Perfect Competition

1
Perfect Competition Overheads
2
Market Structure
Market structure refers to all characteristics of
a market that influence the behavior of buyers
and sellers, when they come together to trade
Market structure refers to all features of a
market that affect the behavior and performance
of firms in that market
3
Key Factors Determining Market Structure
Short run long run objectives of buyers and
sellers in the market
Beliefs of buyers and sellers about the ability
of themselves and others to set prices
Degree of product differentiation
Technologies employed by agents in the market
Amount of information available to agents about
the good and about each other
Degree of coordination or noncooperation of agents
Extent of entry and exit barriers
4
Definition of a competitive agent
A buyer or seller (agent) is said to be
competitive if the agent assumes or believes that
the market price is given and that the agent's
actions do not influence the market price
We sometimes say that a competitive agent is a
price taker
5
Common Market Structures
Perfect (pure) competition
Agents take prices as given
Entry and exit barriers are minimal or nonexistent
6
Common Market Structures
Monopoly (seller) or Monopsony (buyer)
Firm sets price (faces market demand or supply
curve)
Entry and exit barriers result in the existence
of one seller or one buyer
7
Common Market Structures
Oligopoly
Firm sets prices (faces residual demand)
Entry and exit barriers result in the existence
of few sellers or buyers
8
Common Market Structures
Monopolistic competition
Firm sets prices (faces residual demand)
Entry and exit barriers are minimal
9
Perfect Competition
1. Buyers and sellers are competitive or price
takers
2. All firms produce homogeneous (standardized)
goods and consumers view them as identical
3. All buyers and sellers have perfect
information regarding the price and quality of
the product
4. Firms can enter and exit the industry freely
5. There are no transaction costs to participate
in the market
6. Each firm bears the full cost of its
production process
7. There is perfect divisibility of output
10
Competitive agents
Large number of agents
What really matters are beliefs
11
Homogeneous Goods
Price and nothing else matters
The demand for your product goes to zero if you
raise price
12
Perfect Information
Buyers and sellers know everything
quality
opportunities to buy and sell
factors affecting the market in the future
13
Ease of Entry and Exit
New firms enter when there are profits
Existing firms leave when there are losses
14
No Transactions Costs
Firms are not dissuaded by participation fees
Buyers can take advantage of opportunities
15
No Externalities
What is good for this market is good for society
The market fully accounts for all costs
16
Divisible output
Small price changes dont lead to large quantity
jumps
Examples such as buildings and machinery
17
Demand facing the perfectly competitive firm
The demand curve facing a perfectly competitive
firm is horizontal at the market price
If the firm were to raise its price, even a tiny
bit, above this price, its sales would go to zero
And no matter how much the firm produces, this
price will not change
18
Industry Supply-Demand Equilibrium

S(p)
p0
D(p)
Output
Q0
The demand curve for a perfectly competitive firm
is horizontal
If the firm were to raise its price above this
price, sales would go to zero
And no matter how much the firm produces, the
price will not change
19
Behavior of a Single Competitive Firm
The firms goal is to maximize profit
20
What is profit?
Profit is revenue minus costs or
21
The firms goal is then to maximize returns
from the technologies it controls, taking into
account
The demand for final consumption goods
Opportunities for buying and selling factors /
products
The actions of other firms in the market
22
The Firm Solves the Problem
23
Example Problem
P 184
24
y FC VC C AFC AVC ATC MC Price
TR MR Profit 0.00 200 0.00 200.00
184 0 -200.00 64.00 184.00 1.00
200 64.00 264.00 200.00 64.00 264.00
184 184 -80.00 66.00 184.00 2.00
200 130.00 330.00 100.00 65.00 165.00
184 368 38.00 74.00 184.00 3.00
200 204.00 404.00 66.67 68.00 134.67
184 552 148.00 88.00 184.00 4.00
200 292.00 492.00 50.00 73.00 123.00
184 736 244.00 108.00 184.00 5.00
200 400.00 600.00 40.00 80.00 120.00
184 920 320.00 134.00 184.00 6.00
200 534.00 734.00 33.33 89.00 122.33
184 1104 370.00 166.00 184.00 7.00
200 700.00 900.00 28.57 100.00 128.57
184 1288 388.00 204.00 184.00 8.00
200 904.00 1104.00 25.00 113.00 138.00
184 1472 368.00 248.00 184.00 9.00
200 1152.00 1352.00 22.22 128.00 150.22
184 1656 304.00 298.00 184.00 10.00
200 1450.00 1650.00 20.00 145.00 165.00
184 1840 190.00
25
Total Revenue and Cost Curves
4000

3500
3000
2500
2000
1500
1000
500
0
0
2
4
6
8
10
12
14
16
18
Output
Note that TR is linear with slope 184
26
Price, Marginal Cost, and Average Cost
Price MR Demand
400

350
300
250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
27
Add average variable and average fixed costs
400

350
300
250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
28
Maximizing profit
Choose the level of output where the difference
between TR and TC is the greatest
29
y C MC Price TR MR Profit 3 404
184 552 148 88.00 184.00 4 492
184 736 244 108.00 184.00 5 600
184 920 320 134.00 184.00 6 734
184 1104 370 166.00 184.00 7 900
184 1288 388 204.00 184.00 8 1104
184 1472 368 248.00 184.00 9 1352
184 1656 304
30
Profit Max Using MR and MC
An increase in output will always increase
profit if MR gt MC
An increase in output will always decrease
profit if MR lt MC
31
The rule is then
Increase output whenever MR gt MC
Decrease output if MR lt MC
32
y C MC Price TR MR Profit 4.00 492.00
184 736 244.00 108.00 184.00 5.00 600.00
184 920 320.00 134.00 184.00 6.00 734.00
184 1104 370.00 166.00 184.00 7.00
900.00 184 1288 388.00 204.00
184.00 8.00 1104.00 184 1472 368.00 248.0
0 184.00 9.00 1352.00 184 1656 304.00
Yes
Should we increase output from 5 to 6?
Yes
Should we increase output from 6 to 7?
No !
Should we increase output from 7 to 8?
33
Measuring Total Profit
Profit is always given by
Graphically it is the distance between total
revenue and total cost
34
Total Revenue and Cost Curves
4000

3500
3000
2500
2000
1500
1000
500
0
0
2
4
6
8
10
12
14
16
18
Output
35
Profit, price, and average total cost
Profit per unit is given by
36
Cost Curves and Profit

350
300
250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
The distance between price and ATC at the
optimum output level is profit per unit
37
Total profit is given by the area of the
box bounded by
price,
the optimum quantity,
average total cost at the optimum quantity,
and the price axis
38
Cost Curves and Profit

350
300
250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
39
y C AVC ATC MC Price TR Profit 5.00 600.00
80.00 120.00 184 920 320.00 134.00
6.00 734.00 89.00 122.33
184 1104 370.00 166.00 7.00 900.00
100.00 128.57 184 1288 388.00 204.00
8.00 1104.00 113.00 138.00
184 1472 368.00
(184 - 128.5714) 55.4286
(55.4286) (7) 388
The firm earns a profit whenever p gt ATC
40
A firm suffers a loss whenever p lt ATC at the
optimum level of output
Let p 97
We can show that the optimum quantity is 4 units
41
y C AVC ATC MC Price TR Profit 0.00 200.00
97 0 -200.00 64.00 1.00 264.00
64.00 264.00 97 97 -167.00 66.00
2.00 330.00 65.00 165.00 97 194 -136.00
74.00 3.00 404.00 68.00 134.67
97 291 -113.00 88.00 4.00 492.00
73.00 123.00 97 388 -104.00 108.00 5.00
600.00 80.00 120.00 97 485 -115.00 134.00
6.00 734.00 89.00 122.33 97 582 -152.00
166.00 7.00 900.00 100.00 128.57
97 679 -221.00
42
Cost Curves and Profit
400
350

300
250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
43
y FC VC C AFC AVC ATC MC Price TR MR Profit 0.00
200 0.00 200.00 97 0 -200.00 64.00
97.00 1.00 200 64.00 264.00 200.00 64.00
264.00 97 97 -167.00 66.00
97.00 2.00 200 130.00 330.00 100.00 65.00
165.00 97 194 -136.00 74.00
97.00 3.00 200 204.00 404.00 66.67 68.00
134.67 97 291 -113.00 88.00
97.00 4.00 200 292.00 492.00 50.00 73.00
123.00 97 388 -104.00 108.00
97.00 5.00 200 400.00 600.00 40.00 80.00
120.00 97 485 -115.00 134.00
97.00 6.00 200 534.00 734.00 33.33 89.00
122.33 97 582 -152.00 166.00
97.00 7.00 200 700.00 900.00 28.57 100.00
128.57 97 679 -221.00 204.00
97.00 8.00 200 904.00 1104.00 25.00 113.00
138.00 97 776 -328.00 248.00
97.00 9.00 200 1152.00 1352.00 22.22
128.00 150.22 97 873 -479.00 298.00
97.00 10.00 200 1450.00 1650.00 20.00
145.00 165.00 97 970 -680.00
44
Another example problem
P 120
45
y Price TR MR FC VC C AFC AVC ATC MC Profit 0.00
120 0 120 200 0.00 200.00 -200.00 0.25
120 30 120 200 24.14 224.14 800.00 96.56
896.56 93.19 -194.14 0.50 120 60 120 200 46.63
246.63 400.00 93.25 493.25 86.75
-186.63 1.00 120 120 120 200 87.00 287.00
200.00 87.00 287.00 75.00 -167.00 2.00
120 240 120 200 152.00 352.00 100.00 76.00
176.00 56.00 -112.00 3.00 120 360 120 200 201.
00 401.00 66.67 67.00 133.67 43.00
-41.00 4.00 120 480 120 200 240.00 440.00
50.00 60.00 110.00 36.00 40.00 5.00
120 600 120 200 275.00 475.00 40.00 55.00
95.00 35.00 125.00 6.00 120 720 120 200 312.00
512.00 33.33 52.00 85.33 40.00 208.00 7.00
120 840 120 200 357.00 557.00 28.57 51.00
79.57 51.00 283.00 8.00 120 960 120 200 416.00
616.00 25.00 52.00 77.00 68.00 344.00 9.00
120 1080 120 200 495.00 695.00 22.22 55.00
77.22 91.00 385.00 10.00 120 1200 120 200 600.
00 800.00 20.00 60.00 80.00 120.00
400.00 11.00 120 1320 120 200 737.00 937.00
18.18 67.00 85.18 155.00 383.00 12.00
120 1440 120 200 912.00 1112.00 16.67 76.00
92.67 196.00 328.00 14.00 120 1680 120 200 140
0.00 1600.00 14.29 100.00 114.29 296.00
80.00 16.00 120 1920 120 200 2112.00 2312.00
12.50 132.00 144.50 420.00 -392.00
46
For a given price we can find optimal output
HOW?
Choose output level where MC MR P
47
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
P MC ? y 10
48
y Price TR MR Cost MC Profit 7.00
120 840 120 557.00 51.00 283.00 8.00
120 960 120 616.00 68.00 344.00 9.00
120 1080 120 695.00 91.00 385.00 10.00
120 1200 120 800.00 120.00 400.00 11.00
120 1320 120 937.00 155.00 383.00 12.00
120 1440 120 1112.00 196.00 328.00
? 400
The firm is happy!!
And R - VC (ROVC) 600
49
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
P MC ? y 10
50
Now let p 91
y Price TR MR VC C MC Profit 6 91 546 91 312 512
40 34 7 91 637 91 357 557 51 80 8 91 728 91 41
6 616 68 112 9 91 819 91 495 695 91 124 10 91
910 91 600 800 120 110 11 91 1001 91 737 937 155
64 12 91 1092 91 912 1112 196 -20
y 9, ? 124
The firm is still happy!!
And R - VC (ROVC) 324
51
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
52
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
P MC ? y 9
? 124
ROVC 324
53
Now let p 68
y Price TR MR VC C MC Profit 6 68 408 68 312 512
40 -104 7 68 476 68 357 557 51 -81 8 68 544 68 4
16 616 68 -72 9 68 612 68 495 695 91 -83 10 68 6
80 68 600 800 120 -120 11 68 748 68 737 937 155 -
189 12 68 816 68 912 1112 196 -296
y 8, ? -72
The firm is not so happy!!
But R - VC (ROVC) 128
54
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
55
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
P MC ? y 8
? -72
ROVC 128
56
Now let p 51
y Price TR MR VC C MC Profit 6 51 306 51 312 512
40 -206 7 51 357 51 357 557 51 -200 8 51 408 51
416 616 68 -208 9 51 459 51 495 695 91 -236 10 5
1 510 51 600 800 120 -290 11 51 561 51 737 937 15
5 -376 12 51 612 51 912 1112 196 -500
y 7, ? -200
The firm may as well shut down ? ?
57
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
58
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
P MC ? y 7
? -200
ROVC 0
59
Now let p 40
y Price TR MR C MC Profit 5 40 200 40 475 35 -275
6 40 240 40 512 40 -272 7 40 280 40 557 51 -277
8 40 320 40 616 68 -296 9 40 360 40 695 91 -335
10 40 400 40 800 120 -400 11 40 440 40 937 155
-497
y 6, ? -272
The firm should get out in a hurry!
60
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
61
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
P MC ? y 6
? - 272
ROVC -72
62
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
63
Short run supply
At different prices we know how much the firm
will choose to supply
By plotting these points we can obtain the short
run supply curve
64
Short-run supply curve
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
65
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
Short Run Supply Curve
250

200
150
100
50
0
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Output
66
We can connect the dots?
Short Run Supply Curve
250

200
150
100
50
0
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Output
Not really
67
We connect, but with a discontinuity
Short Run Supply Curve
250

200
150
100
50
0
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Output
68
To summarize
The competitive firm's supply curve has two parts

For all prices above the minimum point on the
firms average variable cost (AVC) curve, the
supply curve coincides with the marginal cost
curve (MC)
For prices below the minimum point on the average
variable cost curve (AVC), the firm will shut
down,
so its supply curve is a vertical line at zero
units of output
69
Short Run Supply
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
70
Short Run Supply
300

250
200
AVC
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
71
Short Run Supply
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
72
We write the individual supply curve as
p - price of output
w1, w2, w3, - prices of inputs
z - fixed inputs
73
Assumptions about the industry in the short-run
The number of firms is fixed
The firm is operating on a short-run cost curve
Some inputs are fixed
74
Short run industry or market supply
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
75
The market or industry supply curve, QS, is the
horizontal summation of the individual firm
supply curves
76
The market supply curve is then a curve
indicating the quantity of output that all
sellers in a market will produce at different
prices.
77
Example
L 50
P 120
yi 10
QS (50)(10) 500
78
Example
L 50
P 196
yi 12
QS (50)(12) 600
79
Individual Short Run Supply Curve
P 51, y 7
250

P 68, y 8
200
150
P 120, y 10
100
50
0
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
Output
80
Short Run Market Supply Curve
250
P 51, y 350

200
P 68, y 400
150
Supply
P 120, y 500
100
50
0
0
100
200
300
400
500
600
700
Output
81
Short Run Market (Industry) Equilibrium
Market Demand Curve
250

200
150
100
50
0
0
100
200
300
400
500
600
700
Output
82
Finding the market equilibrium
Short Run Market Supply Demand Curves
250

200
150
100
50
0
0
100
200
300
400
500
600
700
Output
P 120, Q 500
83
Short Run Market Supply Demand Curves
300

250
200
150
100
50
0
0
100
200
300
400
500
600
700
800
Output
P 196, Q 600
84
Short Run Market Supply Demand Curves
300

250
200
150
100
50
0
0
100
200
300
400
500
600
700
800
Output
P 68, Q 400
85
Life is good
300

250
200
yi 10
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
86
What about the equilibrium price of 68.00?
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
Not what the managers had in mind!
87
With short run losses, the firm will only stay in
the industry in the short run
In the long run, a firm with losses will exit the
industry
At the same time, short run profits
will encourage firms to enter the industry
88
And so we must consider the long run!
89
The End
90
Short Run Equilibrium
300

250
200
150
100
50
0
0
2
4
6
8
10
12
14
16
18
Output
P MC ? y 10
? 400
91
Short Run Market Supply Demand Curves
300

250
200
150
100
50
0
0
100
200
300
400
500
600
700
800
Output
P 196, Q 600