Chapter 7
Firms in Perfectly
Competitive Markets
PowerPoint to accompany:
Learning Objectives
1. Explain what a perfectly competitive market is
and why a perfect competitor faces a horizontal
demand curve.
2. Explain how a firm maximises profits in a
perfectly competitive market.
3. Use graphs to show a firm’s profit or loss.
4. Explain why firms may shut down temporarily.
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Learning Objectives
5. Explain how entry and exit ensure that firms
earn zero economic profit in the long run.
6. Explain how perfect competition leads to
economic efficiency.
3
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Perfect competition in the market for
organic food
The market for organically
grown food in Australia has
rapidly expanded over the last
20 years.
Profits were initially higher
than for farmers who grew
food using traditional methods.
This encouraged more farmers
to switch to growing food
organically.
However, as more farmers
switch to organic production,
prices are forced down and
profits fall.
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Market structures
Economists group industries into four market
structures:
 Perfect competition
 Monopolistic competition
 Oligopoly
 Monopoly
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The four market structures: Table 7.1
Characteristic
Perfect
competition
Monopolistic
Competition
Oligopoly
Monopoly
Number of
firms
Large number
Many
Few
one
Type of
product
Identical
Differentiated
Or Similar
Identical or
differentiated
unique
Price
Price takers
Price Makers
Price Maker
Price maker
Market
Information
Perfect
imperfect
Imperfect
imperfect
Ease of entry
High
High or some
barriers exist
Low or more
barriers to entry
Entry blocked
Examples of
industries
– Apples
– Wheat
– Selling DVDs
– Restaurants
–- general stores
– Banking
– Manufacturing
cars
– Letter delivery
– Tap water
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Market structures
The decision about which industry belongs to which
market structure depends on three key characteristics:
1. The number of firms in the industry.
2. The similarity of the good or service produced by
the firms in the industry.
3. The ease with which new firms can enter the
industry.
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LEARNING OBJECTIVE 1
Perfectly competitive markets
The conditions that make a market perfectly
competitive are:
1. There are many buyers and sellers, all of whom are
small relative to the market.
2. All firms sell identical products.
3. There are no barriers to new firms entering the
market or to existing firms leaving the market.
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LEARNING OBJECTIVE 1
Perfectly competitive markets
A perfectly competitive firm cannot affect the
market price
 Price taker: A buyer or seller that is unable to affect
the market price.
 The demand curve for a price taker is horizontal, or
perfectly elastic.
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A perfectly competitive firm faces a perfectly
elastic demand curve: Figure 7.1
Price of oats
(dollars per
bushel)
$4
0
10
Demand
3000
7500
Quantity of oats
(bushels per year)
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LEARNING OBJECTIVE 2
How a firm maximises profit in a
perfectly competitive market
Profit: Total revenue (TR) minus total cost (TC).
Profit = TR - TC
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Market demand and individual firm demand: Figure 7.2
Price of oats
(dollars per
bushel)
1. The intersection of market
supply and market demand
determines the equilibrium price of
oats...
Price of oats
(dollars per
bushel)
Supply of oats
$4
2. …which must be
accepted by Farmer
Jones and every other
seller of oats.
Demand for
Farmer Jones’
oats
$4
Demand for oats
0
80 000 000
Quantity of oats (bushels per year)
(a) Market for oats
12
0
7500
Quantity of oats (bushels per year)
(b) Demand for an individual farmer’s
oats
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LEARNING OBJECTIVE 2
How a firm maximises profit in a
perfectly competitive market
Revenue for a firm in a perfectly competitive
market
Average revenue (AR): Total revenue divided by the
number of units sold.
TR
AR 
Q
P Q
so, AR 
P
Q
Marginal revenue (MR): Change in total revenue from
selling one more unit.
Change in total revenue
ΔTR
Marginal revenue 
or, MR 
Change in quantity
ΔQ
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Farmer Jones’ revenue from oats farming: Table 7.2
14
Number of
bushels (Q)
Market price per
bushel ($P)
Total revenue
(TR)
Average
revenue (AR)
Marginal
revenue (MR)
0
$4
$0
-
-
1
4
4
$4
$4
2
4
8
4
4
3
4
12
4
4
4
4
16
4
4
5
4
20
4
4
6
4
24
4
4
7
4
28
4
4
8
4
32
4
4
9
4
36
4
4
10
4
40
4
4
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LEARNING OBJECTIVE 2
How a firm maximises profit in a
perfectly competitive market
Determining the profit-maximising level of output
Since producers in a perfectly competitive market can
sell as much produce as they wish to at the same
constant price:
 Average revenue (AR) = Marginal revenue (MR)
 Price = AR = MR
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LEARNING OBJECTIVE 2
How a firm maximises profit in a
perfectly competitive market
Determining the profit-maximising level of output,
cont.
 The profit-maximising level of output is where the
difference between total revenue and total cost is
the greatest.
 The profit-maximising level of output is also where
marginal revenue equals marginal cost, or MR = MC.
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Farmer Jones’ profits from oats farming: Table 7.3
Quantity
(bushels)(Q)
Total revenue
(TR)
Total cost
(TC)
Profit (TR
– TC)
Marginal
revenue (MR)
Marginal
cost (MC)
0
$0
$1.00
- $1.00
-
-
1
4.00
4.00
0.00
$4.00
$3.00
2
8.00
6.00
2.00
4.00
2.00
3
12.00
7.50
4.50
4.00
1.50
4
16.00
9.50
6.50
4.00.
2.00
5
20.00
12.00
8.00
4.00
2.50
6
24.00
15.00
9.00
4.00
3.00
7
28.00
19.50
8.50
4.00
4.50
8
32.00
25.50
6.50
4.00
6.00
9
36.00
32.50
3.50
4.00
7.00
10
40.00
40.50
- 0.50
4.00
8.00
17
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The profit-maximising level of output: Figure 7.3
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LEARNING OBJECTIVE 3
Illustrating profit or loss on the cost curve
graph
Profit = (P x Q)  TC
Profit (P  Q) TC


Q
Q
Q
Profit per unit =
or
Profit
 P  ATC
Q
Total profit = (P  ATC) x Q
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The area of maximum profit: Figure 7.4
Price and
cost (dollars
per bushel)
MC
Total profit =
(P – ATC) x Q
ATC
Market
P
price
Demand =
marginal
revenue
Profit per unit of
output (P – ATC)
0
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9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Q
Profit-maximising
level of output
Quantity
LEARNING OBJECTIVE 3
Illustrating profit or loss on the cost curve
graph
Illustrating when a firm is breaking even or
operating at a loss
 If P > ATC; the firm makes a profit.
 If P = ATC; the firm breaks even (its per unit cost
equals per unit revenue; thus, the firm’s total cost
equals its total revenue).
 If P < ATC; the firm experiences losses.
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A firm breaking even: Figure 7.5a
Price and
cost
MC
ATC
Break-even
point
P
0
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Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Demand =
marginal
revenue
Q
Profit-maximising
level of output
Quantity
A firm experiencing losses: Figure 7.5b
Price and
cost
MC
ATC
Losses
ATC
P
0
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9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Demand =
marginal
revenue
Q
Loss minimising
level of output
Quantity
LEARNING OBJECTIVE 3
Solved Problem 1
Determining profit-maximising price and quantity
Suppose that Barbara produces matches and operates in a
perfectly competitive market. Her output per day and her costs
are as follows:
Output per day ('000 boxes)
Total cost $
0
20
1
40
2
50
3
65
4
90
5
129
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Solved Problem 1
LEARNING OBJECTIVE 3
Determining profit-maximising price and quantity
1.
If the current equilibrium price in the market is $25 (per
’000 boxes), to maximise profit from boxes of matches that
Barbara will produce, what price will she charge and how
much profit (or loss) will she make? Draw a graph to
illustrate your answer. Your graph should be labelled clearly
and should include Barbara’s demand, ATC, AVC, MC and
MR curves, the price she is charging, the quantity she is
producing and the area representing her profit (or loss).
2.
Suppose the equilibrium price of matches drops to $15
(per ’000 boxes). What would be Barbara’s new production
level, the price she will charge and the profit or loss she
will make? Draw a graph to illustrate the situation, using
the same instruction as in Question 1.
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Solved Problem 1
LEARNING OBJECTIVE 3
Determining profit-maximising price and quantity
STEP 1: Review the chapter material. The problem is about
using cost curve graphs to analyse perfectly competitive firms,
so you may want to review the section in the textbook,
‘Illustrating profit or loss on the cost curve graph’.
STEP 2: Calculate Barbara’s marginal cost, average total cost
and average variable cost.
To maximise profits, Barbara will produce the level of output
where MR is equal to MC. We can calculate MC from the
information given in the table. We can also calculate ATC and
AVC to draw the required graph. ATC = TC/Q; AVC = VC/Q; VC
= TC - FC.
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LEARNING OBJECTIVE 3
Solved Problem 1
Determining profit-maximising price and quantity
When output is equal to zero, TC = FC. In this case
fixed cost is equal to $20 (per '000 boxes).
27
Output per day ('000
boxes)
TC
FC
VC
ATC
AVC
MC
0
20
20
0
-
-
-
1
40
20
20
40
20
20
2
50
20
30
25
15
10
3
65
20
45
21.7
15
15
4
90
20
70
22.5
17.5
25
5
129
20
109
25.8
21.8
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Solved Problem 1
LEARNING OBJECTIVE 3
Determining profit-maximising price and quantity
STEP 3: Use the information from the table in Step 2 to
calculate how many boxes of matches Barbara will produce,
what price she will charge and how much profit she will earn if
the market price of a thousand boxes of matches is $25.
Barbara’s MR = P = $25. MR = MC when Barbara produces 4000
boxes per day. Barbara is a price-taker, so she will charge $25.
Barbara’s profit is equal to TR - TC. TR is calculated by
multiplying $25 by 4 = $100. Profit is equal to $100 - $90 =
$10.
STEP 4: Use the information from the table in Step 2 to
illustrate your answer to Question 1 with a graph.
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LEARNING OBJECTIVE 3
Solved Problem 1
Determining profit-maximising price and quantity
Price and cost
($ per '000 boxes)
MC
ATC
AVC
$25.00
22.50
Demand = MR
Profit
4
29
Quantity ('000 boxes per day)
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Solved Problem 1
LEARNING OBJECTIVE 3
Determining profit-maximising price and quantity
STEP 5: Calculate how many boxes of matches Barbara will
produce, what price she will charge and how much profit she
will earn if the market price of a thousand boxes of matches is
$15.
Referring to the table in Step 2, we can see that MR = MC when
Barbara produces 3000 boxes per day. She charges the market
price of $15 per thousand boxes of matches. Her TR = $15 x 3
= $45, while her TC = $65, so she will have a loss of $20.
30
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LEARNING OBJECTIVE 3
Solved Problem 1
Determining profit-maximising price and quantity
Price and cost
($ per ’000 boxes)
MC
ATC
AVC
$21.10
15.00
Loss
Demand = MR
3
31
Quantity ('000 boxes per day)
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Making
the
Connection 7.1
Losing money in the medical
screening industry
Providing preventive
medical scans turned
out not to be a
profitable business for
some entrepreneurs.
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LEARNING OBJECTIVE 4
Deciding whether to produce or to
shut down in the short run
 In the short run, a firm suffering losses has two
choices:
– Continue to produce
– Stop production by shutting down temporarily
 Sunk cost: A cost that has already been paid and
cannot be recovered.
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LEARNING OBJECTIVE 4
Deciding whether to produce or to
shut down in the short run
The supply curve of a firm in the short run
 For any given price, the marginal cost curve shows
the quantity of output that a firm will supply.
 Therefore, the perfectly competitive firm’s marginal
cost curve is also its supply curve—but only for
prices at or above average variable cost.
34
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LEARNING OBJECTIVE 4
Deciding whether to produce or to
shut down in the short run
The supply curve of a firm in the short run, cont.
 Even if a firm suffers losses, it should continue to
operate as long as P > AVC.
 Shutdown point: The minimum point on a firm’s
average variable cost curve; if the price falls below
this point, the firm shuts down production in the
short run.
– Shutdown point: P < AVC
35
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The firm’s short-run supply curve: Figure 7.6
Price and
cost
The supply curve for
the firm in the short run
MC
ATC
AVC
The minimum
price at which the
firm will continue
to produce
PMIN
Shutdown point
0
36
QSD
Quantity
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LEARNING OBJECTIVE 4
Deciding whether to produce or to
shut down in the short run
The market supply curve in a perfectly competitive
industry
 The market supply curve is derived from individual
firms’ marginal cost curves.
37
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Firm supply and market supply: Figure 7.7
Price (dollars
per bushel)
Price (dollars
per bushel)
One oats farmer
Oats market
Supply
MC
$4
$4
0
8000
Quantity (bushels)
(a) Individual firm supply
38
0
80 000 000
Quantity (bushels)
(b) Market supply
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Making
the
When to close a laundromat
Connection 7.2
Keeping a business open even when suffering
losses can sometimes be the best decision in the
short run.
39
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LEARNING OBJECTIVE 5
The entry and exit of firms in the
long run
Economic profit and the entry or exit decision
 Economic profit: A firm’s revenues minus all its
costs, implicit and explicit.
 Economic profit in a perfectly competitive industry is
only a short-run occurrence.
 Economic profit leads to the entry of new firms into
the industry.
40
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Costs per year for Anne Moreno’s organic food farm: Table 7.4
Explicit costs
Water
$10 000
Wages
$15 000
Organic fertiliser
$10 000
Electricity
$ 5 000
Payment on bank loan
$45 000
Implicit costs
41
Foregone salary
$30 000
Opportunity cost of the $100 000
she has invested in her farm
$10 000
Total cost
$125 000
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The effect of entry on economic profits: Figure 7.8
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LEARNING OBJECTIVE 5
The entry and exit of firms in the
long run
Economic profit and the entry or exit decision, cont.
 Economic loss: The situation in which a firm’s total
revenue is less than its total cost, including all
implicit costs.
 Economic loss in a perfectly competitive industry is
only a short-run occurrence.
 Economic loss leads to the exit of some firms from
the industry.
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The effect of exit on economic losses: Figure 7.9,
panels (a) and (b)
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The effect of exit on economic losses: Figure 7.9,
panels (c) and (d)
45
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LEARNING OBJECTIVE 5
The entry and exit of firms in the
long run
Long-run equilibrium in a perfectly competitive
market
 Long-run competitive equilibrium: The situation
in which the entry and exit of firms has resulted in
the typical firm breaking even.
 The long-run equilibrium market price is at the
minimum point on the typical firm’s average total
cost curve.
46
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LEARNING OBJECTIVE 5
The entry and exit of firms in the
long run
Long-run equilibrium in a perfectly competitive
market, cont.
 Long-run supply curve: A curve showing the
relationship in the long run between market price
and the quantity supplied.
 The long-run supply curve will be horizontal at the
market price.
47
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LEARNING OBJECTIVE 5
The entry and exit of firms in the
long run
Long-run equilibrium in a perfectly competitive
market, cont.
 In the long run, a perfectly competitive market will
supply whatever amount of a good consumers
demand at a price determined by the minimum
point on the typical firm’s average total cost curve.
48
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The long-run supply curve in a perfectly competitive industry:
Figure 7.10
49
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LEARNING OBJECTIVE 5
The entry and exit of firms in the
long run
Increasing-cost and decreasing-cost industries
 Constant-cost industry: An industry in which a firm’s
average costs do not change as the industry
expands (horizontal long-run supply curve).
 Increasing-cost industry: An industry in which a
firm’s average costs rise as the industry expands
(upward-sloping long-run supply curve).
 Decreasing-cost industry: An industry in which a
firm’s average costs fall as the industry expands
(downward-sloping long-run supply curve).
50
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LEARNING OBJECTIVE 6
Perfect competition and efficiency
 Productive efficiency: When a good or service is
produced using the least amount of resources.
 Allocative efficiency: When production reflects
consumer preferences; in particular, every good or
service is produced up to the point where the last
unit provides a marginal benefit to consumers equal
to the marginal cost of producing it.
51
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LEARNING OBJECTIVE 6
Perfect competition and efficiency
Allocative efficiency
Firms will supply all those goods that provide
consumers with a marginal benefit at least as great as
the marginal cost of producing them:
– The price of a good represents the marginal benefit
consumers receive from the last unit of the good consumed.
– Perfectly competitive firms produce up to the point where
the price of the good equals the marginal cost of producing
the last unit.
– Therefore, firms produce up to the point where the last unit
provides a marginal benefit to consumers equal to the
marginal cost of producing it.
52
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LEARNING OBJECTIVE 6
Perfect competition and efficiency
Dynamic efficiency: Occurs when new technologies
and innovation are adopted over time, and when firms
adapt their product to changes in consumer
preferences and tastes.
– When striving for dynamic efficiency, firms will use new
technology and thereby reduce production costs
(productive efficiency).
– By adapting their product to changes in consumer
preferences, firms will produce goods and services
consumers value the most (allocative efficiency).
53
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An Inside Look
Organics heating up menus: Organics
tipped as hottest trend for chefs
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An Inside Look
Figure 1: The short-run effect of an increase in
demand for organic meals
55
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An Inside Look
Figure 2: The long-run effect of an increase in
demand for organic meals
56
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Key Terms
Allocative efficiency
Marginal revenue (MR)
Average revenue (AR)
Perfectly competitive
market
Dynamic efficiency
Economic loss
Economic profit
Long-run competitive
equilibrium
Long-run supply curve
57
Price taker
Productive efficiency
Profit
Shutdown point
Sunk cost
Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
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Q1. To maximise profit, which of the following should
a firm attempt to do?
a. Maximise revenue
b. Minimise cost
c. Find the largest difference between total revenue
and total cost
d. All of the above simultaneously
58
Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Check Your Knowledge
Q1. To maximise profit, which of the following should
a firm attempt to do?
a. Maximise revenue
b. Minimise cost
c. Find the largest difference between total revenue
and total cost
d. All of the above simultaneously
59
Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Check Your Knowledge
Q2. Refer to the figure below. One of the curves in this
figure is not necessary in order to determine the
profit-maximising level of output. Which curve can
be discarded?
a. The marginal cost curve
b. The demand curve
c. The average total cost
curve
d. All three curves must remain in place in order to
determine which level of output maximises profit.
60
Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
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Q2. Refer to the figure below. One of the curves in this
figure is not necessary in order to determine the
profit-maximising level of output. Which curve can
be discarded?
a. The marginal cost curve
b. The demand curve
c. The average total cost
curve
d. All three curves must remain in place in order to
determine which level of output maximises profit.
61
Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
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Q3. Refer to the figure below. Which demand curve is
associated with the shut-down point?
a. Demand1
b. Demand2
c. Demand3
d. Demand4
62
Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Check Your Knowledge
Q3. Refer to the figure below. Which demand curve is
associated with the shut-down point?
a. Demand1
b. Demand2
c. Demand3
d. Demand4
63
Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Check Your Knowledge
Q4. Which of the following terms best describes how
the forces of competition will drive the market
price to the minimum average cost of the typical
firm?
a. Productive efficiency
b. Allocative efficiency
c. Decreasing-cost industry
d. Competitive markdown
64
Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e
Check Your Knowledge
Q4. Which of the following terms best describes how
the forces of competition will drive the market
price to the minimum average cost of the typical
firm?
a. Productive efficiency
b. Allocative efficiency
c. Decreasing-cost industry
d. Competitive markdown
65
Copyright © 2013 Pearson Australia (a division of Pearson Australia Group Pty Ltd) – 9781442558069/Hubbard and O'Brien/Essentials of Economics/2e