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Chapter 11
PURE
COMPETITION
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-2
Today’s lecture will:
• Discuss the six conditions for a perfectly
•
•
•
competitive market.
Explain why producing an output at which
marginal cost equals price maximizes
total profit for a perfect competitor.
Demonstrate why the marginal cost curve
is the supply curve for a perfectly
competitive firm.
Determine the output and profit of a
perfect competitor graphically and
numerically.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-3
Today’s lecture will:
• Construct a market supply curve by
•
•
adding together individual firms’ marginal
cost curves.
Explain why perfectly competitive firms
make zero economic profit in the long run.
Explain the adjustment process from
short-run equilibrium to long-run
equilibrium.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-4
Perfect Competition
• The concept of competition is used
in two ways in economics.
 Competition as a process is a rivalry
among firms.
 Competition as the perfectly
competitive market structure in which
economic forces operate unimpeded.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-5
A Perfectly Competitive Market
• Both buyers and sellers are price
•
•
•
•
•
takers.
The number of firms is large.
There are no barriers to entry.
The firms’ products are identical.
There is complete information.
Firms are profit maximizers.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-6
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.
• The number of firms is large.
 Large means that what one firm does
has no bearing on what others do.
 Any one firm’s output is minuscule
when compared with the total market.
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Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-7
Conditions
for Perfect Competition
• There are no barriers to entry.
 Barriers to entry are social, political, or
economic impediments that prevent
other firms from entering the market.
 Barriers to entry may be due to:
Patents
Technology
Social forces, such as bankers lending only
to certain people
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Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-8
Conditions
for Perfect Competition
• The firms’ products are identical,
•
indistinguishable from any competitor’s
product.
There is complete information.
 Firms and consumers know everything about
prices, products, and technology.
• Firms are profit maximizers.
 The goal of the firm in a perfectly competitive
market is profit.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-9
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.
When a firm operates in a perfectly
competitive market, its supply curve
is its short-run marginal cost curve
above average variable cost.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-10
Demand Curves for the Firm
and the Industry
• The demand curve facing the
•
•
perfectly competitive firm is different
from the industry demand curve.
A perfectly competitive firm’s
demand schedule is perfectly elastic.
The industry demand curve is
downward sloping.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-11
Market Demand Versus
Individual Firm Demand Curve
Market
Price
$10
Firm
Market supply
Price
$10
8
8
6
6
4
2
0
Market
demand
A
B
Individual firm
demand
C
4
2
0
10 20 30 Quantity
1,000 2,00 3,000 Quantity
0
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-12
Profit-Maximizing
Level of Output
• The goal of the firm is to maximize profits, the
•
•
•
difference between total revenue and total cost.
A firm maximizes profit when MR = MC.
Marginal revenue (MR) – the change in total
revenue associated with a change in quantity.
Marginal cost (MC) – the change in total cost
associated with a change in quantity.
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11-13
Profit Maximization: MC = MR
• A perfect competitor accepts the
•
•
market price as given, so marginal
revenue equals price (MR = P).
Initially, marginal cost falls and then
begins to rise.
To maximize profits, a firm should
produce where MC = MR.
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Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-14
How to Maximize Profit
• The profit-maximizing condition of a
•
•
competitive firm is MC = MR = P.
If MR > MC, a firm can increase profit
by increasing output.
If MR < MC, a firm will decrease its
output.
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11-15
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
McGraw-Hill/Irwin
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
30
A
A
C
B
P = D = MR
20
10
0
1 2 3 4 5 6 7 8 9 10 Quantity
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-16
Cost
The Firm’s Supply Curve is the
MC Curve Above AVC
Marginal cost
C
$61
60
50
A
40
$35
30
B
20
$19.50
10
0
McGraw-Hill/Irwin
1
2
3
4
5
6
7
8
9 10 Quantity
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-17
Profit Maximization
Using Total Revenue and Total
Cost
• Profit is maximized where the
•
difference between total revenue and
total cost is the greatest.
At that output, MR (the slope of the
total revenue curve) and MC (the
slope of the total cost curve) are
equal.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-18
Profit Maximization Using Total
Cost and Total Revenue Curves
Total cost, revenue
TC
$385
350
315
280
245
210
175
140
105
70
35
0
McGraw-Hill/Irwin
TR
Loss
Maximum profit =$81
Profit
$130
Profit =$45
Loss
1 2 3 4 5 6 7 8 9
Quantity
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-19
P=MR Output Total
Cost
Finding
Profit
and
Loss
McGraw-Hill/Irwin
Marginal Average
Total
Profit
Cost
Total Cost Revenue TR-TC
-
0
$40
-
-
0
-$40
$35
1
68
28
68
35
-33
35
2
88
20
44
70
-18
35
3
104
16
34.67
105
1
35
4
118
14
29.50
140
22
35
5
130
12
26
175
45
35
6
147
17
24.50
210
63
35
7
169
22
24.14
245
76
35
8
199
30
24.88
280
81
35
9
239
40
26.56
315
76
35
10
293
54
29.30
350
57
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-20
Determining Profit and Loss
From a Graph
• The output where MC = MR(P) maximizes
•
•
•
•
profits.
Profit per unit at the profit maximizing output =
P – ATC.
If P>ATC, the firm makes a profit.
If P<ATC, the firm incurs a loss.
If P = ATC, economic profit is zero, but all
resources are being paid their opportunity
costs.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-21
Determining 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
B ATC
30
30
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
Profit case
Zero profit case
McGraw-Hill/Irwin
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
Loss case
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-22
The Shutdown Point
• The shutdown point is the point at which
•
•
the firm will be better off if it shuts down.
If price is less than average variable cost,
the firm should shutdown and save the
variable costs.
If total revenue is more than total variable
cost, the firm will temporarily produce at a
loss.
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Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-23
The Shutdown Decision
MC
Price
60
ATC
50
40
Loss
P = MR
30
AVC
20
A
$17.80
10
0
McGraw-Hill/Irwin
2
4
6
8
Quantity
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-24
Short-Run Market Supply and
Demand
• While the firm’s demand curve is
•
perfectly elastic, the industry’s
demand curve is downward sloping.
The market (industry) supply curve is
the horizontal sum of all the firms’
marginal cost curves.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-25
Long-Run Competitive
Equilibrium
• At long-run equilibrium, economic profits are
•
•
zero.
Profits create incentives for new firms to enter,
market supply will increase, and the price will
fall until zero profits are made.
The existence of losses will cause firms to
leave the industry, market supply will
decrease, and the price will increase until
losses are zero.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-26
Long-Run Competitive
Equilibrium
MC
Price
60
50
SRATC LRATC
40
P = MR
30
20
10
0
McGraw-Hill/Irwin
2
4
6
8
Quantity
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-27
Long-Run Competitive
Equilibrium
• Zero profit does not mean that the
•
•
•
entrepreneur does not get anything for his
efforts.
Normal profit – the amount the owners would
have received in their next best alternative.
Normal profits are included as a cost and are
not included in economic profit.
Economic profits are profits above normal
profits.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-28
An 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.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-29
Market Response to an
Increase in Demand
Market
Price
Firm
S0SR
S1SR
B
$9
7
Price
C
SLR
A
MC
AC
$9
7 Profit
B
A
D1
D0
0
McGraw-Hill/Irwin
700
840 1,200 Quantity
0
10 12 Quantity
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-30
Long-Run Market Supply
• If the long-run industry supply curve is
•
•
perfectly elastic, the market is a constantcost industry.
If the long-run industry supply curve is
upward sloping, the market is an
increasing-cost industry.
If the long-run industry supply curve is
downward sloping, the market is a
decreasing-cost industry.
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Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-31
An Increasing Cost Industry
• If inputs are specialized, when production
•
•
and demand for inputs increases, the
factor prices will increase.
The increase in factor costs increases the
price at which firms earn a zero profit.
Therefore, in increasing-cost industries,
the long-run supply curve is upward
sloping.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-32
A Decreasing-Cost Industry
• If input prices decline when industry output
•
•
expands, individual firms’ marginal cost
curves shift down and the long-run supply
curve is downward sloping.
The decrease in factor prices decreases the
price at which firms earn zero profit.
Decreasing costs may occur if new entrants
make it more cost-effective for other firms to
provide services to all firms in the market.
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11-33
A Real World Example
Price
•
MC
•
ATC
Loss
AVC
P = MR
•
Initially Kmart
decided to keep 300
stores with losses
open because P>AVC.
After 2 years of
losses, Kmart
realized that the decrease in demand
was permanent.
They moved from the
short run to the long
run and closed the
stores.
Quantity
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Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-34
Summary
• The necessary conditions for perfect
competition are:
 Buyers and sellers are price takers.
 The number of firms is large.
 There are no barriers to entry.
 Firms’ products are identical.
 There is complete information.
 Sellers are profit-maximizing entrepreneurial
firms
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-35
Summary
• Competitive firms maximize profit where
•
•
•
•
MR = MC.
Profit is P – ATC times output at the profitmaximizing level of output.
Perfectly competitive firms shut down if P
< AVC.
The supply curve of a competitive firm is
its MC curve above minimum AVC.
The short-run market supply curve is the
horizontal sum of the MC curves for all the
firms in the market.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-36
Summary
• In the short run, competitive firms can make a
•
profit or loss. In the long run they make zero
profits.
If there are profits:
 Firms enter the industry
 Supply increases
 Price decreases, eliminating profit
• If there are losses:
 Firms leave the industry
 Supply decreases
 Price increases, eliminating losses
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-37
Summary
• The long-run industry supply curve is a
•
•
•
•
schedule of quantities supplied where firms
are making zero profit.
Constant-cost industries have horizontal longrun supply curves.
Increasing-cost industries have upward
sloping long-run supply curves.
Decreasing-cost industries have downwardsloping supply curves.
The slope of the long-run supply curve
depends on what happens to factor costs
when output increases.
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-38
Given the following costs for a perfectly competitive firm:
Output
0
1
2
3
4
5
AVC
ATC
MC
$30
27.50
28.33
31.25
35
$50
37.50
35
36.25
39
$30
25
30
40
50
Review Question 11-1 If the price of the product is $40,
how much will the firm produce to maximize profit? How
much is profit at that output?
Since P=MR for a competitive firm and the profit
maximizing output is where MR=MC, produce 4 units.
Profit is ($40-36.25)x4 = $15
McGraw-Hill/Irwin
Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
11-39
Given the following costs for a perfectly competitive firm:
Output
0
1
2
3
4
5
AVC
ATC
MC
$30
27.50
28.33
31.25
35
$50
37.50
35
36.25
39
$30
25
30
40
50
Review Question 11-2 How much will the firm produce
and how much will it charge in the long run? How much is
long-run profit (loss)?
In the long run, a perfectly competitive firm will produce
the output where ATC is minimized and price will equal
minimum ATC. So output is 3 and price is $35 and
economic profit is zero. Copyright  2006 by The McGraw-Hill Companies, Inc. All rights reserved.
McGraw-Hill/Irwin