Part 5
Perfect
Competition
© 2006 Thomson Learning/South-Western
Chapter 10
Perfect Competition
in a Single Market
© 2006 Thomson Learning/South-Western
Pricing in the Very Short Run



3
The market period (very short run) is a
short period of time during which quantity
supplied is fixed.
In this period, price acts to ration demand
as it adjusts to clear the market.
This situation is illustrated in Figure 10-1
where supply is fixed at Q*.
FIGURE 10-1: Pricing in the Very
Short Run
Price
S
P1
D
0
4
Q*
Quantity
per week
Pricing in the Very Short Run


5
When demand is represented by the curve
D, P1 is the equilibrium price.
The equilibrium price is the price at
which the quantity demanded by buyers of
a good is equal to the quantity supplied by
sellers of the good.
Shifts in Demand: Price as a
Rationing Device


6
If demand were to increase, as illustrated by
the new demand curve D’ in Figure 10-1, P1
is no longer the equilibrium price since the
quantity demanded exceeds the quantity
supplied.
The new equilibrium price is now P2 where
price has rationed the good to those who
value it the most.
FIGURE 10-1: Pricing in the Very
Short Run
Price
S
P2
P1
D’
D
0
7
Q*
Quantity
per week
Construction of a Short-Run
Supply Curve



8
The quantity that is supplied is the sum of
the quantities supplied by each firm.
The short-run market supply curve is
the relationship between market price and
quantity supplied of a good in the short
run.
In Figure 10-2 it is assumed that there are
only two firms, A and B.
FIGURE 10-2: Short-Run Market
Supply Curve
Price
Price
Price
SA
P
0
qA1
(a) Firm A
9
Output
0
Output
(b) Firm B
0
Quantity
per week
(c) The Market
FIGURE 10-2: Short-Run Market
Supply Curve
Price
Price
Price
SB
SA
P
0
qA1
(a) Firm A
10
Output
0
qB1
Output 0
(b) Firm B
Quantity
per week
(c) The Market
FIGURE 10-2: Short-Run Market
Supply Curve
Price
Price
Price
SB
SA
S
P
0
qA1
(a) Firm A
11
Output
0
qB1
Output 0
(b) Firm B
Q1
Quantity
per week
(c) The Market
Construction of a Short-Run
Supply Curve


Both firm A’s and firm B’s short-run supply
curves (their marginal cost curves) are
shown in Figure 10-2(a) and Figure 10-2(b)
respectively.
The market supply curve is the horizontal
sum of the two firms at every price.

12
In Figure 10-2(c), Q1 equals the sum of q1A and
q1B.
Short-Run Price Determination


13
Figure 10-3 (b) shows the market
equilibrium where the market demand
curve D and the short-run supply curve S
intersect at a price of P1 and quantity Q1.
This equilibrium would persist since what
firms supply at P1 is exactly what people
want to buy at that price.
FIGURE 10-3: Interaction of Many Individuals
and Firms Determine market price in the
Short Run
Price
SMC
Price
S
Price
SAC
P1
D
0
q1 q2
Output
(a) Typical Firm
14
0
Q1
Q2 Quantity
per week
(b) The Market
d
0
q1 q2
q‘1
Quantity
(c) Typical Person
FIGURE 10-3: Interaction of Many Individuals
and Firms Determine market price in the
Short Run
Price
SMC
Price
S
Price
SAC
P2
D’
P1
d’
D
0
q1 q2
Output
(a) Typical Firm
15
0
Q1
Q2 Quantity
per week
(b) The Market
d
0
q1 q2
q‘1
Quantity
(c) Typical Person
Functions of the Equilibrium Price

The price serves as a signal to producers
about how much should be produced.


16
To maximize profit, firms will produce the
output level for which marginal costs equal P1.
This yields an aggregate production of Q1.
Functions of the Equilibrium Price

Given the price, utility maximizing
individuals will decide how much of their
limited incomes to spend



17
At price P1 the total quantity demanded is
Q1.
No other price brings about the balance of
quantity demanded and quantity supplied.
These situations are depicted in Figure
10-3 (a) and (b) for the typical firm and
individual, respectively.
Effect of an Increase in Market
Demand


18
If the typical person’s demand for the good
increases from d to d’, the entire market
demand curve will shift to D’ as shown in
figure 10-3.
The new equilibrium is P2, Q2 where a new
balance between demand and supply is
established.
Effect of an Increase in Market
Demand



19
The increase in demand resulted in a higher
equilibrium price, P2 and a greater equilibrium
quantity, Q2.
P2 has rationed the typical person’s demand so
that only q2 is demanded rather than the q’1 that
would have been demanded at P1.
P2 also signals the typical firm to increase
production from q1 to q2.
Shifts in Demand Curves

Demand will increase, shift outward,
because




20
Income increases
The price of a substitute rises
The price of a complement falls
Preferences for the good increase
Shifts in Demand Curves

Demand will decrease, shift inward,
because




21
Income falls
The price of a substitute falls
The price of a complement rises
Preferences for the good diminish
Shifts in Supply Curves

Supply will increase, shift outward,
because



Supply will decrease, shift inward,
because

22
Input prices fall
Technology improves
Input prices rise
Table 10-1: Reasons for a Shift in
a Demand or Supply Curve
Demand
23
Supply
Shifts outward () because
 Income increases
 Price of substitute rises
 Price of complement falls
 Preferences for good increase
Shifts outward () because
 Input prices fall
 Technology improves
Shifts inward () because
 Income falls
 Price of substitute falls
 Price of complement rises
 Preferences for good diminish
Shifts inward () because
 Input prices rise
Short-Run Supply Elasticity

The short-run elasticity of supply is the
percentage change in quantity supplied in
the short run in response to a 1 percent
change in price.
Percentage change in quantity
supplied in short run
Short - run supply elasticity 
. [10.1]
Percentage change in price
24
Shifts in Supply Curves and the Importance
of the Shape of the Demand Curve

The effect of a shift in supply upon
equilibrium levels of P and Q depends
upon the shape of the demand curve.


25
If demand is elastic, as in Figure 10-4 (a),
a decrease in supply has a small effect on
price but a relatively large effect on
quantity.
If demand is inelastic, as in Figure 10-4 (b),
the decrease in supply has a greater effect
on price than on quantity.
FIGURE 10-4: Effect of a Shift in the Short-Run
Supply Curve on the Shape of the Demand Curve
Price
Price
S
P
D
S
P
D
0
Q Quantity
per week
(a) Elastic Demand
26
0
Q
Quantity
per week
(b) Inelastic Demand
FIGURE 10-4: Effect of a Shift in the Short-Run
Supply Curve on the Shape of the Demand Curve
S’
Price
Price
S’
S
S
P’
P’
P
D
P
D
0
Q’
Q Quantity
per week
(a) Elastic Demand
27
0
Q’ Q
Quantity
per week
(b) Inelastic Demand
Shifts in Demand Curves and the
Importance of the Shape of the Supply
Curve

The effect of a shift in demand upon
equilibrium levels of P and Q depends
upon the shape of the supply curve.


28
If supply is inelastic, as in Figure 10-5 (a), the
effect on price is much greater than on
quantity.
If the supply curve is elastic, as in Figure 10-5
(b), the effect on price is relatively smaller
than the effect on quantity.
Figure 10-5: Effect of A shift in the Demand
Curve Depends on the Shape of the Short-Run
Supply Curve
S
Price
Price
S
P’
P
P
D
0
Q
Quantity 0
per week
(a) Inelastic Supply
29
D
Q
Quantity
per week
(b) Elastic Supply
Figure 10-5: Effect of A shift in the Demand
Curve Depends on the Shape of the Short-Run
Supply Curve
S
Price
Price
S
P’
P
D’
P’
P
D’
D
0
Q Q’
Quantity 0
per week
(a) Inelastic Supply
30
D
Q
Q’
Quantity
per week
(b) Elastic Supply
FIGURE 10-6: Demand and Supply
Curves for CDs
Price
S
10
6
2
0
31
4
D
10
CDs
per week
FIGURE 10-6: Demand and Supply
Curves for CDs
Price
$12
S
10
7
6
5
2
0
32
3456
D D’
10 12
CDs
per week
TABLE 10-2: Supply and Demand Equilibrium
in the Market for CDs
Supply
Price
$10
9
8
7
6
5
4
3
2
1
0
33
Q=P-2
Quantity Supplied
(CDs per Week)
8
7
6
5
4
3
2
1
0
0
0
New equilibrium
Demand
Case 1
Case 2
Q = 10 – P
q = 12 – P
Quantity Demanded Quantity Demanded
(CDs per Week)
(CDs per Week)
0
2
1
3
2
4
3
5
6
4
5
7
6
8
7
9
8
10
9
11
10
12
Initial equilibrium
Profit Maximization

It is assumed that the goal of each firm is
to maximize profits.


34
Since each firm is a price taker, this implies
that each firm produce where price equals
long-run marginal cost.
This equilibrium condition, P = MC determines
the firm’s output choice and its choice of
inputs that minimize their long-run costs.
Entry and Exit

Entry will cause the short-run market
supply curve to shift outward causing
the market price to fall.


35
This will continue until positive economic
profits are no longer available.
Exit causes the short-run market supply
curve to shift inward causing the market
price to increase, eliminating the
economic losses.
Long-Run Equilibrium



36
P = MC results from the assumption that
firm’s are profit maximizers.
P = AC results because market forces
cause long run economic profits to equal
zero.
In the long run, firm owners will only earn
normal returns on their investments.
Long-Run Supply: The Constant
Cost Case



37
The constant cost case is a market in which
entry or exit has no effect on the cost curves
of firms.
Figure 10-7 demonstrates long-run
equilibrium for the constant cost case.
Figure 10-7 (b) shows that market where the
market demand and supply curves are D and
S, respectively, and equilibrium price is P1.
FIGURE 10-7: Long-Run Equilibrium for a
Perfectly Competitive Market: Constant
Cost Case
Price
Price
SMC
MC
S
AC
P
1
D
0
q1
(a) Typical Firm
38
Output 0
Q1
(b) Total Market
Quantity
per week
FIGURE 10-7: Long-Run Equilibrium for a
Perfectly Competitive Market: Constant
Cost Case
Price
Price
SMC
MC
S
AC
P2
P
1
D
D
0
q1 q2
(a) Typical Firm
39
Output 0
Q1 Q
2
(b) Total Market
Quantity
per week
FIGURE 10-7: Long-Run Equilibrium for a
Perfectly Competitive Market: Constant Cost
Case
Price
Price
SMC
MC
S
AC
S’
P2
LS
P
1
D
D
0
q1 q2
(a) Typical Firm
40
Output
0
Q1 Q2
Q3
(b) Total Market
Quantity
per week
Long-Run Supply: The Constant
Cost Case




41
The typical firm will produce output level
q1 which results in Q1 in the market.
The typical firm is maximizing profits since
price is equal to long-run marginal cost.
The typical firm is earning zero economic
profits since price equals long-run
average total costs.
There is no incentive for exit or entry.
A Shift in Demand



42
If demand increases to D’, the short-run
price will increase to P2.
A typical firm will maximize profits by
producing q2 which will result in short-run
economic profits (P2 > AC).
Positive economic profits cause new firms
to enter the market until economic profits
again equal zero.
A Shift in Demand



43
Since costs do not increase with entry, the
typical firm’s costs curves do not change.
The supply curve shifts to S’ where the
equilibrium price returns to P1 and the
typical firm produces q1 again.
The new long-run equilibrium output will
be Q3 with more firms in the market.
Long-Run Supply Curve



44
Regardless of the shift in demand, market
forces will cause the equilibrium price to
return to P1 in the long-run.
The long-run supply curve is horizontal at
the low point of the firms long-run average
total cost curves.
This long-run supply curve is labeled LS in
Figure 10-7 (b).
FIGURE 10-8: Increasing Costs Result in a
Positively Sloped Long-Run Supply Curve
Price
Price
Price
SMC
MC
SMC
S
D
AC
MC
P2
AC
P3
P3
P1
0
P1
q1
q2
Output
(a) Typical Firm before
Entry
45
0
q3
Output
(b) Typical Firm after
Entry
0
2
Q1
(c) The Market
Quantity
per week
FIGURE 10-8: Increasing Costs Result in a
Positively Sloped Long-Run Supply Curve
Price
Price
SMC
q1
q2
Output 0
S
D
P1
(a) Typical Firm before Entry
46
D’
P2
AC
P1
0
Price
AC
MC
P2
SMC
MC
q3
Output 0
(b) Typical Firm after Entry
2
Q1
Q2 Q3
(c) The Market
Quantity
per week
FIGURE 10-8: Increasing Costs Result in a
Positively Sloped Long-Run Supply Curve
Price
Price
SMC
MC
P2
Price
SMC
MC
D
AC
P1
q2
Output 0
(a) Typical Firm before Entry
47
S’
LS
P3
P1
q1
S
P2
AC
P3
0
D’
q3
Output 0
(b) Typical Firm after Entry
2
Q1
Q2 Q3
(c) The Market
Quantity
per week
The Increasing Cost Case


48
This case is shown in Figure 10-8, where
the initial equilibrium price is P1 with the
typical firm producing q1 with total output
Q1. Economic profits are zero.
The increase in demand to D’, with shortrun supply curve S, causes equilibrium
price to increase to P2 with the typical firm
producing q2 resulting in positive profits.
The Increasing Cost Case




49
The positive profits entice firms to enter
which drives up costs.
The typical firm’s new cost curves are
shown in Figure 10-8 (b).
The new long-run equilibrium price is P3
with market output Q3.
The long-run supply curve, LS, is positively
sloped because of the increasing costs.
Long-Run Supply Elasticity

The long-run elasticity of supply is the
percentage change in quantity supplied in
the long run in response to a 1 percent
change in price.
Percentage change in quantity
supplied in the long run
Long - run elasticity of supply 
Percentage change in price
50
[10.5]
TABLE 10-3: Estimated Long-Run
Supply Elasticities
51
Industry
Elasticity Estimate
Agriculture
Corn
Soybeans
Wheat
Aluminum
Coal
Medical Care
Natural Gas (U.S.)
Crude Oil (U.S.)
+ 0.27
+ 0.13
+ 0.03
Nearly infinite
+ 15.0
+ 0.15 - + 0.60
+ 0.50
+0.75
The Decreasing Cost Case



52
The initial equilibrium is shown as P1, Q1
in Figure 10-9 (c).
The increase in demand from D to D’
results in the short-run equilibrium, P2, Q2
where the typical firm is earning positive
economic profits.
Entry drives down costs for the typical
firm, as shown in Figure 10-9 (b).
FIGURE 10-9: Decreasing Costs Result
in a Negatively Sloped Long-Run Supply
Curve
Price
Price
SMC
D
MC
P2
AC
P1
0
Output 0
(a) Typical Firm before Entry
53
SMC
MC
AC
q1
S
Price
P1
Output 0
(b) Typical Firm after Entry
2
Q1
(c) The Market
Quantity
per week
FIGURE 10-9: Decreasing Costs Result
in a Negatively Sloped Long-Run Supply
Curve
Price
Price
Price
SMC
D
MC
P2
AC
P1
0
P2
SMC
MC
AC
q1
q2
Output 0
P1
Output 0
(a) Typical Firm before Entry (b) Typical Firm after Entry
54
S
D’
2
Q1
Q2
(c) The Market
Quantity
per week
FIGURE 10-9: Decreasing Costs Result
in a Negatively Sloped Long-Run Supply
Curve
Price
Price
Price
SMC
D
MC
P2
P2
AC
SMC
P1
q1
q2
Output 0
(a) Typical Firm before Entry
55
S’
MC
AC
P3
0
S
D’
P1
2
P3
q3
Output 0
(b) Typical Firm after Entry
LS
Q1
Q2
(c) The Market
Q3
Quantity
per week
The Decreasing Cost Case



56
Entry continues until short-run economic
profits are eliminated.
The new long-run equilibrium is P3, Q3 as
shown in Figure 10-9 (c).
The long-run supply curve is downward
sloping due to the decreasing costs as
labeled LS in Figure 10-9 (c).