Download 4. The model of Perfect Competition

Topic 4. Market structure: Perfect
competition
February 24th 2003
Lecture slides available from Nancy’s
website:
http://www.staff.city.ac.uk/n.j.devlin
The aim of today’s lecture is to:
 Introduce you to the assumptions
underpinning the model of perfect
competition
 Show supply, demand and short-run
equilibrium for the industry and the firm
Essential reading:
 BFD Ch. 8.
 Sloman, J. Economics. Prentice Hall
[library shelfmark: 330 SLO]
1. Industrial market structure and
economic performance
 Structure → conduct → performance of
markets and industries
Types of industry structure:
 Perfect competition
 Monopoly
 Monopolistic competition
 Oligopoly
2. Structure of the market or industry
Key features:
 Number of sellers
 Number of buyers
 Ability to enter and exit the market
 Availability of market information
3. Conduct and performance of the
market or industry
Key features are:
 Price at which products are sold
 Quantity of products sold
 Profit levels
 Economic efficiency
4. The model of Perfect Competition
Perfect competition is an extreme form of
market organisation where all firms in an
industry are price takers.
Assumptions:
 Many firms selling homogeneous
products
 Many buyers
 No restrictions on entry
 No restrictions on exit
What is the purpose of the model of
perfect competition?
5. Supply and demand for the industry and the firm
INDUSTRY
Price
FIRM
Price
Market Supply
Firm’s demand
Market Demand
Quantity
Quantity
Supply is the sum of
firms’ supply.
Sell as much as
they wish at the
market price.
6. Demand curve for the firm
Price
P
Quantity
Price = Average Revenue = Marginal
Revenue
7. Profit maximisation
Price
Marginal cost
P2
P1
Q1
Quantity
Π maximizing Q:
MR = MC
If the industry price increased to P2,
what is the new Π -maximising
quantity chosen by the firm?
 short run Marginal Cost defines
the short run supply curve for a
price-taking firm.
[But note that we will qualify this statement in a later slide when we discuss the ‘shut
down’ point for the firm].
8. Short run equilibrium – zero
economic profits
Price
Marginal cost
Average cost
P
Q
Quantity
Total Revenue (TR) = AR x Q
Total Cost (TC) = AC x Q
For profit maximisation, MR = MC
AR = MR = MC = AC
Therefore TR = TC
 what does ‘zero economic profits’
mean?
 The concept of ‘normal profits’
9. Short run equilibrium – positive
economic profits
Price
Marginal cost
Average cost
P
Q
Quantity
Total Revenue (TR) = AR x Q
Total Cost (TC) = AC x Q
For profit maximisation, MR = MC
AR = MR = MC > AC
Therefore AR > AC and TR > TC
 ‘supernormal economic profits’
10. Short run equilibrium: economic
loss
Price
Marginal cost
Average cost
P
Q
Total Revenue (TR) = AR x Q
Total Cost (TC) = AC x Q
For profit maximisation, MR = MC
AR = MR = MC < AC
Therefore AR < AC and TR < TC
 ‘Subnormal economic profits’
Quantity
11.The ‘shut down’ point for the
firm.
In the short run, the firm might make
either supernormal, normal or
subnormal economic profits.
If the firm makes an economic loss,
will it shut down?
 By shutting down, the firm avoids
its variable costs…
BUT cannot avoid its fixed costs.
Even if it is making an economic
loss, the firm will continue to
produce so long as its revenue
covers its variable costs.
WHY?
11.The ‘shut down’ point for the firm
(cont).

Average Variable Cost (AVC)
Price
AC
MC
AVC
P1
P2
P3
Quantity
At P1, P2 & P3, Π maximising quantity
is Q1, Q2 & Q3 respectively.
 At P1, P > AVC: stay in business
 At P2, P = AVC: stay in business
 At P3, P < AVC: shut down
 Identifying the ‘shut down point’
 What does this mean for the
firm’s supply curve?
Friday’s lecture:
 Long-run equilibrium for the
industry and the firm under perfect
competition
 The effects of changes in demand.
Read: Ch.8 BFD