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Perfect Competition
*MADE BY RACHEL STAND* :)
I. Perfect Competition: A
Model
A. Basic Definitions
1. Perfect Competition: a model of the market based primarily on the
assumption that a large number of firms produce identical goods
consumed by a large number of buyers.
2. Other assumptions include ease of entry and exit from the market and
complete information for buyers and sellers in the market.
A. Assumptions of the Model
a. No one buyer or seller has any influence over the market price.
Individuals who must take the market price as given are called price
takers.
• Identical goods
• One unit of the good or service cannot be differentiated from any
other on any basis.
• The goods and services in a perfectly competitive market are
sometime called homogeneous.
• Since the goods are identical, there is no brand loyalty. You don’t
know or care the brand of the good (ex: apples, lettuce)
• A large number of buyers and sellers
• A “large number” is not a specific number of buyers and sellers.
• A “large number” is however many there must be to assure that no
one of them can influence the market price.
I. Perfect Competition: A
Model
• Ease of entry and exit (in the long run)
4. Because of this assumption, firms must deal not only with current
competitors but also with potential competitors.
5. Because of this assumption, firms are free to exit one market and
enter another. Ease of exit is necessary to assume ease of entry.
6. Example: farming (switching from growing one crop to another is
easy).
• Complete information
• All sellers have complete information about prices, technology,
and all other information relevant to the operation of the market.
• All buyers know the prices offered by every seller.
• The assumption of complete information implies that acquiring
information is low cost.
• Perfect Competition and the Real World
• The strong assumptions of the perfectly competitive market may appear
unrealistic.
• The of demand and supply presented in previous chapters is based on
the perfectly competitive market.
• Even though the actual markets of the world seldom meet all the
assumptions of the perfectly competitive model, the model is strong
enough to explain many real- world phenomena.
II. Output Determination in the
Short Run
A. Price and Revenue
1. As price takers, competitive firms expect that market price to
prevail whether they produce large amounts or small amounts.
2.Total Revenue:
a. Total revenue for a perfectly competitive firm: the market
price times the quantity that the firm produces.
b. The total revenue curve is a linear upward- sloping line. If
the market price changes, the total revenue curve pivots
around the origin.
3.Price, marginal revenue, and average revenue
a. Marginal Revenue: the change in total revenue generated
by selling an additional unit of output.
b. Marginal revenue= the slope of the total revenue curve (the
marginal revenue curve is the derivative of the total revenue
curve).
c. Since market price is fixed for the perfectly competitive firm,
marginal revenue equals the price.
II. Output Determination in the Short
d. Average Revenue: the total
revenue divided by quantity. Since all units
Run
sell for the same price, the average revenue must equal price.
1. The marginal revenue curve is a horizontal line at the market price. The
average revenue curve is the same horizontal line at the market price.
1.Marginal revenue, price, and demand for the perfectly competitive firm.
1. Marginal revenue= average revenue= price
• The demand curve for an individual perfectly competitive firm is
horizontal at the price. The AR and MR curves coincide with the individual
firm’s demand curve. Marginal revenue= firm’s demand curve.
• Revenue, Cost, and Economic Profit
• A firm’s economic profit= total revenue minus total opportunity cost of its
operations.
• Marginal cost= firm’s supply curve.
• The total revenue curve of a perfectly competitive firm has a constant slope. The
total cost curve becomes ever steeper as diminishing returns set in.
•The maximum profit is found where the slopes of the total revenue curve and
the total cost curve are equal.
• Applying the Marginal Decision Rule
• Because marginal revenue and marginal cost are the slopes of the total revenue
and total cost curves respectively, profit is maximized where marginal revenue
equals marginal cost.
• A producer makes $0 economic profit
• If a worker makes $80,000 at job A but could have made $80,000 at job
B, the worker has made $0 economic profit because they did not do any
better at job A than at the next best alternative.
II. Output Determination in the Short
Run
2. Marginal revenue and marginal cost are the marginal benefit and
marginal cost of selling an additional unit
a. The marginal decision rule says to expand production if MR exceeds
MC, to decrease production if MC exceeds MR, and to retain the present
output if MR= MC.
b. Economic profit can be demonstrated numerically or graphically by
multiplying economic profit per unit by the number of units produced.
• Economic Losses in the Short Run
• Background information
• In the short run, the firm cannot leave the industry because one or
more of its inputs are fixed.
• As a result, even if a firm shuts down, it must pay fixed costs.
• Thus in the short run, a firm may run an economic loss, the
amount by which its total cost exceeds its total revenue.
•Producing to minimize economic losses
• In the short run, a perfectly competitive firm will continue to
produce and sell even at an economic loss if the price is above the
firm’s average variable cost.
• The minimum level of average variable cost, which occurs at the
intersection of the marginal cost curve and the average variable
cost curve, is the shutdown point.
II. Output Determination in the Short
Run
• Marginal Cost and Supply
E. A supply curve tells us the quantity that will be produced at each price,
which is what the marginal cost curve tells us.
F.The marginal cost curve is the firm’s supply curve in the short run for
prices above the minimum value of average variable cost. At prices below
average variable cost, the firm’s output is zero.
III. Perfect Competition in the Long
A. Economic Profit and EconomicRun
Loss
1. Economic versus accounting concepts of profit and loss
a. Explicit costs: include charges that must be paid for factors of
production such as labor and capital, together with an estimate of
depreciation.
b. Profit computed using explicit costs is accounting profit.
• A cost that is included in the economic concept of opportunity cost
but that is not an explicit cost is called an implicit cost.
• Profit computed using explicit and implicit costs is economic profit.
• The long run and zero economic profits- economic profits in a system of
perfectly competitive markets will, in the long run, be driven to zero in all
industries.
III. Perfect Competition in the Long
3. Eliminating economic profit: Run
the role of entry
a. Economic profits encourage new firms to enter the market thereby
increasing the market supply and reducing the market price.
b. The reduction in the market price continues until the economic
profit is eliminated.
4. Eliminating losses: the role of exit:
a. Economic losses encourage some firms to exit the market, thereby
decreasing the market supply and increasing the market price.
b. The increase in the market price continues until the economic
losses are eliminated.
5. Entry, exit, and production costs.
a. When expansion of an industry does not affect the prices of factors
of production, it is a constant- cost industry.
b. An industry in which the entry of new firms bids up the prices of
factors of production and thus increases production costs is an
increasing- cost industry.
c. An industry in which production costs fall as new firms enter in the
long run, is a decreasing- cost industry.
• In a constant- cost industry, exit will not affect the input prices of
remaining firms. In an increasing- cost industry, exit will reduce the
input prices of remaining firms. In a decreasing- cost industry, input
prices may rise with the exit of existing firms.
III. Perfect Competition in the Long
i. The long- run industry supply curve is a curve that relates the
Run
price of a good or service to the quantity produced after all longrun adjustments to a price change have been completed.
ii. Every point on a long- run industry supply curve in a perfectly
competitive industry therefore shows a price and quantity supplied
at which firms in the industry are earning zero economic profit.
B. Changes in Demand and in Production Cost
1. Changes in demand
a. A change in demand for any reason causes a change in the market
price, thus shifting the marginal revenue curves of firms in the
industry
b. An increase in demand generates short- term profits that attract
other firms to the industry, thereby wiping out the economic profits for
the enlarged number of firms.
c. A decrease in demand generates short- term losses that cause
some firms to exit the industry, thereby restoring the zero economic
profit position for the remaining firms.
a. Changes in production cost
a. Changes in production cost shift the ATC curve
b. If the changes in production cost affect variable costs, a firm’s
marginal cost curves will shift in addition to the ATC curve.
III. Perfect Competition in the Long
Runa similar change in industry supply.
c. Any change in marginal cost produces
d. A reduction in production cost shifts the firm’s cost curves down, creating
economic profit that is eliminated by the entry of new firms to the industry.
e. An increase in production cost shifts the firm’s cost curves up creating
economic loss that is eliminated by the exit of firms from the industry