Perfect Competition

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CHAPTER
Perfect Competition
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After studying this chapter you will be able to

• Define perfect competition
• Explain how firms make their supply decisions and
  why they sometimes shut down temporarily and lay
  off workers
• Explain how price and output in an industry are
  determined and 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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The Busy Bee

• The busy bee pollinates plants and beekeepers
  rent their hives to farmers.
• Across the United States from Vermont to
  California, a parasite is killing off bees and
  the rent farmers pay for hives has more than
  doubled.
• How does competition in beekeeping and other
  industries affect prices and profits?
• We study a fiercely competitive market in this
  chapter.
• We explain the changes in price and output as the
  firms in perfect competition respond to changes
  in demand and technological advances.

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What Is Perfect 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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What Is Perfect 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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What Is Perfect 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 priceit 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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What Is Perfect 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.
• A firms marginal revenue is the change in total
  revenue that results from a one-unit increase in
  the quantity sold.

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What Is Perfect Competition?

• Figure 11.1 illustrates a firms revenue
  concepts.
• Part (a) shows that market demand and market
  supply determine the market price that the firm
  must take.

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What Is Perfect Competition?

• Figure 11.1(b) shows the firms total revenue
  curve (TR)the relationship between total revenue
  and quantity sold.

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What Is Perfect Competition?

• Figure 11.1(c) shows the marginal revenue curve
  (MR).
• The firm can sell any quantity it chooses at the
  market price, so marginal revenue equals price
  and the demand curve for the firms product is
  horizontal at the market price.

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What Is Perfect Competition?

• The demand for the firms product is perfectly
  elastic because one of Cindys sweaters is a
  perfect substitute for the sweater of another
  firm.
• The market demand is not perfectly elastic
  because a sweater is a substitute for some other
  good.

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The Firms Decisions in Perfect Competition

• A perfectly competitive firm faces two
  constraints
• 1. A market constraint summarized by the market
  price and the firms revenue curves.
• 2. A technology constraint summarized by firms
  product curves and cost curves (like those in
  Chapter 10).
• The goal of the firm is to make maximum economic
  profit, given the constraints it faces.
• So the firm must make four decisions Two in the
  short run and two in the long run.

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The Firms Decisions in Perfect Competition

• Short-Run Decisions
• In the short run, the firm must decide
• 1. Whether to produce or to shut down
  temporarily.
• 2. If the decision is to produce, what quantity
  to produce.
• Long-Run Decisions
• In the long run, the firm must decide
• 1. Whether to increase or decrease its plant
  size.
• 2. 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 economic profit (or
loss), shown by the curve EP in part (b).
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The Firms Decisions in Perfect Competition

• At low output levels, the firm incurs an economic
  lossit cant cover its fixed costs.

At intermediate output levels, the firm makes an
economic profit.
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The Firms Decisions in Perfect Competition

• At high output levels, the firm again incurs an
  economic lossnow the firm faces steeply rising
  costs because of diminishing returns.

The firm maximizes its economic profit when it
produces 9 sweaters a day.
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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 making an economic
  profit or incurring an economic loss, we compare
  the firms average total cost 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 average total cost and
  the firm makes zero economic profit (breaks even).

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The Firms Decisions in Perfect Competition

• In part (b), price exceeds average total cost and
  the firm makes a positive economic profit.

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The Firms Decisions in Perfect Competition

• In part (c) price is less than average total cost
  and the firm incurs an economic losseconomic
  profit is negative.

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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 an economic loss equal to total fixed
  cost.
• This economic loss is the largest that the firm
  must bear.
• If the firm were to produce just 1 unit of output
  at a price below minimum 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

• Short-Run Supply Curve
• 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

• Figure 11.6 shows the supply curve for an
  industry that has 1,000 firms like Cindys.
• 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
  costthe shutdown pricethe 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.

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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 make an
  economic profit, break even, or incur an economic
  loss.
• Which of these outcomes occurs determines how the
  industry adjusts 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 make 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

• 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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Output, Price, and Profit in Perfect Competition

• The 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 loss of each firm remaining in the
industry decreases.
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Output, Price, and Profit in Perfect Competition

• Changes in Plant Size
• A firm changes its plant size whenever doing so
  is profitable.
• If average total cost exceeds the minimum
  long-run average cost, the firm changes its plant
  size to lower average costs and increase economic
  profit.
• 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 a sweater, the firm is making
  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, the firms short-run
  supply increases, the average total cost falls,
  and its economic profit increases.

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Output, Price, and Profit in Perfect Competition

• As all firms in the industry change their plant
  size, industry supply increases, the market price
  falls, and economic profit decreases.

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Output, Price, and Profit in Perfect Competition

• Long-run equilibrium occurs when each firm is
  producing at minimum long-run average cost and is
  making 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.

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Changing Tastes and Advancing Technology

• A Permanent Change in Demand
• A decrease in demand shifts the market demand
  curve leftward. The price falls and the quantity
  decreases.
• Figure 11.10 illustrates the effects of a
  permanent decrease in demand when the industry is
  in long-run equilibrium.

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Changing Tastes and Advancing Technology

• A decrease in demand shifts the industry demand
  curve leftward. The market price falls, and each
  firm decreases the quantity it produces.

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Changing Tastes and Advancing Technology

• The market price is now below each firms minimum
  average total cost, so firms incur economic
  losses.

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Changing Tastes and Advancing Technology

• Economic losses induce some firms to exit, which
  decreases the industry supply and the price
  starts to rise.

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Changing Tastes and Advancing Technology

• As the price rises, the quantity produced by the
  industry continues to decrease as more firms
  exit, but each firm remaining in the industry
  starts to increase its quantity.

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Changing Tastes and Advancing Technology

• A new long-run equilibrium occurs when the price
  has risen to equal minimum average total cost.
  Firms do not incur economic losses, and firms no
  longer exit the industry.

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Changing Tastes and Advancing Technology

• The main difference between the initial and new
  long-run equilibrium is the number of firms in
  the industry.
• Fewer firms produce the equilibrium quantity.

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Changing Tastes and Advancing Technology

• A permanent increase in demand has the opposite
  effects to those just described and shown in
  Figure 11.9.
• An increase in demand shifts the demand curve
  rightward. The price rises and the quantity
  increases.
• Economic profit induces entry, which increases
  short-run supply and shifts the short-run
  industry supply curve rightward.
• As industry supply increases, the price falls and
  the market quantity continues to increase.

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Changing Tastes and Advancing Technology

• With a falling price, each firm decreases
  production in a movement along the firms
  marginal cost curve (short-run supply curve).
• A new long-run equilibrium occurs when the price
  has fallen to equal minimum average total cost so
  that firms do not make economic profits, and
  firms no longer enter the industry.
• The main difference between the initial and new
  long-run equilibrium is the number of firms in
  the industry. In the new equilibrium, a larger
  number of firms produce the equilibrium quantity.

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Changing Tastes and Advancing Technology

• External Economics and Diseconomies
• The change in the long-run equilibrium price
  following a permanent change in demand depends on
  external economies and external diseconomies.
• External economies are factors beyond the control
  of an individual firm that lower the firms costs
  as the industry output increases.
• External diseconomies are factors beyond the
  control of a firm that raise the firms costs as
  industry output increases.

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Changing Tastes and Advancing Technology

• In the absence of external economies or external
  diseconomies, a firms costs remain constant as
  industry output changes.
• Figure 11.11 illustrates the three possible cases
  and shows the long-run industry supply curve.
• The long-run industry supply curve shows how the
  quantity supplied by an industry varies as the
  market price varies after all the possible
  adjustments have been made, including changes in
  plant size and the number of firms in the
  industry.

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Changing Tastes and Advancing Technology

• Figure 11.11(a) shows that in the absence of
  external economies or external diseconomies, an
  increase in demand does not change the price in
  the long run.
• The long-run industry supply curve LSA is
  horizontal.

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Changing Tastes and Advancing Technology

• Figure 11.11(b) shows that when external
  diseconomies are present, an increase in demand
  brings a higher price in the long run.
• The long-run industry supply curve LSB is upward
  sloping.

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Changing Tastes and Advancing Technology

• Figure 11.11(c) shows that when external
  economies are present, an increase in demand
  brings a lower price in the long run.
• The long-run industry supply curve LSC is
  downward sloping.

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Changing Tastes and Advancing Technology

• Technological Change
• New technologies are constantly discovered that
  lower costs.
• A new technology enables firms to produce at a
  lower average cost and a lower marginal
  costfirms cost curves shift downward.
• Firms that adopt the new technology make an
  economic profit.

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Changing Tastes and Advancing Technology

• New-technology firms enter and old-technology
  firms either exit or adopt the new technology.
• Industry supply increases and the industry supply
  curve shifts rightward.
• The price falls and the quantity increases.
• Eventually, a new long-run equilibrium emerges in
  which all firms use the new technology, the price
  equals minimum average total cost, and each firm
  makes zero economic profit.

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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

• Choices, Equilibrium, and Efficiency
• We can describe an efficient use of resources in
  terms of the choices of consumers and firms
  coordinated in market equilibrium.
• Choices
• A consumers demand curve shows how the best
  budget allocation changes as the price of a good
  changes.
• So consumers get the most value out of their
  resources at all points along their demand
  curves.
• With no external benefits, the market demand
  curve is the marginal social benefit curve.

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Competition and Efficiency

• A competitive firms supply curve shows how the
  profit-maximizing quantity changes as the price
  of a good changes.
• So firms get the most value out of their
  resources at all points along their supply
  curves.
• With no external cost, the market supply curve is
  the marginal social cost curve.

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Competition and Efficiency

• Equilibrium and Efficiency
• In competitive equilibrium, resources are used
  efficientlythe quantity demanded equals the
  quantity supplied, so marginal social benefit
  equals marginal social cost.
• The gains from trade for consumers is measured by
  consumer surplus.
• The gains from trade for producers is measured by
  producer surplus.
• Total gains from trade equal total surplus, and
  in long-run equilibrium total surplus is
  maximized.

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Competition and Efficiency

• Figure 11.12 illustrates an efficient allocation
  of resources in a perfectly competitive industry.
• In part (a), each firm is producing at the lowest
  possible long-run average total cost at the price
  P and the quantity q.

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Competition and Efficiency

• Figure 11.12(b) shows the market.
• Along the market demand curve D MSB, consumers
  are efficient.
• Along the market supply curve S MSC, producers
  are efficient.

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Competition and Efficiency

• The quantity Q and price P are the competitive
  equilibrium values.
• So competitive equilibrium is efficient.

Total surplus, the sum of consumer surplus and
producer surplus is maximized.
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THE END