Download Chapter 8: Perfect Competition:

Chapter 8: Perfect Competition:
Definition: Market Structure: The characteristics of a market that influence how trading
takes place.
 By market structure, we mean all the characteristics of a market that influence
the behavior of buyers and sellers when they come together to trade.
 The structure of any particular market can be determined by the answers to the
following three questions:
1. How many buyers and sellers are there in the market?
2. 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?
3. Are there any barriers to entry or exit, or can outsiders easily enter and
leave this market?
 The four basic types of markets are:
1) Perfect competition
2) Monopoly
3) Monopolistic competition
4) Oligopoly
The focus of this chapter is perfect competition.
What is Perfect Competition?
 In economics, the term “competition” describes a situation of diffuse, impersonal
competition in a highly populated environment.
Definition: Perfect competition: A market structure in which there are many buyers and
sellers, the product is standardized, and sellers can easily enter or exit the market.
The Three Requirements of Perfect Competition:
 Perfect competition is a market structure with three important
characteristics:
1. There are large numbers of buyers and sellers, and each buys or
sells a tiny fraction of the total quantity in the market.
2. Sellers offer a standardized, homogenous product..
3. Sellers can easily enter into or exit from the market.
 In a perfectly competitive market, each buyer and seller is a
price taker.
A Large Number of Buyers and Sellers:
 In a perfectly competitive market, the number of buyers and sellers is so large that no
individual decision maker can significantly affect the price of the product by
changing the quantity it buys or sells.
Examples: Wheat, cotton, gold, silver, stocks, bonds.
A Standardized Product Offered by Sellers:
 In perfectly competitive markets, buyers do not distinguish considerable differences
of the products of one seller to another. Buyers see the products in perfectly
competitive markets essentially as identical.
 The manufacturers of Wheaties have no preference of Bob’s wheat over Andy’s.
Easy Entry and Exit from the Market:
 Easy entry into a market does not mean a free entry—the new entrant must incur
some overhead costs, yet a perfectly competitive market has no significant barriers to
discourage new entrants.
 Some markets do have barriers to entry, often imposed by the
government; for example, the number of taxicabs licensed to
operate in New York City is fixed by the local government.
Zoning laws are another government imposed barrier to entry.
 Existing sellers’ market dominance can also create barriers to entry
without any government action. Consumer brand loyalty and
significant economies of scale often give existing firms a cost
advantage over new entrants.
 Perfect competition also requires 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
obstacle. If shutting down the plant requires intense union litigation, the capital
equipment too specialized to be immediately sold, or if significant barriers to exit
arise, then the firm will not conform to the assumptions of perfect competition.
The Perfectly Competitive Firm:
Goals and Constraints of the Competitive Firm:
 A perfectly competitive firm faces a cost constraint like any other firm. The cost of
producing any given level of output depends on the firms’ production technology and
the prices it must pay for its inputs.
The
Competitive Industry
Industry and
and
The Competitive
Firm
Firm
(a)
(a)
Market
Market
Price
Price
per
per
Ounce
Ounce
(b)
(b)
Firm
Firm
Price
Price
per
per
Ounce
Ounce
SS
$400
$400
$400
$400
DD
Ounces
Ouncesof
of
Gold
Goldper
perDay
Day
Demand
Demand
Curve
Curve
Facing
Facing
the
theFirm
Firm
Ounces
Ouncesof
of
Gold
Goldper
perDay
Day
 In panel (a), the market supply and demand curves intersect to determine a market
price of $400 per ounce. The typical firm in panel (b) can sell all it wants at that
price. The demand curve facing the competitive firm is a horizontal line at the market
price.
The Demand Curve Facing a Perfectly Competitive Firm:
 Panel (b) of the figure above shows the demand curve facing the perfectly
competitive firm Small Time Gold Mines. Note that the shape of the demand
curve is horizontal, or infinitely price elastic. This tells us that no matter how
much gold Small Time produces, it will always sell it at the same price: $400
per ounce.
 In perfect competition, the firm is a price taker—it treats the price of its output as
given.
Definition: Price taker: Any firm that treats the price of its product as given and beyond
its control.
Cost and Revenue Data for Small Time Gold Mines:
(1)
(2)Price
(3) Total
(4)
(5) Total
Output
(per troy revenue
Marginal cost
(troy
ounce)
Revenue
ounces
per day)
0
$400
$0
$550
$400
1
$400
$400
$1,000
$400
2
$400
$800
$1,200
$400
3
$400
$1,200
$1,250
$400
4
$400
$1,600
$1,350
$400
5
$400
$2,000
$1,500
$400
6
$400
$2,400
$1,750
$400
7
$400
$2,800
$2,100
$400
8
$400
$3,200
$2,550
$400
9
$400
$3,600
$3,100
$400
10
$400
$4,000
$3,750
(6)
Marginal
cost
(7) Profit
-$550
$450
-$600
$200
-$400
$50
-$50
$100
$250
$150
$500
$250
$650
$350
$700
$450
$650
$550
$500
$650
$250
 Because Small Time Gold mines is a perfectly competitive firm—a price taker—its
price per ounce remains constant at $400, no matter how many ounces it produces.
 Marginal revenue remains constant at $400. Why? Price remains constant
at $400 and each time the firm produces another ounce of gold, total
revenue increases by $400.
The
The Perfectly
Perfectly Competitive
Competitive Firm
Firm
(a)
(a)
Dollars
Dollars
$2,800
$2,800
TR
TR TC
TC
Ma
Maximum
ximum
Profit
Profit
per
perDa
Dayy
==$700
$700
2,100
2,100
550
550
Slope
Slope==400
400
11 22 33 44 55 66 77 88 99 10
10
Ounces
Ouncesof
of
Gol
Golddper
perDDaayy
(b)
(b)
Dollars
Dollars
MC
MC
$400
$400
dd==MR
MR
11 22 33 44 55 66 77 88 99 10
10
Ounces
Ouncesof
of
Gol
Golddper
perDDaayy
Panel (a) shows a competitive firm’s total revenue (TR) and total cost (TC) curves. TR is
a straight line with slope equal to the market price. Profit is maximized at 7 ounces per
day, where the vertical distance between TR and TC is greatest. Panel (b) shows that
profit is maximized where the marginal cost (MC) curve intersects the horizontal demand
(d) and marginal revenue (MR) curves.
Small Time’s total revenue and marginal revenue is plotted above.
 Notice that the total revenue (TR) curve in panel (a) is a straight line that slopes
upward—each time output increases by one unit, TR rises by the same $400 we
considered with marginal revenue. Therefore the slope of the TR curve is equal to the
price of output.
 Marginal revenue is constant at $400 (market price); therefore it is represented above
by a horizontal line. Recall that marginal revenue is the additional revenue the firm
earns from selling an additional unit of output. This brings up a very important point:
 For a competitive firm, marginal revenue at each quantity is the same as the market
price. For this reason, the marginal revenue curve and the demand curve facing the
firm are the same—a horizontal line at the market price.
 It is especially important to notice that in panel (b) the horizontal line is labeled “d =
MR”—since this line is both the firm’s demand curve (d) and its marginal revenue
curve (MR).
Finding the Profit Maximizing Output Level: (recall chapter 7)
 Competitive firms, like all firms, want to maximize profits, and to do so it
will use the principles demonstrated in chapter 7 (the TR/TC approach and
the MR/MC approach)
 For the following examples refer to the table and figure above.
1. The total revenue and total cost approach: Recall that in the total revenue and
total cost approach, profit is calculated by subtracting TR – TC at each output
level. Recall also that profit is maximized by finding the output level with the
highest profit. At 7 ounces per day, Small Time Gold Mines maximizes profit at
$700 per day. You should be able to use the graph in panel (a) of figure 2 above
to verify that the greatest distance between the TR and TC curves occurs when the
firm is producing 7 (troy) ounces of gold per day and indeed their profit is $700.
2. The marginal revenue and marginal cost approach: Recall that in the MR and MC
approach, the firm should continue to increase output as long as marginal
revenue is greater than marginal cost. Notice how the firm keeps producing
more as long as MR>MC, when producing more will raise profit; however, once
the firm is producing 7 units, MR<MC, thus further increasing output will reduce
profit. Examine (b) of figure 2 and find the output levels where the MR and MC
curves intersect. Notice how the MC intersects the MR curve twice. However, we
can rule out the first crossing point because there, the MC curve crosses the MR
curve from above. Remember that the profit maximizing output is found where
the MC curve crosses the MR curve from below.
 The profit maximizing output level for competitive firms only requires
you top use what you learned in chapter 7—however, Ned’s Beds, the firm
we examined in chapter 7 did not operate under perfect competition. As a
result, both its demand curve and its marginal revenue curve sloped
downward. Small Time, however, operates under perfect competition, so
its demand and MR curves are the same horizontal line.
Measuring Total Profit:
 We already know that the vertical distance between the TR and TC curves
gives us a firm’s profit. Now we will learn another way to measure profit:
 Profit per unit = P - ATC
Measuring
Measuring Profit
Profit or
or Loss
Loss
(b)
(b)Economic
EconomicLoss
Loss
(a)
(a)Economic
EconomicProfit
Profit
Dollars
Dollars
Dollars
Dollars
ATC
ATC
Prof
Profitit per
per MC
MC
Ounce
Ounce
$100
$100
Loss
Lossper
per
Ounce
Ounce
$100
$100
dd==MR
MR
$400
$400
300
300
ATC
ATC
$300
$300
200
200
11 22
33 44 55
66 77 88 99 10
10
Ounces
Ouncesof
of
per
Gold
Gold perDay
Day
MC
MC
dd==MR
MR
11 22 33 44 55 66 77 88 99 10
10
Ounces
Ouncesof
of
per
Gold
Gold perDay
Day
 The competitive firm in panel (a) produces where marginal cost equals marginal
revenue, or 7 units of output per day. Profit per unit at that output level is equal to
revenue per unit ($400) minus cost per unit ($300) or $100 per unit. Total profit
(indicated by the blue shaded rectangle) is equal to profit per unit times the number
of units sold, $100*7 = $700. In panel (b), the firm faces a lower market price of
$200 per ounce. The best it can do is produce 5 ounces per day and suffer a loss by
the red area. It loses $100 per ounce on each of those 5 ounces produced, so the
total loss is $500—the area of the red-shaded rectangle.
 A firm earns a profit whenever P>ATC. Its total profit at the best output level equals
the area of a rectangle with height equal to the distance between P and ATC, and
width equal to the level of output.
 A firm suffers a loss whenever P<ATC at the best level of output. Its total loss equals
the area of a rectangle with height equal to the distance between P and ATC, and
width equal to the level of output.
The Firm’s Short-Run Supply Curve:
 How does a competitive firm maximize profit when market price changes in the short
run?
Short
Supply Curve
Curve
Short--Run
Run Supply
(b)
(b)
(a)
(a)
Dollars
Dollars
Price
Price
per
perBushe
Bushel l
$3
$3.50
.50
MC
MC
dd1 ==MR
1 MR11
ATC
ATC
22.50
.50
22.00
.00
dd2 ==MR
2 MR22
AVC
AVCd = MR
d33 = MR33
2.50
2.50
2.00
2.00
11.00
.00
00.50
.50
dd4 ==MR
4
4 MR 4
dd5 ==MR
MR5
1.00
1.00
0.50
0.50
5
1,000
1,000
2,000
2,000
4,000
4,000
5,000
5,000
5
7,000
7,000 Bushels
Bushels
per
perYear
Year
Firm’s
Firm’s
Su
Supply
pply
Curve
Curve
$3.50
$3.50
2,000
2,000
4,000
4,000
5,000
5,000
7,000
Bushels
7,000 Bushels
per
perYear
Year
 Panel (a) shows a typical competitive firm facing various market prices. For prices
between $1 and $3.50 per bushel, the profit maximizing quantity is found by sliding
along the MC curve. Below $1 per bushel, the firm is better off shutting down,
because P<AVC, so TR<TVC. Panel (b) shows that the firms supply curve consists
of two segments. Above the shutdown price of $1 per bushel it follows the MC curve;
below that price it is synchronized with the vertical axis.
 The figure above shows ATC, AVC, and MC curves for a competitive
producer of wheat. Note that there are five different demand curves that the
firm could face.
Market Price
Demand curve
Profit Maximizing level
(MC = MR)
$3.50
d1
7,000 bushels per year
$2.50
d2
5,000
$2.00
d3
4,000
$1.00
d4
2,000 Indifferent
$0.50
d5
1,000 [ALWAYS SHUT
DOWN]
 As the price of output changes, the firm will slide along its MC curve in
deciding how much to produce.
Recall:
1. AVC * Q = TVC
2. A firm should never shut down when TR>TVC
3. A firm should always shut down when TR<TVC
Definition: Shutdown Price: The price at which a firm is indifferent between producing
and shutting down. [The firm will] shut down at a price any lower and stay open at any
price higher.
 For all prices above the minimum point on the AVC curve, the firm will stay open and
will produce the level of output at which MR = MC. For these prices, the firm slides
along its MC curve in deciding how much output to produce. But for any price below
the minimum AVC, the firm will shut down and produce zero units.
Definition: Firm’s supply curve: A curve that shows the quantity of output a
competitive firm will produce at different prices.
 The competitive firm’s supply curve has two parts. For all the prices
above the minimum point on its AVC curve, the supply curve coincides
with the MC curve.
 For all prices below the minimum point on the AVC curve, the firm will
shut down, so its supply curve is a vertical segment at zero units of output
(see graph above).
 In the short run, the number of firms in the industry is fixed.
The Short-Run Market Supply Curve:
Definition: Market Supply Curve: A curve indicating the quantity of output that all
sellers in a market will produce at different prices. To obtain the market supply curve, we
add up all the quantities of output supplied by all firms in the market at each price.
 The market supply curve of panel (b) is obtained by adding up the
quantities of output supplied by all the firms in the market at each price,
as shown in panel (a).
The
Market Supply
Supply Curve
Curve
The Market
(b)
(b)
Market
Market
(a)
(a)
Firm
Firm
Price
Price
per
perBushel
Bushel
Firm’s
Firm’s
Supply
Supply
Curve
Curve
$3.50
$3.50
Price
Price
per
perBushel
Bushel
$3.50
$3.50
2.50
2.50
2.00
2.00
2.50
2.50
2.00
2.00
1.00
1.00
0.50
0.50
1.00
1.00
0.50
0.50
2,000
2,000
4,000
4,000
5,000
5,000
7,000
Bushels
7,000 Bushels
per
perYear
Year
Market
Market
Supply
Supply
Curve
Curve
700,000
400,000
400,000
700,000Bushels
Bushels
per
500,000
200,000
200,000
500,000
perYear
Year
Short
Equilibrium
Short--Run
Run Equilibrium
(a)
(a)
Market
Market
(b)
(b)
Firm
Firm
Dollars
Dollars
Price
Price
per
per
Bushel
Bushel
SS
MC
MC ATC
ATC
$3.50
$3.50
$3.50
$3.50
2.00
2.00
DD11
2.00
2.00
dd11
Loss
Lossper
per
Bushel
Bushel
at
atpp==$2
$2
Profit
Profitper
per
Bushel
Bushel
atatpp==$3.50
$3.50
dd22
DD22
400,000
400,000
700,000
700,000 Bushels
Bushels
per
perYear
Year
4,000
4,000
7,000
7,000
Bushels
Bushels
per
perYear
Year
Short Run Equilibrium (in perfect competition)—An Example
In panel (a) demand curve D1 intersects supply curve S to determine a market price of
$3.50 per bushel. The firm in panel (b) takes that price as given, produces 7,000 bushels
per year—determined at the intersection of its marginal cost curve with the horizontal
demand curve, d1—and earns a short run profit. If the market demand curve shifts left to
D2, the market price falls to $2 per bushel. The typical firm then reduces production to
4,000 bushels per year and suffers a short run loss.
Let’s take a look at two possible short-run equilibria in the wheat market:
1. Suppose market demand is represented by curve D1, as illustrated in panel (a).
The short run equilibrium price would be $3.50. Each firm would face the
horizontal demand curve d1, and, as plotted in panel (b), would decide to produce
7,000 bushels, and with 100 firms 7,000*100 = 700,000 bushels. Note that the
price is $3.50; thus each firm will earn an economic profit because P>ATC.
2. Now let the market demand curve be D2, and equilibrium price will equal $2.00.
Each firm would then face the horizontal demand curve d2, and would produce
4,000 bushels. Equilibrium market quantity would then be 400,000 bushels
with 100 firms and each firm would suffer an economic loss since P<ATC.
 Thus, in the short run equilibrium, competitive firms can earn an
economic profit or suffer an economic loss.
 In perfect competition, the market sums up the buying and selling preferences of
individual consumers and producers, and determines the market price. Each buyer
and seller then takes the market price as given, and each is able to buy or sell the
desired quantity.
Competitive Markets in the Long Run:

In the short run, we know that the number of firms in a perfectly competitive is
fixed; however, in the long run entry and exit can occur.
Profit and Loss and the Long Run:
 In a competitive market, economic profit and loss are the forces driving
long run change. The expectation of continued economic profit causes
outsiders to enter the market; the expectation of continued economic
losses causes firms in the market to exit.
Long-Run Equilibrium: From Short-Run Profit to Long-Run Equilibrium:

Assume the market for wheat is in short-run equilibrium at $4.50 per bushel and
the equilibrium price lays above the ATC curve per bushel for a given firm. With
P>ATC the firm will earn an economic profit in the short run.
 Attracted to economic profit, new firms enter the market and increase
overall market production effectively causing the market supply curve to
shift rightward:
1. The market price will fall.
2. As the market price falls, the marginal revenue and demand
curve for the firm shift further downward.
3. Attempting to maximize profit, the firm will decrease output
and slide down its marginal cost curve.
 New entrants will continue to shift the market supply rightward until
the market supply shifts so far rightward such 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.
From Short Run Loss to Long-Run Equilibrium:
 In a competitive market, economic losses continue to cause exit unit the
losses are reduced to zero.
The Notion of Zero Profit in Perfect Competition:
Definition: Normal Profit: Another name for zero economic profit
 In the long run, every competitive firm will earn normal profit—that is,
zero economic profit.
Perfect Competition and Plant Size:
 In the long-run equilibrium, every competitive firm will select its plant size
and output level so that it operates at the minimum point of its LRATC
curve.
Competitive
Competitive Markets
Markets in
in the
the
Long
Long Run
Run
(a)
(a)
(b)
(b)
Dollars
Dollars
Dollars
Dollars
LRA
LRATC
TC
LRA
LRATC
TC
MC
MC11ATC1
ATC1
PP11
MC
MC2ATC
2ATC22
dd11 ==MR
MR11
PP* *
qq11
Output
Output
per
per
Period
Period
EE
dd22==MR
MR22
qq* *
Output
Output
per
per
Period
Period
The firm in panel (a) faces a price of P1, and produces quantity q1. It earns zero profit
because price equal average cost. In the long run, the firm will want to expand. By
sliding down the LRATC curve, it could produce more output at a lower cost per unit and
earn an economic profit. In turn, economic profit will attract entry, and that will reduce
the market price. The firm’s long-run equilibrium position is shown in panel (b). The
firm earns zero profit by operating at minimum LRATC.
Summary: The Perfectly Competitive Firm in the Long Run

At each competitive firm in the long run, P = MC = Minimum ATC =
minimum LRATC.
Producing goods at the minimum average cost means that firms are producing at the
lowest possible cost per unit, which results in economic efficiency.
A Change in Demand:
A Change in Demand
INI TIA L EQUILIB RIU M
(b) Firm
(a) Marke t
Price
per
Unit
Dollars
S1
MC
ATC1
P1
P1
A
d1 = MR1
A
D1
NEW EQUI LIBRI U M
(c) Marke t
Price
per
Unit
Output
per
Period
(d) Firm
Dollars
B
MC
S1
S2
P SR
SLR
C
P2
P1
q1
Output
per
Period
Q1
B
P SR
C
P2
P1
A
A
dSR = MRSR
ATC2
ATC1
d2 = MR2
d1 = MR 1
D2
D1
Q1
Q SR Q 2
Output
per
Period
q1 q2 qSR
Output
per
Period
At point A in panel (a), the market is in long run equilibrium. The typical firm in panel
(b) earns zero economic profit. If demand increases market price rises. Individual firms
increase output and earn an economic profit at point B. Profit attracts entry, increasing
market supply and driving up ATC. When long run equilibrium is reestablished at point
C in panel (c), price is higher, but the typical firm again earns zero economic profit. The
long-run market supply curve is and upward sloping line found by connecting points like
A and C in panel (c).
 The long run supply curve shows the relationship between market price
and market quantity produced after all long-run adjustments have taken
place.
 An increasing cost industry in which the long-run supply curve slopes
upward because each firm’s ATC curve shifts upward as industry output
increases.
 A constant cost industry is an industry in which the long-run supply
curve is horizontal because each firm’s ATC curve is unaffected by
changes in industry output.
 A decreasing cost industry is an industry in which the long run supply
curve slopes downward because each firm’s ATC curve shifts downward
as industry output increases.
 In a market economy, price changes act as market signals,
ensuring that the pattern of production matches the pattern of
consumer demands. When demand increases, a rise in price
signals firms to enter the market, increasing industry output.
When demand decreases, a fall in price signals firms to exit the
market, decreasing industry output.