Perfect
Competition
Chapter 9
Slides by Pamela L. Hall
Western Washington University
©2005, Southwestern
Introduction



Perfect competition is a theoretical extreme
 Some markets may approach it but none really obtain it
Economists use perfectly competitive market model to
evaluate efficiency of actual markets
With perfect competition as the standard, applied
economists measure how actual markets and economies
with missing markets allocate resources
 Develop policies and programs to improve resource allocation
efficiency


Our aim in this chapter is to develop conditions under which
a perfectly competitive market structure would exist
 Determine equilibrium market price and output
Investigate shifts in market demand and supply curves in
terms of how a market equilibrium is restored
2
Introduction



Law of One Price is based on assumption of a perfectly
competitive market
Short-run market supply curve is horizontal summation of
individual firms’ short-run supply curves
Based on short-run market supply curve and with a market
demand curve, we determine market equilibrium price and
quantity
 Given this price, we derive profit-maximizing output condition of
equating marginal cost to marginal revenue for individual firms
• At this profit-maximizing output, we investigate conditions for a firm
earning a pure profit, earning a normal profit, operating at a loss, or
going out of business


Derive competitive firm’s short-run supply curve
We develop a model of market demand and supply shifters
3
Introduction
Discuss long-run adjustment to equilibrium
by firms freely entering and exiting an
industry and phenomenon of cost adjusting
to price
 State conditions for long-run equilibrium
 Investigate effects of a change in market

demand for constant-cost, decreasing-cost, and
increasing-cost industries

We conclude by examining long-run perfectly
competitive equilibrium
4
Law of One Price

A firm is a price taker and is operating in a
perfectly competitive market structure if
 It takes equilibrium price where supply equals
demand as given
• U.S. agricultural production provides a close example
of this market structure

Establishment of this competitive price and
quantity in a perfectly competitive market is
based on certain assumptions
 Households maximize utility and firms maximize
profits
5
Law of One Price

Additional assumptions include
 Small size, large numbers
• Every firm is so small, relative to market as a whole, it cannot
exert a perceptible influence on price
 Homogeneous products
• All producers sell commodities that are identical with respect to
physical characteristics, location, and time of availability
 Free mobility of resources
• Implies that inputs are not monopolized by an owner or producer

Firms can enter and exit an industry without extraordinary costs
6
Law of One Price

Perfect knowledge
 Consumers, producers, and resource owners
have perfect knowledge concerning
• Price
• Physical characteristics
• Availability of each commodity

Transactions are costless
 Agents (buyers and sellers) incur no
extraordinary costs in making exchanges
7
Law of One Price


Given these assumptions, there is only one market price for
a commodity
 Law of One Price
If commodity were traded at different prices
 Buyers would purchase it where it is cheapest
 Firms would only supply commodity where it is more expensive
• Would result in an equalization of prices

No market actually fulfills all assumptions of perfect
competition
 Some markets come close
• For example, stock and commodity exchanges in New York and Chicago
8
Market Period

Market-period equilibrium results in no supply response
 Illustrated in Figure 9.1

All inputs are fixed
 Change in price does not result in change in market supply
• An example is wilderness areas


Supply of wilderness areas is fixed, so an increase in demand results in no supply
response
In Figure 9.1, a shift in demand curve from QD to QD' results in same
level of supply, Q*
 Supply curve is perfectly inelastic


Generally not very useful, as most markets do exhibit some supply
response
In short run, existing firms can change their quantity supplied
 In long run new firms can enter an industry
9
Figure 9.1 Market-period equilibrium
with no supply response
10
Short Run
In short run, number of firms in industry is
fixed
 Assumed cost of new firms entering and
existing firms exiting is prohibitive
 Although existing firms can only feasibly
liquidate their fixed inputs in long run
 Can adjust supply in response to changing

market conditions in short run
• For example, a firm may reduce its supply to zero
when facing a low price for its output
11
Market Supply Curve

Law of One Price implies that at a given price firms will
supply a certain quantity of output
 At this given price, sum of all output across all firms is total market
supply for commodity
• Can plot this as a point on a curve for the commodity


Continuously varying price and summing individual supply
across all firms
 Trace out market supply curve (also called industry supply curve)
Specifically, short-run market supply curve is horizontal
summation of individual firms’ supply curves
 See Figure 9.2
• At a price level of p', market supply curve is Q' = q1' + q2'
12
Figure 9.2 Market supply curve
13
Elasticity of Market Supply

Elasticity of supply
 Measure of supply response by an industry to a change in output
price
• SQ,p = (∂Q/∂p)(p/Q) = ∂ln Q/∂ ln p
 Similar to elasticity of demand
• Measures responsiveness of quantity demanded to a price change

Given that short-run quantity supplied will rise as output
price increases, then SQ,p > 0
 Relatively large values of SQ,p imply that market supply is relatively
responsive to a price change
 Low values indicate that supply is not very responsive
• For SQ,p > 1 supply is elastic
• For SQ,p < 1 supply is inelastic
14
Profit




Objective of any firm is profit maximization
 Subject to a technology constraint
Every firm faces two important decisions
 How much to produce
 What price to charge
Profit can be either pure profit or normal profit
Short-run profit is total revenue minus short-run total cost
  = TR - STC
• TR is output price times quantity

Normal profit is implicit cost of production and occurs when
TR equals STC
 Owners of firm are receiving a return on the inputs they own at a
level where there is no tendency for them to employ the inputs in
another production activity
15
Short-Run Price and Output
Determination

Production technology is expressed in STC
 STC curve is determined given some level of
technology and input prices
• For an individual firm’s profit-maximization problem,
technology constraint is imbedded in objective
function
• F.O.C. is d/dq = dTR/dq - ∂STC/∂q = 0
MR – SMC = 0
 dTR/dq is marginal revenue, MR
 ∂STC/∂q = SMC

16
Short-Run Price and Output
Determination

Marginal revenue (MR) is change in total revenue
for a change in output
 For profit maximization, firm equates MR to SMC
 Firm will adjust output until marginal increase in revenue

just equals marginal increase in costs
Incremental change in profit is zero at MR = SMC
• If MR > SMC, incremental increase in output will add more to
revenue than to cost

Profit will increase
• If SMC > MR, incremental decrease in output will decrease cost
more than decrease revenue

Also increase profit
17
Short-Run Price and Output
Determination


Under perfect competition, a firm’s demand curve is
perfectly elastic
 p = MR
A perfectly competitive firm increasing output does
not result in a market price decline
 Additional revenue associated with a unit increase in

output is price per unit firm receives
• Firm can sell all the output it wants at a given price
Profit-maximizing condition for a perfectly competitive
firm is p = SMC
• Illustrated in Figure 9.3
18
Figure 9.3 Profit maximization
under perfect competition
19
Short-Run Price and Output
Determination

Demand curve facing competitive firm is horizontal (perfectly elastic)
 Firm is a price taker

At output level qe, firm is maximizing profit
 MR = SMC

• Corresponds to equality of slopes associated with TR and STC curves
At output q', MR > SMC
 Output level is not profit-maximizing level

Increasing output from q' to qe results in change in TR represented by
area q'ABqe and change in STC represented by q'EBqe
 Difference, EAB, is increase in pure profit from increasing output

To operate at q" is as wrong as operating at q' in terms of maximizing
profit
 As long as TR curve cuts STC curve, positive pure profits are possible

At the points where TR = STC, only normal profits exist
 Where TR is below STC, firm is operating at a loss
20
Market Equilibrium

Established when, at the prevailing price, all
producers and all consumers are satisfied with the
amount they are producing or consuming
 Market demand and market supply are equal
• See Figure 9.4

Market-clearing price, pe
 Quantity demanded, QD, is equal to quantity supplied, QS
• If QD > QS, inventories are depleted, resulting in an upward
pressure on price

Dampens quantity demanded and increases quantity supplied
 Brings QD and QS toward equality
• For QD < QS, inventories expand, triggering price cuts

Stimulates quantity demanded and reduces quantity supplied
21
Individual Firm’s Supply Curve

Based on equilibrium market-clearing price perfectly competitive
individual firms determine their profit-maximizing price and output
 Take market-clearing price as given

With MR = SMC as condition for profit maximization
 SMC curve indicates how much a firm is willing and able to supply

• See Figure 9.4
Firm equates MR to SMC in order to maximize profits
 MR is equal to p
• Each individual competitive firm is facing a horizontal perfectly elastic demand
curve

Where equilibrium price intersects SMC curve, equilibrium level of firm’s
output is determined
 As long as firm is willing to supply a positive level of output
• SMC curve is firm’s supply curve
22
Figure 9.4 Short-run equilibrium
representing a firm earning a pure profit
23
Pure Profit

When OPEC oil cartel restricts world supply
of oil
 Price of gasoline increases
• Gas stations earn short-run pure profits


Illustrated in Figure 9.4
SATC curve indicates whether firm (gas
station) is earning a pure profit, a normal
profit, or is operating at a loss
 If p > SATC pure profit exists
•  = TR – STC = pq – SATCq = (p – SATC)q > 0
24
Normal Profit and Loss

If pe = SATCe
 Firm earns a normal profit
•  = TR – STC = (p – SATC)q = 0


Illustrated in Figure 9.5
When p < SATC
 Firm is operating at a loss
•  = TR – STC = (p – SATC)q < 0

Illustrated in Figure 9.6
25
Figure 9.5 Short-run equilibrium representing
a firm earning a normal profit
26
Figure 9.6 Short-run equilibrium
for a firm operating at a loss
27
Shutting Down

As long as a firm can cover its variable cost of operation, it
will remain open
 Once it pays all its variable cost
• Can apply any remaining revenue to fixed operating cost

If firm is currently operating at a loss profit-maximizing firm
may minimize this loss by remaining open
 In long run, firms can eliminate possibility of operating at a loss by
going out of business
 However, in short run firms do not have this exiting ability
• Their only limited control in minimizing their losses is to determine
whether they should operate or shut down

If a firm shuts down, its output is zero and thus it incurs only fixed cost
28
Shutting Down

At an output level of zero
 STVC is zero, so STC = TFC
 Profit, S, is –TFC




• S = TR – STC = 0 – TFC = -TFC, shut down
Firm can continue to operateloss will be
• O = TR – STC = TR – STVC – TFC, operate
A firm will minimize losses by choosing larger of S and
O
If TR > STVC firm will minimizes losses by operating
If TR < STVC firm minimizes losses by shutting down
29
Shutting Down

Operating threshold may also be stated in terms of
per-unit output
 If p > SAVC (p < SAVC)


• Firm will minimize losses by continuing to operate (shutting down)
SAVC curve indicates whether a firm should operate or not
• Illustrated in Figure 9.7
Example of firms operating where SATC < p > SAVC
 Nightly operations of convenience stores and gas stations
• Major portion of average variable cost

Wage rate for one employee
• As long as firm can cover this variable cost, it will remain open at
night
30
Figure 9.7 Short-run equilibrium for a firm
determining whether it should operate or …
31
Firm’s Supply Curve
(SMC Above SAVC)



Minimum point on SAVC curve determines operate/shutdown condition of firm
 If price is above (below) minimum, firm will operate (shut down)
Minimum is demarcation between Stage I and Stage II of
production
 Illustrated in Figure 9.7
Firm will operate only in Stage II of production
 When profit-maximizing point of price equaling SMC falls below
SAVC curve (Stage I), firm will shut down
• TR < STVC, firm is not able to cover its variable cost of operation


Loss will be less by not producing any output
SMC above SAVC is firm’s short-run supply curve
 Indicates how much a firm is willing and able to supply at a given
price
32
Firm’s Supply Curve
(SMC above SAVC)


Economic implications from short-run cost curves
are listed in Table 9.1
Have not yet discussed average fixed cost (AFC)
curve
 Does not aid in determining any short-run decisions
facing a firm
• In short-run, fixed costs are fixed


Firms have no control over them
 Little or no value in being concerned about things over which
firm has no control
For short-run maximization of profits, firms are not
concerned with fixed costs
 Are unrecoverable in short run
33
Table 9.1 Implications of the
Short-Run Cost Curves
34
Market Demand Shifters


Short-run market equilibrium depends on economic conditions remaining
unchanged
Changes in determinants of market demand, other than its price, will
shift demand curve
 Changes in consumers’ income and preferences
 Changes in price of related commodities (substitutes and complements)
 Changes in population (number of consumers)

Changes likely to trigger a shift to the right of market demand curve
 Increase in aggregate consumer income, population, or preferences for a


commodity
Fall in price of a complement commodity
Rise in price of a substitute
• Shift will generally occur unless only a small segment of individual consumers’
demands are affected
35
Market Demand Shifters

Shift in demand from QD to QD'
 Increases quantity demanded from Qe to Q'

• Illustrated in Figure 9.8
Quantity demanded > quantity supplied
• Drives down inventories, which exerts an upward pressure on
price


Leads to a decrease in quantity demanded
Firms will increase output to maintain their profit-maximizing
position of equating price to SMC
 Results in a movement upward along market supply curve
 Eliminates initial excess demand
 New short-run equilibrium price will be established with a
corresponding market-clearing quantity
 Degree to which price and quantity change as a result of a
demand shift depends on elasticity of supply
36
Figure 9.8 Short-run equilibrium
adjustment from an increase in demand
37
Market Demand Shifters

The more inelastic the supply curve
 The less responsive supply is to a shift in
demand
• Illustrated in Figure 9.9
Major determinant of supply elasticity
 Ability to vary inputs
 If a firm has more time in which to vary inputs
 Supply curve will become more elastic

38
Figure 9.9 Relative elasticity of
supply and demand curve shifts
39
Market Demand Shifters


Incentive of individual firms to increase output from qe to qe'
 Illustrated by increase in pure profit (shaded area in Figure 9.8)
Initially assumed that firms are earning a normal profit at
price and output combination pe and Qe
 Increase in price and associated output results in a short-run pure
profit
• In short-run, new firms are unable to enter this industry and existing
firms cannot be sold

Without government agencies free market will respond to a
shift in consumer demand by
 Rationing quantity supplied
 Increasing production of commodity
• Ability of markets to allocate supply without planning or programs by
government agencies is “the invisible hand”

Also works given a leftward shift in market demand curve
40
Figure 9.10 Short-run equilibrium
adjustment from a decrease in demand
41
Market Supply Shifters

Certain changes in supply will shift market supply curve
 Large entrance or exodus of firms into a perfectly competitive industry
 Changes in input prices and technology that shift an individual firm’s supply
curve

Effect of a shift in market supply depends on elasticity of market demand
 If market demand curve is relatively elastic
• Rightward shift of market supply curve will not depress output price as much as
when demand curve is relatively inelastic


Illustrated in Figure 9.11
For example, if in short run existing firms are earning pure profits
 In long run new firms will enter industry
• If market demand curve is relatively elastic, large increase in output from new
firms entering will not cause a large decline in output price

Relative unresponsiveness of price will slow erosion of pure profits as new firms enter
the industry and will allow a large increase in output
42
Figure 9.11 Short-run equilibrium
adjustment from an increase in supply
43
Market Supply Shifters

Influence demand elasticity has on market price
and output has implications for technological
development in particular industries
 If market demand curve is relatively inelastic
• Main benefits from an improvement in technology will be passed
on to consumers

Lower prices
 If market demand curve is relatively elastic
• Main impact of technological improvement is manifested in output
increases

Directly benefits firms within industry
 Industries with relatively inelastic demand curves may be less
likely to invest in technological development
44
A Market Demand and Supply
Shifters Model

Need a model to predict effects of shifts in
demand and supply
 Cobb-Douglas market demand function
• QD = apb

Constant elasticity of demand function
 b<0
 DQ,p =  ln QD/ ln p = b
 a is a constant that shifts demand curve
45
A Market Demand and Supply
Shifters Model

Assume constant elasticity of supply function
 QS = opd
 Elasticity of supply is
• SQ,p =  ln QS/ ln p = b
• o is a constant that shifts supply curve

Quantity demanded must equal quantity supplied at
equilibrium price
 QD = QS or apbe = opde
 Ultimately
• %∆pe = [1/(d – b)](%∆a - %∆o)

Can use model in applications to investigate effects of a change in a
policy that shifts demand or supply curves
46
Long Run
In long run, all inputs can vary
 Producers are free to enter or exit an industry
 Perfectly competitive model assumes there
are no special costs of entering or exiting an
industry
 For an analysis of long run, initially assume a
short-run market equilibrium
 With a representative firm earning a pure profit

47
Long Run

With assumption of perfect knowledge, all firms have
identical cost curves associated with a given level of
production
 All current firms within this industry are earning pure profits
• In long run, these short-run pure profits provide incentives for firms to
expand their facilities and for new firms to enter industry


Shifts market supply curve to right, resulting in a reduction in equilibrium
price
 As equilibrium price falls, pure profits are reduced
 Decreases incentives for existing firms to increase production or new
firms to enter into production
As price continues to fall, pure profits are squeezed further
 When price falls to where it is equal to SATC all pure profits are
squeezed out
• Firms earn only normal profits

No longer incentive for existing firms to further expand production or new
firms to enter
48
Long-Run Cost Adjustment


Long-run adjustments are also possible in terms of costs
For example, assume that a number of firms enjoy some
special advantage
 A relatively more productive soil
 Entry of new firms might push price down to normal profits for all
firms except those with relatively more productive land
• Firms with more productive land can continue to reap pure profits in
short run

See Figure 9.15
• Eventually profitable land will be sold to new owners

Prospective new owners would be willing to pay more for land that yields a
pure profit
 Increase in cost of land raises production cost
 If sellers of more productive land are shrewd bargainers, they will
obtain a price that pushes SATC just up to SATC'
• In long run, when firms are sold, only normal profits will result
49
Figure 9.15 Long-run cost
adjustment
50
Long-Run Cost Adjustment


Phenomenon of cost adjusting to price is
particularly important in U.S. agricultural policy
Currently a major problem for tobacco growers
 Despite pressure to discontinue support of tobacco
• Government must consider losses tobacco growers will
experience

Cost adjustments also occur when firms are
operating at a loss in short run
 In long run, owners will sell these losing firms
• New owners will not be willing to pay a price for firms in which
they would also operate at a loss

Price of a firm will decline until new owners receive a normal profit
51
Figure 9.16 Agricultural support
prices
52
Equilibrium Conditions


Assume that all firms have identical cost (identical
knowledge)
Long-run equilibrium conditions require every firm
to earn exactly a zero pure profit (normal profit)
 Thus, a perfectly competitive market is in long-run
equilibrium only if following conditions hold for every firm
• SMC = SATC = LMC = LAC = pe

Imply that a market equilibrium exists where the demand curve for
each firm is tangent to its LAC curve at minimum point
 See Figure 9.18
53
Figure 9.18 Long-run market
equilibrium
54
Equilibrium Conditions

Assuming fixed input is size of a firm’s physical plant
 Every firm in industry is driven to optimum plant size in long run
• Minimum point of long-run average cost

Firm is operating at full capacity
 Minimum of short-run average total cost curve
• Costs per unit of output (average costs) are at a minimum both in short
run and long run


Firm is employing optimum level of its fixed inputs
 Within this optimum level is operating at full capacity
Goal of individual firms is to equate MR to LMC for profit
maximization
 Not to equate price to LAC for zero profits
55
Equilibrium Conditions


Consequence of a perfectly competitive firm
maximizing profit
 Long-run condition of price equaling LAC
Assume all firms have same LAC and currently
market is in long-run equilibrium
 Market equilibrium price is pe
 Equilibrium output for each firm is qe
• If there are n firms in industry, then total industry output is Q =
nqe
 If market demand increases, creating an initial
disequilibrium,
• Economic forces will work to return market to equilibrium
56
Equilibrium Conditions

An increase in market demand results in a
shift in demand curve
 Short-run increase in price from pe to p' (See
Figure 9.19)
• Quantity increases from Qe to QS
 Implies a new short-run equilibrium after firms
complete their short-run output adjustments
• Individual firms in this market are now earning a pure
profit

Shaded area in Figure 9.19
57
Figure 9.19 Constant-cost
industry
58
Equilibrium Conditions

Short-run pure profits result in new firms entering
industry in long run
 If there are no entry and exit costs, firms will generally

only enter an industry when price rises above long-run
average cost
If there are entry and exit costs, firms will generally only
enter an industry when price rises substantially above
long-run average cost
• Called the hurdle rate

Typically three or four times interest rate on borrowed money
59
Constant-Cost Industry


New long-run equilibrium depends on effect new
firms entering industry have on LAC
If prices of inputs used by industry remain constant
regardless of amounts of each input demanded
 Long-run average cost curve will be unaffected
• Assume that firms within this industry are facing perfectly elastic
supply curves for inputs used in their production


Called a constant-cost industry
Examples include microbreweries, bookstores,
drugstores, tanning salons, and hair salons
 Do not have sufficient demands on inputs to influence
input prices
60
Constant-Cost Industry
 Effect
of new firms entering is to shift
short-run supply curve to right
 New firms will continue to enter as long as
price is above SATC
• Results in a drop in price and an increase in
output
 As
a result of drop in price long-run market supply
curve is horizontal
 Implies a perfectly elastic long-run market
supply curve
61
Increasing-Cost Industry



Long-run equilibrium price is directly related to number of
firms in industry and total industry output
Increased demand in industry leads to increased input
prices and associated increased LTC
 Due to increasing industry outputs
As number of firms and total output increase, problems of
industry concentrations within an area may also arise
 Upward shift in LAC curve may be result of increased nonpecuniary
costs, including
• Air pollution
• Waste management
• Strains on infrastructure

An example is a dairy industry that has problems with manure disposal
 Increased dairy production may result in increased average cost of
manure disposal
62
Increasing-Cost Industry
 Increase
in demand for inputs will have
an effect on input prices
 Industry as a whole is large enough to
have some influence on price of inputs
• Results in an upward shift in LAC curve and
an increase in long-run equilibrium price
 Illustrated
in Figure 9.20
63
Figure 9.20 Increasing-cost
industry
64
Increasing-Cost Industry

In short run, an increase in market demand, from QD to QD', results in a
price rise to p'
 Resulting pure profit for an existing firm is represented by shaded area
• In long run, pure profits will attract new firms


Market supply curve shifts rightward
 Reduces market price
However, associated increase in average cost of production results in
LAC increasing to LAC'
 Equilibrium price does not fall back to initial level
 All pure profits are squeezed out at pe'


Increase in cost results in a long-run market supply curve with a positive
slope
However, long-run market supply curve will still be more elastic than
short-run market supply curve
65
Decreasing-Cost Industry

Results in a long-run equilibrium price that is
inversely related to number of firms in industry and
total industry output
 U.S. automobile industry from 1900s through 1960s is an
example
• Average price for an automobile declined in terms of real income
during this period
• Input prices for automobile production declined

Economies of scale
• Large number of relatively low-cost automobiles were produced

Another example of a decreasing-cost industry is
handheld calculator industry
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Decreasing-Cost Industry

For a decreasing-cost industry, increased demand in
industry leads to decreased input prices due to increased
industry output
 As demand for inputs increase, input suppliers may experience
economies of scale
• Resulting in declining average cost of production and price



In short run, an increase in market demand results in a price rise
 Illustrated in Figure 9.21
Resulting pure profit for an existing firm is represented by shaded area
In long run, presence of pure profits will attract new firms
into this industry
 As new firms enter, input prices fall
• Results in a downward shift of LAC curve
• Decrease in equilibrium price

Long-run market supply curve has a negative slope
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Figure 9.21 Decreasing-cost
industry
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