Chpt 12:
Perfect Competition
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Quick Reference to Basic Market Structures
Market Structure
Seller Entry Barriers
# of Sellers
Buyer Entry Barriers
# Buyers
Perfect Competition
No
Many
No
Many
Monopolistic competition
No
Many
No
Many
Oligopoly
Yes
Few
No
Many
Oligopsony
No
Many
Yes
Few
Monopoly
Yes
One
No
Many
Monopsony
No
Many
Yes
One
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market structure describes the state of a market with respect
to competition.
The major market forms are:
◦ Perfect competition, in which the market consists of a very large
number of firms producing a homogeneous product.
◦ Monopolistic competition, also called competitive market, where
there are a large number of independent firms which have a very
small proportion of the market share.
◦ Oligopoly, in which a market is dominated by a small number of
firms which own more than 40% of the market share.
◦ Oligopsony, a market dominated by many sellers and a few
buyers.
◦ Monopoly, where there is only one provider of a product or
service.
◦ Natural monopoly, a monopoly in which economies of scale cause
efficiency to increase continuously with the size of the firm.
◦ Monopsony, when there is only one buyer in a market.
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Atomicity
◦ There is a large number of small producers and consumers on a given market,
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each so small that its actions have no significant impact on others.
◦ Firms are price takers, meaning that the market sets the price that they must choose.
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Homogeneity
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Perfect and complete information
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Equal access
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Free entry
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Individual buyers and sellers act independently
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Behavioral assumptions of perfect competition are that:
◦ Goods and services are perfect substitutes; that is, there is no product differentiation.
(All firms sell an identical product)
◦ All firms and consumers know the prices set by all firms
◦ All firms have access to production technologies, and resources are perfectly mobile.
◦ Any firm may enter or exit the market as it wishes (no barriers to entry).
◦ The market is such that there is no scope for groups of buyers and/or sellers to come
together to change the market price (collusion and cartels are not possible under this
market structure)
◦ Consumers aim to maximize utility/well-being
◦ Producers aim to maximize profits.
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Competitive market
◦
◦
◦
◦
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Market with many buyers and sellers
Trading identical products
Each buyer and seller is a price taker
Firms can freely enter or exit the market
Implying
◦ No firm or individual has any “market power”
 No ability to set or effect market equilibrium price
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1
Costs
and
Revenue
The firm maximizes profit
by producing the quantity
at which marginal cost
equals marginal revenue.
MC
ATC
MC2
P=MR1=MR2
P=AR=MR
AVC
MC1
0
Q1
QMAX
Q2
Quantity
At the quantity Q1, marginal revenue MR1 exceeds marginal cost MC1, so raising production
increases profit. At the quantity Q2, marginal cost MC2 is above marginal revenue MR2, so
reducing production increases profit. The profit-maximizing quantity QMAX is found where the
horizontal price line intersects the marginal-cost curve.
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In the short-run, it’s possible for a firm (or
firm’s) to earn above a normal rate of return
(or an economic profit)
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Positive economic profit
cannot be sustained
◦ Entry of new firms causes:
 Market supply curve to shift to
the right
 Lowering the market
equilibrium price and
 Lowering each firm’s demand
curve (or constant price)
◦ In the long run, the firm will make
only normal profit (zero economic
profit). Its horizontal demand
curve will touch its average total
cost curve at its lowest point
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Firms would prefer to avoid perfect
competition.
◦ Firms become victims of their own efficiency.
◦ In the short-run, if one firm adopts a costsavings technology -> short-run economic
profits
◦ In the long-run -> others will imitate and reduce
their costs
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Price-taker -> can’t affect market price
◦ No control over it’s (firm’s) demand
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Allocative Efficiency: MV=MC
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Productive Efficiency
 Total Surplus is as large as possible
 Consumers’ (marginal) value of last (marginal) unit equals
the resource’s marginal cost
 Opportunity costs (value) of alternative use of resource is
given by marginal cost
◦ Goods are produced at minimum cost
 In the long-run: competitive firms produce at minimum
of LRAC
◦ Economic welfare is maximized
 Sum of consumer and producer surplus
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Technological Innovation
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◦ Allocatively efficient – way which goods are
allocated to consumers results in largest gain to
society
◦ Means that Total Surplus is largest
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4
Costs
Long run, the
firm produces on the
MC curve if P= min(ATC) .
MC
ATC
2. ...but
exits if
P<ATC
0
Quantity
Long run: firms earn zero economic profit (opportunity costs included!)
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Firms choose the scale/size that minimizes
costs of production for the expected level of
demand
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Incentive is the possibility of short-run
economic profits
How do PC firms earn a short-run economic
profit?
◦ “hope to get lucky” - an unexpected increase in
demand
 Firm has no control over that
◦ Reduce it’s costs of production
 More efficient use of resources
 Better/improved technology
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In the short-run: adopting a new/more efficient technology reduces the firm’s costs of production;
allows it to earn a positive economic profit
In the long-run: all surviving firms will adopt the same technology; economic profits go to zero
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Consider an increase in demand:
◦ The increase in demand leads to an increase in
price.
◦ The higher price causes firms to earn an economic
profit.
◦ Economic profits cause new firms to enter the
market.
◦ As new firms enter, the price falls.
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Types
◦ Constant cost -> no change in price
◦ Decreasing cost -> price will fall
◦ Increasing cost -> price will increase
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What does the supply expansion path tell us
about industry costs?
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An constant-cost industry is an industry in
which production costs remain unchanged
as the industry expands.
◦ As a result, price is driven back down to the
initial level by the entry of new firms.
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An increasing-cost industry is an industry
in which production costs increase as the
industry expands.
◦ As a result, price cannot be driven back down to
the initial level by the entry of new firms.
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A decreasing-cost industry is an industry in
which production costs decrease as the
industry expands.
◦ As a result, price will be driven below the initial
level by the entry of new firms.
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Expansion path tells us in which portion of
the cost curve the industry operates in
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Perfect competition is the least
concentrated of the four market structures.
The model of perfect competition assumes
a large number of buyers and sellers, an
identical product, perfect information, and
freedom of entry and exit.
Perfectly competitive firms are price takers.
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Perfectly competitive firms maximize profit
by producing the level of output for which
marginal revenue equals marginal cost.
A perfectly competitive firm’s supply curve
is the portion of the short-run MC curve
above AVC.
◦ The market supply curve is found by summing
the individual firms’ supply curves.
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In the long run, perfectly competitive firms
earn zero economic profits.
The long-run supply curve shows the
quantity that all firms are willing to supply
at different prices.
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