10/8/19
O U T L IN E
CH 23:
PERFECT COMPETITION
• The Theory of Perfect Competition
• The Perfectly Competitive Firm
• Production in the Short Run
• Conditions of Long-Run Competitive Equilibrium
Jessica Ann C. Jola
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T H E O RY O F P E R F E C T
C O M P E T IT IO N
M A R K E T ST RU C T U R E
A theory of market structure based on four
assumptions:
• The particular environment of a firm, the
characteristics of which influence the firm’s pricing
and output decisions.
(1)There are many sellers and many buyers, none of
which is large in relation to total sales or purchases.
(2)Each firm produces and sells a homogeneous
product.
(3)Buyers and sellers have all relevant information with
respect to prices, product quality, sources of supply,
and so on.
(4)There is easy entry into and exit from the industry.
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MARKET DEMAND CURVE AND FIRM
DEMAND CURVE IN PERFECT COMPETITION
A PERFECTLY COMPETITIVE
FIRM IS A PRICE TAKER
• A seller that does not have the ability to control the
price of the product it sells; it takes the price
determined in the market.
• The market, composed of all buyers and sellers, establishes the
equilibrium price. (a)
• A single perfectly competitive firm then faces a horizontal (flat,
perfectly elastic) demand curve. (b)
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THE DEMAND CURVE AND THE
MARGINAL REVENUE CURVE FOR A
PERFECTIVELY COMPETITIVE FIRM
M A R G IN A L R E V E N U E (M R )
The change in total revenue that results from selling one
additional unit of output.
𝑀𝑅 =
∆𝑇𝑅
∆𝑄
• By computing marginal revenue, we find that it is equal to price.
• By plotting columns 1 and 2, we obtain the firm’s demand curve;
• By plotting columns 2 and 4, we obtain the firm’s marginal revenue curve.
• The two curves are the same.
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IN -C L A SS AC T IV IT Y 2 3 -1
1.
IN -C L A SS AC T IV IT Y 2 3 -1
2. Why is a perfectly competitive firm a
price taker?
If a firm is a price taker, it does not have
the ability to control the price of the
product it sells. What does this mean?
The easy and incomplete answer is that a perfectly
competitive firm is a price taker because it is in a market
where it cannot control the price of the product it sells.
But this simply leads to the question why can’t it control
the price? The answer is that it is in a market where its
supply is small relative to the total market supply, it sells a
homogeneous good, and all buyers and sellers have all
relevant information.
The firm cannot change the price of the product it sells by
its actions. For example, if firm A cuts back on the supply of
what it produces and the price of its product does not
change, then we’d say that the firm cannot control the price
of the product it sells. In other words, if price is
independent of a firm’s actions, the firm does not have any
control over price.
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IN -C L A SS AC T IV IT Y 2 3 -1
IN -C L A SS AC T IV IT Y 2 3 -1
3.The horizontal demand curve for the
perfectly competitive firm signifies
that it cannot sell any of its product
for a price higher than the market
equilibrium price. Why not?
4. Suppose the firms in a real-world market
do not sell a homogeneous product. Does
it necessarily follow that the market is not
perfectly competitive?
No. A market doesn’t have to perfectly match all assumptions
of the theory of perfect competition for it to be labeled a
perfectly competitive market. What is important is whether it
acts as if it is perfectly competitive. “If it walks like a duck and it
quacks like a duck, it’s a duck.” Well, if it acts like a perfectly
competitive market, it’s a perfectly competitive market.
If a perfectly competitive firm tries to charge a price higher
than equilibrium price, all buyers will know this
(assumption 3). These buyers will then simply buy from
another firm that sells the same (homogeneous) product
(assumption 2)
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QUANTITY OF
OUTPUT THE
PERFECTLY
COMPETITIVE
FIRM WILL
PRODUCE
P RO F IT-M A X IM IZ AT IO N RU L E
• Profit is maximized by producing the
quantity of output at which MR = MC.
• The firm’s demand
curve is horizontal
at the equilibrium
price. Its demand
curve is its marginal
revenue curve. The
firm produces that
quantity of output at
which MR = MC.
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• For Perfect Competition, profit is maximized
when P = MR = MC*
* This condition is unique for perfect competition and does not hold
for other market structures.
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R E SO U R C E A L L O C AT IV E
E F F IC IE N C Y
CH 25:
MONOPOLISTIC
COMPETITION, OLIGOPOLY,
AND GAME THEORY
• Producing a good—any good—until price equals
marginal cost ensures that all units of the good are
produced that are of greater value to buyers than the
alternative goods that might have been produced.
• A firm that produces the quantity of output at which
price equals marginal cost (P = MC) is said to exhibit
resource allocative efficiency.
Jessica Ann C. Jola
• For a perfectly competitive firm, profit maximization
and resource allocative efficiency are not at odds.
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O U T L IN E
M O N O P O L IST IC C O M P E T IT IO N
• Monopolistic Competition
The theory of monopolistic competition is built
on three assumptions:
• Excess Capacity Theorem
1. There are many sellers and buyers.
• Oligopoly
2. Each firm in the industry produces and sells a
slightly differentiated product.
• Cartel Theories
• Game Theory
3. There is easy entry and exit.
• Theory of Contestable Markets
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M O N O P O L IST IC C O M P E T IT IO N
IN -C L A SS AC T IV IT Y 2 5 -1
1. How is a monopolistic competitor
like a monopolist? How is it like a
perfect competitor?
• The monopolistic competitor is a price searcher.
• For the monopolistic competitor, P > MR, and
the marginal revenue curve lies below the
demand curve.
A monopolistic competitor is like a monopolist in that it
faces a downward-sloping demand curve; it is a price
searcher, P > MR; and it is not resource allocative efficient.
• The monopolistic competitor produces the
quantity of output at which MR =MC.
It is like a perfect competitor in that it sells to many
buyers and competes with many sellers, and there is
easy entry into and exit from the market.
• It charges the highest price per unit for this
output.
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IN -C L A SS AC T IV IT Y 2 5 -1
O L IG O P O LY
A theory of market structure based on three
assumptions:
2. Why do monopolistic competitors
operate at excess capacity?
• There are few sellers and many buyers.
Essentially, monopolistic competitors face downward
sloping demand curves. Because the demand curve is
downward sloping, it cannot be tangent to the lowest point
on a U-shaped ATC curve.
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• Interdependence among firms
• Firms produce and sell either homogeneous or
differentiated products.
• There are significant barriers to entry.
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O L IG O P O L IST
C O N C E N T R AT IO N R AT IO
• The oligopolist is a price searcher.
• Used to define oligopolistic market structure.
• It produces the quantity of output at which MR
= MC.
• The percentage of industry sales (or assets, output,
labor force, or some other factor) accounted for
by x number of firms in the industry.
• Four-Firm Concentration Ratio: CR4 = Percentage of
industry sales accounted for by four largest firms
• Eight-Firm Concentration Ratio: CR8 = Percentage of
industry sales accounted for by eight largest firms
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C A RT E L
THE BENEFITS OF A C ARTEL
(TO C ARTEL MEMBERS)
• The key behavioral assumption of the cartel
theory is that, within a given industry,
oligopolists act as if there were only one firm.
• We assume the industry is in
long-run competitive
equilibrium, producing Q1
and charging P1. There are no
profits.
• They form a cartel to capture the benefits that
would exist for a monopolist. A cartel is an
organization of firms that reduces output and
increases price in an effort to increase joint
profits.
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• A reduction in output to QC
through the formation of a
cartel raises prices to PC and
brings profits of CPCAB.
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THE BENEFITS OF CHEATING ON
THE CARTEL AGREEMENT
PROBLEMS ASSOCIATED WITH
C ARTELS
• The situation for a
representative firm of a cartel:
in long-run competitive
equilibrium, it produces q1 and
charges P1, earning zero
economic profits.
• the problem of forming the cartel,
• the problem of formulating policy,
• the problem of entry into the industry, and
• As a consequence of the cartel
agreement, it reduces output to
qC and charges PC.
• the problem of cheating.
• Its profits are the area CPCAB.
• If it cheats on the cartel
agreement and others do not,
the firm will increase output to
qCC and reap profits of FPCDE.
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IN -C L A SS AC T IV IT Y 2 5 -2
THE BENEFITS OF CHEATING
ON THE C ARTEL AGREEMENT
1. “Firms have an incentive to form a
cartel, but once it is formed, they have
an incentive to cheat.” What,
specifically, is the incentive to form the
cartel, and what is the incentive to
cheat on the cartel?
• Note, however, that if this firm can cheat on the
cartel agreement, so can others. Given the
monetary benefits gained by cheating, it is likely
that the cartel will exist for only a short time.
The incentive in both cases is the same: profit. Firms have
an incentive to form a cartel to increase their profits. After
the cartel is formed, however, each firm has an incentive to
break the cartel to increase its profits even further. If there
is no cartel agreement, the firm is earning zero profits. But it
can earn even higher profits by cheating on the cartel.
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IN -C L A SS AC T IV IT Y 2 5 -2
G A M E T H E O RY
2. Is an oligopolistic firm a price taker or
price searcher? Explain your answer.
A mathematical technique used to analyze the
behavior of decision makers who
An oligopolistic firm is a price searcher. A price searcher faces
a downward-sloping demand curve, which an oligopolistic firm
faces. Also, an oligopolistic firm has some control over the
price it charges, which is the hallmark of a price searcher.
• (1) try to reach an optimal position for themselves
through game playing or the use of strategic
behavior,
• (2) are fully aware of the interactive nature of the
process at hand, and
• (3) anticipate the moves of other decision makers.
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GAME THEORY EXAMPLE:
PRISONER’S DILEMMA
CARTELS AND PRISONER’S
DILEMMA
Nathan and Bob each have two choices: confess or not confess.
No matter what Bob does, it is always better for Nathan to confess.
No matter what Nathan does, it is always better for Bob to confess.
Both Nathan and Bob confess and end up in box 4 where each pays a
$3,000 fine.
• Both men would have been better off had they not confessed. That way
they would have ended up in box 1 paying a $2,000 fine.
•
•
•
•
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• Both firms A and B earn higher profits holding to a (cartel) agreement than not, but
each will earn even higher profits if it breaks the agreement while the other firm holds
to it.
• If cartel formation is a prisoner’s dilemma situation, we predict that cartels will be
short-lived.
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