Download Perfect Competition Slides by: John & Pamela Hall PERFECT COMPETITION

Perfect Competition
Slides by: John & Pamela Hall
ECONOMICS 3e / HALL & LIEBERMAN
PERFECT COMPETITION
© 2005 South-Western/Thomson Learning
Perfect Competition
• Sellers want to sell at the highest possible price
– Buyers seek lowest possible price
– All trade is voluntary
• When we observe buyers and sellers in action
– See that different goods and services are sold in vastly
different ways
• When economists turn their attention to
differences in trading they think immediately about
market structure
– Characteristics of a market that influence behavior of
buyers and sellers when they come together to trade
2
Perfect Competition
• To determine structure of any particular market, we begin
by asking
– How many buyers and sellers are there in the market?
– Is each seller offering a standardized product, more or less
indistinguishable from that offered by other sellers
• Or are there significant differences between the products of different
firms?
– Are there any barriers to entry or exit, or can outsiders easily enter
and leave this market?
• Answers to these questions help us to classify a market
into one of four basic types
–
–
–
–
Perfect competition
Monopoly
Monopolistic
Oligopoly
3
The Three Requirements of Perfect
Competition
• Large numbers of buyers and sellers, and
– Each buys or sells only a tiny fraction of the
total quantity in the market
– Sellers offer a standardized product
– Sellers can easily enter into or exit from market
4
A Large Number of Buyers and
Sellers
• In perfect competition, there must be many
buyers and sellers
– How many?
• Number must be so large that no individual decision
maker can significantly affect price of the product by
changing quantity it buys or sells
5
A Standardized Product Offered by
Sellers
• Buyers do not perceive significant
differences between products of one seller
and another
– For instance, buyers of wheat do not prefer one
farmer’s wheat over another
6
Easy Entry into and Exit from the
Market
• Entry into a market is rarely free—a new seller must
always incur some costs to set up shop, begin production,
and establish contacts with customers
– But perfectly competitive market has no significant barriers to
discourage new entrants
• Any firm wishing to enter can do business on the same terms as firms
that are already there
• In many markets there are significant barriers to entry
– Legal barriers
– Existing sellers have an important advantage that new entrants can
not duplicate
• Brand loyalty enjoyed by existing producers would require a new
entrant to wrest customers away from existing firms
– Significant economies of scale may give existing firms a cost
advantage over new entrants
7
Easy Entry into and Exit from the
Market
• Perfect competition is also characterized by
easy exit
– A firm suffering a long-run loss must be able to
sell off its plant and equipment and leave the
industry for good, without obstacles
• Significant barriers to entry and exit can
completely change the environment in
which trading takes place
8
Is Perfect Competition Realistic?
• Assumptions market must satisfy to be perfectly
competitive are rather restrictive
• In vast majority of markets, one or more of assumptions of
perfect competition will, in a strict sense, be violated
– Yet when economists look at real-world markets, they use perfect
competition more often than any other market structure
• Why is this?
– Model of perfect competition is powerful
– Many markets—while not strictly perfectly competitive—come
reasonably close
• We can even—with some caution—use model to analyze
markets that violate all three assumptions
• Perfect competition can approximate conditions and yield
accurate-enough predictions in a wide variety of markets
9
The Perfectly Competitive Firm
• When we examine a competitive market
from a distance, we get one view of what is
occurring
– When we closely examine the individual
competitive firm, we get an entirely different
picture
• In learning about competitive firm, must also
discuss competitive market in which it
operates
10
Figure 1: The Competitive Industry
and Firm
11
Goals and Constraints of the
Competitive Firm
• Perfectly competitive firm faces a cost
constraint like any other firm
• Cost of producing any given level of output
depends on
– Firm’s production technology
– Prices it must pay for its inputs
12
The Demand Curve Facing a
Perfectly Competitive Firm
• Panel (b) of Figure 1 shows demand curve
facing Small Time Gold Mines
– Notice special shape of this curve
• It’s horizontal, or infinitely price elastic
• Why should this be?
– In perfect competition output is standardized
– No matter how much a firm decides to produce,
it cannot make a noticeable difference in
market quantity supplied
• So cannot affect market price
13
The Demand Curve Facing a
Perfectly Competitive Firm
• Means Small Time has no control over the
price of its output
– Simply accepts market price as given
• In perfect competition, firm is a price taker
– Treats the price of its output as given and beyond its
control
• Since a competitive firm takes the market
price as given
– Its only decision is how much output to produce
and sell
14
Cost and Revenue Data for a
Competitive Firm
• For a competitive firm, marginal revenue at
each quantity is the same as the market
price
• For this reason, marginal revenue curve
and demand curve facing firm are the same
– A horizontal line at the market price
15
Figure 2: Profit Maximization in
Perfect Competition
16
The Total Revenue and Total Cost
Approach
• Most direct way of viewing firm’s search for
the profit-maximizing output level
• At each output level, subtract total cost from
total revenue to get total profit at that output
level
– Total Profit = TR - TC
17
The Marginal Revenue and Marginal
Cost Approach
• Firm should continue to increase output as
long as marginal revenue > marginal cost
• Remember that profit-maximizing output is
found where MC curve crosses MR curve
from below
• Finding the profit-maximizing output level
for a competitive firm requires no new
concepts or techniques
18
Measuring Total Profit
• Start with firm’s profit per unit
– Revenue it gets on each unit minus cost per unit
• Revenue per unit is the price (P) of the firm’s output, and cost
per unit is our familiar ATC, so we can write
– Profit per unit = P – ATC
• Firm earns a profit whenever P > ATC
– Its total profit at the best output level equals area of a
rectangle with height equal to distance between P and
ATC, and width equal to level of output
• A firm suffers a loss whenever P < ATC at the best
level of output
– Its total loss equals area of a rectangle
• Height equals distance between P and ATC
• Width equals level of output
19
Figure 3: Measuring Profit or Loss
20
The Firm’s Short-Run Supply Curve
• A competitive firm is a price taker
– Takes market price as given and then decides how
much output it will produce at that price
• Profit-maximizing output level is always found by
traveling from the price, across to the firm’s MC
curve, and then down to the horizontal axis, or
– As price of output changes, firm will slide along its MC
curve in deciding how much to produce
• Exception
– If the firm is suffering a loss large enough to justify
shutting down
• It will not produce along its MC curve
• It will produce zero units instead
21
Figure 4: Short-Run Supply Under
Perfect Competition
22
The Shutdown Price
• Price at which a firm is indifferent between producing and
shutting down
• Can summarize all of this information in a single curve—
firm’s supply curve
– Tells us how much output the firm will produce at any price
• Supply curve has two parts
– For all prices above minimum point on its AVC curve, supply curve
coincides with MC curve
– For all prices below minimum point on AVC curve, firm will shut
down
• So its supply curve is a vertical line segment at zero units of output
• For all prices below $1—the shutdown price—output is
zero and the supply curve coincides with vertical axis
23
Competitive Markets in the ShortRun
• Short-run is a time period too short for firm
to vary all of its inputs
– Quantity of at least one input remains fixed
• Let’s extend concept of short-run from firm
to market as a whole
• Conclusion
– In short-run, number of firms in industry is fixed
24
The (Short-Run) Market Supply
Curve
• Once we know how to find supply curve of each
individual firm in a market
– Can easily determine the short-run market supply curve
• Shows amount of output that all sellers in market will offer at
each price
– To obtain market supply curve sum quantities of output supplied
by all firms in market at each price
• As we move along this curve, we are assuming
that two things are constant
– Fixed inputs of each firm
– Number of firms in market
25
Figure 5: Deriving The Market
Supply Curve
26
Short-Run Equilibrium
• How does a perfectly competitive market
achieve equilibrium?
– In perfect competition, market sums buying and
selling preferences of individual consumers and
producers, and determines market price
• Each buyer and seller then takes market price as
given
– Each is able to buy or sell desired quantity
• Competitive firms can earn an economic
profit or suffer an economic loss
27
Figure 6: Perfect Competition
28
Figure 7: Short-Run Equilibrium in
Perfect Competition
(a)
Market
(b)
Firm
Dollars
Price
per
Bushel
MC ATC
S
$3.50
$3.50
d1
Loss per
Bushel
at p = $2
2.00
D1
2.00
Profit per
Bushel
at p = $3.50
d2
D2
400,000
700,000 Bushels
per Year
4,000
7,000
Bushels
per Year
29
Profit and Loss and the Long Run
• In a competitive market, economic profit and loss are the
forces driving long-run change
– Expectation of continued economic profit (losses) causes outsiders
(insiders) to enter (exit) the market
• In real world entry and exit occur literally every day
– In some cases, we see entry occur through formation of an entirely
new firm
– Entry can also occur when an existing firm adds a new product to
its line
• Exit can occur in different ways
– Firm may go out of business entirely, selling off its assets and
freeing itself once and for all from all costs
– Firm switches out of a particular product line, even as it continues
to produce other things
30
From Short-Run Profit to Long-Run
Equilibrium
• As we enter long-run, much will change
– Economic profit will attract new entrants
• Increasing number of firms in market
– As number of firms increases, market supply curve will shift
rightward causing several things to happen
» Market price begins to fall
» As market price falls, demand curve facing each firm
shifts downward
» Each firm—striving as always to maximize profit—will
slide down its marginal cost curve, decreasing output
31
From Short-Run Profit to Long-Run
Equilibrium
• This process of adjustment—in the market and
the firm—continues until…well, until when?
– When the reason for entry—positive profit—no longer
exits
– Requires market supply curve to shift rightward enough,
and the price to fall enough
• So that each existing firm is earning zero economic profit
• In a competitive market, positive economic profit
continues to attract new entrants until economic
profit is reduced to zero
32
Figure 8: From Short-Run Profit To
Long-Run Equilibrium
33
From Short-Run Loss to Long-Run
Equilibrium
• What if we begin from a position of loss?
– Same type of adjustments will occur, only in the
opposite direction
• In a competitive market, economic losses
continue to cause exit until losses are reduced to
zero
• When there are no significant barriers to exit
– Economic loss will eventually drive firms from the
industry
• Raising market price until typical firm breaks even again
34
Distinguishing Short-Run from LongRun Outcomes
• In short-run equilibrium, competitive firms
can earn profits or suffer losses
– In long-run equilibrium, after entry or exit has
occurred, economic profit is always zero
• When economists look at a market, they
automatically think of short-run versus longrun
– Choose the period more appropriate for
question at hand
35
The Notion of Zero Profit in Perfect
Competition
• We have not yet discussed plant size of
competitive firm
• The same forces—entry and exit—that
cause all firms to earn zero economic profit
also ensure
– In long-run equilibrium, every competitive firm
will select its plant size and output level so that
it operates at minimum point of its LRATC curve
36
Perfect Competition and Plant Size
• Figure 9(a) illustrates a firm in a perfectly competitive
market
– But panel (a) does not show a true long-run equilibrium
– How do we know this?
• In long-run typical firm will want to expand
• Why?
– Because by increasing its plant size, it could slide down its LRATC curve
and produce more output at a lower cost per unit
– By expanding firm could potentially earn an economic profit
• Same opportunity to earn positive economic profit will attract new
entrants that will establish larger plants from the outset
• Entry and expansion must continue in this market until the
price falls to P*
– Because only then will each firm—doing the best that it can do—
earn zero economic profit
37
Figure 9: Perfect Competition and
Plant Size
38
A Summary of the Competitive Firm
in the Long-Run
• Can put it all together with a very simple
statement
– At each competitive firm in long-run equilibrium
• P = MC = minimum ATC = minimum LRATC
• In figure 9(b), this equality is satisfied when the
typical firm produces at point E
– Where its demand, marginal cost, ATC, and LRATC
curves all intersect
• In perfect competition, consumers are getting the
best deal they could possibly get
39
A Change in Demand
• Short-run impact of an increase in demand is
– Rise in market price
– Rise in market quantity
– Economic profits
• What happens in long-run after demand curve
shifts rightward?
– Market equilibrium will move from point A to point C
• Long-run supply curve
– Curve indicating quantity of output that all sellers in a
market will produce at different prices
• After all long-run adjustments have taken place
40
Figure 10: An Increasing-Cost
Industry
41
Figure 10: An Increasing-Cost
Industry
NEW EQUILIBRIUM
Firm
Market
Price
per
Unit
Dollars
MC
B S1
PSR
S2
C
SLR
P2
P1
A
B
PSR
C
ATC1
P2
P1
ATCdSR= MRSR
A
d2= MR2
d1= MR1
D2
D1
Q1
QSR Q2
Output
per
Period
q1 q2 qSR
Output
per
Period
42
Increasing, Decreasing, and
Constant Cost Industries
• Increase in demand for inputs causes price
of those inputs to rise
• This type of industry (which is the most
common) is called an increasing cost
industry
– Entry causes input prices to rise
• Shifts up typical firm’s ATC curve
– Raises market price at which firms earn zero economic
profit
» As a result, long-run supply curve slopes upward
43
Increasing, Decreasing, and
Constant Cost Industries
• Other possibilities
– Industry might use such a small percentage of total inputs that—
even as new firms enter—there is no noticeable effect on input
prices
• Called a constant cost industry
– Entry has no effect on input prices, so typical firm’s ATC curve stays put
» Market price at which firms earn zero economic profit does not
change
» Long-run supply curve is horizontal
– Decreasing cost industry, in which entry by new firms actually
decreases input prices
• Entry causes input prices to fall
– Causes typical firm’s ATC curve to shift downward
» Lowers market price at which firms earn zero economic profit
» As a result, long-run supply curve slopes downward
44
Market Signals and the Economy
• In real world, demand curves for different goods and
services are constantly shifting
• As demand increases or decreases in a market, prices
change
• Economy is driven to produce whatever collection of
goods consumers prefer
• In a market economy, price changes act as market signals,
ensuring that pattern of production matches pattern of
consumer demands
– When demand increases, a rise in price signals firms to enter
market, increasing industry output
– When demand decreases, a fall in price signals firms to exit
market, decreasing industry output
45
Market Signals and the Economy
• Market signal
– Price changes that cause firms to change their
production to more closely match consumer demand
• No single person or government agency directs
this process
– This is what Adam Smith meant when he suggested
that individual decision makers act for the overall
benefit of society
• Even though, as individuals, they are merely trying to satisfy
their own desires
• As if guided by an invisible hand
46
Using the Theory: Changes in
Technology
• Competitive markets ensure that technological advances
are turned into benefits for consumers
• One industry that has experienced especially rapid
technological changes in the 1990s is farming
• Let’s see what happens when new, higher-yield corn
seeds are made available
– Suppose first that only one farm uses the new technology
• In long-run, economic profit at this farm will cause two
things to happen
– All other farms in market will have a powerful incentive to adopt
new technology—to plant the new, genetically engineered seed
themselves
– Outsiders will have an incentive to enter this industry with plants
utilizing the new technology
• Shifting market supply curve rightward and driving down the market
price
47
Using the Theory: Changes in
Technology
• Can draw two conclusions about technological
change under perfect competition
– All farms in the market must use the new technology
– Gainers are consumers of corn, since they benefit from
the lower price
• Impact of technological change
– Under perfect competition, a technological advance
leads to a rightward shift of market supply curve,
decreasing market price
• In short-run, early adopters may enjoy economic profit, but in
long-run, all adopters will earn zero economic profit
• Firms that refuse to use the new technology will not survive
48
Using the Theory: Changes in
Technology
• Technological advances in many
competitive industries have spread quickly
– Shifting market supply curves rapidly and
steadily rightward over the past 100 years
• While this has often been hard on individual
competitive firms it has led to huge rewards for
consumers
49
Figure 11: Technological Change in
Perfect Competition
(b) Firm
(a) Market
Price
per
Bushel
Dollars
per
Bushel
S1
S2
ATC1
A
ATC2
d1 = MR1
$3
$3
B
2
2
d2 = MR2
D
Q1
Q2
Bushels
per Day
1000
Bushels
per Day
50