CHAPTER
5
Perfect Competition:
Short Run and
Long Run
Prepared by: Jamal Husein
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
Perfectly Competitive Market
A perfectly Competitive market is
characterized by:
1. There are many firms.
2. The product is standardized, or
homogeneous.
3. Firms can freely enter or leave the
market in the long run.
4. Each firm takes the market price as
given.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
2
The Short-run Output Decision

The firm’s objective is to produce the
level of output that will maximize
profit.

Economic profit = total revenue (TR)
minus total economic cost (TC).
revenue = price × quantity sold.
 The cost structure of the business firm
is the same as the one we studied
earlier.
 Total
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
3
The Firm’s TC Structure (Revisited)
The shape of the total cost curve
comes from diminishing returns
in the short run.
STC  TFC  STVC
Short-run
Short-run
Total Fixed
= Cost
+ Total Variable
Total Cost
Cost
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
Output:
Rakes per
Minute
Fixed
Cost
Q
0
1
2
3
4
5
6
7
8
9
10
FC
36
36
36
36
36
36
36
36
36
36
36
Total
Sh
Variable Short-run Ma
Cost
Total Cost
TVC
0
8
12
15
20
27
36
48
65
90
130
STC
36
44
48
51
56
63
72
84
101
126
166
S
4
The Revenue Structure of the
Competitive Business Firm
The perfectly competitive firm is
a price-taking firm. This means
that the firm takes the price
from the market.
 As long as the market remains
in equilibrium, the firm faces
only one price—the equilibrium
market price.

© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
5
Computing the Total Revenue of a
Price-taker
Price ($)
Total
Revenue
($)
C o s t in $
Output:
Rakes per
Minute
Total Revenue
250
200
150
Q
0
1
2
3
4
5
6
7
8
9
10
P
25
25
25
25
25
25
25
25
25
25
25
© 2005 Prentice Hall Business Publishing
TR
0.00
25.00
50.00
75.00
100.00
125.00
150.00
175.00
200.00
225.00
250.00
100
50
0
0
1
2
3
4
5
6
7
8
9
10
Output: Rakes per minute

Since the perfectly competitive firm
faces a constant price, the shape of its
total revenue is an upward-sloping
line. Total revenue changes only with
changes in the quantity sold.
Survey of Economics, 2/e
O’Sullivan & Sheffrin
6
The Totals Approach to Profit Maximization

To maximize profit, a
producer finds the
largest gap between total
revenue and total cost.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
Output:
Rakes per
Minute
Total
Revenue
($)
Short-run
Total Cost
Profit
Q
0
1
2
3
4
5
6
7
8
9
10
TR
0.00
25.00
50.00
75.00
100.00
125.00
150.00
175.00
200.00
225.00
250.00
STC
36
44
48
51
56
63
72
84
101
126
166
-36
-19
2
24
44
62
78
91
99
99
84
O’Sullivan & Sheffrin
P
7
The Marginal Approach

The other way to decide how much
output to produce involves the
marginal principle.
Marginal PRINCIPLE
Increase the level of an activity if its marginal
benefit exceeds its marginal cost, but reduce the
level if the marginal cost exceeds the marginal
benefit. If possible, pick the level at which the
marginal benefit equals the marginal cost.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
8
Marginal Revenue

The benefit of producing and
selling rakes is the revenue the
firm collects. If the firm sells
one more rake, total revenue
increases by $25.
Marginal benefit = marginal
revenue = market price
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
9
The Marginal Rule for Profit Maximization

A firm maximizes
profit in accordance
with the marginal
principle—by
setting marginal
revenue (or market
price) equal to
marginal cost.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
Output:
Rakes per
Minute
Marginal
Revenue =
Price ($)
Short-run
Marginal
Cost
Profit
Q
0
1
2
3
4
5
6
7
8
9
10
P
25
25
25
25
25
25
25
25
25
25
25
SMC
8
4
3
5
7
9
12
17
25
40
-36
-19
2
24
44
62
78
91
99
99
84
O’Sullivan & Sheffrin
Ou
Rak
Mi
1
10
Profit Maximization Using the
Marginal Approach
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
11
Economic Profit

Profit per unit
equals revenue per
unit (or price)
minus cost per unit
(or average total
cost).
($25 - $14) = 11

Total economic profit equals:
(price – average cost) × quantity produced
($25 - $14) x 9 = $99
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
12
Shut-down Decision

The firm should continue to operate if
the benefit of operating (total revenue)
exceeds the cost of operating, or total
variable cost.
 TR = (P × Q) must be greater than STVC
= SAVC × Q, therefore,
If P > SAVC, the firm should
continue to operate
If P < SAVC, the firm should
shut down
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
13
The Shut-down Decision



When price drops to
$9, the firm adjusts
output down to 6
rakes per minute to
maintain P=SMC.
The average
variable cost of
producing 6 rakes
per minute is $6.
The firm suffers a loss, but since price is
greater than AVC, the firm continues to
operate.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
14
The Shut-down Decision


The firm’s shutdown price is the
price at which the
firm is indifferent
between operating
and shutting down.
At $5, P = SAVC. Above this price, the firm is
better off continuing to produce at a loss. Below
this price, the firm is better off shutting down
because it could not recover its operating cost.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
15
Short-run Supply Curve

The firm’s short-run supply
curve shows the relationship
between the market price and
the quantity supplied by the
firm over a period of time
during which one input—the
production facility—cannot
be changed.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
16
The Firm’s SR Supply Curve



For any price above
the shut-down price,
the firm adjusts
output along its
marginal cost curve
as the price level
changes.
Below the shut-down
price, quantity
supplied equals zero.
The short-run supply curve is the firm’s SMC
curve rising above the minimum point on the
SAVC curve.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
17
The Market Supply Curve

The short-run market supply curve shows the
relationship between the market price and the
quantity supplied by all firms in the short run.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
18
A Market in Long-run Equilibrium
A market reaches a long-run equilibrium when
three conditions hold:
1. The quantity of the product supplied equals
the quantity demanded
2. Each firm in the market maximizes its profit,
given the market price
3. Each firm in the market earns zero economic
profit, so there is no incentive for other firms
to enter the market
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
19
A Market in Long-run Equilibrium


In short-run equilibrium, quantity
supplied equals quantity demanded
and each firm in the market
maximizes profit.
In addition to the conditions above,
in long-run equilibrium the typical
firm earns zero economic profit so
there is no further incentive for
firms to enter the market.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
20
A Market in Long-run Equilibrium

In long-run equilibrium, price = marginal cost (the
profit-maximizing rule), and price = short-run
average total cost (zero economic profit).
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
21
The LR Supply Curve for an
Increasing-cost Industry


An increasing-cost industry is an
industry in which the average cost
of production increases as the total
output of the industry increases.
The average cost increases as the
industry grows for two reasons:


Increasing input prices
Less productive inputs
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
22
Industry Output and Average
Production Cost
Number of
Firms
Industry
Output
Rakes per
Firm
50
100
150
350
700
1,050
7
7
7

Typical
Cost for
Typical
Firm
$70
84
96
Average
Cost per
Rake
$10
12
14
The rake industry is an increasing-cost industry
because the average cost of production increases
as the total output of the industry increases.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
23
Drawing the Long-run Market Supply
Curve
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e

Each point on the
long-run supply curve
shows the quantity of
rakes supplied at a
particular price (i.e.,
at a price of $12, 100
firms produce 700
rakes).

The long-run
industry supply curve
is positively-sloped
for an increasing cost
industry.
O’Sullivan & Sheffrin
24
SR Increase in Demand and the
Incentive to Enter

An increase in market demand puts upward
pressure on price. As price increases, there is an
opportunity to earn profit in the short run, and the
industry attracts new firms.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
25
The Long-run Effects of an Increase in
Demand

© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
In the short-run,
firms respond to
the increase in
demand by
adjusting output in
their existing
production
facilities, and the
price adjusts from
$12 to $17.
O’Sullivan & Sheffrin
26
The Long-run Effects of an Increase in
Demand
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e

In the long run,
after new firms
enter, equilibrium
settles at $14.

The new price is a
higher price than
the price before the
increase in demand
(increasing cost
industry).
O’Sullivan & Sheffrin
27
Long-run Supply Curve for an
Constant-cost Industry

In a constant-cost industry, firms
continue to buy inputs at the same
prices.

The long-run supply curve is
horizontal at the constant average cost
of production.

After the industry expands, the
industry settles at the same long-run
equilibrium price as before.
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e
O’Sullivan & Sheffrin
28
Long-run Supply Curve for the Ice
Industry
© 2005 Prentice Hall Business Publishing
Survey of Economics, 2/e

An increase in
the demand for
ice increases the
price of ice to $5
per bag.

In the long-run,
the price of ice
returns to its
original level.
O’Sullivan & Sheffrin
29