Chapter 6
Perfect
Competition
and the Supply
Curve
Slides created by Dr. Amy Scott
©2010  Worth Publishers
DOING WHAT COMES NATURALLY
Demand for organic foods and beverages
increased rapidly over the past decade,
at an average growth rate of 20% per
year resulting in high prices.
The supply of organic food, although relatively priceinelastic in the short run, was surely price-elastic in the
long run.
- existing organic farms increase their capacity
- conventional farmers would enter the organic food
business
In this chapter, we will use our understanding of costs as
the basis for an analysis of the supply curve.
Chapter Objectives
1. A perfectly competitive market and its
characteristics
2. A Price-taking producer and its profitmaximizing quantity of output
3. How to assess profitability and short run
performance
4. Why industries behave differently in the short
run and the long run
5. The industry supply curve in short run and the
long run
Perfect Competition and Price-takers
A
price-taking producer is one whose actions
have no effect on the market price of the good it
sells.
 A price-taking consumer is one whose actions
have no effect on the market price of the good he
or she buys.
 A perfectly competitive market is a market in
which all participants are price-takers.
 A perfectly competitive industry is an industry
in which all producers are price-takers.
Two Necessary Conditions for Perfect
Competition
1) For an industry to be perfectly competitive, it must contain
many producers, none of whom have a large market
share.
 A producer’s market share is the fraction of the total
industry output accounted for by that producer’s
output.
2) An industry can be perfectly competitive only if consumers
regard the products of all producers as equivalent.
 A good is a standardized product, also known as a
commodity, when consumers regard the products of
different producers as the same good.
For each of the following, is the market perfectly
competitive?:
There are two producers of aluminum in the world, a good
sold in many places.
perfectly competitive
not perfectly competitive
1.
2.
Only a handful of companies produce natural gas from the
North Sea. The price of natural gas is determined by global
supply and demand, of which North Sea production
represents a small share.
1.
2.
perfectly competitive
not perfectly competitive
What’s a Standardized Product?



A perfectly competitive industry must produce
a standardized product. People must think that
these products are the same.
Producers often go to great lengths to convince consumers
that they have a distinctive, or differentiated, product even
when they don’t.
So is an industry perfectly competitive if it sells products that
are indistinguishable except in name but that consumer’s don’t
think are standardized? No. When it comes to defining the
nature of competition, the consumer is always right. If
consumers believe a product is differentiated, then it is.
The Pain of Competition: Pharmaceuticals



In pharmaceuticals, the conditions for perfect competition are
often met as soon as the patent on a popular drug expires.
The field is then open for other companies to sell their own
versions of the drug—marketed as “generics” and sold under the
medical name of the drug. Generics are standardized products,
much like aspirin, and are often sold by many producers.
The shift to perfect competition is accompanied by a sharp fall
in market price.
Free Entry and Exit
 Free
entry and exit into and from an industry is
when new producers can easily enter or leave that
industry.
 Free
entry and exit ensure:
 that the number of producers in an industry can
adjust to changing market conditions, and,
 that producers in an industry cannot artificially
keep other firms out.
Production and Profits
10
Quick Review
Total Revenue = Price * Quantity
Profit = Total Revenue – Total Cost
Using Marginal Analysis to Choose the ProfitMaximizing Quantity of Output
Marginal
revenue is the change in total
revenue generated by an additional unit of
output.
MR = ∆TR/∆Q
The Optimal Output Rule
 Optimal
output rule says that profit is
maximized by producing the quantity of output at
which the marginal cost of the last unit produced
is equal to its marginal revenue.
 MR
= MC
 Profit maximization is also loss minimization
Short-Run Costs for Jennifer and Jason’s
Farm
What if MR and MC Aren’t Exactly Equal?



The optimal output rule says to max profit, produce
the quantity where MR = MC.
But what if there’s no output level at which marginal
revenue equals marginal cost? Then produce the largest
quantity for which marginal revenue exceeds
marginal cost.
MR > MC
When production involves large numbers, marginal cost,
comes in small increments and there is always a level of
output at which marginal cost almost exactly equals
marginal revenue.
Marginal Analysis Leads to ProfitMaximizing Quantity of Output
The
optimal output rule says profit is max is
when MR = MC
The
marginal revenue curve shows how marginal
revenue varies as output varies.
Note:
when firm is a price taker, MR curve is a
flat (horizontal) line which is perfectly elastic
The Price-Taking Firm’s Profit-Maximizing
Quantity of Output
Price, cost
of bushel
$24
Market
price
MC
Optimal
point
20
18
16
E
MR = P
12
8
6
0
1
2
3
4
5
6
Profit-maximizing
quantity
7
Quantity
of
tomatoes
(bushels)
The profitmaximizing
point is where
MC crosses MR
curve (horizontal
line at the
market price):
at an output of 5
bushels of
tomatoes (the
output quantity
at point E).
Costs




Economic profit: firm’s revenue minus
opportunity costs of resources
Explicit costs: cost that involve actual outlay
of money
Implicit costs: do not require an outlay of
money; measured by value in dollar terms, of
benefits forgone
Accounting profit: firm’s revenue minus
explicit cost (usually larger than economic
profit)
When Is Production Profitable?

If TR > TC, the firm is profitable.

If TR = TC, the firm breaks even.

If TR < TC, the firm incurs a loss.

Profitability depends on whether market price
is more or less than minimum ATC
Short-Run Average Costs
Costs and Production in the Short Run
Price, cost of
bushel
$30
MC
Minimum average
total cost
18
Break
even
price
ATC
C
MR = P
14
0
1
2
3
4
Minimum-cost
output
At point C (the minimum
average total cost), the
market price is $14 and
output is 4 bushels of
tomatoes (the minimumcost output).
5
6
7
Quantity of
tomatoes
(bushels)
This is where MC cuts the ATC curve at its minimum. Minimum average total cost is equal to the
firm’s break-even price.
Profitability and the Market Price
Price, cost
of bushel
Market Price = $18
Minimum
average
total cost
MC
E
$18
14.40
14
Break
even
price
0
MR = P
ATC
Profit
Z
C
1
2
3
4
The farm is profitable
because price exceeds
minimum average total cost,
the break-even price, $14.
The farm’s optimal output
choice is (E)  output of 5
bushels.
The average total cost of
producing bushels is (Z on
the ATC curve) $14.40
5
6
7
Quantity of tomatoes (bushels)
The vertical distance
between E and Z:
farm’s per unit profit, $18.00
− $14.40 = $3.60
Total profit:5 × $3.60 =
$18.00
Profitability and the Market Price
Price, cost of
bushel
Market Price = $10
Minimum
average
total cost
ATC
Y
$14.67
14
Break
even 10
price
0
MC
C
Loss
MR = P
A
1
2
The farm is unprofitable
because the price falls below
the minimum average total
cost, $14.
The farm’s optimal output
choice is (A)  output of 3
bushels.
The average total cost of
producing bushels is (Y on
the ATC curve) $14.67
3
4
5
6
Quantity of tomatoes (bushels)
7
The vertical distance
between A and Y:
farm’s per unit loss, $14.67 −
$10.00 = $4.67
Total profit:3 × $4.67 =
approx. $14.00
Profit, Break-Even or Loss
The
break-even price of a price-taking firm is the
market price at which it earns zero profits.
Whenever market price exceeds minimum
average total cost, the producer is profitable.
P > min ATC
Profit
Whenever the market price equals minimum
average total cost, the producer breaks even.
P = min ATC
Break Even
Whenever market price is less than minimum
average total cost, the producer is unprofitable.
P < min ATC
Loss
Economic Profit, Again
 Why
would firms enter an industry when they will do little
more than break even? Wouldn’t people prefer to go into
other businesses that yield a better profit?
 The
answer is that here, as always, when we calculate cost,
we mean opportunity cost—the cost that includes the
return a business owner could get by using his or her
resources elsewhere.
 And
so the profit that we calculate is economic profit; if the
market price is above the break-even level, potential
business owners can earn more in this industry than they
could elsewhere.
Profit – another way





Profit = TR – TC
TR = P*Q
TC = ATC*Q
Profit = (TR/Q – TC/Q)*Q
Or
Profit = (P – ATC)*Q
The Short-Run Individual Supply Curve
Price, cost
of bushel
Short-run
individual
supply
curve
$18
16
14
12
Shut-down 10
price
0
MC
The short-run individual
supply curve shows how an
individual producer’s optimal
output quantity depends on
the market price, taking fixed
cost as given.
ATC
E
AVC
C
B
A
1
2
Minimum
average variable
cost
3 3.5 4
5
6
Quantity of tomatoes (bushels)
7
A firm will cease
production in the short
run if the market price
falls below the shutdown price, which is
equal to minimum
average variable cost.
Short Run Production Decision





Fixed costs are irrelevant because they cannot
be changed in the short run.
Shut-down price: when price is equal to
minimum average variable cost
Sunk cost: already been incurred and is nonrecoverable. Not included in production
decisions
Operate if P > AVC - incur loss in short run
Shut down when P < AVC
Summary of the Competitive Firm’s
Profitability and Production Conditions
Prices Are Up… But So Are Costs




Congress passed the Energy Policy Act in 2005,
mandating to add, by 2012, 7.5 billion gallons of
alternative oil—mostly corn-based ethanol—to the
American fuel supply with the goal of reducing gasoline
consumption.
Due to this mandate demand for corn and its price skyrocketed.
American farmers like Ronnie Gerick of Texas, responded by
increasing the U.S. acreage planted in corn by a total of 15%.
Even though the price of corn increased, so did the cost of raw
materials needed to grow the corn.
Farmers will increase their corn acreage until the marginal cost of
producing corn is approximately equal to the market price of corn—
which shouldn’t come as a surprise because corn production satisfies
all the requirements of a perfectly competitive industry.
The firm should shut down immediately when
price is ______.
1.
2.
3.
between 0 and P1
between P1 and P2
above P2
The firm should operate in the short run
(despite sustaining a loss) when the price is
_____.
1.
2.
3.
between 0 and P1
between P1 and P2
above P2
The firm operates while making a profit at a
price _____.
1.
2.
3.
between 0 and P1
between P1 and P2
above P2
Industry Supply Curve: Short Run
 The
industry supply curve shows the relationship
between the price of a good and the total output of
the industry as a whole.
 SHORT RUN: The short-run industry supply curve
shows how the quantity supplied by an industry
depends on the market price given a fixed number
of producers.
 There is a short-run market equilibrium when
the quantity supplied equals the quantity
demanded, taking the number of producers as
given.
The Long-Run Industry Supply Curve



A market is in long-run market
equilibrium when the quantity supplied
equals the quantity demanded, given that
sufficient time has elapsed for entry into
and exit from the industry to occur.
All have fully adjusted to optimal long run
choices.
No incentive to enter or exit.
The Short-Run Market Equilibrium
Price, cost
of bushel
Short-run industry
supply curve, S
$26
22
Market
price
E
MKT
18
D
14
Shut-down
price
The short-run industry
supply curve shows how
the quantity supplied by an
industry depends on the
market price given a fixed
number of producers.
10
0
200
300
400
500
600
700
Quantity of tomatoes (bushels)
There is a short-run
market equilibrium when
the quantity supplied
equals the quantity
demanded, taking the
number of producers as
given.
The Long-Run Market Equilibrium
(a) Market
Price,
cost of
bushel
$18
S
1
E
MKT
(b) Individual Firm
S
2
S
3
Price,
cost of
bushel
$18
E
A
D
MKT
16
MC
16
ATC
D
B
14.40
C
MKT
D
14
0
500
750
1,000
Quantity of tomatoes
(bushels)
Breakeven
price
14
0
C
3
Y
Z
4 Quantity
4.5 5of tomatoes
6
(bushels)
A market is in long-run market equilibrium when the quantity supplied equals the quantity
demanded, given that sufficient time has elapsed for entry into and exit from the industry to
occur.
Effect of Increase in Demand in Short Run and
Long Run
Price,
cost
(a) Existing Firm
Response to Increase in
Demand
An increase
in demand
raises price
and profit.
$18
14
0
Price
(b) Short-Run and
Long-Run Market
Response to Increase
in Demand
Long-run
industry
supply
S curve,LRS S
1
2
MC
Y
ATC
X
MKT
The LRS shows how the quantity
supplied responds to the price once
producers have had time to enter or
exit the industry.
Price,
cost
Higher industry
output from new
entrants drive
price and profit
back down.
Y
Y
MKT
X
Quantity
(a) Existing Firm
Response to New
Entrants
0
QXQY
ATC
Z
D
Z
MKT 2
D
1
QZ Quantity
MC
0
Quantity
Increase in
output from
new entrants
D↑  P↑  non-zero profits  entry  S↑  P↓  back
to zero profit (on LRS curve)
Short-Run vs. Long-Run Industry Supply
Curves
Price
LRS may slope upward, but it is
always flatter—more elastic—
than the short-run industry supply
curve.
Short-run industry
supply curve, S
Long-run
industry supply
curve, LRS
The long-run industry supply
curve is always flatter – more
elastic than the short-run industry
supply curve.
Quantity
This is because of entry
and exit:
 a higher price attracts
new entrants in the long
run, resulting in a rise in
industry output and lower
price;
 a fall in price induces
existing producer to exit in
the long run, generating a
fall in industry output and a
rise in price.
Conclusions: Cost of Production and Efficiency in
Long Run
1.
2.
3.
In a perfectly competitive industry in equilibrium,
marginal cost is the same for all firms.
In a perfectly competitive industry with free entry
and exit, each firm will have zero economic profits
in long-run equilibrium
Long-run market equilibrium of a perfectly
competitive industry is efficient: no mutually
beneficial transactions go unexploited.
A Crushing Reversal




Starting in the mid-1990s, Americans began drinking a lot more wine.
Part of this increase in demand may have reflected a booming
economy, but the surge in wine consumption continued even after the
economy stumbled in 2001.
At first, the increase in wine demand led to sharply higher prices;
between 1993 and 2000, the price of red wine rose approximately
50%, and California grape growers earned high profits.
As a result, there was a rapid expansion of the industry. Between
1994 and 2002, production of red wine grapes almost doubled.
The result was predictable: the price of grapes fell as the supply curve
shifted out. As demand growth slowed in 2002, prices plunged by
17%. The effect was to end the California wine industry’s expansion.
Given the following costs for Alicia’s Apple Pies, a perfectly
competitive firm, find the profit-maximizing or lossminimizing output for each price…
If the price of a pie is $3, how many pies should be produced in the short-run?
1.
2.
3.
4.
1
2
3
4
4
4.28
If the price of a pie is $3 and Alicia decides to produce 3
pies, what is her short-run profit or loss?
1.
2.
3.
4.
$0
$4.74 loss
$1.75 loss
$2.25 profit
4
4.28
If the price of a pie is $6, how many pies should be
produced in the short-run?
1.
2.
3.
4.
3
4
5
6
4
4.28
If the price of a pie is $6 and Alicia produces 5 pies, how
much is her short-run profit or loss?
1.
2.
3.
4.
0
$4.70
$7.80
$21.00
4
4.28
Which of the following events will induce firms to
enter an industry? Which will induce firms to exit?
1a) A technological advance lowers the fixed cost of production of every
firm in the industry.
1.
enter
2.
exit
3.
no change
4.
entry and exit
1b) The wages paid to workers in the industry go up.
1.
2.
3.
4.
enter
exit
no change
entry and exit
Which of the following events will induce firms to
enter an industry? Which will induce firms to exit?
1c) A permanent change in consumer tastes increases demand for the
good.
1.
enter
2.
exit
3.
no change
4.
entry and exit
1d) The price of a key input rises due to a shortage of that input.
1.
2.
3.
4.
enter
exit
no change
entry and exit
Given the following costs for Alicia’s Apple Pies, a perfectly
competitive firm, find the long-run equilibrium price and
quantity…
How many pies will Alicia produce in the long run?
1.
2.
3.
4.
0
3
4
5
4
4.28
What price will Alicia charge in the long run?
1.
2.
3.
4.
0
$3.38
$4.28
$5
4
4.28
Summary
1.
2.
1 of 4
In a perfectly competitive market all producers are
price-taking producers and all consumers are
price-taking consumers—no one’s actions can
influence the market price.
There are two necessary conditions for a perfectly
competitive industry: there are many producers, none
of whom have a large market share, and the industry
produces a standardized product or commodity—
goods that consumers regard as equivalent. A third
condition is often satisfied as well: free entry and
exit into and from the industry.
Summary
3.
4.
2 of 4
A producer chooses output according to the optimal
output rule: produce where marginal revenue
equals marginal cost. For a price-taking firm,
marginal revenue is equal to price and its marginal
revenue curve is a horizontal line at the market price.
A firm is profitable if total revenue exceeds total cost
or, equivalently, if the market price exceeds its breakeven price—minimum average total cost. If market
price exceeds the break-even price, the firm is
profitable; if it is less, the firm is unprofitable; if it is
equal, the firm breaks even. When profitable, the
firm’s per-unit profit is P − ATC; when unprofitable, its
per-unit loss is ATC − P.
Summary
5.
6.
3 of 4
Fixed cost is irrelevant to the firm’s optimal short-run
production decision. When the market price is equal to
or exceeds the shut-down price, the firm produces
where MR = MC. When the market price falls below the
shut-down price, the firm ceases production in the
short run. This generates the firm’s short-run
individual supply curve.
Fixed cost matters over time. If the market price is
below minimum average total cost for an extended
period of time, firms will exit the industry in the long
run. If above, existing firms are profitable and new
firms will enter the industry in the long run.
Summary
7.
8.
4 of 4
The short-run industry supply curve is the industry
supply curve given that the number of firms is fixed.
The short-run market equilibrium is given by the
intersection of the short-run industry supply curve and
the demand curve.
The long-run industry supply curve is the industry
supply curve given sufficient time for entry into and
exit from the industry. In the long-run market
equilibrium—given by the intersection of the long-run
industry supply curve and the demand curve—no
producer has an incentive to enter or exit. The long-run
industry supply curve is often horizontal.