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CHAPTER
Perfect Competition
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by:
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Andreea CHIRITESCU
CHIRITESCU
Andreea
Eastern Illinois
Illinois University
University
Eastern
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1
Market Structure
• Market structure
– All the characteristics of a market that
influence how trading takes place
• Four basic kinds of market structure
– Perfect competition
– Monopoly
– Monopolistic competition
– Oligopoly
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2
What Is Perfect Competition?
• Competition
– A situation of diffuse, impersonal
competition in a highly populated
environment
• Perfect competition
1. Large numbers of buyers and sellers
2. Sellers offer a standardized product
3. Sellers can easily enter into or exit from
the market
4. Buyers and sellers are well-informed
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3
What Is Perfect Competition?
• Large number of buyers and sellers
– No individual decision maker can
significantly affect the price of the product
by changing the quantity it buys or sells
• Standardized product offered by sellers
– Buyers do not perceive differences
between the products of one seller and
another
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4
What Is Perfect Competition?
• Easy entry into and exit from the market
– No significant barriers or special costs to
discourage new entrants
– No barriers to exit
• Well-informed buyers and sellers
– Buyers and sellers have all information
relevant to their decision to buy or sell
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5
What Is Perfect Competition?
• Is perfect competition realistic?
– Yes: the market for wheat
– Other markets, one or more of the
assumptions of perfect competition will not
be met
– The model of perfect competition is
powerful
– Many markets, while not strictly perfectly
competitive, come reasonably close
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
6
The Perfectly Competitive Firm
• A perfectly competitive firm
– Faces a demand curve that is horizontal
(perfectly elastic) at the market price
– Price taker
• Treats the price of its product as given and
beyond its control
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7
Figure 1
The Competitive Industry and Firm
Price per
Ounce
(a) Market
2. determines the equilibrium
market price.
Price per
Ounce
3. The typical firm can sell all
it wants at the market price . . .
S
$800
(b) Firm
d
Demand Curve
Facing the Firm
$800
D
1. The intersection of the market
supply and the market demand
curves . . .
Ounces of
Gold per Day
4. so it faces a
horizontal
demand curve.
Ounces of
Gold per Day
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
8
The Perfectly Competitive Firm
• Total revenue (TR) curve
– Straight line that slopes upward
– Slope of the TR curve = the price of output
• Marginal revenue (MR) curve
– Horizontal line at the market price
– MR = the market price
– Same as the demand curve facing the firm
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9
Table
1
Cost and Revenue Data for Small Time Gold Mines
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10
Figure 2
Profit Maximization in Perfect Competition
Dollars
TR
(a)
TC
$5,600
4,200
Maximum Profit
per Day = $1,400
Slope = 800
1,100
1
Dollars
2
3
4
5
6
7
8
9
10 Output
(b)
MC
d=MR
$800
1
2
3
4
5
6
7
8
9
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
marginal revenue (MR)
curve, which is also the
firm’s demand curve.
10 Output
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11
The Perfectly Competitive Firm
• Marginal cost (MC)
– First falls and then rises
• Total cost
– Rises first at a decreasing rate and then at
an increasing rate
• Total profit = TR + TC
• Profit-maximizing output
– Where the MC curve crosses the MR
curve from below
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
12
The Perfectly Competitive Firm
•
•
•
•
Profit per unit = P – ATC
Firm earns profit: P > ATC
Firm suffers a loss: P < ATC
Total profit (or loss)
– At the best output level
– Area of a rectangle
• Height = distance between P and ATC
• Width = quantity of output
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13
Figure 3
Measuring Profit or Loss (a) Economic Profit
Dollars
MC
Profit per
Ounce ($200)
d=MR
$800
ATC
600
1
2
3
4
5
6
7
8
9
10
Ounces of
Gold per 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 ($800)
minus cost per unit ($600), or $200 per unit. Total profit (indicated by the blue-shaded rectangle)
is equal to profit per unit times the number of units sold, $200 × 7 = $1,400.
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14
Figure 3
Measuring Profit or Loss (b) Economic Loss
Dollars
MC
Loss per
Ounce ($200)
ATC
600
d=MR
$400
1
2
3
4
5
6
7
8
9
10
Ounces of
Gold per Day
In panel (b), we assume that the market price is lower, at $400 per ounce. The best the firm can
do is to produce 5 ounces per day and suffer a loss shown by the red area. It loses $200 per
ounce on each of those 5 ounces produced, so the total loss is $1,000—the area of the redshaded rectangle.
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15
The Perfectly Competitive Firm
• Shut down if
– TR < TVC
– P < AVC
• Shutdown price
– The price at which a firm is indifferent
between producing and shutting down
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
16
The Perfectly Competitive Firm
• Firm’s short-run supply curve
– A curve that shows the quantity of output a
competitive firm will produce at different
prices
– Is its MC curve for all prices above
minimum AVC
• For all prices below minimum AVC, the firm
will shut down
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17
Figure 4
Short-Run Supply under Perfect Competition
$7
Price per (b)
Bushel
d1=MR1
$7
5
d2=MR2
5
4
d3=MR3
4
d4=MR4
2
d5=MR5
1
Dollars
(a)
ATC
Firm’s
Supply
Curve
AVC
2
MC
1
1,000
2,000
4,000
7,000 Bushels
5,000
per Year
7,000
2,000 4,000
5,000
Bushels per Year
Panel (a) shows a typical competitive firm facing various market prices. For prices between $2 and $7
per bushel, the profit-maximizing quantity is found by sliding along the MC curve. Below $2 per bushel,
the firm is better off shutting down, because P < AVC. Panel (b) shows the firm’s supply curve, which
is the same as its MC curve for all prices above the shutdown price of $2 per bushel.
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18
Competitive Markets in the Short Run
• In the short run
– The number of firms in the industry is fixed
• Market supply curve
– A curve indicating the quantity of output
• That all sellers in a market will produce
• At different prices
• In the short run
– Add up the quantities of output supplied by
all firms in the market at each price
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19
Figure 5
Deriving the Market Supply Curve
Dollars
(a) Firm
$7
1. At each price . . .
Firm’s
Supply
Curve
Price per
Bushel
$7
(b) Market
Market
Supply
Curve
5
5
AVC
4
4
2
2
1
1
4,000
2,000
5,000
2. the typical firm supplies the
profit-maximizing quantity.
7,000 Bushels
per Year
400,000 700,000
200,000 500,000
Bushels per Year
3. The total supplied by all firms at different
prices is the market supply curve
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20
Competitive Markets in the Short Run
• Short run equilibrium
– Economic profit
• If P > ATC
– Economic loss
• If AVC < P < ATC
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21
Figure 6
Perfect Competition
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22
Figure 7
Short-Run Equilibrium in Perfect Competition
Price per
Bushel
1. When the demand curve is D1 and
market equilibrium is here . . .
2. the typical firm operates here, earning
economic profit in the short run.
Dollars
S
MC
ATC
$7
$7
d1=MR1
Loss per
Bushel at
p =$4
D1
Profit per Bushel
at p =$7
d2=MR2
4
4
D2
400,000
700,000 Bushels per Year
3. If the demand curve shifts to D2 the
market equilibrium moves here . . .
4,000
7,000 Bushels per Year
4. and the typical firm operates here,
suffering a short-run loss.
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23
Competitive Markets in the Short Run
• Perfect competition
– Market
• Sums up the buying and selling preferences
of individual consumers and producers
• Determines the market price
– Each buyer and seller
• Takes the market price as given
• Able to buy or sell the desired quantity
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24
Competitive Markets in the Long Run
• Long run
– New firms can enter a competitive market
• Expectations of continued economic profit
• Positive economic profit continues to attract
new entrants until economic profit is reduced
to zero
– Existing firms can exit the market
• Expectations of continued economic loss
• Economic losses continue to cause exit until
the losses are reduced to zero
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25
Competitive Markets in the Long Run
• Entry into a market
– Entirely new firm enters a market
– An existing firm adds a new product line
– An existing firm creates a new branch
(local market)
• Exit from a market
– Going out of business
– A firm switches out of a particular product
line, even as it continues to produce other
things
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26
Competitive Markets in the Long Run
• Short-run profit to long-run equilibrium
– Short-run equilibrium
• Economic profit, P > ATC
– Long-run: attract new entrants
• Market supply curve shifts rightward
– Market price falls
– Horizontal demand curve facing each firm shifts
downward
– Each firm will slide down its marginal cost curve,
decreasing output
• Until each firm is earning zero economic profit
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27
Figure 8
From Short-Run Profit to Long-Run Equilibrium (a, b)
Price per
Bushel
Dollars
MC
S1
ATC
A
A
$9
$9
d1
D
so each firm
earns an
economic
profit.
900,000
With initial supply curve
S1, market price is $9 . . .
Bushels
per Year
5,000
9,000
Bushels
per Year
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28
Figure 8
From Short-Run Profit to Long-Run Equilibrium (c, d)
Price per
Bushel
Dollars
MC
S1
ATC
A
S2
A
$9
$9
E
d1
E
5
5
d2
D
900,000
1,200,000
Profit attracts entry, shifting the
supply curve rightward . . .
Bushels
per Year
5,000
9,000
Bushels
per Year
until market price falls to $5 and
each firm earns zero economic profit.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
29
Competitive Markets in the Long Run
• Short-run loss to long-run equilibrium
– Short-run equilibrium
• Economic loss, P < ATC
– Long-run: firms exit the market
• Until each firm is earning zero economic profit
• Zero economic profit (Normal profit)
– Just enough accounting profit to cover
implicit costs
– Not the same as zero accounting profit
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30
Competitive Markets in the Long Run
• Perfect competition and plant size
– Long-run equilibrium: plant and output
level that bring it to the bottom of its
LRATC curve
• In long-run equilibrium
– The competitive firm operates where:
MC = minimum ATC = minimum LRATC = P
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31
Figure 9
Perfect Competition and Plant Size
Dollars
Dollars
MC1 ATC1
3. As all firms increase plant size
and output, market price falls to
its lowest possible level . . .
LRATC
LRATC
d1=MR1
P1
MC2 ATC2
E
P*
d2=MR2
2. But the firm could earn
positive profit with a larger
plant, producing here.
q1
Output Per
Period
1. With its current plant and ATC curve,
this firm earns zero economic profit.
q*
Output Per
Period
4. and each earns zero economic
profit, producing at minimum LRATC.
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32
What Happens When Things Change?
• Initial long-run equilibrium and market
demand curve shifts rightward
– Short-run
• A rise in market price
• A rise in market quantity
• A rise in economic profits
– Long-run: entry of new firms
• Market supply shifts rightward
• Drives down the price
• Economic profit is eliminated
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33
What Happens When Things Change?
• Constant cost industry
– An industry in which the long-run supply
curve is horizontal
• Each firm’s cost curves are unaffected by
changes in industry output
• Long-run supply curve
– A curve indicating price and quantity
combinations in an industry
– After all long-run adjustments have taken
place
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34
What Happens When Things Change?
• In a constant cost industry
– In which industry output has no effect on
individual firms’ cost curves
– The long-run supply curve is horizontal
– In the long-run, the industry will supply any
amount of output demanded at an
unchanged price
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
35
Figure 10
A Constant Cost Industry (a, b)
Dollars
Dollars
(b)
(a)
MC
S1
ATC
LRATC
A
A
P1
P1
d1=MR1
D1
Q1
Output per period
q1
Output per period
At point A in panel (a), the market is in long-run equilibrium. The typical firm in panel (b) operates at the
minimum of its ATC and LRATC curves, and earns zero economic profit. The lower panels show what
happens if demand increases.
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36
Figure 10
A Constant Cost Industry (c, d)
Dollars
Dollars
(c)
(d)
MC
S1
S2
B
PSR
B
PSR
A
A
C
SLR
P1
P1
ATC
dSR=MRSR
LRATC
d1=MR1
D2
D1
Q1
QSR
Q2
Output per period
q1 qSR
Output per period
In the short run, the market reaches a new equilibrium at point B in panel (c), and the typical firm in panel (d)
earns economic profit at the higher price PSR. In the long run, profit attracts entry, increasing market supply
and lowering price. Entry continues until economic profit at the typical firm in panel (d) is reduced to zero,
which requires the price to drop to P1, its original level. In panel (d), the typical firm returns to point A, and in
panel (c), the new long-run market equilibrium is point C. The increase in demand raises output, but leaves
price unchanged, as shown by the horizontal long-run supply curve connecting points A and C.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
37
What Happens When Things Change?
• Increasing cost industry
– An industry in which the long-run supply
curve slopes upward
• Each firm’s LRATC curve shifts upward as
industry output increases
• In an increasing cost industry
– A rise in industry output shifts up each
firm’s LRATC curve, so that zero economic
profit occurs at a higher price
– The long-run supply curve slopes upward
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
38
Figure 11
An Increasing Cost Industry
Dollars
Dollars
(a) Market
(b) Firm
S1
S2
LRATC2
B
PSR
P2
P1
C
LRATC1
SLR
C
d2=MR2
P2
P1
A
d1=MR1
A
D2
D1
Q1
Q2
Output per period
q1
Output per period
Point A in both panels shows the initial long-run market equilibrium, with the typical firm earning zero economic
profit. After demand increases, the market reaches a new short-run equilibrium at point B in panel (a). At the
higher price, the typical firm earns economic profit (not shown). In the long run, profit attracts entry, supply
increases and price begins to fall. But in an increasing cost industry, the rise in industry output also causes
costs to rise, shifting up the LRATC curve. In the final, long-run market equilibrium (point C in both panels),
price at P2 is higher than originally, and the typical firm once again earns zero economic profit. The increase in
demand raises both output and price, as shown [in panel (a)] by the upward-sloping long-run supply curve.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
39
What Happens When Things Change?
• Decreasing cost industry
– An industry in which the long-run supply
curve slopes downward
• Each firm’s LRATC curve shifts downward as
industry output increases
• In a decreasing cost industry
– A rise in industry output shifts down each
firm’s LRATC curve, so that zero economic
profit occurs at a lower price
– Long-run supply curve slopes downward
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
40
Figure 12
A Decreasing Cost Industry
Dollars
Dollars
(a) Market
(b) Firm
S1
B
LRATC1
PSR
LRATC2
S2
A
A
P1
P1
C
P2
SLR
d1=MR1
P2
D2
d2=MR2
C
D1
Q1
Q2
Output per period
q1
Output per period
Point A in both panels shows the initial long-run market equilibrium, with the typical firm earning zero economic
profit. After demand increases, the market reaches a new short-run equilibrium at point B in panel (a). At the
higher price, the typical firm earns economic profit (not shown). In the long run, profit attracts entry, supply
increases, and price begins to fall. But in a decreasing cost industry, the rise in industry output causes costs to
fall, shifting down the LRATC curve. In the final, long-run market equilibrium (point C in both panels), price at
P2 is lower than originally, and the typical firm once again earns zero economic profit. The increase in demand
raises output but lowers price, as shown [in panel (a)] by the downward-sloping long-run supply curve.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
41
What Happens When Things Change?
• As demand increases or decreases in a
market
– Prices change: act as signals for firms to
enter or exit an industry
• When demand increases
– Price tends to initially overshoot its longrun equilibrium value
• Sizable temporary profits for existing firms
• Pulls new firms into the market
• Increase industry output
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
42
What Happens When Things Change?
• When demand decreases
– Price falls below its long-run equilibrium
value
• Sizable losses for existing firms
• Drive existing firms out of the market
• Decrease industry output
• Market signals
– Price changes that cause changes in
production to match changes in consumer
demand
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
43
Figure 13
How a Change in Demand Reallocates Resources
Price
Per
Bottle
S1
B
P2
A
C
P1
D1
Quantity
Of Other
Goods
Q1
Q2
Q3
A
B
C
Q1
Q2
Q3
In the upper panel, an increased
desire for bottled water shifts the
S2
market demand curve rightward,
from D1 to D2. Price and quantity
rise in the short run, and we move
from A to B along short-run supply
curve S1. The lower panel shows
the corresponding short-run
movement from A to B along the
economy’s PPF: Greater
production of bottled water, less
D2
production of other things. In the
long run, the higher price creates
Quantity of Bottled Water economic profit, attracting new
firms, and shifting the supply curve
rightward (upper panel). Price falls
and quantity rises further. In the
Production
figure, we assume bottled water is
an increasing cost industry, so
possibilities
entry brings the price down to P3,
frontier
at point C, which is higher than the
original price. In the lower panel,
the further long-run increase in
bottled water production moves us
Quantity of Bottled Water along the PPF, from B to C.
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44
What Happens When Things Change?
• Technological advance
– Rightward shift of the market supply curve
– Decreasing market price
– In the short run
• Early adopters may enjoy economic profit
– In the long run
• All adopters will earn zero economic profit
– Firms that refuse to use the new
technology will not survive
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45
Figure 14
Technological Change in Perfect Competition
Price per
Installed
Watt
(a) Market
Dollars per
Installed
Watt
S1
(b) Firm
LRATC1
S2
LRATC2
A
$9.50
$9.50
d1=MR1
B
7
7
d2=MR2
D
Q1
Q2
Watts Installed
per Month
q1
Watts Installed
per Month
Technological change may reduce LRATC. In panel (b), the first solar panel firms to adopt new, costsaving technologies earn economic profit in the short run, because they can initially sell at the old
market price of $9.50 per installed watt. That profit leads its competitors to adopt the same technology
and attracts new entrants. As market supply increases, price falls until it reaches $7 per installed watt,
and each firm is once again earning zero economic profit.
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
46
Real Estate Agents and the
Zero-Profit Result
• Markets in which entry and exit do not
affect the market price
– The zero-profit result still holds: with a
twist
– In these markets, instead of prices, costs
adjust to eliminate economic profit and
loss
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
47
Real Estate Agents and the
Zero-Profit Result
• Real estate agent (seller)
– Commission = 3% of the price
• Horizontal MR curve
– Costs
• Office space, transportation, a computer
• Agent’s time: showing homes to finicky
buyers, negotiating with buyers’ agents
• MC curve slopes upward
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48
Real Estate Agents and the
Zero-Profit Result
• Profit-maximizing agent
– Increase the number of homes sold until
MC = MR
– Earns zero economic profit
• Long-run equilibrium
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
49
Real Estate Agents and the
Zero-Profit Result
• An increase in the price of homes
– Higher dollar commission
– Economic profit in the short run
– Long-run: more real-estate agents
• Higher MC cost curve
• Zero economic profit
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
50
Figure 15
After Commissions Rise, Long-Run Profit Returns to Zero
Commission
per Sale
(a)
(b)
Commission
per Sale
MC2
MC1
B
$12,000
d2=MR2
ATC2
C
B
$12,000
ATC1
$6,000
A
A
$6,000
15 Number of
Homes Sold
per Year
d2=MR2
ATC1
d1=MR1
10
MC1
d1=MR1
5
10
15 Number of
Homes Sold
per Year
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
51
Figure 16
Membership in National Association of Realtors
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52