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Lecture notes
Prepared by Anton Ljutic
CHAPTER EIGHT
Perfect Competition
© 2004 McGraw–Hill Ryerson Limited
This Chapter Will Enable
You to:
• Distinguish between a firm, an industry and a
market
• Explain the conditions necessary for a perfectly
competitive market to exist
• Use two approaches to explain how a firm might
maximize its profits
• Explain what is meant by break-even price and shut
down price
• Explain how a firm’s supply curve is derived
• Explain the effect of a change in market demand or
market supply on both the industry and the firm
© 2004 McGraw–Hill Ryerson Limited
Industry vs. Market
• Industry
– A name for a group of producers
• Market
– Refers to the interaction of both producers and
consumers
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Characteristics of Different Markets
• Perfect competition
– Many sellers, identical product, easy entry, no seller’s
control over price: commodities such as wheat market
in which all buyers and sellers are price takers
– There are many firms, selling an identical product
• Monopoly
– There is a single firm, selling a unique product
• Monopolistic competition
– There are many firms, selling a differentiated product
• Differentiated oligopoly
– There are few firms, selling an identical product
© 2004 McGraw–Hill Ryerson Limited
Characteristics of Different Markets
• Undifferentiated vs.
Differentiated oligopoly
– Few sellers, identical vs.
differentiated product,
difficult entry, moderate
vs. substantial control
over price
– Example: oil refining vs.
automotive and tobacco
• Monopoly
– One firm, unique
product, very difficult
entry, substantial control
over price
– Example: local telephone
© 2004 McGraw–Hill Ryerson Limited
providers, cable
• Perfect competition
– Numerous sellers,
identical product, easy
entry, no control over
price
– Example: commodities
such as wheat
• Monopolistic competition
– Many sellers,
differentiated product,
easy entry, low control
over price
– Example: restaurants
Conditions for Perfect Competition to Exist
• Large number of small buyers and sellers,
all of whom are price takers
• No preferences shown (undifferentiated
product)
• Easy entry and exit by both buyers and
sellers
• The same market information available to all
to make rational production and purchasing
decisions
© 2004 McGraw–Hill Ryerson Limited
Examples of Perfectly Competitive Markets
• World markets for commodities like
aluminum, zinc, cotton, rubber, oil,wheat
• Agricultural products (though Canada has
marketing boards)
True competition exists between a wheat farmer in
Alberta and another in Manitoba, not between
Coca-Cola and Pepsi or between Reebok and Nike
© 2004 McGraw–Hill Ryerson Limited
The Competitive Industry and the Firm
Single firm’s D
Market S and D
P
S1
D*=AR=MR
$10
D1
Q
© 2004 McGraw–Hill Ryerson Limited
Q
Figure 8.1
Total, Average and Marginal Revenue
• Total revenue (TR)
– Price times output (P x Q)
• Average revenue (AR)
– The amount of revenue received per unit sold
– To calculate it, you divide total revenue (TR) by output
(Q)
• Marginal revenue
– The extra revenue derived from the sale of one more
unit
AR = TR / Q ; MR =  TR /  Q
© 2004 McGraw–Hill Ryerson Limited
Price, Profit and Output Under Perfect
Competition (I)
• Total profits
– the difference between total revenue and total
cost (TR – TC)
• Break-even output
– The level of output at which the sales revenue
of the firm just covers fixed and variable costs,
including normal profit (i.e., where TR = TC)
© 2004 McGraw–Hill Ryerson Limited
Price, Profit and Output Under Perfect
Competition (II)
• A higher price opens a wider range of
profitable outputs, increased production and
greater profits
• A lower price reduces the range of
profitable outputs and results in lower
production and smaller profit for producers
© 2004 McGraw–Hill Ryerson Limited
Total Revenue, Costs and Profits
TC
TR
TC
Break-even
TR
T
Figure 8.3
T
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Q
The Marginal Approach to Profitability
• Marginal profit
– The additional economic profit from the
production and sale of of an extra unit of output
– To calculate it, divide  total profit by  output
• To maximize its total profit, the firm should
increase production to the point at which the
marginal profit is zero, that is , where
marginal revenue is equal to marginal cost
© 2004 McGraw–Hill Ryerson Limited
Average and Total Profits
Figure 8.5
AR,
AC
MC
Break-even
points
AC
P= AR= MR
P1
Profit-max. Q
MR=MC
Q
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Break-Even and Shutdown Price
• Break-even price
– The price at which the firm makes only normal
profits, that is, makes zero economic profits
• Shutdown price
– The price that is just sufficient to cover a firm’s
variable costs
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Break-Even and Shutdown Price for
Competitive Firm
AR,
cost
MC
ATC
AVC
•The breakeven price is
Pbe.
•The shutdown price is
Psd
Pbe
Pbe=Break-even P
Psd
Psd=Shut-down P
Q
© 2004 McGraw–Hill Ryerson Limited
Figure 8.7
Should the Firm Produce?
At any output – is the price higher than AC?
NO
YES
Firm
makes
economic
profit
Is price higher than AVC?
Firm
produces
at a loss
YES
NO
Shut-down
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The Firm’s Supply Curve
AR,
cost
MC=supply
ATC
AVC
The firm’s
supply
curve is the
marginal
cost curve
MC above
minimum
AVC
Figure 8.8
Q
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The Industry Demand and Supply Curves
S = MC
P
$35
D
60
Q
© 2004 McGraw–Hill Ryerson Limited
•The industry’s
supply curve is the
total of all the firms’
MC curves.
•The equilibrium
price is $35 and the
equilibrium quantity
is 60.
Short vs. Long Run
Period
Firm
Industry
Overall
Effect
Short-run
Firm size is No. of firms
fixed
is fixed
Fixed
Capacity
Long-run
Size of firm No. of firms
can vary
can vary
Variable
Capacity
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The Long-Run Effects of an Increase in Demand
P
S1
S2
P2
P1
b
a
c
D2
D1
Q
© 2004 McGraw–Hill Ryerson Limited
•The increase in
demand (D1 to D2)
causes P to rise to P2
and Q to rise from a to
b
•In the long run
new firms enter the
industry and the supply
shifts to S2 and Q rise to
c
•the market price falls
back to P1
•P1 is the long-run
equilibrium price
The Long-Run Effects of a Decrease in Demand
P
S2
P1
c
S1
a
P2
D1
b
D2
Q
© 2004 McGraw–Hill Ryerson Limited
•The decrease in
demand (D1 to D2)
causes P to fall to P2
and Q to fall from a to b
•In the long run
Some firms exit the
industry and the supply
shifts left to S2 and Q
falls to c
•the market price rises
back to P1
•P1 is the long-run
equilibrium price
Constant-Cost Industry
P
D1
S1
D2
S2
D3 S3
LRS
Q
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•Increases in
demand are
met by exact
increases in
supply.
•Price is
unaffected.
•The LRS
curve is
horizontal
Decreasing-Cost Industry
P
D1
S1
D2 S2
D3
S3
LRS
Q
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•Industry
expansion
leads to lower
costs.
•Price falls.
•The LRS
curve is
downwardsloping
Increasing-Cost Industry
P
D1 S1
D2 S2
D3 S3
LRS
Q
© 2004 McGraw–Hill Ryerson Limited
•Industry
expansion
leads to
increasing
costs.
•Price rises.
•The LRS
curve is
upwardsloping
Chapter Summary:
What to Study and Remember
• distinction between a firm, an industry and a
market
• conditions necessary for a perfectly competitive
market to exist
• two approaches to explain how a firm might
maximize its profits
• what is meant by break-even price and shut down
price
• the derivation of a firm’s supply curve
• the effect of a change in market demand or market
supply on both the industry and the firm
© 2004 McGraw–Hill Ryerson Limited