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8
Perfect Competition
 What is a perfectly competitive market?
 What is marginal revenue? How is it related
to total and average revenue?
 How does a competitive firm determine the
quantity of output that maximizes profits?
 When might a competitive firm shut down in
the short run? Exit the market in the long
run?
8
Perfect Competition
 What does the market supply curve look like
in the short run? In the long run?
 What is so “perfect” about perfect
competition?
Introduction: A Scenario
 Three years after graduating, you run your own
business.
 You have to decide how much to produce, what
price to charge, how many workers to hire, etc.
 What factors should affect these decisions?
• Your costs (studied in preceding chapter)
• How much competition you face
 We begin by studying the behavior of firms in
perfectly competitive markets
Characteristics of Perfect Competition
1. Many buyers and many sellers
2. The goods offered for sale are identical.
3. Firms can freely enter or exit the market.
The Revenue of a Competitive Firm
 Total revenue (TR)
TR = P x Q
 Average revenue (AR)
TR
=P
AR =
Q
 Marginal Revenue (MR):
The change in TR from
selling one more unit.
∆TR
MR =
∆Q
2A:
Identifying a firm’s profit
ACTIVE LEARNING
A competitive firm
Determine
this firm’s
total profit.
Identify the
area on the
graph that
represents
the firm’s
profit.
Costs, P
MC
MR
ATC
P = $10
$6
50
Q
5
2B:
Identifying a firm’s loss
ACTIVE LEARNING
A competitive firm
Determine
this firm’s
total loss.
Identify the
area on the
graph that
represents
the firm’s
loss.
Costs, P
MC
ATC
$5
MR
P = $3
30
Q
6
Shutdown vs. Exit
 Shutdown:
A short-run decision not to produce anything
because of market conditions.
 Exit:
A long-run decision to leave the market.
The Long-Run
 In the long run, firms can expand the scale of
their operations or they can enter or leave the
market
 What would lead a firm to want to enter a
market?
 What would lead a firm to exit a market?
Long-Run Market Supply:
Assumptions
1) All existing firms and potential entrants have
identical costs.
2) Each firm’s costs do not change as other firms
enter or exit the market (constant-cost industry).
Long-Run Equilibrium in Competition
 In the long run, if positive profit is being made,
firms will enter driving the price of the good (and
profits) down
 The process will continue until profit is zero
• remember we are talking about “economic
profit”
The Zero-Profit Condition
 Long-run equilibrium:
The process of entry or exit is complete –
remaining firms earn zero economic profit.
 Zero economic profit occurs when P = ATC.
 Since firms produce where P = MR = MC,
the zero-profit condition is P = MC = ATC.
 Recall that MC intersects ATC at minimum ATC.
 Hence, in the long run, P = minimum ATC.
What is So Perfect about Perfect
Competition?
 Productive efficiency
• firms produce at minimum ATC
What is So Perfect about Perfect
Competition?
 Allocative efficiency
• Profit-maximization:
MC = MR
• Perfect competition:
P = MR
• So, in perfect competition: P = MC
 Recall, MC is cost of producing the marginal
(last) unit.
P is value to buyers of the marginal (last) unit.
 So, if P = MC, the marginal benefit to the
consumer is equal to the marginal cost
What is So Perfect about Perfect
Competition?
 MC is cost of producing the marginal (last) unit.
P is value to buyers of the marginal (last) unit.
 So, if P = MC, the marginal benefit to the
consumer is just equal to the marginal cost for
the last unit produced
Producer Surplus
 Producer surplus is
Price received by seller – willingness to sell
Price received by seller – MC
 For a market as a whole it is the area below
price and above the supply curve
• market supply is simply a summation of each
firm’s supply (MC) curve
ACTIVE LEARNING
Producer Surplus
2:
P
50
A. Find marginal
45
seller’s cost
40
at Q = 10.
35
B. Find PS for
30
P = $20.
25
Suppose P rises to $30. 20
Find the increase
15
in PS due to…
10
C. selling 5
5
additional units
0
D. getting a higher price
0
on the initial 10 units
supply curve
5
10
15
20
Q
25
16