expands, individual firms' marginal cost curves shift down and the long-run supply curve is downward sloping.

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A Decreasing-Cost Industry DecreasingInput prices may decline to the zero-profit condition when output rises.  New entrants make it more cost-effective for other firms to provide services to all firms in the market.


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An Example in the Real World

K-mart decided to close over 300 stores after experiencing two years of losses (a shutdown decision).  K-mart thought its losses would be temporary.


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An Example in the Real World



Price exceeded average variable cost, so it continued to keep some stores open even though those stores were losing money.

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An Example in the Real World

Price MC

ATC Loss AVC P = MR

Quantity
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An Example in the Real World

After two years of losses, its prospective changed.  The company moved from the short run to the long run.


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An Example in the Real World

They began to think that demand was not temporarily low, but permanently low.  At that point they shut down those stores for which P < AVC.


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Perfect Competition

End of Chapter 11

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