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Perfect Competition
CHAPTER
8
© 2003 South-Western/Thomson Learning
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Terminology
An industry consists of all firms that
supply output to a particular market,
interchangeable with market
Many of the firm’s decisions depend on
the structure of the market in which it
operates
Market structure describes the
important features of a market
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Market Structure
Aspects of market structure
Number of suppliers
• Many or few
Product’s degree of uniformity
• Do firms in the market supply identical products
or are there differences across firms?
The ease of entry into the market
• Can new firms enter easily or are they blocked by
natural or artificial barriers?
Forms of competition among firms
• Do firms compete only through prices or are
advertising and product differences common as
well?
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Perfectly Competitive Market Structure
Characteristics of perfect competition
Many buyers and sellers  so many that
each buys and sells only a tiny fraction of
the total amount exchanged in the market
Firms sell a standardized or homogeneous
product
Buyers and sellers are fully informed about
the price and availability of all resources
and products
Firms and resources are freely mobile 
over time they can easily enter or leave the
industry
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Perfect Competition
If these conditions are present in a
market, individual participants have no
control over the price
Price is determined by market supply
and demand  the perfectly
competitive firm is a price taker  it
must “take” or accept, the market price
Once the market establishes the price,
each firm is free to produce whatever
quantity maximizes profit
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Perfect Competition
The model of perfect competition allows
us to make a number of predictions that
hold up when compared with the real
world
It provides us with an important
benchmark for evaluating the efficiency
of other types of markets
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Demand Under Perfect Competition
Suppose the market in question is the
world market for wheat and the firm in
question is a wheat firm
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Demand
Each firm is so small relative to the market
that each has no impact on the market
price  each farmer is a price taker
Because all farmers produce an identical
product, anyone who charges more than
the market price will sell no wheat
No farmer would sell at a lower price
because they can sell all they want at the
higher price
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Demand
The demand curve facing an individual
farmer is therefore a horizontal line
drawn at the market price
Ironically, two neighboring wheat
farmers in perfect competition are not
really rivals  they both can sell as
much wheat as they want to at the
market price because the amount one
sells has no effect on the market price
or the amount the other can sell
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Short-Run Profit Maximization
How does the perfectly competitive firm
maximize profit?
The perfectly competitive firm has no
control over price, however, what the
firm does control is the amount
produced – the rate of output  the
question facing the wheat farmer is
How much should I produce to earn the
most profit?
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Total Revenue Minus Total Cost
The firm maximizes economic profit by
finding the rate of output at which total
revenue exceeds total cost by the
greatest amount
Total revenue is simply output times the
price per unit
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Marginal Revenue Equals Marginal Cost Approach
Another way to find the profitmaximizing rate of output is to focus on
marginal revenue and marginal cost
Marginal revenue, MR, is the change in
total revenue from selling another unit
of output
Since the firm in perfect competition is
a price taker, marginal revenue from
selling one more unit is the market price
 MR = P
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Marginal Revenue Equals Marginal Cost Approach
Marginal cost is the change in total cost
resulting from producing another unit of
output
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Marginal Revenue Equals Marginal Cost
Approach
Golden rule of profit maximization:
Generally, a firm will expand output as
long as marginal revenue exceeds
marginal cost and will stop expanding
output before marginal cost exceeds
marginal revenue
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Economic Profit in the Short Run
Because the perfectly competitive firm
can sell any quantity for the same price
per unit, marginal revenue is also
average revenue
Average revenue, AR, equals total revenue
divided by quantity  AR = TR / q
Regardless of the rate of output, the
following equality holds along the firm’s
demand curve
Market price = marginal revenue = average
revenue
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Minimizing Short-Run Losses
Sometimes the price that the firm is
required to “take” will be so low that no
rate of output will yield an economic
profit
Faced with losses at all rates of output,
the firm has two options
It can continue to produce at a loss, or
Temporarily shut down
It cannot shut down in the short run
because by definition the short run is a
period too short to allow existing firms to
leave or new firms to enter
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Fixed Cost and Minimizing Losses
The firm has two types of costs in the
short run
Fixed cost
Variable cost
A firm that shuts down in the short run
must still pay its fixed costs
But, by producing, a firm’s revenue may
more than cover variable cost  a firm
will produce if the revenue thus
generated exceeds the variable cost of
production  can cover a least a portion
of its fixed cost
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Shutting Down in the Short Run
As long as the loss that results from
producing is less than the shutdown
loss, the firm will remain open for
business in the short run
However, if the average variable cost of
production exceeds the price of all rates
of output, the firm will shut down
A re-examination of Exhibit 4 indicates
that if the price of wheat were to fall to
$2 per bushel, average variable cost
exceeds $2 at all rates of output
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Shutting Down in the Short Run
Note that shutting down is not the same
as going out of business
In the short run, even a firm that shuts
down keeps its productive capacity
intact  that when demand increases
enough, the firm will resume operation
If market conditions look grim and are
not expected to increase, the firm may
decide to leave the market  a long run
decision
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Firm and Industry Short-Run Supply Curves
If the price exceeds average variable
cost, the firm will produce the quantity
where marginal revenue equals
marginal cost
Further, the firm will vary output as the
market price changes
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Short-Run Firm Supply Curve
As long as the price covers average
variable cost, the firm will supply the
quantity resulting from the intersection
of its upward-sloping marginal cost
curve and its marginal revenue, or
demand curve
Thus, that portion of the firm’s marginal
cost curve that intersects and rises
above the lowest point on its average
variable cost curve becomes the short-
run firm supply curve
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Summary
A perfectly competitive firm selects the
short-run output rate that maximizes
profit or minimizes loss
When confronting a loss, a firm either
produces an output that minimizes that
loss or shuts down temporarily
Given the conditions for perfect
competition, the market will converge
toward the equilibrium price and
quantity
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Perfect Competition in Long Run
In the short run, the quantity of variable
resources can change, but other
resources, which generally determine
firm size, are fixed
However, in the long run, firms have
time to enter and exit and to adjust
their size  adjust the scale of their
operations  there is no distinction
between fixed and variable cost
because all resources under the firm’s
control are variable
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Perfect Competition in Long Run
Short-run economic profit will in the
long run encourage new firms to enter
the market and may prompt existing
firms to expand the scale of their
operations
Economic profit will attract resources
from industries where firms earn only
normal profit or suffer losses
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Perfect Competition in Long Run
The expansion in the number and size of
firms will shift the industry supply curve
rightward in the long run, driving down
the price
New firms will continue to enter a
profitable industry and existing firms
will continue to increase in size as long
as economic profit is greater than zero
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Perfect Competition in Long Run
Conversely, a short-run loss will, in the
long run, force some firms to leave the
industry or to reduce the scale of
operation
In the long run, departures and
reductions in scale shift market supply
to the left  market price increases
until the remaining firms just earn a
normal profit
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Long-Run Adjustment to a Change in Demand
To explore the long-run adjustment
process, let’s consider how a firm and
an industry respond to an change in
market demand
Further, suppose that the costs facing
each individual firm do not depend on
the number of firms in the industry
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Long-Run Industry Supply Curve
Connecting these long-run equilibrium
points yields the long-run industry
supply curve, labeled S* in both of these
Exhibits
The long-run industry supply curve
shows the relationship between price
and quantity supplied once firms fully
adjust to any short-term economic
profit or loss resulting from a shift in
demand
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Constant-Cost Industry
The industry we have studied thus far is
called a constant cost industry because
each firm’s long-run average cost curve
does not shift as industry output
expands
Resource prices and other production
costs remain constant in the long run as
industry output increases or decreases
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Constant-Cost Industry
In a constant-cost industry, each firm’s
per-unit production costs are
independent of the number of firms in
the industry  the firm’s long-run
average cost curve remains constant in
the long run as firms enter or leave the
industry
The industry uses such a small portion of
the resources available that increasing
industry output does not bid up resource
prices
The long-run supply curve for a
constant-cost industry is horizontal
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Increasing-Cost Industry
Firms in some industries encounter
higher average costs as industry output
expands in the long run
Firms in these increasing-cost industries
find that expanding output bids up the
prices of some resources or otherwise
increases per-unit production costs 
each firm’s cost curves shift upward
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Summary
In constant-cost industries, each firm’s
costs depend simply on the scale of its
plant and its rate of output
For firms in increasing-cost industries,
costs depend also on the number of
firms in the market
By bidding up the price of resources, longrun expansion in an increasing-cost industry
increases each firm’s marginal and average
costs
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Perfect Competition and Efficiency
How does perfect competition stack up
as an efficient allocator of resources?
There are two concepts of efficiency
used to judge market performance
Productive efficiency refers to producing
output at the least possible cost
Allocative efficiency refers to producing the
output that consumers value the most
Perfect competition guarantees both
allocative and productive efficiency in the
long run
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Productive Efficiency
Productive efficiency occurs when the
firm produces at the minimum point on
its long-run average-cost curve  the
market price equals the minimum
average total cost
The entry and exit of firms and any
adjustment in the scale of each firm
ensure that each firm produces at the
minimum point on its long-run average
cost curve
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Productive Efficiency
Firms that do not reach minimum longrun average cost curve must, to avoid
continued losses, either adjust their size
or leave the industry
Thus, perfect competition produces
output at the least possible cost per unit
in the long run
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Allocative Efficiency
Just because production occurs at the
least possible cost does not mean that
the allocation of resources is the most
efficient one possible
The goods being produced may not be
the ones consumers most prefer  they
may be producing the wrong goods
efficiently from the perspective of
minimum costs
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Allocative Efficiency
Allocative efficiency occurs when firms
produce the output that is most valued
by consumers
How do we know that perfect
competition guarantees allocative
efficiency?
The answer lies with the market supply
and demand curves
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Allocative Efficiency
The demand curve reflects the marginal
value that consumers attach to each
unit  the market price is the amount
of money that people are willing and
able to pay for the final unit they
consume
We also know that, in both the short run
and the long run, the equilibrium price
in perfect competition equals the
marginal cost of supplying the last unit
sold
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Allocative Efficiency
Marginal cost measures the opportunity
cost of all resources employed by the
firm to produce the last unit sold  the
supply and demand curves intersect at
the combination of price and quantity at
which the marginal value, or the
marginal benefit that consumers attach
to the final unit purchased, just equals
the opportunity cost of the resources
employed to produce that unit  there
is no way to reallocate resources to
increase the total utility consumers reap
from production
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What’s So Perfect About Perfect Competition
This should not be taken to mean that market
exchange confers no net benefits to
participants
Market exchange benefits both consumers and
producers
Recall that consumers garner a surplus from market
exchange because the maximum amount they would
be willing to pay for each unit of the good exceeds
the amount they in fact pay
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Producer Surplus
Producer surplus is not the same as
economic profit
Any price that exceeds average variable
cost will result in a short-run producer
surplus, even though that price could
result in a short-run economic loss
The definition of producer surplus
ignores fixed cost, because fixed cost is
irrelevant to the firm’s short-run
production decision
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