Ch. 11: Perfect Competition.
 Explain how price and output are determined in
perfect competition
 Explain why firms sometimes shut down temporarily
and lay off workers
 Explain why firms enter and leave the industry
 Predict the effects of a change in demand or a
technological advance
 Explain why perfect competition is efficient
Perfect Competition
Perfect competition is an industry in which:




Many firms sell identical products to many buyers.
no restrictions to entry into the industry.
Established firms have no advantages over new ones.
Sellers and buyers are well informed about prices.
Perfect competition arises when
 When firm’s minimum efficient scale is small relative to
market demand
 Homogeneous products – only price matters to buyers.
Perfect Competition
• In perfect competition, each firm is a price
taker.
 No single firm can influence the price
 Each firm’s output is a perfect substitute for the
output of the other firms,
 Demand for each firm’s output is perfectly elastic.
Perfect Competition
• Firms’s goal: maximize economic profit.
 = TR – TC
TR=PXQ
TC=opportunity costs of production, including normal
profit for the owner.
Perfect Competition
– Market demand and supply determine the price that the firm must take.
– A firm’s marginal revenue is the change in TR resulting from a one-unit
increase in the quantity sold.
– In perfect competition, MR=P.
Firm
Industry
S
P
MR=P
D
Profit Max. in Perfect Comp.
A perfectly competitive firm faces two constraints:
 A market constraint summarized by the market price
and the firm’s revenue curves
 A technology constraint summarized by firm’s
product curves and cost curves.
Profit Max. in Perfect Comp.
• 2 decisions in the short run:
 Whether to produce or to shut down.
 If the decision is to produce, what quantity to produce.
• A firm’s long-run decisions are:
 Whether to increase or decrease its plant size.
 Whether to stay in the industry or leave it.
Profit Max. in Perfect Comp.
• At low output levels, the
firm incurs an economic
loss—it can’t cover its
fixed costs.
• Profits maximized at 9
units of output.
Profit Max. in Perfect Comp.
• Marginal Analysis
– The firm can use marginal analysis to determine
the profit-maximizing output.
– Because MR is constant and MC eventually
increases as output increases, profit is maximized
by producing the output at which
(P=)MR = MC
Profit Max. in Perfect Comp.
Profit Max. in Perfect Comp.
• Profit = (P-ATC)*Q
Profit Max. in Perfect Comp.
• The Firm’s Short-Run Supply Curve
 shows how the firm’s profit-maximizing output
varies as the market price varies, other things
remaining the same.
 linked to its MC curve.
 but there is a price below which the firm produces
nothing and shuts down temporarily.
Profit Max. in Perfect Comp.
• SR decision to shut down.
 P = (P-ATC)*Q

= (P-AVC)*Q –TFC
 If P < minimum of AVC, the firm shuts down temporarily
and incurs a loss equal to TFC.
 If P> minimum of AVC, the firm produces the quantity at
which P=MC, even if profits are negative.
Graphic representation of firm’s profit maximizing output for various prices
Use the diagram below to answer the next 4 questions.
What is the profit maximizing level of
output?
No
ne
of
th
ea
b.
..
17
25% 25% 25% 25%
14
0
14
17
None of the above
0
1.
2.
3.
4.
At the profit maximizing output, what
are profits?
1.
2.
3.
4.
$7
-$7
$109
-$109
25%
$7
25%
25%
($7)
$109
25%
($109)
The price that would result in zero
economic profits is:
1.
2.
3.
4.
$11
$16
$22
$23
25%
$11
25%
25%
$16
$22
25%
$23
This firm would produce nothing in the
short run if and only if the price falls
below ____
25%
25%
25%
25%
1.
2.
3.
4.
$23
$22
$16
$11
$23
$22
$16
$11
• SR Industry Supply Curve
– The quantity supplied by the industry at any
given price is the sum of the quantities supplied
by all the firms in the industry at that price.
– Entry of new firms shifts industry supply curve to
the right
– Exit of old firms shifts industry supply curve to
the left.
LR adjustments
• In SR, economic profits could be positive,
negative or zero.
• In the LR,
– Firms enter if economic profits are positive
– Firms exit if economic profits are negative.
– No entry or exit if economic profits are zero.
Changes in Plant Size
– Firms change their plant size whenever doing so is
profitable.
– If ATC exceeds the minimum of LRATC, firms
change their plant size to lower costs and increase
profits.
– Suppose a new technology emerges that reduces
LRATC at a higher level than previously.
Changes in Plant Size
– Why can’t a firm survive in LR at Q=6?
– Why is LR equilibrium at Q where LRATC is minimized?
LR adjustments
• Effect of entry/exit on economic profits in LR
• At LR equilibrium
 P=MC=ATC
 P=0
 ATC is at a minimum
Industry
Typical Firm
LR adjustments
• Effect of increase in demand on economic profits in LR
• At LR equilibrium
 P=MC=ATC
 P=0
 ATC is at a minimum
Industry
Typical Firm
SR vs. LR Adjustments
• Summary of effects of an increase in demand when starting
from a LR equilibrium.
SR effect
Price
Firm output
Industry output
Number of firms
Profits
ATC
LR effect
LR equilibrium
Long-run equilibrium occurs in a competitive industry
when:
 P is zero, so firms have no incentive to enter or exit the
industry.
 LRATC is at its minimum, so firms can’t reduce costs by
changing plant size.
Use the diagram below to answer the questions that folllow
Given the starting price of $16, in the
long run this industry should have
n.
..
25%
Fir
m
se
nt
er
a
n.
..
se
nt
er
a
an
se
xit
Fir
m
Fir
m
se
xit
an
d.
..
25% 25%
d.
..
25%
Fir
m
1. Firms exit and prices
rise.
2. Firms exit and prices
fall.
3. Firms enter and
prices rise.
4. Firms enter and
prices fall.
External Economies and Diseconomies
• Constant cost industry
– Industry output has no effect on a given firm’s ATC
• External economies
– decreasing cost industry
– Firm’s costs fall as industry output rises
• External diseconomies
– Increasing cost industry
– Firm’s costs rise as industry output rises
External Economics and Diseconomies
• LR supply curve reflects how change in
industry output affects ATC.
– External economies  LR supply upward sloping
– External diseconomies  LR supply downward sloping
– Constant cost industry  LR supply horizontal.
LR adjustment to change in demand with
Constant cost industry
Industry
Typical Firm
LR adjustment to change in demand with
decreasing cost industry
Industry
Typical Firm
LR adjustment to change in demand with
increasing cost industry
Industry
Typical Firm
Refer to the diagram below to answer
the questions that follow.
If the industry is at a long run
equilibrium, the price must be:
1.
2.
3.
4.
$8
$10
$12
$16
25%
$8
25%
25%
$10
$12
25%
$16
Suppose that the industry was initially at a long
run equilibrium, if demand for the product
increases, in the short run, profits should ____,
and output should _____
25%
25%
25%
no
t
l;
l.
fa
l
l;
Fa
l
ch
an
...
ise
Ri
se
;r
Fa
l
se
;n
ot
c
ha
n.
..
Rise; not change
Rise; rise
Fall; not change
Fall; fall.
Ri
1.
2.
3.
4.
25%
Suppose that the industry was initially at a long
run equilibrium and demand for the product
increases. If this is a constant cost industry, in
the long run the price should settle
33%
33%
33%
...
na
igi
or
At
th
e
lo
w
Be
Ab
o
ve
th
e
th
e
or
ig.
..
or
ig.
..
1. Above the original price.
2. Below the original price.
3. At the original price.
Suppose that the industry was initially at a long
run equilibrium and demand for the product
increases. If this is an increasing cost industry, in
the long run the price should settle
33%
33%
33%
...
na
igi
or
At
th
e
lo
w
Be
Ab
o
ve
th
e
th
e
or
ig.
..
or
ig.
..
1. Above the original price.
2. Below the original price.
3. At the original price.
Technological Advances
• New-technology firms enter and old-technology firms
either exit or adopt the new technology.
• Optimal sized firm could be either larger or smaller
• Industry supply increases and the industry supply
curve shifts rightward.
• The price falls and the quantity increases.
• Eventually, a new long-run equilibrium emerges in
which
 all the firms use the new technology
 the price has fallen to the minimum average total cost,
 each firm earns normal profit (zero economic profit)
Competition and Efficiency
• Competitive equilibrium is efficient only if
there are no external benefits or costs.
– Positive externalities.
– Negative externalities.
Applications
• Effect of barriers to entry on competitive
market
• SR versus LR effect of increase in variable
input price
• SR versus LR effect of commodity taxes