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A Lecture Presentation
to accompany
Exploring Economics
3rd Edition
by Robert L. Sexton
Copyright © 2005 Thomson Learning, Inc.
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Printed in the United States of America
ISBN 0-324-26086-5
Copyright © 2002 by Thomson Learning, Inc.
Chapter 11
Perfect Competition
Copyright © 2002 by Thomson Learning, Inc.
11.1 The Four Market
Structures

Economists have identified four market
structures in which firms operate:

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


perfect competition
monopoly
monopolistic competition
oligopoly
Each structure has key characteristics, but
it is sometimes difficult to decide which
structure a given firm or industry most
appropriately fits.
Copyright © 2002 by Thomson Learning, Inc.
Perfect Competition


In perfect competition, no single firm
produces more than an extremely
small proportion of output, so no firm
can influence the market price or
quantity.
Firms are price takers, who must
accept the market price as
determined by the forces of demand
and supply.
Copyright © 2002 by Thomson Learning, Inc.

At one end of the spectrum, perfect
competition involves



a large number of buyers and sellers,
a homogeneous (standardized) product,
and
easy market entry and exit.
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
In a perfectly competitive market,
consumers believe that all firms sell
identical (homogeneous) products, so
the products are perfect substitutes.
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Monopoly

On the other end of the continuum of
market environments is monopoly.

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There is one firm that sells the product
that has no close substitutes.
There are significant barriers to potential
entrants into the market.
Examples: public utilities (water, natural
gas and electric) DeBeers (the South
African diamond producer.
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Monopolistic Competition

Monopolistic competition falls between
perfect competition and monopoly; firms
have elements of both competition and
monopoly power.

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Each firm's product is differentiated from
competitors’, so each has some monopoly
power.
However, because there are so many
competitors, it also has an element of
competitive markets.
Examples: restaurants, retail and furniture
stores.
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Oligopoly

Oligopoly also falls between perfect
competition and monopoly, where a few
firms produce similar or identical goods,
as opposed to one firm or many.
 Unlike pure monopoly, oligopoly allows
for some competition between firms.
 Unlike competition, individual firms
have a significant share of the total
market for the good being produced.
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

An oligopolist is very conscious of the
actions of competing firms, and its
behavior is closely related to that of
its competitors.
Oligopoly may include differentiated
(automobiles, refrigerators, or TV’s)
or standardized products (steel,
aluminum, crude oil).
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A Perfectly Competitive Market

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In a perfectly competitive market
there are many buyers and sellers
trading identical goods.
Because each firm is so small in
relation to the industry, its production
decision have no influence on the
market—each firm regards price as
something over which it has little
control.
Copyright © 2002 by Thomson Learning, Inc.


Consumers believe that all firms in
perfectly competitive markets sell
identical or homogeneous products.
For example, in the wheat market we
are assuming that it is not possible to
determine any significant and
consistent qualitative differences in
the wheat produced by different
farmers.
Copyright © 2002 by Thomson Learning, Inc.


Product markets characterized by
perfect competition have no
significant barriers to entry or exit.
This means that it is fairly easy for
entrepreneurs to become suppliers of
the product or, if they are already
producers, to stop supplying the
product.
Copyright © 2002 by Thomson Learning, Inc.


Barriers to entry are modest, so large
numbers of firms can enter the
business if they so desire.
Because of easy market entry and
exit, perfectly competitive markets
generally consist of a large number
of small suppliers.
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
Highly organized markets for
securities and agricultural
commodities are the best examples
of a perfectly competitive market.
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
While the assumptions for perfect
competition may seem a bit
unrealistic, the model is useful.


Many markets resemble perfect
competition: Firms face very elastic
demand curves and relatively easy entry
and exit.
It gives us a standard of comparison.
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11.2 An Individual Price
Taker’s Demand Curve
 Perfectly competitive firms are price
takers, selling at the marketdetermined price.

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An individual seller cannot sell at any
price higher than the current market
price because buyers could purchase the
same good from someone else at the
market price.
A seller would not charge a lower price
when he could sell all he wants at the
market price.
Copyright © 2002 by Thomson Learning, Inc.
An Individual Firm’s Demand Curve

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In a perfectly competitive market, an
individual seller can change his output
and it will not alter the market price.
Each producer provides such a small
fraction of the total supply that a
change in the amount he or she offers
does not have a noticeable effect on
market price.
Copyright © 2002 by Thomson Learning, Inc.


In a perfectly competitive market,
then, an individual firm can sell as
much as it wishes to place on the
market at the prevailing price.
In other words, the demand, as seen
by the seller, is perfectly elastic at the
market price.
Copyright © 2002 by Thomson Learning, Inc.


Since a perfectly competitive seller
won't charge more than the market
price because no one will buy at higher
prices, and will not charge less because
the seller can sell all she wants at the
market price.
Thus, the demand curve is horizontal at
the market price over the entire range
of output that she could possibly
produce.
Copyright © 2002 by Thomson Learning, Inc.
Price
Copyright © 2002 by Thomson Learning, Inc.
A Change in Market Price and the
Firm’s Demand Curve


The position or height of each firm’s
demand curve varies with every
change in the market price.
Sellers are provided with current
information about market demand
and supply conditions as a result of
price changes.
Copyright © 2002 by Thomson Learning, Inc.

The perfectly competitive model does
not assume any knowledge on the
part of individual buyers and sellers
about market demand and
supplythey only have to know the
price of the good they sell.
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Price
Copyright © 2002 by Thomson Learning, Inc.
11.3 Profit Maximization


The firm’s objective is to maximize
profits.
It wants to produce the amount that
maximizes the difference between its
total revenues and total costs.
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Total Revenue

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Total revenue (TR) is the revenue
that the firm receives from the sale
of its products.
Total revenue for a perfectly
competitive firm equals the market
price of the good (P) times the
quantity (q) of units sold:
(TR = P x q).
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Average Revenue and
Marginal Revenue


Average revenue (AR) equals total
revenue divided by the number of
units soldP of
 q the product (TR/q).
Marginal qrevenue (MR) is the
additional revenue derived from the
sale of one more unit of the good.
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
In a perfectly competitive market,
 additional units of output can be
sold without reducing the market
price,
 therefore marginal revenue is
constant and equal to the market
price, which is also the average
revenue.
Copyright © 2002 by Thomson Learning, Inc.


In perfect competition, marginal
revenue, average revenue, and price
are all equal: P = MR = AR.
There are two methods for identifying
a firm's profit maximizing output.


the marginal approach
the total cost-total revenue approach
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How Do Firms Maximize Profits?

In all types of market environments,
firms will maximize profits at that
output where one maximizes the
difference between total revenue and
total costs, which is the same output
level where marginal revenue equals
marginal costs.
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Equating Marginal Revenue
and Marginal Cost

The importance of equating marginal
revenue and marginal costs for
maximizing profits is straightforward.
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

As long as the marginal revenue derived
from expanded output exceeds the
marginal cost of that output, the
expansion of output creates additional
profits.
However, expansion of output when the
marginal cost of production exceeds
marginal revenue will lead to losses on
the additional output, decreasing profits.
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
The profit-maximizing output rule
says a firm should always produce
where its MR = MC.
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
Total revenues and total costs and the
profit-maximizing output rule give the
same result.
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11.4 Short-Run Profits and
Losses
 Producing at the profit-maximizing
output level does not mean that a
firm is actually generating profits.


It merely means that a firm is
maximizing its profit opportunity at a
given price level.
A firm could be
earning profits
 generating losses
 breaking even

Copyright © 2002 by Thomson Learning, Inc.
The Three-Step Method

Three easy steps to determine economic
profits, economic losses, or zero economic
profits:
 Where MR equals MC proceed down to
horizontal axis to find q*, the profitmaximizing output level.
 At q*, go straight up to demand curve, then
to price axis to find the market price, P*.
 Now you can find TR at the profitmaximizing output level because TR = P x q.
Copyright © 2002 by Thomson Learning, Inc.

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
The last step is to find total costs.
Go straight up from q* to the shortrun average total cost (SRATC) curve;
this will give you the average cost per
unit.
If we multiply average total costs by
the output level, we can find the total
costs (TC = ATC x q).
Copyright © 2002 by Thomson Learning, Inc.

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If TR > TC at the profit-maximizing output
level, the firm is generating economic
profits.
If TR < TC, the firm is generating economic
losses.
If TR - TC, the firm is earning zero
economic profits,
 Covering both implicit and explicit costs,
economists sometimes call zero
economic profit a normal rate of return.
Copyright © 2002 by Thomson Learning, Inc.
P* = $6
ATC = $5
Copyright © 2002 by Thomson Learning, Inc.
Evaluating Economic Losses
in the Short Run

A firm generating an economic loss
faces a tough choice:



Should it continue to produce or
shut-down its operation?
To make this decision, we need to
consider average variable costs.
Copyright © 2002 by Thomson Learning, Inc.
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Copyright © 2002 by Thomson Learning, Inc.

If a firm cannot generate enough
revenues to cover its variable costs,
then it will have larger losses if it
operates than if it shuts down


(losses in that case = fixed costs).
Thus, a firm will not produce at all unless
the price is greater than its average
variable costs.
Copyright © 2002 by Thomson Learning, Inc.

At price levels greater than or equal
to average variable costs, a firm may
continue to operate in the short run
even if average total costsvariable
and fixed costsare not completely
covered.

Because fixed costs continue whether the
firm produces or not, it is better to earn
enough to cover a portion of these costs
rather than earn nothing at all.
Copyright © 2002 by Thomson Learning, Inc.

When price is less than average total
costs but more than average variable
costs, the firm produces in the short
run, but at a loss.

To shut down would make this firm
worse off because it can cover at least
some of its fixed costs with the excess
of revenue over its variable costs.
Copyright © 2002 by Thomson Learning, Inc.
Copyright © 2002 by Thomson Learning, Inc.

When the price a firm is able to
obtain for its product is below its
average variable costs at all ranges
of output, it is unable to cover even
its variable costs in the short run.

Since it is losing even more than the
fixed costs it would lose if it shut down,
it is most logical for the firm to cease
operations.
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
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At all prices above minimum AVC, the
firm produces in the short run, even if
ATC is not completely covered.
At all prices below the minimum AVC the
firm shuts down.
Therefore the short-run supply curve of
an individual competitive seller is identical
with that portion of the MC curve that lies
above the minimum of the AVC curve.
Copyright © 2002 by Thomson Learning, Inc.


As a cost relation, the MC curve
above minimum AVC shows the
marginal cost of producing any given
output.
As a supply curve, the MC curve
above minimum AVC shows the
equilibrium output that the firm will
supply at various prices in the short
run.
Copyright © 2002 by Thomson Learning, Inc.

Beyond the point of lowest AVC, the
MC of successively larger outputs are
progressively greater, so the firm will
supply larger amounts only at higher
prices.
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Quantity
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Deriving the Short-Run
Market Supply Curve


The short-run market supply curve
is the summation of the individual firms'
supply curves, providing that input
prices are not affected by increased
production of existing firms.
Because the short run is too brief for
new firms to enter the market, the
market supply curve is the horizontal
summation of existing firms.
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Copyright © 2002 by Thomson Learning, Inc.
11.5 Long-Run Equilibrium

If perfectly competitive producers make
economic profits,
 resources devoted to that lucrative
business increase.
 more firms enter the industry and existing
firms expand, shifting the market supply
curve to the right over time.
 the impact of increasing supply, other
things equal, is to reduce the equilibrium
price.
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Economic Profits and Losses
Disappear in the Long Run
 As entry into the profitable industry
pushes down the market price,
producers will move from making a
profit (P > ATC) to zero economic
profits (P = ATC).
 In long-run equilibrium, perfectly
competitive firms make zero
economic profits, earning a normal
return on the use of their capital.
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
Zero economic profits is an
equilibrium or stable situation
because any positive economic
(above-normal) profits signal
resources into the industry, beating
down prices and thus revenues to
the firm.
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

Economic losses signal resources to
leave the activity, reducing supply
which leads to increased prices and
higher firm revenues to the remaining
firms.
Only at zero economic profits is there
no tendency for firms to either enter
or leave the business.
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Price
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The Long-Run Equilibrium for
the Competitive Firm


The long-run competitive equilibrium
for a perfectly competitive firm can be
graphically illustrated.
Where MC = MR, short-run and longrun average total costs are also
equal.

The ATC curves touch the MC and MR
(demand) curves at the equilibrium
output point.
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
Because the MR curve is also the AR
curve, average revenues and average
total costs are equal at the
equilibrium point.
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
The long-run equilibrium output in
perfect competition occurs at the
lowest point on the ATC curve, so the
equilibrium condition in the long run
in perfect competition is for firms to
produce at that output that minimizes
per-unit total costs.
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Copyright © 2002 by Thomson Learning, Inc.
11.6 Long-Run Supply

When the output of an entire industry
changes, we consider two possible
industry cost conditions:



constant costs
increasing costs
The shape of the long-run supply
curve depends on the extent to which
input costs change when there is
entry or exit of firms in the industry.
Copyright © 2002 by Thomson Learning, Inc.
A Constant-Cost Industry

In a constant-cost industry, the
prices of inputs do not change as
output is expanded. The industry
does not use inputs in sufficient
quantities to affect input prices.
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
Because the industry is one of
constant costs, industry expansion
does not alter firm's cost curves,
and the industry long-run supply
curve is horizontal.
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


The short-run higher profits from an
increase in demand attracts entry until
long-run equilibrium is again reached.
The long-run equilibrium price is at the
same level that prevailed before
demand increased.
The only long-run effect of the increase
in demand is an increase in industry
output.
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Quantity of Blueberries
(firm)
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Quantity of Blueberries
(market)
Continued . . .
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An Increasing-Cost Industry

In an increasing-cost industry,
the cost curves of the individual
firms rise as the total output of the
industry increases.
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
When an industry utilizes a large portion of
an input,
 input prices will rise when the industry
uses more of that input as it expands
output,
 which will shift firms' cost curves upward.
 Examples include “extractive” industries,
which utilize large portions of the total
supply of specialized natural resources
such as land or mineral deposits.
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

The short-run higher profits from an
increase in demand attracts entry
until long-run equilibrium is again
reached; producers' MC and AC
curves will be higher, so that the new
long-run equilibrium is at a higher
price.
The long-run industry supply curve in
this case has a positive slope.
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
Even in this case, the long-run supply
is usually more elastic than the shortrun supply because in the long run,
firms can enter and exit the industry.
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Perfect Competition and
Economic Efficiency


The output that results from
equilibrium conditions of market
demand and supply in perfectly
competitive markets is economically
efficient.
Only at this outcome can maximum
output be obtained from our scarce
resources.
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

Once the competitive equilibrium is
reached,
 the buyers' marginal benefit equal the
sellers' marginal cost (both equal to the
price) and
 the sum of consumer and producer
surplus is maximized.
If there are no externalities, then total
welfare is maximized and resources are
allocated efficiently.
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Price
Copyright © 2002 by Thomson Learning, Inc.