Download The Necessary Conditions for Perfect Competition

Perfect Competition
Chapter 11
© 2003 McGraw-Hill Ryerson Limited.
11 - 2
Laugher Curve
Q. How many economists does it take to
screw in a light bulb?
A. Eight.
One to screw it in and seven to hold
everything else constant.
© 2003 McGraw-Hill Ryerson Limited.
11 - 3
Perfect Competition

The concept of competition is used in
two ways in economics.
 Competition
as a process is a rivalry
among firms.
 Competition as a market structure.
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11 - 4
Competition as a Process
Competition involves one firm trying to
take away market share from another
firm.
 As a process, competition pervades the
economy.

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11 - 5
A Perfectly Competitive
Market

A perfectly competitive market is one
which has highly restrictive
assumptions, but which provides us with
a reference point we can use in
comparing different markets.
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11 - 6
A Perfectly Competitive
Market

In a perfectly competitive market:
 The
number of firms is large.
 The firms' products are identical.
 There is free entry and exit, that is, there
are no barriers to entry.
 There is complete information.
 Firms are profit maximizers.
 Both buyers and sellers are price takers.
© 2003 McGraw-Hill Ryerson Limited.
11 - 7
The Necessary Conditions for
Perfect Competition

The number of firms is large.
 Large
number of firms means that any one
firm's output is very small when
compared with the total market.
 What one firm does has no bearing on
market quantity or market price.
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11 - 8
The Necessary Conditions for
Perfect Competition

Firms' products are identical.
 This
requirement means that each firm's
output is indistinguishable from any other
firm’s output.
 Firms sell homogeneous product.
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11 - 9
The Necessary Conditions for
Perfect Competition

There is free entry and free exit.
 Firms
are free to enter a market in response
to market signals such as price and profit.
 Barriers to entry are social, political, or
economic impediments that prevent other
firms from entering the market.
© 2003 McGraw-Hill Ryerson Limited.
11 - 10
The Necessary Conditions for
Perfect Competition

There is free entry and free exit.
 Technology
may prevent some firms from
entering the market.
 There must also be free exit, without
incurring a loss.
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11 - 11
The Necessary Conditions for
Perfect Competition

There is complete information.
 Firms
and consumers know all there is to
know about the market – prices, products,
and available technology.
 Any technological advancement would be
instantly known to all in the market.
© 2003 McGraw-Hill Ryerson Limited.
11 - 12
The Necessary Conditions for
Perfect Competition

Firms are profit maximizers.
 The
goal of all firms in a perfectly
competitive market is profit and only
profit.
 There is no non-price competition (based
on quality, brand name, or the like).
© 2003 McGraw-Hill Ryerson Limited.
11 - 13
The Necessary Conditions for
Perfect Competition

Both buyers and sellers are price
takers.
A
price taker is a firm or individual who
takes the market price as given.
 Neither supplier nor buyer possesses
market power.
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11 - 14
The Definition of Supply
and Perfect Competition

Supply is a schedule of quantities of
goods that will be offered to the market
at various prices.
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11 - 15
The Definition of Supply
and Perfect Competition

This definition of supply requires the
supplier to be a price taker.
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11 - 16
The Definition of Supply
and Perfect Competition

Because of the definition of supply, if
any of the conditions required for
perfect competition are not met, the
formal definition of supply disappears.
© 2003 McGraw-Hill Ryerson Limited.
11 - 17
The Definition of Supply
and Perfect Competition

That the number of suppliers be large
means that they do not have the ability
to collude (act together with other firms
to control price or market share).
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11 - 18
The Definition of Supply
and Perfect Competition
Other conditions make it impossible for
any firm to forget about the hundreds of
other firms waiting to replace their
supply.
 A firm's goal is specified by the
condition of profit maximization.

© 2003 McGraw-Hill Ryerson Limited.
11 - 19
The Definition of Supply
and Perfect Competition

Even if the conditions for a perfectly
competitive market are not met, supply
forces are still strong and many of the
insights of the competitive model can be
applied to firm behavior in other market
structures.
© 2003 McGraw-Hill Ryerson Limited.
11 - 20
Demand Curves for the Firm
and the Industry
The demand curve facing the firm is
different from the industry demand
curve.
 A perfectly competitive firm’s demand is
horizontal (perfectly elastic), even
though the demand curve for the
industry is downward sloping.

© 2003 McGraw-Hill Ryerson Limited.
11 - 21
Demand Curves for the Firm
and the Industry

Each firm in a competitive industry is so
small that it does not need to lower its
price in order to sell additional output.
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11 - 22
Market Demand Curve Versus
Individual Firm Demand Curve,
Fig 11-1(a and b), p 236
Market
Firm
Market supply
Price
$10
Price
$10
8
8
6
6
4
Market
demand
2
0
1,000
3,000 Quantity
A
B
10
20
C
Individual
firm demand
4
2
0
30
Quantity
© 2003 McGraw-Hill Ryerson Limited.
11 - 23
The Profit-Maximizing Level
of Output
The goal of the firm is to maximize
profits.
 When it decides what quantity to
produce it continually asks how
changes in quantity would affect its
profit.

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11 - 24
Profit-Maximizing Level of
Output
Since profit is the difference between
total revenue and total cost, what
happens to profit in response to a
change in output is determined by
marginal revenue (MR) and marginal
cost (MC).
 A firm maximizes profit when MC = MR.

© 2003 McGraw-Hill Ryerson Limited.
11 - 25
Profit-Maximizing Level of
Output
Marginal revenue (MR) is the change
in total revenue associated with a
change in quantity.
 Marginal cost (MC) is the change in
total cost associated with a one unit
change in quantity.

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11 - 26
Marginal Revenue

Since a perfect competitor accepts the
market price as given, for a perfectly
competitive firm marginal revenue is
equal to price (MR = P).
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11 - 27
Marginal Cost

Initially, marginal cost falls and then
begins to rise.
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How to Maximize Profit

To maximize profits, a firm should
produce where marginal cost equals
marginal revenue.
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11 - 29
How to Maximize Profit
If marginal revenue does not equal
marginal cost, a firm can increase profit
by changing output.
 The supplier will continue to produce as
long as marginal cost is less than
marginal revenue.

© 2003 McGraw-Hill Ryerson Limited.
11 - 30
How to Maximize Profit
The supplier will cut back on production
if marginal cost is greater than marginal
revenue.
 Thus, the profit-maximizing condition
of a competitive firm is MC = MR = P.

© 2003 McGraw-Hill Ryerson Limited.
11 - 31
Marginal Cost, Marginal
Revenue, and Price Fig. 11-2a, p. 237
Price = MR
35
Quantity
0
Total Cost
Marginal Cost
40
28
35
1
68
20
35
2
88
16
35
3
104
35
4
118
14
12
35
5
130
17
35
6
147
22
35
7
169
35
8
199
30
40
35
9
239
54
35
10
293
© 2003 McGraw-Hill Ryerson Limited.
11 - 32
Marginal Cost, Marginal
Revenue, and Price, Fig. 11-2b, p. 237
MC
Costs
60
50
40
30
20
Area 2
A
Area
1
C
B
P = D = MR
10
0
1 2 3 4 5 6 7 8 9 10 Quantity
© 2003 McGraw-Hill Ryerson Limited.
11 - 33
The Marginal Cost Curve Is
the Supply Curve

The marginal cost curve, above the
point where price exceeds average
variable cost, is the firm's supply curve
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11 - 34
The Marginal Cost Curve Is
the Supply Curve
The MC curve tells the competitive firm
how much it should produce at a given
price.
 The firm can do no better than
producing the quantity at which
marginal cost equals price which in turn
equals marginal revenue.

© 2003 McGraw-Hill Ryerson Limited.
11 - 35
The Marginal Cost Curve Is the
Firm’s Supply Curve, Fig. 11-3, p. 239
Cost, Price
$70
Marginal cost
C
60
50
40
A
30
B
20
10
0 1
2
3
4
5
6
7
8
9 10 Quantity
© 2003 McGraw-Hill Ryerson Limited.
11 - 36
Firms Maximize Total Profit
Firms maximize total profit, not profit per
unit.
 As long as an increase in output yields
even a small amount of additional profit,
a profit-maximizing firm will increase
output.

© 2003 McGraw-Hill Ryerson Limited.
11 - 37
Profit Maximization Using
Total Revenue and Total Cost
Profit is maximized where the vertical
distance between total revenue and
total cost is greatest.
 At that output, MR (the slope of the total
revenue curve) and MC (the slope of
the total cost curve) are equal.

© 2003 McGraw-Hill Ryerson Limited.
11 - 38
Profit Determination by Total
Cost and Revenue Curves, Fig. 11-4b,
p 240
Total cost, revenue
$385
350
315 Maximum profit =$81
280
245
210
$130
175
140
105
70
Loss
35
0
TC
TR
Loss
Profit
1 2 3 4 5 6 7 8 9
Quantity
© 2003 McGraw-Hill Ryerson Limited.
11 - 39
Total Profit at the ProfitMaximizing Level of Output

While the P = MR = MC condition tells
us how much output a competitive firm
should produce to maximize profit, it
does not tell us the profit the firm
makes.
© 2003 McGraw-Hill Ryerson Limited.
11 - 40
Determining Profit and Loss
From a Table of Costs
Profit can be calculated from a table of
costs and revenues.
 Profit is determined by total revenue
minus total cost.

© 2003 McGraw-Hill Ryerson Limited.
11 - 41
Determining Profit and Loss
From a Table of Costs
The profit-maximizing output choice is
not necessarily a position that
minimizes either average variable cost
or average total cost.
 It is only the choice that maximizes total
profit.

© 2003 McGraw-Hill Ryerson Limited.
11 - 42
Costs Relevant to a Firm, Table 11-1, p
241
Profit Maximization for a Competitive Firm
P = MR Output Total Cost
—
35.00
35.00
35.00
35.00
35.00
35.00
0
1
2
3
4
5
6
40.00
68.00
88.00
104.00
118.00
130.00
147.00
Total
Marginal Average
Total Cost Revenue
Cost
—
28.00
20.00
16.00
14.00
12.00
17.00
—
68.00
44.00
34.67
29.50
26.00
24.50
0
35.00
70.00
105.00
140.00
175.00
210.00
Profit
TR-TC
–40.00
–33.00
–18.00
1.00
22.00
45.00
63.00
© 2003 McGraw-Hill Ryerson Limited.
11 - 43
Costs Relevant to a Firm, Table 11-1, p
241
Profit Maximization for a Competitive Firm
P = MR Output Total Cost
35.00
35.00
35.00
35.00
35.00
35.00
35.00
4
5
6
7
8
9
10
118.00
130.00
147.00
169.00
199.00
239.00
293.00
Total
Marginal Average
Total Cost Revenue
Cost
14.00
12.00
17.00
22.00
30.00
40.00
54.00
29.50
26.00
24.50
24.14
24.88
26.56
29.30
140.00
175.00
210.00
245.00
280.00
315.00
350.00
Profit
TR-TC
22.00
45.00
63.00
76.00
81.00
76.00
57.00
© 2003 McGraw-Hill Ryerson Limited.
11 - 44
Determining Profit and Loss
From a Graph
Find output where MC = MR.
 The intersection of MC = MR (P)
determines the quantity the firm will
produce if it wishes to maximize profits.

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11 - 45
Determining Profit and Loss
From a Graph
Find profit per unit where MC = MR.
 To determine maximum profit, you must
first determine what output the firm will
choose to produce.
 See where MC equals MR, and then
draw a line down to the ATC curve.
 This is the profit per unit.

© 2003 McGraw-Hill Ryerson Limited.
Determining Profits Graphically,
Fig. 11-5, p 243
MC
MC
Price
Price
65
65
60
60
55
55
50
50
ATC
45
45
40 D
A
P = MR 40
35
35
P = MR
Profit
30
30
B ATC
25 C
25
AVC
AVC
E
20
20
15
15
10
10
5
5
0
0
1 2 3 4 5 6 7 8 9 10 12
1 2 3 4 5 6 7 8 9 10 12
Quantity
Quantity
(a) Positive economic profit
(b) Zero economic profit
Price
65
60
55
50
45
40
35
30
25
20
15
10
5
0
MC
ATC
Loss
P = MR
AVC
1 2 3 4 5 6 7 8 910 12
Quantity
(c) Economic loss
© The McGraw-Hill Companies, Inc., 2000
11 - 47
Zero Profit or Loss Where
MC=MR
Firms can also earn zero profit or even
a loss where MC = MR.
 Even though economic profit is zero, all
resources, including entrepreneurs, are
being paid their opportunity costs.

© 2003 McGraw-Hill Ryerson Limited.
11 - 48
Zero Profit or Loss Where
MC=MR

In all three cases (profit, loss, zero
profit), determining the profit-maximizing
output level does not depend on fixed
cost or average total cost, but only
where marginal cost equals price.
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11 - 49
The Role of Profits as Market
Signals, Table 11-2, p 243
Profit
Type of Profit
Calculation
Market Signal
>0
Positive economic
profit, or
Economic profit
Entry. Resources are
drawn into the industry.
=0
Zero economic profit,
Zero profit, or
Normal profit
Static. The industry is in
long run equilibrium.
<0
Economic loss
Exit. Resources leave
the industry.
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11 - 50
The Shutdown Point

The firm will shut down if it cannot cover
variable costs.
A
firm should continue to produce as long
as price is greater than average variable
cost.
 Once price falls below that point it will be
cheaper to shut down temporarily and
save the variable costs.
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11 - 51
The Shutdown Point

The shutdown point is the point at
which the firm will be better off by
shutting down than it will if it stays in
business.
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11 - 52
The Shutdown Point

As long as total revenue is more than
total variable cost, temporarily
producing at a loss is the firm’s best
strategy since it is taking less of a loss
than it would by shutting down (loss
minimization).
© 2003 McGraw-Hill Ryerson Limited.
11 - 53
The Shutdown Decision, Fig.11-6a,
p 245
MC
Price
60
ATC
50
40
Loss
P = MR
30
AVC
20
$17.80
A
10
0
2
4
6
8 Quantity
© 2003 McGraw-Hill Ryerson Limited.
11 - 54
Long-Run Competitive
Equilibrium, Fig.11-6b, p 245
MC
Price
60
50
SRATC
LRATC
40
P = MR
30
20
10
0
2
4
6
8
Quantity
© 2003 McGraw-Hill Ryerson Limited.
11 - 55
Short-Run Market Supply
and Demand
While the firm's demand curve is
perfectly elastic, the industry demand is
downward sloping.
 Industry supply is the sum of all firms’
supply curves.

© 2003 McGraw-Hill Ryerson Limited.
11 - 56
Short-Run Market Supply
and Demand

In the short run when the number of
firms in the market is fixed, the market
supply curve is just the horizontal sum
of all the firms' marginal cost curves.
© 2003 McGraw-Hill Ryerson Limited.
11 - 57
Short-Run Market Supply
and Demand

Since all firms have identical marginal
cost curves, a quick way of summing
the quantities is to multiply the
quantities from the marginal cost curve
of a representative firm by the number
of firms in the market.
© 2003 McGraw-Hill Ryerson Limited.
11 - 58
The market supply
In the long run, the number of firms may
change in response to market signals,
such as price and profit.
 As firms enter the market in response
to economic profits being made, the
market supply shifts to the right.
 As economic losses force some firms
to exit, the market supply shifts to the
left.

© 2003 McGraw-Hill Ryerson Limited.
11 - 59
Long-Run Competitive
Equilibrium
Profits and losses are inconsistent with
long-run equilibrium.
 Profits create incentives for new firms to
enter, output will increase, and the price
will fall until zero economic profits are
made.
 Only zero economic profit will stop
entry.

© 2003 McGraw-Hill Ryerson Limited.
11 - 60
Long-Run Competitive
Equilibrium
The existence of losses will cause some
firms to leave the industry.
 In a long run equilibrium firms make no
economic profit (the zero profit
condition).

© 2003 McGraw-Hill Ryerson Limited.
11 - 61
Long-Run Competitive
Equilibrium

Zero profit does not mean that the
entrepreneur does not get anything for
his efforts.
© 2003 McGraw-Hill Ryerson Limited.
11 - 62
Long-Run Competitive
Equilibrium

In order to stay in business the
entrepreneur must receive his
opportunity cost or normal profits (the
amount the owners of business would
have received in the next-best
alternative).
© 2003 McGraw-Hill Ryerson Limited.
11 - 63
Long-Run Competitive
Equilibrium

Normal profits are included as a cost.
Economic profits are profits above
normal profits.
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11 - 64
Long-Run Competitive
Equilibrium

Even if some firm has super efficient
workers or machines that produce rent,
it will not take long for competitors to
match these efficiencies and drive down
the price, until all economic profits are
eliminated.
© 2003 McGraw-Hill Ryerson Limited.
11 - 65
Long-Run Competitive
Equilibrium
The zero profit condition is enormously
powerful.
 As long as there is free entry and exit,
price will be pushed down to the
average total cost of production.

© 2003 McGraw-Hill Ryerson Limited.
11 - 66
Adjustment from the Short
Run to the Long Run

Industry supply and demand curves
come together to lead to long-run
equilibrium.
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11 - 67
An Increase in Demand
An increase in demand leads to higher
prices and higher profits.
 Existing firms increase output and new
firms will enter the market, increasing
industry output still more, price will fall
until all profit is competed away.

© 2003 McGraw-Hill Ryerson Limited.
11 - 68
An Increase in Demand
If the the market is a constant-cost
industry, the new equilibrium will be at
the original price but with a higher
market output.
 A market is a constant-cost industry if
the long-run industry supply curve is
perfectly elastic (horizontal).

© 2003 McGraw-Hill Ryerson Limited.
11 - 69
An Increase in Demand

The original firms return to their original
output but since there are more firms in
the market, the total market output
increases.
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11 - 70
An Increase in Demand
In the short run, the price does more of
the adjusting.
 In the long run, more of the adjustment
is done by quantity.

© 2003 McGraw-Hill Ryerson Limited.
11 - 71
Market Response to an
Increase in Demand,Fig. 11-7, p 248
Market
Price
Price
Firm
S0SR
$9
7
AC
S1SR
B
C
A
SLR
MC
$9
Profit
7
B
A
D1
D0
0
700
840 1,200 Quantity
0
1012 Quantity
© 2003 McGraw-Hill Ryerson Limited.
11 - 72
Long-Run Market Supply

Two other possibilities exist:
 Increasing-cost
industry – factor prices
rise as new firms enter the market and
existing firms expand capacity.
 Decreasing-cost industry – factor prices
fall as industry output expands.
© 2003 McGraw-Hill Ryerson Limited.
11 - 73
An Increasing-Cost Industry

If inputs are specialized, factor prices
are likely to rise when the increase in
the industry-wide demand for inputs to
production increases.
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11 - 74
An Increasing-Cost Industry

This rise in factor costs would raise
costs for each firm in the industry and
increase the price at which firms earn
zero profit (break even).
© 2003 McGraw-Hill Ryerson Limited.
11 - 75
An Increasing-Cost Industry

Therefore, in increasing-cost industries,
the long-run supply curve is upward
sloping.
© 2003 McGraw-Hill Ryerson Limited.
11 - 76
A Decreasing-Cost Industry
If input prices decline when industry
output expands, individual firms' cost
curves shift down.
 The price at which firms break even
now decreases, and the long-run
market supply curve is downward
sloping.

© 2003 McGraw-Hill Ryerson Limited.
11 - 77
An Example: Canadian Retail
Industry

During the 1990s the Canadian retail
industry illustrated how a competitive
market adjusts to changing market
conditions.
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11 - 78
An Example: Canadian Retail
Industry
Many retailers were lost or absorbed by
competitors: Eaton’s, Bretton’s,
Pascal’s, Robinson’s, K-Mart and many
others.
 Initially, these firms saw their losses as
the temporary result of reduced demand
in a slowing economy.

© 2003 McGraw-Hill Ryerson Limited.
11 - 79
An Example: Canadian Retail
Industry
As prices fell, P=MR fell below their
ATC.
 But since price remained above the
AVC, many firms closed their less
profitable locations and continued to
operate.

© 2003 McGraw-Hill Ryerson Limited.
11 - 80
An Example: Canadian Retail
Industry
When demand did not recover, firms ran
out of options.
 Many firms realized as they moved into
the long run that they have to exit the
Canadian retail industry.

© 2003 McGraw-Hill Ryerson Limited.
11 - 81
An Example: A Shutdown
Decision, Fig. 11-8, p 250
Price
MC
ATC
Loss
AVC
P = MR
Quantity
© 2003 McGraw-Hill Ryerson Limited.
Perfect Competition
End of Chapter 11
© 2003 McGraw-Hill Ryerson Limited.