PERFECT COMPETITION

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PERFECT COMPETITION
CHAPTER
2
Objectives

• After studying this chapter, you will able to
• Define perfect competition
• Explain how price and output are determined in
  perfect competition
• Explain why firms sometimes shut down temporarily
  and lay off workers
• Explain why firms enter and leave the industry
• Predict the effects of a change in demand and of
  a technological advance
• Explain why perfect competition is efficient

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Competition

• Perfect competition is an industry in which
• Many firms sell identical products to many
  buyers.
• There are no restrictions to entry into the
  industry.
• Established firms have no advantages over new
  ones.
• Sellers and buyers are well informed about prices.

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Competition

• How Perfect Competition Arises
• 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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Competition

• Price Takers
• In perfect competition, each firm is a price
  taker.
• A price taker is a firm that cannot influence the
  price of a good or service.
• No single firm can influence the price - it must
  take the equilibrium market price.
• Each firms output is a perfect substitute for
  the output of the other firms, so the demand for
  each firms output is perfectly elastic.

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Competition

• Economic Profit and Revenue
• The goal of each firm is to maximize economic
  profit, which equals total revenue minus total
  cost.
• Total cost is the opportunity cost of production,
  which includes normal profit.
• A firms total revenue equals price, P,
  multiplied by quantity sold, Q, or P ? Q.

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Competition

• A firms marginal revenue is the change in total
  revenue that results from a one-unit increase in
  the quantity sold.
• Figure 11.1 illustrates a firms revenue curves.

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Competition

• Figure 11.1(a) shows that market demand and
  supply determine the price that the firm must
  take.

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Competition

• Figure 11.1(b) shows the demand curve for the
  firms product, which is also its marginal
  revenue curve.

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Competition

• Because in perfect competition the price remains
  the same as the quantity sold changes, marginal
  revenue equals price.

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Competition

• Figure 11.1(c) shows the firms total revenue
  curve.

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The Firms Decisions in Perfect Competition

• A perfectly competitive firm faces two
  constraints
• A market constraint summarized by the market
  price and the firms revenue curves
• A technology constraint summarized by firms
  product curves and cost curves (like those in
  Chapter 10).

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The Firms Decisions in Perfect Competition

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

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The Firms Decisions in Perfect Competition

• Profit-Maximizing Output
• A perfectly competitive firm chooses the output
  that maximizes its economic profit.
• One way to find the profit maximizing output is
  to look at the firms the total revenue and total
  cost curves.
• Figure 11.2 on the next slide looks at these
  curves along with the firms total profit curve.

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The Firms Decisions in Perfect Competition

• Part (a) shows the total revenue, TR, curve.

Part (a) also shows the total cost curve, TC,
which is like the one in Chapter 10. Total
revenue minus total cost is profit (or loss),
shown in part (b).
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The Firms Decisions in Perfect Competition

• Profit is maximized when the firm produces 9
  sweaters a day.

At low output levels, the firm incurs an economic
loss - it cant cover its fixed costs.
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The Firms Decisions in Perfect Competition

• At intermediate output levels, the firm earns an
  economic profit.

At high output levels, the firm again incurs an
economic loss - now it faces steeply rising costs
because of diminishing returns.
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The Firms Decisions in Perfect Competition

• Marginal Analysis
• The firm can use marginal analysis to determine
  the profit-maximizing output.
• Because marginal revenue is constant and marginal
  cost eventually increases as output increases,
  profit is maximized by producing the output at
  which marginal revenue, MR, equals marginal cost,
  MC.
• Figure 11.3 on the next slide shows the marginal
  analysis that determines the profit-maximizing
  output.

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The Firms Decisions in Perfect Competition

• If MR gt MC, economic profit increases if output
  increases.

If MR lt MC, economic profit decreases if output
increases.
If MR MC, economic profit decreases if output
changes in either direction, so economic profit
is maximized.
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The Firms Decisions in Perfect Competition

• Profits and Losses in the Short Run
• 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.
• Figure 11.4 on the next slide shows the three
  possible profit outcomes.

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The Firms Decisions in Perfect Competition

• In part (a) price equals ATC and the firm earns
  zero economic profit (normal profit).

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The Firms Decisions in Perfect Competition

• In part (b), price exceeds ATC and the firm earns
  a positive economic profit.

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The Firms Decisions in Perfect Competition

• In part (c) price is less than ATC and the firm
  incurs an economic loss - economic profit is
  negative and the firm does not even earn normal
  profit.

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The Firms Decisions in Perfect Competition

• The Firms 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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The Firms Decisions in Perfect Competition

• Temporary Plant Shutdown
• If price is less than the minimum average
  variable cost, the firm shuts down temporarily
  and incurs a loss equal to total fixed cost.
• This loss is the largest that the firm must bear.
• If the firm were to produce just 1 unit of output
  at price below average variable cost, it would
  incur an additional (and avoidable) loss.

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The Firms Decisions in Perfect Competition

• 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.
• At the shutdown point, the firm is indifferent
  between producing and shutting down temporarily.
• It incurs a loss equal to total fixed cost from
  either action.

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The Firms Decisions in Perfect Competition

• 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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The Firms Decisions in Perfect Competition

• Figure 11.5 shows how the firms short-run supply
  curve is constructed.
• If price equals minimum average variable cost,
  17 in this example, the firm is indifferent
  between producing nothing and producing at the
  shutdown point, T.

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The Firms Decisions in Perfect Competition

• If the price is 25, the firm produces 9 sweaters
  a day, the quantity at which P MC.

If the price is 31, the firm produces 10
sweaters a day, the quantity at which P MC.
The blue curve in part (b) traces the firms
short-run supply curve.
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The Firms Decisions in Perfect Competition

• Short-Run Industry Supply Curve
• The short-run industry supply curve shows the
  quantity supplied by the industry at each price
  when the plant size of each firm and the number
  of firms remain constant.

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The Firms Decisions in Perfect Competition

• The quantity supplied by the industry at any
  given price is the sum of the quantities supplied
  by all the firms in the industry at that price.

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The Firms Decisions in Perfect Competition

• At a price equal to minimum average variable cost
  - the shutdown price - the industry supply curve
  is perfectly elastic because some firms will
  produce the shutdown quantity and others will
  produces zero.

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Output, Price, and Profit in Perfect Competition

• Short-Run Equilibrium
• Short-run industry supply and industry demand
  determine the market price and output.
• Figure 11.7 shows a short-run equilibrium at the
  intersection of the demand and supply curves.

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Output, Price, and Profit in Perfect Competition

• A Change in Demand
• An increase in demand bring a rightward shift of
  the industry demand curve the price rises and
  the quantity increases.

A decrease in demand bring a leftward shift of
the industry demand curve the price falls and
the quantity decreases.
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Output, Price, and Profit in Perfect Competition

• Long-Run Adjustments
• In short-run equilibrium, a firm may earn an
  economic profit, earn normal profit, or incur an
  economic loss and 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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Output, Price, and Profit in Perfect Competition

• Entry and Exit
• New firms enter an industry in which existing
  firms earn an economic profit.
• Firms exit an industry in which they incur an
  economic loss.
• Figure 11.8 on the next slide shows the effects
  of entry and exit.

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Output, Price, and Profit in Perfect Competition

• 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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Output, Price, and Profit in Perfect Competition

• 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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Output, Price, and Profit in Perfect Competition

• 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.
• Figure 11.9 on the next slide shows the effects
  of changes in plant size.

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Output, Price, and Profit in Perfect Competition

• If the price is 25, firms earn zero economic
  profit with the current plant.

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Output, Price, and Profit in Perfect Competition

• But if the LRAC curve is sloping downward at the
  current output, the firm can increase profit by
  expanding the plant.

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Output, Price, and Profit in Perfect Competition

• As the plant size increases, short-run supply
  increases, the price falls, and economic profit
  decreases.

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Output, Price, and Profit in Perfect Competition

• 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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Output, Price, and Profit in Perfect Competition

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