Chapter 23
Perfect
Competition
Copyright © 2012 Pearson Addison-Wesley. All rights reserved.
Introduction
Most gold mines in California ceased operations by the
1960s.
Since 2007, a number of mining companies have
modernized some of these gold mines and begun
extracting gold once again.
To understand why these gold mines were closed and
reopened again, you must learn about the theory of
perfect competition—the topic of this chapter.
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23-2
Learning Objectives
• Identify the characteristics of a perfectly
competitive market structure
• Discuss the process by which a perfectly
competitive firm decides how much output
to produce
• Understand how the short-run supply
curve for a perfectly competitive firm is
determined
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23-3
Learning Objectives (cont'd)
• Explain how the equilibrium price is
determined in a perfectly competitive
market
• Describe what factors induce firms to enter
or exit a perfectly competitive industry
• Distinguish among constant-, increasing-,
and decreasing-cost industries based on
the shape of the long-run industry supply
curve
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23-4
Chapter Outline
• Characteristics of a Perfectly Competitive Market
Structure
• The Demand Curve of the Perfect Competitor
• How Much Should the Perfect Competitor
Produce?
• Using Marginal Analysis to Determine the ProfitMaximizing Rate of Production
• Short-Run Profits
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23-5
Chapter Outline (cont'd)
• The Short-Run Breakeven Price and the ShortRun Shutdown Price
• The Supply Curve for a Perfectly Competitive
Industry
• Price Determination Under Perfect Competition
• The Long-Run Industry Situation: Exit and Entry
• Long-Run Equilibrium
• Competitive Pricing: Marginal Cost Pricing
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Did You Know That ...
• More than 1,600 U.S. auto dealerships closed
during 2009?
• Ease of exit from an industry is a fundamental
characteristic of the theory of perfect
competition —the topic of this chapter.
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23-7
Characteristics of a Perfectly Competitive
Market Structure
• Perfect Competition
– A market structure in which the decisions of
individual buyers and sellers have no effect on
market price
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Characteristics of a Perfectly Competitive Market
Structure (cont'd)
• Perfectly Competitive Firm
– A firm that is such a small part of the total
industry that it cannot affect the price of the
product or service that it sells
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23-9
Characteristics of a Perfectly Competitive Market
Structure (cont'd)
• Price Taker
– A competitive firm that must take the price of
its product as given because the firm cannot
influence its price
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23-10
Characteristics of a Perfectly Competitive Market
Structure (cont'd)
• Why a perfect competitor is a price taker
1. Large number of buyers and sellers
2. Homogenous products are perfect substitutes
3. Both buyers and sellers have equal access to
information
4. No barriers to entry or exit (any firm can enter
or leave the industry without serious
impediments)
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The Demand Curve of the Perfect
Competitor
• Question
– If the perfectly competitive firm is a price
taker, who or what sets the price?
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23-12
The Demand Curve of the Perfect
Competitor (cont'd)
• The perfectly competitive firm is a price
taker, selling a homogenous commodity
with perfect substitutes.
– Will sell all units for $5
– Will not be able to sell at a higher price
– Will face a perfectly elastic demand curve at
the going market price
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Figure 23-1 The Demand Curve for a Producer of
Titanium Batteries
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How Much Should the Perfect
Competitor Produce?
• Perfect competitor accepts price as given
– Firm raises price, it sells nothing
– Firm lowers its price, it earns less revenues
than it otherwise would
• Perfect competitor has to decide how much
to produce
– Firm uses profit-maximization model
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23-15
How Much Should the Perfect
Competitor Produce? (cont'd)
• The model assumes that firms attempt to
maximize their total profits.
– The positive difference between total revenues
and total costs
• The model also assumes firms seek to
minimize losses
– When total revenues may be less than total
costs
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23-16
How Much Should the Perfect
Competitor Produce? (cont'd)
• Total Revenues
– The price per unit times the total quantity sold
– The same as total receipts from the sale of
output
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23-17
How Much Should the Perfect
Competitor Produce? (cont'd)
Profit
p = Total revenue (TR) – Total cost (TC)
TR = P x Q
TC = TFC + TVC
P is determined by the market in perfect competition
Q is determined by the producer to maximize profit
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23-18
How Much Should the Perfect
Competitor Produce? (cont'd)
• For the perfect competitor, price is also
equal to average revenue (AR) because
TR PQ
AR =
=
= P
Q
Q
• The demand curve is the average revenue
curve
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Figure 23-2 Profit Maximization, Panel
(a)
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Figure 23-2 Profit Maximization, Panel
(b)
Total
Output/
Sales/ Total
day
Costs
Market
Price
Total
Revenue
Total
Profit
0
$10
$5
$0
$10
1
15
5
5
10
2
18
5
10
8
3
20
5
15
5
4
21
5
20
1
5
23
5
25
2
6
26
5
30
4
7
30
5
35
5
8
35
5
40
5
9
41
5
45
4
10
48
5
50
2
11
56
5
55
1
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Figure 23-2 Profit Maximization, Panel
(c)
Total
Output/
Sales/ Market
day
Price
0
$5
1
5
2
5
3
5
4
5
5
5
6
5
7
5
8
5
9
5
10
5
11
5
Marginal
Cost
Marginal
Revenue
$5
$5
3
5
2
5
1
5
2
5
3
5
4
5
5
5
6
5
7
5
8
5
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How Much Should the Perfect
Competitor Produce? (cont'd)
• Profit-Maximizing Rate of Production
– The rate of production that maximizes total
profits, or the difference between total
revenues and total costs
– Also, the rate of production at which marginal
revenue equals marginal cost
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23-23
Using Marginal Analysis to Determine the ProfitMaximizing Rate of Production
• Marginal Revenue
– The change in total revenues divided by the
change in output
MR =
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change in TR
change in Q
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Using Marginal Analysis to Determine the ProfitMaximizing Rate of Production (cont’d)
• Marginal Cost
– The change in total cost divided by the change
in output
MR =
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change in TC
change in Q
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Using Marginal Analysis to Determine the ProfitMaximizing Rate of Production (cont'd)
• Profit maximization occurs at the rate of
output at which
– marginal revenue equals marginal cost
MR = MC
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Short-Run Profits
• To find out what our competitive individual
secure digital cards producer is making in
terms of profits in the short run, we have
to determine the excess of price above
average total cost
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Short-Run Profits (cont'd)
• From Figure 23-2 previously, if we have
production and sales of seven Titanium batteries,
TR = $35, TC = $30, and profit = $5 per hour.
• Now we take info from column 6 in panel (a) and
add it to panel (c) to get Figure 23-3.
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Figure 23-3 Measuring Total Profits
• Profits are maximized where
MR = MC
• This occurs at Q = 7.5 units
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Short-Run Profits (cont'd)
• Graphical depiction of maximum profits
and graphical depiction of minimum losses
– The height of the rectangular box in the
previous figure represents profits per unit
– The length represents the amount of units
produced
– When we multiply these two quantities, we get
total economic profits
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23-30
Short-Run Profits (cont'd)
• Short-run average profits are determined
by comparing ATC with P = MR = AR at
the profit-maximizing Q
• In the short run, the perfectly competitive
firm can make either economic profits or
economic losses
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Figure 23-4 Minimization of Short-Run
Losses
• Losses are minimized where
MR = MC
• This occurs at Q = 5.5 units
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Short-Run Profits (cont’d)
• We see in the previous Figure 23-4 that the
marginal revenue (d2) curve is intersected (from
below) by the marginal cost curve at an output
rate of 5 batteries per hour
• The firm is clearly not making profits because
average total costs at that output rate are greater
than the price of $3 per battery.
• The losses are shown in the shaded area.
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The Short-Run Break-Even Price and the
Short-Run Shutdown Price
• What do you think?
– Would you continue to produce if you were
incurring a loss?
• In the short run?
• In the long run?
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23-34
The Short-Run Break-Even Price and the ShortRun Shutdown Price (cont'd)
• As long as the loss from staying in
business is less than the loss from
shutting down, the firm will continue to
produce.
• A firm goes out of business when the
owners sell its assets; a firm temporarily
shuts down when it stops producing, but
is still in business.
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23-35
The Short-Run Break-Even Price and the ShortRun Shutdown Price (cont'd)
• As long as the price per unit sold exceeds
the average variable cost per unit
produced, the earnings of the firm’s
owners will be higher if it continues to
produce in the short run than if it shuts
down.
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23-36
The Short-Run Break-Even Price and the ShortRun Shutdown Price (cont'd)
• Short-Run Break-Even Price
– The price at which a firm’s total revenues equal
its total costs
– At the break-even price, the firm is just making
a normal rate of return on its capital
investment (it’s covering its explicit and implicit
costs).
• Short-Run Shutdown Price
– The price that just covers average variable
costs
– It occurs just below the intersection of the
marginal cost curve and the average variable
cost curve.
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23-37
Figure 23-5 Short-Run Break-Even
and Shutdown Prices
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The Short-Run Break-Even Price and the ShortRun Shutdown Price (cont'd)
• The meaning of zero economic profits
• Question
– Why produce if you are not making a profit?
• Answer
– Distinguish between economic profits and
accounting profits
– Remember when economic profits are zero a
firm can still have positive accounting profits
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23-39
Example: Why Firms Stubbornly Produced
Aluminum in the Late 2000s
• Between the summer of 2008 and the end of the
winter of 2009, the market clearing price of
aluminum fell by more than 50 percent.
• Meanwhile, almost all aluminum firms maintained
their production operations until early in the
spring of 2009.
• They did so because, even though the equilibrium
price fell below the short-run break-even price,
for several months the price remained above the
short-run shutdown price.
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23-40
The Supply Curve for a Perfectly
Competitive Industry
• Question
– What does the short-run supply curve for the
individual firm look like?
• Answer
– The firm’s short-run supply curve in a
competitive industry is its marginal cost curve
at and above the point of intersection with the
average variable cost curve
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23-41
Figure 23-6 The Individual Firm’s
Short-Run Supply Curve
• Given the price, the
quantity is determined
where MC = MR
• Short-run supply = MC
above minimum AVC
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23-42
The Supply Curve for a Perfectly
Competitive Industry (cont'd)
• The Industry Supply Curve
– The locus of points showing the minimum
prices at which given quantities will be
forthcoming
– Also called the market supply curve
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23-43
Figure 23-7 Deriving the Industry
Supply Curve
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The Supply Curve for a Perfectly
Competitive Industry (cont'd)
• Factors that influence the industry supply
curve (determinants of supply)
– Firm’s productivity
– Factor costs (wages, prices of raw materials)
– Taxes and subsidies
– Number of sellers
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23-45
Price Determination Under Perfect
Competition
• Question
– How is the market, or “going,” price
established in a competitive market?
• Answer
– This price is established by the interaction of all
the suppliers (firms) and all the demanders
(consumers)
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23-46
Price Determination Under Perfect
Competition (cont'd)
• The competitive price is determined by the
intersection of the market demand curve
and the market supply curve
– The market supply curve is equal to the
horizontal summation of the supply curves of
the individual firms
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23-47
Figure 23-8 Industry Demand and Supply Curves
and the Individual Firm Demand Curve, Panel (a)
Pe is the price
the firm must take
Pe and Qe determined by
the interaction of the
industry S and market D
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23-48
Figure 23-8 Industry Demand and Supply Curves
and the Individual Firm Demand Curve, Panel (b)
• Given Pe, firm produces qe where MC = MR
 If AC = AC1, break-even
• If AC = AC2, losses
• If AC = AC3, economic profit
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The Long-Run Industry Situation:
Exit and Entry
• Profits and losses act as signals for
resources to enter an industry or to leave
an industry
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23-50
The Long-Run Industry Situation:
Exit and Entry (cont'd)
• Signals
– Compact ways of conveying to economic
decision makers information needed to make
decisions
– An effective signal not only conveys
information but also provides the incentive to
react appropriately
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23-51
The Long-Run Industry Situation:
Exit and Entry (cont'd)
• Exit and entry of firms
– Economic profits
• Signal resources to enter the market
– Economic losses
• Signal resources to exit the market
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23-52
The Long-Run Industry Situation:
Exit and Entry (cont'd)
• Allocation of capital and market signals
– Price system allocates capital according to the
relative expected rates of return on alternative
investments.
– Investors and other suppliers of resources
respond to market signals about their highestvalued opportunities.
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23-53
The Long-Run Industry Situation:
Exit and Entry (cont'd)
• Tendency toward equilibrium (note that
firms are adjusting all of the time)
– At break-even, resources will not enter or exit
the market
– In competitive long-run equilibrium, firms will
make zero economic profits
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23-54
The Long-Run Industry Situation:
Exit and Entry (cont'd)
• Long-Run Industry Supply Curve
– A market supply curve showing the relationship
between prices and quantities after firms have
been allowed time to enter or exit from an
industry, depending on whether there have
been positive or negative economic profits
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23-55
The Long-Run Industry Situation:
Exit and Entry (cont'd)
• Constant-Cost Industry
– An industry whose total output can be
increased without an increase in long-run perunit costs
– Its long-run supply curve is horizontal.
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23-56
Figure 23-9 Constant-Cost, Increasing-Cost, and
Decreasing-Cost Industries, Panel (a)
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23-57
The Long-Run Industry Situation:
Exit and Entry (cont'd)
• Increasing-Cost Industry
– An industry in which an increase in industry
output is accompanied by an increase in longrun per unit costs
– Its long-run industry supply curve slopes
upward
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23-58
Figure 23-9 Constant-Cost, Increasing-Cost, and
Decreasing-Cost Industries, Panel (b)
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23-59
The Long-Run Industry Situation:
Exit and Entry (cont'd)
• Decreasing-Cost Industry
– An industry in which an increase in industry
output leads to a reduction in long-run per-unit
costs
– Its long-run industry supply curve slopes
downward.
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23-60
Figure 23-9 Constant-Cost, Increasing-Cost, and
Decreasing-Cost Industries, Panel (c)
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Long-Run Equilibrium
• In the long run, the firm can change the
scale of its plant, adjusting its plant size in
such a way that it has no further incentive
to change; it will do so until profits are
maximized
• In the long run, a competitive firm
produces where price, marginal revenue,
marginal cost, short-run minimum average
cost, and long-run minimum average cost
are equal
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23-62
Figure 23-10 Long-Run Firm
Competitive Equilibrium
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23-63
Why Not … eliminate economic profits entirely?
• If companies were prohibited from earning more
than zero economic profits, entrepreneurs would
have little incentive to try new ways of doing
things in an effort to reduce costs and gain
profits.
• There would also be no incentive for new firms to
enter an industry experiencing growing demand.
• Thus, society benefits from the market signals
created when firms experience positive short-run
economic profits.
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23-64
Competitive Pricing: Marginal Cost
Pricing
• Marginal Cost Pricing
– A system of pricing in which the price charged
is equal to the opportunity cost to society of
producing one more unit of the good or service
in question
– The opportunity cost is the marginal cost to
society.
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23-65
Competitive Pricing: Marginal Cost
Pricing (cont'd)
• Market Failure
– A situation in which an unrestrained market
operation leads to either too few or too many
resources going to a specific economic activity
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23-66
You Are There: The Coal Mining Industry
Confronts a Changing Cost Structure
• In past decades, coal mining was a decreasingcost industry and the market clearing price of coal
steadily declined relative to other goods and
services.
• Today, coal mining has become an increasing-cost
industry as miners have to dig deeper and move
more earth to extract coals from aging mines.
• So, in the long run, the equilibrium price will rise
as the demand for coal increases.
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23-67
Issues & Applications: A Higher Price Sets Off a
New California Gold Rush
• Since 2000, both the current dollar and the
inflation-adjusted price of gold have more than
tripled.
• As the theory of perfect competition predicts, the
increase in the price of gold has touched off
renewed interest by mining firms in trying to
extract gold from California mines abandoned
decades ago.
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23-68
Issues & Applications: A Higher Price Sets Off a
New California Gold Rush (cont’d)
• The gold mining industry satisfies the key
characteristics of perfect competition:
– Units of each type of gold are homogeneous, even
though it has different qualities
– Many mining firms have the technology to extract gold
from earth
– The potential output of each mining firm is small relative
to total gold production
– It is easy to enter or leave the industry
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23-69
Figure 23-11 Index Measures of the Current-Dollar
and Inflation-Adjusted Prices of Gold
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Summary Discussion of Learning
Objectives
• The characteristics of a perfectly
competitive market structure
1. Large number of buyers and sellers
2. Homogeneous product
3. Buyers and sellers have equal access to
information
4. No barriers to entry and exit
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23-71
Summary Discussion of Learning
Objectives (cont'd)
• How a perfectly competitive firm decides
how much to produce
– Economic profits are maximized when marginal
cost equals marginal revenue as long as the
market price is not below the short-run
shutdown price, where the marginal cost curve
crosses the average variable cost curve
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23-72
Summary Discussion of Learning
Objectives (cont'd)
• The short-run supply curve of a perfectly
competitive firm
– The rising part of the marginal cost curve
above minimum average variable cost
• The equilibrium price in a perfectly
competitive market
– A price at which the total amount of output
supplied by all firms is equal to the total
amount of output demanded by all buyers
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23-73
Summary Discussion of Learning
Objectives (cont'd)
• Incentives to enter or exit a perfectly
competitive industry
– Economic profits induce entry of new firms
– Economic losses will induce firms to exit the
industry
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23-74
Summary Discussion of Learning
Objectives (cont'd)
• The long-run industry supply curve and constant-,
increasing-, and decreasing-cost industries
– The relationship between price and quantity after firms
have been able to enter or exit the industry
– Constant-cost industry
• Horizontal long-run supply curve
– Increasing-cost industry
• Upward-sloping long-run supply curve
– Decreasing-cost industry
• Downward-sloping long-run supply curve
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