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LECTURE NOTES X
THE PERFECTLY COMPETITIVE MARKET
OUTLINE:
I. Introduction to Market Structure
II. Characteristics of Perfect Competition
III. Perfect Competition Graphically
IV. Revenue for the Firm
V. Short Run Equilibrium – Profit Maximization
VI. Graphically
A. A Profit
B. A Loss
C. Breaking even
VII. The Shutdown Rule
VIII. The Firm’s Short Run Supply Curve
IX. Long-Run Equilibrium in a Perfectly Competitive Market
X. Permanent Changes in Market Demand
1) An Increase in Market Demand
2) A Decrease in Market Demand
Productivity
Product Curves
Short run
Firms (Choice of Q)
Costs
Long run
Customer Demand
(Market Conditions)
Market Structures (4)
INTRODUCTION TO MARKET STRUCTURE
Market Spectrum
(Ch.11)
Perfect
Competition
(Ch.13)
Monopolistic
Competition
(Ch.13)
Oligopoly
(Ch.12)
Pure
Monopoly
I. Perfect Competition – Characteristics:
(Market forces to operate unimpeded)
1)
2)
3)
4)
5)
6)
7)
8)
all firms sell an identical (homogeneous) product
So consumers are indifferent to different sellers
Many sellers or firms – (LRATC hits low point at relatively small level of output)
Firms are price takers
Their market share isn’t large enough to affect the market price
NO MARKET POWER
Free entry and exit – no barriers to entry or exit such as
- exclusive control of a resource
- unusually high start up costs
Instantaneous entry and exit
Complete information
Firms maximize profits – no firms operating charitably
II. Perfect Competition Graphically
S
Market
demand
curve
25
D
0
9
20
Quantity (thousands
of sweaters per day)
market
demand
curve
50
MR
25
0
Total revenue (dollars per day)
50
Price (dollars per sweater)
Price (dollars per sweater)
Demand, Price, and
Revenue in Perfect
Competition
9
20
Quantity (sweaters
per day)
Demand and
marginal revenue
TR
a
225
0
10
20
Quantity (sweaters
per day)
total revenue
Copyright © 2000 Pearson Education Canada Inc.
Slide 12-10
Each firm’s demand curve is perfectly elastic
A change in q of any firm is not significant enough to change the market demand, D, so
one firm can not impact the market price.
If a firm tries to increase its price, it will lose all of its customers
III. Revenue for the firm
Total Revenue = TR = Pe q
Marginal Revenue:
Revenue from selling one more unit of the good
MR = Pe
IV. Short-Run Equilibrium - Profit Maximizing Output levels
Profit = TR – TC
Total revenue and total cost
(dollars per day)
Total Revenue, Total Cost,
and Economic Profit
TC
TR
300
Economic
loss
225
Economic
profit =
TR – TC
183
100
Economic
loss
0
4
9
12
Quantity (sweaters per day)
Slide 12-15
Copyright © 2000 Pearson Education Canada Inc.
Total revenue
and total cost
(dollars per
day)
Total Revenue, Total Cost,
and Economic Profit
TC
100
0
Profit/loss
(dollars per day)
TR
300
225
183
4
9
12
Quantity (sweaters per day)
42
20
0
-20
-40
Copyright © 2000 Pearson Education Canada Inc.
Economic
profit
Economic
loss
4
9
Profitmaximizing
quantity
12
Quantity (sweaters per day)
Profit/
loss
Slide 12-16
MR=MC The Profit Maximizing Condition
V. Graphically – looking at profit
A) A firm earning a positive economic profit
As long as Pe > ATC where MR=MC, the firm is earning a positive economic profit
Price and cost (dollars per sweater)
Economic Profit
30.00
25.00
MC
ATC
MR
Economic
profit
20.33
15.00
0
9 10
Quantity (sweaters per day)
Copyright © 2000 Pearson Education Canada Inc.
Profit = TR – TC
Profit = Pe*q – (ATC)q
Slide 12-24
B) A firm earning zero economic profit (normal rate of return) may still be earning a
positive accounting profit
As long as Pe = ATC where MR=MC, the firm is earning zero economic profit
Price and cost (dollars per sweater)
Normal Profit
30.00
25.00
MC
BreakBreak-even
point
ATC
20.00
MR
15.00
0
8
10 Quantity (sweaters per day)
Slide 12-23
Copyright © 2000 Pearson Education Canada Inc.
Profit = TR – TC
Profit = Pe*q – (ATC)q
Normal rate of Return
C) A firm earning a negative economic profit (economic loss)
If Pe < ATC where MR = MC, the firm is suffering an economic loss
GRAPH
Profit = TR – TC
Profit = Pe*q – (ATC)q
VI. The Shutdown Rule
How do you know when to shut down and when to keep producing?
When Pe < ATC (LOSS)
If Pe > AVC the firm will keep operating
Even though suffering a loss, still paying some fixed costs
If Pe < AVC the firm will shut down
The firm shuts down because it is not covering its fixed costs of production
Shut down is a temporary decision – close down operation until market conditions look
better
If we expect P < ATC indefinitely we get out of business – this is a long run decision –
getting out of business for good
Maximizing profit also means minimizing loss
VII. The firm’s short-run supply curve
If D shifts in the market, Pe changes causing MR or d to shift.
New output determined where MR1 = MC
The part of MC curve above AVC is the firm’s short-run supply curve
Shows relationship between P and q for the producer
Price and cost
(dollars per sweater)
A Firm’s Supply Curve
MC
31
25
MR2
MR1
Shutdown
point
AVC
s
MR0
17
0
7
9 10
Quantity (sweaters per day)
Copyright © 2000 Pearson Education Canada Inc.
Slide 12-28
The industry supply curve is the horizontal summation of the supply curves of individual
firms.
VIII. Review of the Perfect Competition and Long-Run Equilibrium in a Perfectly
Competitive Market
1) QD = QS in the market no P
2) Firms are breaking even or earning a normal rate of return no  # firms
a) Existing firms cannot be suffering losses (This would include exit from the
market)
b) Existing firms cannot be earning an economic profit (This would induce new
entry into the market)
This is called the zero profit condition
3) Allocative efficiency: (Pe = MC) (this implies that the firm is putting their resources
into best paying use)
for perfect competition this is also true in the short run no  resource allocation
4) Productive efficiency: (Pe = min ATC) Must be at minimum of LRATC so that
expansion of plant size will not lower costs
Low point of LRATC is called minimum efficient scale
So no incentive to change plant size. no  plant size
Economic or productive efficiency
IX. Permanent changes in Market Demand
1) An increase in market demand
GRAPHS
Suppose D shifts from D0 to D1.
a) In the short-run (a to b)
As demand increases, (D0 to D1), the firms demand curve increases due to the
higher equilibrium price, (d0 to d1) or (MR0 to MR1).
The profit maximizing output increases from q0 to q1 as existing firms increase
output and respond to the higher price level and the ability to earn greater profits.
(by running factories overtime)
Existing firms increase output by moving along up their supply curve (i.e. the
marginal cost curve).
As existing firms increase production, this is a short run response. Market output
increases as we move along S0 from point a to point b.
Is point b a long run equilibrium?
No – P > min ATC
b) In the short-run (a to c)
In the long run – the profits of existing firms send a signal to new firms to enter
the market.
As new firms enter what happens to the market supply curve?
It shifts out to the right
As S0 shifts to S1, the market price falls hence pushing the firms demand curve
back to its original level.
The lower price encourages firms to cut production back to q0.
So now we have more firms, but all producing at the old equilibrium output level.
Point c is along run equilibrium.
The long run market supply curve connects the dots representing the long run
equilibrium. In this case it is perfectly flat. This shows that the industry has
constant costs.
There are also industries where the cost of inputs change when firms enter and
exit the markets, however, we will not focus on such cases.
2) A decrease in the market demand
Suppose D shifts from D0 to D1.
c) In the short-run
As demand decreases, (D0 to D1), the firms demand curve decreases due to the
lower equilibrium price, (d0 to d1) or (MR0 to MR1).
The profit maximizing output decreases from q0 to q1 as existing firms decrease
output and respond to the lower price level and the ability to suffer greater losses.
Existing firms decrease output by moving down their supply curve (i.e. the
marginal cost curve).
As existing firms decrease production, this is a short run response. Market output
decreases as we move along S0 from point a to point b.
Is point b a long run equilibrium?
No – P > min ATC
d) In the long run – the losses of existing firms send a signal to new firms to exit
the market.
As some firms exit the market supply curve shifts back to the left
As S0 shifts to S1, the market price rises hence pushing the firms demand curve
back to its original level.
The higher price encourages firms to increase production back to q0.
So now we have fewer firms, but all producing at the old equilibrium output level.
Point c is a long run equilibrium.
The long run market supply curve connects the dots representing the long run
equilibrium. In this case it is perfectly flat. This shows that the industry has
constant costs.
There are also industries where the cost of inputs change when firms enter and
exit the markets, however, we will not focus on such cases.