Chapter 12 Perfect Competition

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Chapter 12Perfect Competition

• Definition of perfect competition
• Firms decisions
• Short run
• Long run
• Competition and efficiency

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• Market Structure market characteristics
• number of firms
• product differentiation / homogeneity
• ease of entry / exit
• Types
• perfect competition
• monopolistic competition
• oligopoly
• monopoly

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Perfect Competition

• Perfect competition is
• a model
• many firms
• identical products
• many buyers
• free entry
• complete information
• Each firm is price taker (no market power)

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• Perfect competition arises
• When firms minimum efficient scale is small
  relative to market demand so there is room for
  many firms in the industry.
• And when each firm is perceived to produce a good
  or service that has no unique characteristics, so
  consumers dont care which firm they buy from.

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• A perfectly competitive firm faces two
  constraints
• A market constraint summarized by the market
  price and the firms revenue curves. Marginal
  revenue is equal to the price.
• 2. A technology constraint summarized by firms
  product curves and cost curves.

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The Firms Decisions in Perfect Competition

• The competitive firm makes two decisions in the
  short run
• 1. Whether to produce or to shut down.
• 2. If the decision is to produce, what quantity
  to produce.
• A firms long-run decisions are
• 1. Whether to increase or decrease its plant
  size.
• 2. Whether to stay in the industry or leave it.
• A perfectly competitive firm chooses the output
  that maximizes its economic profit.

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Short run profits and losses

• Maximum profit is not always a positive economic
  profit.
• To determine whether a firm is earning an
  economic profit or incurring an economic loss, we
  compare the firms average total cost, ATC, at
  the profit-maximizing output with the market
  price.

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Short run supply curve

• A perfectly competitive firms short-run supply
  curve shows how the firms profit-maximizing
  output varies as the market price varies, other
  things remaining the same.
• Because the firm produces the output at which
  marginal cost equals marginal revenue, and
  because marginal revenue equals price, the firms
  supply curve is linked to its marginal cost
  curve.
• But there is a price below which the firm
  produces nothing and shuts down temporarily.

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Short run supply curve

• The shutdown point is the output and price at
  which the firm just covers its total variable
  cost.
• This point is where average variable cost is at
  its minimum. It is also the point at which the
  marginal cost curve crosses the average variable
  cost curve.
• If the price exceeds minimum average variable
  cost, the firm produces the quantity at which
  marginal cost equals price. Price exceeds average
  variable cost, and the firm covers all its
  variable cost and at least part of its fixed
  cost.

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Long run Adjustments

• In short-run equilibrium, a firm may make an
  economic profit, make normal profit, or incur an
  economic loss.
• Which of these states exists determines the
  further decisions the firm makes in the long run.
• In the long run, the firm may
• Enter or exit an industry
• Change its plant size

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Effects of entry

• As new firms enter an industry, industry supply
  increases. The industry supply curve shifts
  rightward.

The price falls, the quantity increases, and the
economic profit of each firm decreases.
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Effects of exit

• As firms exit an industry, industry supply
  decreases. The industry supply curve shifts
  leftward.

The price rises, the quantity decreases, and the
economic profit of each firm increases.
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Changes in plant size

• Firms change their plant size whenever doing so
  is profitable.
• If average total cost exceeds the minimum
  long-run average cost, firms change their plant
  size to lower costs and increase profits.
• If the firms earn zero economic profit with the
  current plant and the LRAC curve slopes downward
  at the current output, the firm can increase
  profit by expanding the plant. As the plant size
  increases, short-run supply increases, the price
  falls.

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• Long-run equilibrium occurs when the firm is
  producing at the minimum long-run average cost
  and earning zero economic profit.

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Long run equilibrium

• Long-run equilibrium occurs in a competitive
  industry when
• (1) Economic profit is zero, so firms neither
  enter nor exit the industry.
• (2) Long-run average cost is at its minimum, so
  firms dont change their plant size.

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Competition and Efficiency

• Efficient Use of Resources
• Resources are used efficiently when no one can be
  made better off without making someone else worse
  off.
• This situation arises when marginal social
  benefit equals marginal social cost.

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Competition and Efficiency

• We can describe an efficient use of resources in
  terms of the choices of consumers and firms
  coordinated in market equilibrium.
• Choices
• We derive a consumers demand curve by finding
  how the best budget allocation (most valued by
  the consumer) changes as the price of a good
  changes.
• So consumers get the most value out of their
  resources at all points along the market demand
  curve, which is also the marginal social benefit
  curve.

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Competition and Efficiency

• We derive the firms supply curve by finding the
  profit-maximizing quantity at each price.
• So firms get the most value out of their
  resources at all points along the market supply
  curve, which is also the marginal social cost
  curve.
• Equilibrium
• In competitive equilibrium, the quantity demanded
  equals the quantity supplied, so marginal social
  benefit equals marginal social cost. Total
  surplus is maximized.

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Competition and Efficiency

• Efficiency
• Competitive equilibrium is efficient only if
  there are no external benefits or costs.
• External benefits are benefits that accrue to
  people other than the buyer of a good.
• External costs are costs that are borne not by
  the producer of a good or service but by someone
  else.