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Chapter 10:
Perfect
Competition
Prepared by:
Kevin Richter, Douglas College
Charlene Richter,
British Columbia Institute of Technology
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rights reserved.
1
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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2
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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3
Perfectly Competitive Market

A perfectly competitive market is one in
which economic forces operate unimpeded.

It has highly restrictive assumptions which
provide us with a reference point we can use
in comparing different markets.
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4
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.
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5
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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6
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.
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7
Necessary Conditions for Perfect
Competition

There are no barriers to entry.

Barriers sometimes take the form of patents
granted to produce a certain good.
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8
Necessary Conditions for Perfect
Competition

There are no barriers to entry.

Technology may prevent some firms from entering
the market.

Social forces such as bankers only lending to
certain people may create barriers.

There must also be free exit, without incurring a
loss.
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9
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 breakthrough would be instantly
known to all in the market.
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10
Necessary Conditions for Perfect
Competition

Firms are profit maximizers.



The goal of all firms in a perfectly competitive
market is profit and only profit.
The only compensation firm owners receive is
profit, not salaries.
There is no non-price competition (based on
quality, brand name, or the like).
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11
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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12
Definition of Supply and Perfect
Competition

If all the necessary conditions for perfect
competition exist, we can talk formally about
the supply of a produced good.
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13
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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14
Definition of Supply and Perfect
Competition

When a firm operates in a perfectly
competitive market, its supply curve is that
portion of its short-run marginal cost curve
above average variable cost.
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15
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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16
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.
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17
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
behaviour in other market structures.
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18
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
schedule is perfectly elastic even though the
demand curve for the market is downward
sloping.
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19
Demand Curves for the Firm and the
Industry

Individual firms will increase their output in
response to an increase in demand even
though that will cause the price to fall thus
making all firms collectively worse off.

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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20
Market Demand Curve Versus Individual
Firm Demand Curve
Price
$10
Market
Market supply
Firm
Price
$10
8
8
6
6
4
Market
demand
2
0
1,000
3,000 Quantity
A
B
C
Individual firm
demand
4
2
0
10
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20
30
Quantity
21
Profit-Maximizing Level of Output

The goal of the firm is to maximize profits.

Profit is the difference between total revenue
and total cost.
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22
Profit-Maximizing Level of Output

When it decides what quantity to produce it
continually asks how changes in quantity
would affect its profit.
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23
Profit-Maximizing Level of Output

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.
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24
Profit-Maximizing Level of Output

Marginal revenue (MR) – the change in total
revenue associated with a one-unit change in
quantity.

Marginal cost (MC) – the change in total
cost associated with a one-unit change in
quantity.
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25
Marginal Revenue

A perfect competitor accepts the market price
as given.

As a result, marginal revenue is equal to
price (MR = P).
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26
Marginal Cost

Initially, marginal cost falls and then begins to
rise.

Marginal concepts are best defined between
the numbers.
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27
Profit Maximization: MC = MR

To maximize profits, a firm should produce
where marginal cost equals marginal
revenue.
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28
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 more as
long as marginal cost is less than marginal
revenue.
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29
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.
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30
Price = MR
35
Quantity
0
Total Cost
Marginal Cost
40
28
35
1
68
20
35
2
88
16
35
3
104
14
35
4
118
12
35
5
130
17
35
6
147
22
35
7
169
30
35
8
199
40
35
9
239
54
35
10
293
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31
Marginal Cost, Marginal Revenue, and
Price
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
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32
Marginal Cost, Marginal Revenue, and
Price
Price = MR Quantity
Produced
$35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
35.00
0
1
2
3
4
5
6
7
8
9
10
Marginal
Cost
Costs
$28.00
20.00
16.00
14.00
12.00
17.00
22.00
30.00
40.00
54.00
68.00
50
MC
60
40
A
30
A
C
B
P = D = MR
20
10
0
1 2 3 4 5 6 7 8 9 10 Quantity
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33
Marginal Cost Curve Is the Firm’s
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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34
Marginal Cost Curve Is the Firm’s
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 produce the
quantity at which marginal cost equals
marginal revenue which in turn equals price.
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35
Marginal Cost Curve Is the Firm’s
Supply Curve
Marginal cost
$70
C
Cost, Price
60
50
40
A
30
B
20
10
0
1
2
3
4
5
6
7
8
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9 10 Quantity
36
Firms Maximize Total Profit

Firms seek to maximize total profit, not profit
per unit.

Firms do not care about profit per unit.

As long as an increase in output yields even a
small amount of additional profit, a profitmaximizing firm will increase output.
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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.
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38
Profit Maximization Using Total
Revenue and Total Cost
Total cost, revenue
TC
Loss
$385
350
315 Maximum profit =$81
280
245
210
$130
175
140
105
Profit =$45
70
Loss
35
0
1 2 3 4 5 6 7 8 9
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TR
Profit
Quantity
39
Total Profit at the Profit-Maximizing
Level of Output

The P = MR = MC condition tells us how
much output a competitive firm should
produce to maximize profit.

It does not tell us how much profit the firm
makes.
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40
Determine 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.
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41
Determine 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.
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42
Costs Relevant to a Firm
Profit Maximization for a Competitive Firm
Total
P = MR Output Total Cost Marginal Average
Cost Total Cost Revenue
Profit
TR-TC
—
35.00
35.00
35.00
35.00
35.00
35.00
–40.00
–33.00
–18.00
1.00
22.00
45.00
63.00
0
1
2
3
4
5
6
40.00
68.00
88.00
104.00
118.00
130.00
147.00
—
28.00
20.00
16.00
14.00
12.00
17.00
—
68.00
44.00
34.67
29.50
26.00
24.50
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0
35.00
70.00
105.00
140.00
175.00
210.00
43
Costs
Relevant
to
a
Firm
Profit Maximization for a Competitive Firm
Marginal Average
Total
P = MR Output Total Cost
Cost Total Cost Revenue
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
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
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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
44
Determine Profit 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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45
Determine Profit 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.
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46
Determine Profit and Loss From a
Graph

The firm makes a profit when the ATC curve
is below the MR curve.

The firm incurs a loss when the ATC curve is
above the MR curve.
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47
Determine Profit and Loss From a Graph

Zero economic profit or loss occurs where MC=MR.

Firms can earn zero economic profit or even a loss
where MC = MR at the relevant output.

Even though economic profit is zero, all resources,
including entrepreneurs, are being paid their
opportunity costs at the relevant output.
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48
Determine Profits Graphically
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) Economic Profit
(b) Zero economic profit
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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) Loss
49
Shutdown Point

The firm will shut down if it cannot cover its
variable costs.

A firm should continue to produce as long as price
is greater than average variable cost.

If price falls below that point it makes sense to
shut down temporarily and save the variable
costs.

The firm still pays fixed costs.
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50
Shutdown Point

The shutdown point is the point at which the
firm will be better off if it shuts down than if it
stays in business.
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51
Shutdown Point

If total revenue is more than total variable
cost, the firm’s best strategy is to temporarily
produce at a loss.

It is taking less of a loss than it would by
shutting down.
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52
Shutdown Decision
MC
Price
60
ATC
50
40
Loss
P = MR
30
AVC
20
$17.80
A
10
0
2
4
6
8
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rights reserved.
Quantity
53
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.
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54
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.
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55
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.
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56
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.
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57
Profits as Signals
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58
Long-Run Competitive Equilibrium

Profits and losses are inconsistent with longrun equilibrium.

Profits create incentives for new firms to
enter, output will increase, and the price will
fall until economic profits fall to zero.

The existence of losses will cause firms to
leave the industry.
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59
Long-Run Competitive Equilibrium

Only at zero profit will entry and exit stop.

The zero profit condition defines the long-run
equilibrium of a competitive industry.
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60
Long-Run Competitive Equilibrium
MC
Price
60
50
SRAC
LRAC
40
P = MR
30
20
10
0
2
4
6
8
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Quantity
61
Long-Run Competitive Equilibrium

Zero profit does not mean that the
entrepreneur does not get anything for his
efforts.
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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).
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63
Long-Run Competitive Equilibrium

Normal profits are included as a cost.
Economic profits are profits above normal
profits.
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64
Long-Run Competitive Equilibrium

Firms with super-efficient workers or
machines will find that the price of these
specialized inputs will rise.

Rent is the income received by those
specialized factors of production.
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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.
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66
Increase in Demand

An increase in demand leads to higher prices
and higher profits.

Existing firms increase output.

New firms enter the market, increasing output still
more.

Price falls until all profit is competed away.
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67
Increase in Demand

If input prices remain constant, the market is
a constant-cost industry, and the new
equilibrium will be at the original price but
with a higher output.
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68
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).
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69
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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70
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.
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71
Market Response to an Increase in
Demand
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
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rights reserved.
1012 Quantity
72
Long-Run Market Supply

In the long run firms earn zero profits.

If the long-run industry supply curve is
perfectly elastic, the market is a constantcost industry.
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73
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.
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74
Increasing-Cost Industry

If inputs are specialized, factor prices are
likely to rise in response to the increase in the
industry-wide demand for inputs to production
increases.
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75
Increasing-Cost Industry

This rise in factor costs would force costs up
for each firm in the industry and increases the
price at which firms earn zero profit.

Therefore, in increasing-cost industries, the
long-run supply curve is upward sloping.
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76
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.
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77
Canadian Retail Industry

During the 1990s the Canadian retail industry
illustrated how a competitive market adjusts
to changing market conditions.
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78
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.
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79
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.
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80
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.
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81
Shutdown Decision
Price
MC
ATC
Loss
AVC
P = MR
Quantity
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82
Perfect Competition
End of Chapter 10
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83