Economics 147
John F. Stewart
Theory of Perfectly
Competitive Markets
University of North Carolina
Chapel Hill
Theory: The Structure of an
Economic Model
Economic theory is based on deductive logic,
if => then reasoning
Inside the box & outside the box
The Structure of an Economic Model
Formal
Economic
Assumption
Structure
Deduction
Optimization
Equilibrium
Conclusion
Outcome
Practical
Who, What, Why
Constraint
Algebra, Calculus
other "pure logic"
tools
Answer
Structural Assumptions of Perfect
Competition:
The Firm
Who: the FIRM
What: chooses the quantity of output to
produce and sell
Why: to maximize profits (P xQ) - total cost
Constraints
technology and input markets
it must sell what it produces (demand)
Econ 147 UNC-CH
JF Stewart
Econ 147 (3_p) Perfect Comp.prz, 1-3
01/14/04
Structural Assumptions of Perfect
Competition:
The Market
Large number of small sellers (and buyers)
homogeneous good
full and free information
entry and exit are easy and inexpensive
Step 1: Costs
Decision 1: How much "stuff"
to buy to make this good => "cost"
Result 1: Profit maximizing firm
will choose inputs (given prices
and tech.) in such a way as to
minimize cost of producing the
desired level of output.
Usable Construct: Cost
Curves (long & short run, Total,
Average, & Marginal)
Step 2: Firm's Output decision
Decision 2: How much should the firm produce?
(Marginal Analysis)
If an increase in Q makes profits go up, DO IT.
If an increase in Q makes profits go down, UNDO IT.
Result 2: Profits are maximized (given cost and
demand) when firm has chosen a Q such that
MC = δTC/ δQ MR = δTR/ δQ dProfits = MR - MC
MR = MC
Econ 147 UNC-CH
JF Stewart
Econ 147 (3_p) Perfect Comp.prz, 4-6
01/14/04
Step 3: Marginal Revenue for a
competitive firm
Given the structural assumptions we made about perfect competition,
The firm's demand and marginal revenue curves are
a horizontal straight line at the current price P
Result 3: Firm will choose Q such that
MC(Q) = P
Usable Construct: Supply Curve of the firm
Step 4: Where did the price come
from?
Usable Construct: Market Supply curve (if one firm
maximizes profits at MC(Q) = P, so would all the
others)
Putting the Pieces Together
At a given price, there is an amount each firm is willing to produce because
that amount will maximize profits.
Add those amount all up and you have the total amount that would be
produced at any given price.
At a given price consumers would be willing to purchase a certain amount
(demand curve)
IF AT THE GIVEN PRICE, THE AMOUNT THE CONSUMERS ARE
WILLING TO PURCHASE IS NOT THE SAME AS THE AMOUNT
FIRMS ARE WILLING TO SELL, SOMETHING HAS GOT TO GIVE.
That something is the market price
For each Firm P =MC(Q) (they want to max profits)
In the Market P must be such that Quant.. Demanded = Quant. Supplied.
Econ 147 UNC-CH
JF Stewart
Econ 147 (3_p) Perfect Comp.prz, 7-9
01/14/04
Short Run Competitive Market
Equilibrium
Long Run Perfectly Competitive
Market Equilibrium
Show on the graph where the long run equilibrium price
and market quantity will be.
What causes the market supply curve to shift?
If it is possible to earn ECONOMIC PROFITS (revenues are larger than total costs),
other owners of resources will want to produce the good and, with nothing to stop
them, firms will enter, supply will shift out, price will fall.
Typical Firm
$
$
MC
AC
$100
Total Market
Supply
(100 firms)
Market
Demand
$100
$50
4 5
Qfirm
500
800
QMarket
Each firm producing at point where P = MC = AC
Quantity demanded = Quantity supplied
Firm has to
Firm wants to
Some Technical Footnotes
Short Run Profit Maximizing
breakeven and shutdown points
Relationship between marginal revenue and
price elasticity
Relationship between scale economies and
cost
Econ 147 UNC-CH
JF Stewart
Econ 147 (3_p) Perfect Comp.prz, 10-12
01/14/04
Where is the shut down point? What is the logic behind it?
Where is the competitive firm's short run supply curve?
Shutdown & Break Even points
SRMC
$
SRATC
AVC
Quantiy
MR and Price Elasticity
TR = P × Q = P (Q )Q
MR =
δTR δP( Q) Q
δP( Q)
δQ
=
=Q
+ P( Q)
δQ
δQ
δQ
δQ
= P+Q
where η = −
δP( Q)

Q δP 

1
= P 1 +
 = P 1 − 
δQ

P δQ 

η
P δQ
; the price elaticity of demand
Q δP
For a linear demand function
P = a − bQ
TR = aQ − bQ2
MR = a − 2bQ
MR and Price Elasticity
Tne Lerner Index

1
MR = P 1 −  = MC for profit max

η
thus:
Econ 147 UNC-CH
JF Stewart
P − MC 1
=
P
η
Econ 147 (3_p) Perfect Comp.prz, 13-15
01/14/04
Scale economies
If Q0 = f ( K0 , L0 ) ,
for a positive number α
f (αK0 ,αL0 ) = αQ0 implies constant returns to scale
f (αK0 ,αL0 ) > αQ0 implies increasing returns to scale
f (αK0 ,αL0 ) < αQ 0 implies decreasing returns to scale
$
increasing, constant, decreasing ,
returns to scale
LRAC
Q
Real Competition
Agriculture
Actual structure:
lots of firms, but not equal in size
largest "firms" dominate in output (& profits)
"corporate" farms
Real Competition
Agriculture
Actual structure:
Technological progress
Feed Required for Broiler Chickens
450
400
350
Feed per 100 lbs
300
250
200
150
1934
1950
1940
1970
1960
1990
1980
Source: Adams and Brock. The
Structure of American Industry,
Prentice Hall 2001
Econ 147 UNC-CH
JF Stewart
Econ 147 (3_p) Perfect Comp.prz, 16-18
01/14/04
Real Competition
Agriculture
Supply & Demand
relatively inelastic demand for many products
higher short run fixed cost, steep SRMC,
rapidly shifting supply curves
Farm Product Elasticities
Price Fluctuation and Public Policy
P
D1
S1
S2
Q
Econ 147 UNC-CH
JF Stewart
Econ 147 (3_p) Perfect Comp.prz, 19-21
01/14/04
Price Fluctuation and Public Policy
D1
P
S1
Target Price
Q
Next Time
Theory of Monopoly
Markets
University of North Carolina
Chapel Hill
Econ 147 UNC-CH
JF Stewart
Econ 147 (3_p) Perfect Comp.prz, 22-24
01/14/04