Assumptions for Perfect Competition

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Get it while you can
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Assumptions for Perfect Competition

• Many firms and consumers, each too small to
  affect market demand or supply
• Firms have identical products, information, and
  production technologies
• Free entry and exit

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The U.S. Market is characterized by entry and
exitExample Job creation and destruction in
manufacturing

• Annual averages
• Shutdowns responsible for 23 of job destruction
• Start-ups responsible for 16 of job creation
• Haltiwanger, Davis and Schuh, Job Creation and
  Job Destruction. MIT Press. 1996.
• Quarterly averages
• 7.4 of jobs disappear forever
• 8.3 of jobs appear for the first time
• Pivetz, Searson and Spletzer. Measuring job and
  establishment flows with BLS longitudinal
  microdata. Monthly Labor Review April, 2001..

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Even if conditions for perfectly competitive
markets are not satisfied

• Assumptions are close enough for predictions of
• Firm entry or exit
• Price increase or decrease
• Increase or decrease in industry quantity
• Increase or decrease in firm quantity

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Conditions for profit maximization

• Short-run Firm
• Set Price Marginal Cost
• P gt AVC
• Short-run Industry
• Industry supply industry demand

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Apply to market and firm interaction

• Firm Industry

S
P
P
P0
D
q
Q
1000
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Case 1 Short-run Profit Maximization10 firms
each producing 100 unitsShort-run equilibrium
conditions met (K fixed)

• Firm Industry

S
P
P
MC
ATC
P0
P0
D
q
Q
1000
100
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But firm is making positive economic profitLong
Run equilibrium?Incentive for entry or exit?

• Firm Industry

S
P
P
MC
ATC
P0
P0
Profitgt0
D
q
Q
1000
100
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Long-run equilibrium conditions

• Short-run
• Firm Price Marginal Cost Firms maximize
  profits
• Industry supply demand
• Long-run
• Firm Price ATC Zero economic profit
• No incentive to enter or exit

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Positive Economic Profit Invites Entry in the
Long-run Causes Industry Supply to Rise

• Firm Industry

S
P
P
S
MC
ATC
P0
P0
P1
P1
D
q
Q
1000
100
90
1080
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Long-run equilibrium Number of firms rises to12
firms 1080/90P ATC

• Firm Industry

S
P
P
S
MC
ATC
P0
P0
P1
P1
D
q
Q
1000
100
90
1080
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Case 2 Short-run Profit Maximization15 firms
each producing 80 unitsShort-run equilibrium
conditions met (K fixed)

• Firm Industry

P
P
ATC
MC
S
AVC
P0
P0
D
q
Q
1200
80
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Short-run Profit Maximization15 firms each
producing 80 unitsShort-run equilibrium
conditions met (K fixed)

• Firm Industry

P
P
ATC
MC
S
AVC
P0
LOSS
P0
D
q
Q
1200
80
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Negative Economic Profit Induces Exit in the
Long-run, Industry Supply Falls

• Firm Industry

P
P
S
ATC
MC
S
AVC
P1
P1
P0
P0
D
q
Q
1200
80
90
1080
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Long-run equilibrium Number of firms falls to12
firms 1080/90

• Firm Industry

P
P
S
ATC
MC
S
AVC
P1
P1
P0
P0
D
q
Q
1200
80
90
1080
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Distinguishing Short-Run from Long-Run Outcomes

• Short-run equilibrium competitive firms can earn
  profits or suffer losses
• Long-run equilibrium, after entry or exit has
  occurred, economic profit is always zero

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Economic Efficiency and Returns to scale

• Efficient scale at minimum of LRATC curve.
• In long run competition and profit maximization
  cause firms to pick cost minimizing production
  minimum efficient scale

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Perfect Competition and Plant Size

• Suppose firm is below minimum efficient scale,
  and all other equilibrium conditions hold
• Firm will want to expand
• Firm can produce more output at a lower cost per
  unit
• Same opportunity to earn positive economic profit
  will induce other firms to establish larger
  plants
• As this happens, industry supply rises and price
  falls
• Entry and expansion must continue in this market
  until the price falls to P
• Because only then will each firmdoing the best
  that it can doearn zero economic profit

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Example of exploiting returns to scale
LRATC
LRATC
MC1
ATC1
d1 MR1
MC2
P1
ATC2
E
P
P
d2 MR2
q1
q
.
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Price
S
S
P1
P
D
Q1
Q
Quantity
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A Summary of the Competitive Firm in the Long-Run

• Put it all together
• At each competitive firm in long-run equilibrium
• P MC Firms maximize profit
• P MC minimum ATC Firms make zero profit, no
  incentive to enter or exit
• P MC minimum ATC minimum LRATC Firms have
  no incentive to change technologies
• At point E, demand, marginal cost, ATC, and LRATC
  curves all intersect
• With perfect competition, consumers will get the
  product at the least cost (most efficient)
  production method

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Using the Theory Changes in Technology

• Pork production has experienced rapid changes in
  technologies
• Antiobiotics, vaccines
• Artificial insemination
• Improved genetics
• Confined operations
• Various segregation methods (by sex, by litter,
  by size)
• Improved information technologies
• Technologies are complementary
• with farm size

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Example of exploiting returns to scale
LRATC
S
MC1
ATC1
S
MC2
ATC2
P1
P1
P
P
D
q1
Q
q2
Q1
.
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Increasing Returns to Scale
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Average Prices have Fallen 7
http//www.econ.iastate.edu/outreach/agriculture/p
eriodicals/chartbook/Chartbook2/frames.html
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Large Firms atypically likely to survive at lower
prices
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• Market Share of
• Farms gt10K rose from 20 to 85
• Farms lt 3K fell from 62 to 10

Two-thirds of US hogs are produced by less than
200 firms
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Using the Theory Changes in Technology

• Technological advance that results in increasing
  returns to scale will
• Induce some firms to change technologies and
  produce more
• lead to a rightward shift of market supply curve,
  decreasing market price
• In short-run, early adopters may enjoy economic
  profit
• in long-run, more will adopt, economic profit
  falls to zero
• Firms that refuse to use the new technology will
  not survive

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Using the Theory Changes in Technology

• Technological advances in many competitive
  industries have spread quickly
• Improved technologies shift market supply curves
  to the right or else improving quality which
  shifts demand to the right
• Some technologies are biased toward large firms,
  others toward smaller firms. If technologies
  lower minimum efficient scale, more firms will
  enter