Perfect Competition Chapter 7

1
Perfect CompetitionChapter 7

• LIPSEY CHRYSTAL
• ECONOMICS 12e

2
Learning Outcomes

• The impact of the product market on firms prices
  and output choices is determined by the nature of
  the product and the market structure in which
  they operate.
• In perfect competition firms produce a
  homogeneous product and are price-takers in their
  output markets.
• All profit-maximising firms choose their output
  to equate marginal cost and marginal revenue.

3
Learning Outcomes

• Under perfect competition marginal cost will
  equal the market price, and so the supply curve
  of firms is determined by the marginal cost
  curve.
• The long-run supply curve of a competitive
  industry may be positively sloped, horizontal, or
  negatively sloped depending on how input prices
  are affected by the industrys expansion.
• Perfect competition maximizes benefits that
  consumers receive from the output of the product
  in question.

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CHAPTER 7 PERFECT COMPETITION

• Market Structure and Firm Behaviour
• Competitive behaviour refers to the extent to
  which individual firms compete with each other to
  sell their products.
• Competitive market structure refers to the power
  that individual firms have over the market -
  perfect competition occurring where firms have no
  market power and hence no need to react to each
  other.
• Perfectly Competitive Markets
• The theory of perfect competition is based on the
  following assumptions firms sell a homogenous
  product customers are well informed each firm
  is a price-taker the industry can support many
  firms, which are free to enter or leave the
  industry.

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CHAPTER 7 PERFECT COMPETITION

• Short-run Equilibrium
• Any firm maximizes profits producing the output
  where its marginal cost curve intersects the
  marginal revenue curve from below - or by
  producing nothing if average cost exceeds price
  at all outputs.
• A perfectly competitive firm is a
  quantity-adjuster, facing a perfectly elastic
  demand curve at the given market price and
  maximizing profits by choosing the output that
  equates its marginal cost to price.
• The supply curve of a firm in perfect competition
  is its marginal cost curve, and the supply curve
  of a perfectly competitive industry is the sum of
  the marginal cost curves of all its firms.
• The intersection of this curve with the market
  demand curve for the industrys product
  determines market price.

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CHAPTER 7 PERFECT COMPETITION

• Long-run Equilibrium
• Long-run industry equilibrium requires that each
  individual firm be producing at the minimum point
  of its LRAC curve and be making zero profits.
• The long-run industry supply curve for a
  perfectly competitive industry may be i
  positively sloped, if input prices are driven up
  by the industrys expansion ii horizontal, if
  plants can be replicated and factor prices remain
  constant or iii negatively sloped, if some
  other industry that is not perfectly competitive
  produces an input under conditions of falling
  long-run costs.
• The Allocative Efficiency of Perfect Competition
• Perfect competition produces an optimal
  allocation of resources because it maximizes the
  sum of consumers and producers surplus by
  producing equilibrium where marginal cost equals
  price.

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The Demand Curve for a Competitive Industry and
for One Firm
5
5
S
4
4
Price
Dfirm
3
Price
3
2
2
1
1
D
60
100
200
300
400
10
20
30
40
50
Quantity millions of tons
Quantity thousands of tons
i Competitive industrys demand curve
ii Competitive firms demand curve
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The Demand Curve for a Competitive Industry and
for One Firm

• The industrys demand curve is negatively sloped,
  the firms demand curve is virtually horizontal.
• The competitive industry has output of 200
  million tonnes when the price is 3.
• The individual firm takes that market price as
  given and considers producing up to say, 60,000
  tonnes.
• The firms demand curve in part (ii) is
  horizontal because any change in output that this
  one firm could manage would leave price virtually
  unchanged at 3.

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Revenue Concepts for a Price-taking Firm
Quantity sold (Units) (q) 10 11 12 13
Price (p) 3.00 3.00 3.00 3.00
TR pq () 30.00 33.00 36.00 39.00
AR TR/q () 3.00 3.00 3.00 3.00
MR ?TR/?q () 3.00 3.00 3.00
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Revenue Concepts for a Price-taking Firm

• The table shows the calculation of total (TR),
  average (AR), and marginal revenue (MR) when
  market price is 3.00.
• For example when sales rise from 11 to 12 units,
  revenue rises form 33 to 36 making marginal
  revenue equal to 3.
• The table illustrates the general result that
  when price I fixed average revenue, marginal
  revenue, and price are all equal.

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Revenue Curve for a Firm
per unit
TR
AR MP p
3
39

30
13
10
10
0
0
Output
Output
i Average and marginal revenue
ii Total revenue
12
Revenue Curve for a Firm

• Because price does not change as the firm varies
  its output, neither marginal nor average revenue
  varies with output -both are equal to price.
• When price is constant, total revenue is a
  straight line through the origin whose constant
  positive slope is the price per unit.

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The Short-run Equilibrium of a Firm in Perfect
Competition
per unit
AVC
Output
14
The Short-run Equilibrium of a Firm in Perfect
Competition
MC
per unit
AVC
Output
15
The Short-run Equilibrium of a Firm in Perfect
Competition
MC
per unit
AVC
E
pMRAR
q2
qE
q1
Output
16
The Short-run Equilibrium of a Firm in Perfect
Competition

• The firm chooses the output for which pMC above
  the level of AVC.
• When price equals marginal cost, as at output qE,
  the firm loses profits if it either increases or
  decreases its output.
• At any point left of qE, say q2, price is greater
  than the marginal cost, and it pays to increase
  output (as indicated by the left-hand arrow).
• At any point to the right of qE, say q1, price is
  less than the marginal cost, and it pays to
  reduce output (as indicated by the right-hand
  arrow).

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Total Cost and Revenue Curves
TC
TR

0
qE
Output
18
Total Cost and Revenue Curves

• At each output the vertical distance between the
  TR and TC curves shows by how much total revenue
  exceeds or falls short of total cost.
• The gap is largest at output qE which is the
  profit-maximizing output.

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The Supply Curve for a Price-taking Firm
MC
5
5
per nut
4
4
AVC
Price
3
3
E0
p0
2
2
1
1
q0
Output
Quantity
ii The supply curve
i Marginal cost and average variable cost curves
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The Supply Curve for a Price-taking Firm
MC
5
5
per nut
4
4
AVC
Price
E1
p1
3
3
E0
p0
2
2
1
1
q0
q1
Output
Quantity
ii The supply curve
i Marginal cost and average variable cost curves
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The Supply Curve for a Price-taking Firm
MC
5
5
E2
p2
4
4
AVC
per nut
Price
E1
p1
3
3
E0
p0
2
2
1
1
q0
q1
q2
Output
Quantity
ii The supply curve
i Marginal cost and average variable cost curves
22
The Supply Curve for a Price-taking Firm
MC
S
E3
p3
5
5
E2
p2
4
4
AVC
per nut
Price
E1
p1
3
3
E0
p0
2
2
1
1
q0
q1
q2
q3
Output
Quantity
i Marginal cost and average variable cost curves
ii The supply curve
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The Supply Curve for a Price-taking Firm

• For a price-taking firm the supply curve has the
  same shape as its MC curve above the level of
  AVC.
• The point E0, where price, p0, equals AVC is the
  shutdown point.
• As price rises from 2 to 3 to 4 to 5, the
  firm increases its production from q0 to q1 to q2
  to q3 .
• For example at a price of 3, the firm produces
  output q1 and earns the contribution to fixed
  costs shown by the dark blue shaded rectangle.
• The firms supply curve is shown in part (ii). It
  relates market price to the quantity the firm
  will produce and offer for sale.
• It has the same shape as the firms MC curve for
  all prices above AVC.

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Alternative Short-run Equilibrium Positions for a
Firm in Perfect Competition
SRATC i
per unit
MC
E
p1
SARVC
Output
q1
0
25
Alternative Short-run Equilibrium Positions for a
Firm in Perfect Competition
SRATC ii
per unit
MC
E
p2
Output
q2
0
MC
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Alternative Short-run Equilibrium Positions for a
Firm in Perfect Competition
SRATC iii
MC
per unit
E
p3
q3
0
Output
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Alternative Short-run Equilibrium Positions for a
Firm in Perfect Competition
SRATC
i
ii
per unit
per unit
MC
MC
SRATC
E
E
p1
p2
SARVC
Output
Output
q1
q2
0
0
MC
iii
SRATC
per unit
E
p3
q3
0
Output
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(i) The firm is making losses
Short-run Equilibrium Positions for a Firm in
Perfect Competition

• The market price is p1. Because this price is
  below average total cost, the firm is suffering
  losses shown by the light blue area.
• Because price exceeds average variable cost, the
  firm continues to produce in the short run.
• Because price is less than ATC, the firm will not
  replace its capital as it wears out.

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(ii) The firm is just covering all its costs
Short-run Equilibrium Positions for a Firm in
Perfect Competition

• The market price is p2.
• The firm is just covering its total costs.
• It will replace its capital as it wears out since
  its revenue is covering the full opportunity cost
  of its capital.

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(iii) The firm is making pure profits
Short-run Equilibrium Positions for a Firm in
Perfect Competition

• The market price is p3.
• The firm is earning pure (or economic) profits in
  excess of all its costs, as shown by the dark
  blue area.
• The firm will replace its capital as it wears
  out.

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Consumers and Producers Surplus
S
Price
E
Consumer surplus
Market price
p0
Producers surplus
D
Total variable cost
0
q0
Quantity
32
Consumers and Producers Surplus

• Consumers surplus is the area under the demand
  curve and above the market price line.
• The equilibrium price and quantity are p0 and q0.
  
• The total value that consumers place on q0 units
  of the product is given by the sum of the dark
  yellow, light yellow, and light blue areas.
• The amount that they pay is p0q0, the rectangle
  that consists of the light yellow and light blue
  areas.
• The difference, shown as the dark yellow area, is
  consumers surplus.

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Consumers and Producers Surplus

• Producers surplus is the area above the supply
  curve and below the market price line.
• The receipts of producers from the sale of q0
  units are also p0q0.
• The area under the supply curve, the blue-shaded
  area, is total variable cost, which is the
  minimum amount that producers must receive to
  induce them to supply the output.
• The difference, shown as the light yellow area,
  is producers surplus.

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The Allocative Efficiency of Perfect Competition
S
Price
E
Competitive market price
p0
D
0
q0
q2
q1
Quantity
35
The Allocative Efficiency of Perfect Competition

• At the competitive equilibrium E consumers
  surplus is the dark yellow area above the price
  line.
• Producers surplus is the light yellow area below
  the price line.
• Reducing the output to q1 but keeping price at p0
  lowers consumers surplus by area 1.
• It lowers producers surplus by area 2.

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The Allocative Efficiency of Perfect Competition

• Assume that producers are forced to produce
  output q2 and to sell it to consumers, who are in
  turn forced to buy it at price p0.
• Producers surplus is reduced by area 3 (the
  amount by which variable costs exceed revenue on
  those units).
• Consumers surplus is reduced by area 4 (the
  amount by which expenditure exceeds consumers
  satisfactions on those units).
• Only at the competitive output, q0, is the sum of
  the two surpluses maximized.

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Short-run and Long-run Equilibrium of a Firm in
Perfect Competition
SRATC0
MC0
per unit
p0
MC
c0
SRATC
LRAC
p
q0
q
0
38
Short-run and Long-run Equilibrium of a Firm in
Perfect Competition

• The firms existing plant has short-run cost
  curves SRATC0 and MC0 while market price is p0.
• The firm produces q0, where MC0 equals price and
  total costs are just being covered.
• Although the firm is in short-run equilibrium, it
  can earn profits by building a larger plant and
  so moving downwards along its LRAC curve.

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Short-run and Long-run Equilibrium of a Firm in
Perfect Competition

• Thus the firm cannot be in long-run equilibrium
  at any output below q, because average total
  costs can be reduced by building a larger plant.
• If all firms do this, industry output will
  increase and price will fall until long-run
  equilibrium is reached at price p.
• Each firm is then in short-run equilibrium with a
  plant whose average cost curve is SRATC and
  whose short-run marginal cost curve, MC,
  intersects the price line p at an output of q.
• Because the LRAC curve lies above p everywhere
  except at q, the firm has no incentive to move
  to another point on its LRAC curve by altering
  the size of its plant.
• Thus a perfectly competitive firm that is not at
  the minimum point on its LRAC curve cannot be in
  long-run equilibrium.

40
Long-run Industry Supply Curves
S0
S0
Price
Price
S0
Quantity
Quantity
Price
Quantity
41
Long-run Industry Supply Curves
D0
S0
S0
D0
Price
E0
E0
p0
p0
Price
S0
D0
q1
q1
Quantity
Quantity
p0
E0
Price
q1
Quantity
42
Long-run Industry Supply Curves
D1
D1
D0
S0
S0
D0
E1
Price
E1
E0
p0
Price
E0
p0
S0
D0
q1
q1
Quantity
Quantity
E1
D1
E0
p0
Price
q1
Quantity
43
Long-run Industry Supply Curves
D1
(ii)
D1
D0
S0
S0
(i)
D0
E1
Price
E2
E1
p0
LRS
E0
E2
p0
Price
E0
LRS
p0 p2
q2
D1
S0
q2
q1
q1
D0
Quantity
Quantity
E1
(iii)
E0
p0
Price
E2
LRS
p0
q2
Quantity
q1
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(i) A constant long-run industry supply curve

• The initial curves are at D0 and S0.
• Equilibrium is at E0 with price p0 and quantity
  q0.
• A rise in demand shifts the demand curve to D1,
  taking the short-run equilibrium to E1.
• New firms now enter the industry, shifting the
  short-run supply curve outwards.
• Price is pushed down until pure profits are no
  longer being earned. At this point the supply
  curve is S1.
• The new equilibrium is E2 with price at p2 and
  quantity q2.
• The curves shift so that price returns to its
  original level, making the long-run supply curve
  horizontal.

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(ii) A Rising long-run industry supply curve

• The initial curves are at D0 and S0.
• Equilibrium is at E0 with price p0 and quantity
  q0.
• A rise in demand shifts the demand curve to D1,
  taking the short-run equilibrium to E1.
• New firms now enter the industry, shifting the
  short-run supply curve outwards.
• Price is pushed down until pure profits are no
  longer being earned.
• At this point the supply curve is S1.
• The new equilibrium is E2 with price at p2 and
  quantity q2.
• Profits are eliminated and entry ceases before
  price falls to its original level, giving the LRS
  curve a positive slope.

46
(iii) A falling long-run industry supply curve

• The initial curves are at D0 and S0.
• Equilibrium is at E0 with price p0 and quantity
  q0.
• A rise in demand shifts the demand curve to D1,
  taking the short-run equilibrium to E1.
• New firms now enter the industry, shifting the
  short-run supply curve outwards.
• Price is pushed down until pure profits are no
  longer being earned. At this point the supply
  curve is S1.
• The new equilibrium is E2 with price at p2 and
  quantity q2.
• The price falls below its original level before
  profits return to normal, giving the LRS curve a
  negative slope.