Chapter 24

Chapter 24

Perfect

Competition

Introduction

Why has the range of choices among providers of digital photo printing services expanded so much during the 2000s?

How has this expansion contributed to the decline in the price of printed digital photos?

Does this expansion relate to the concept of perfect competition?

In this chapter, you will find some answers.

Copyright © 2008 Pearson Addison Wesley. All rights reserved.

24-2

Learning Objectives

• Identify the characteristics of a perfectly competitive market structure

• Discuss the process by which a perfectly competitive firm decides how much output to produce

• Understand how the short-run supply curve for a perfectly competitive firm is determined


24-3

Learning Objectives (cont'd)

• Explain how the equilibrium price is determined in a perfectly competitive market

• Describe what factors induce firms to enter or exit a perfectly competitive industry

• Distinguish among constant-, increasing-, and decreasing-cost industries based on the shape of the long-run industry supply curve


24-4

Chapter Outline

• Characteristics of a Perfectly Competitive

Market Structure

• The Demand Curve of the Perfect Competitor

• How Much Should the Perfect

Competitor Produce?

• Using Marginal Analysis to Determine the

Profit-Maximizing Rate of Production

• Short-Run Profits


24-5

Chapter Outline (cont'd)

• The Short-Run Breakeven Price and the Short-Run

Shutdown Price

• The Supply Curve for a Perfectly

Competitive Industry

• Price Determination Under Perfect Competition

• The Long-Run Industry Situation: Exit and Entry

• Long-Run Equilibrium

• Competitive Pricing: Marginal Cost Pricing


24-6

Did You Know That...

• In common speech, competition simply means “rivalry?”

• Under extreme perfectly competitive situations, individual buyers and sellers cannot affect the market price?

• Economic profits that perfectly competitive firms may earn for a time ultimately disappear as other firms enter the industry?


24-7

Characteristics of a Perfectly Competitive

Market Structure

• Perfect Competition

 A market structure in which the decisions of individual buyers and sellers have no effect on market price


24-8


Market Structure (cont'd)

• Perfectly Competitive Firm

 A firm that is such a small part of the total industry that it cannot affect the price of the product or service that it sells


24-9



• Price Taker

 A competitive firm that must take the price of its product as given because the firm cannot influence its price


24-10



• Why a perfect competitor is a price taker

1.

Large number of buyers and sellers

2.

Homogenous products are perfect substitutes

3.

Buyers and sellers have equal access to information

4.

No barriers to entry or exit


24-11

E-Commerce Example: A Monastery

Takes Advantage of Unhindered Entry

• When they discovered that they could purchase generic printing supplies, remanufacture printer ink cartridges, and offer them for sale on the Internet, a new business called Lasermonk.com was born.


24-12

E-Commerce Example:

A Monastery Takes Advantage of

Unhindered Entry (cont'd)

• By the mid-2000s, the business was earning more than $3 million per year, which the monastery uses to fund activities ranging from computer classes for orphans to food programs for homeless children.


24-13

The Demand Curve of the Perfect Competitor

• Question

 If the perfectly competitive firm is a price taker, who or what sets the price?


24-14

Figure 24-1 The Demand Curve for a Producer of Flash Memory Pen

Drives, Panel (a)

Neither an individual buyer nor seller can influence the price

The interaction of market supply and demand yields an equilibrium price of $5

24-15 Copyright © 2008 Pearson Addison Wesley. All rights reserved.

The Demand Curve of the Perfect Competitor (cont'd)

• The perfectly competitive firm is a price taker, selling a homogenous commodity with perfect substitutes.

 Will sell all units for $5

 Will not be able to sell at a higher price

 Will face a perfectly elastic demand curve at the going market price


24-16

Figure 24-1 The Demand Curve for a

Producer of Flash Memory Pen Drives


24-17

How Much Should the Perfect

Competitor Produce?

• Perfect competitor accepts price as given

 Firm raises price, it sells nothing

 Firm lowers its price, it earns less revenues than it otherwise would

• Perfect competitor has to decide how much to produce

 Firm uses profit-maximization model


24-18


Competitor Produce? (cont'd)

• The model assumes that firms attempt to maximize their total profits.

 The positive difference between total revenues and total costs

• The model also assumes firms seek to minimize losses.

 When total revenues may be less than total costs


24-19



• Total Revenues

 The price per unit times the total quantity sold

 The same as total receipts from the sale of output


24-20



Profit p

= Total revenue (TR) – Total cost (TC)

TR = P x Q

TC = TFC + TVC

P determined by the market in perfect competition

Q determined by the producer to maximize profit


24-21

Figure 24-2

Profit Maximization, Panel (a)


24-22

Figure 24-2

Profit Maximization, Panel (b)

Total

Output/

Sales/ Total Market day Costs Price

4

5

2

3

0

1

6

7

8

9

10

11

$10

15

18

20

21

23

26

30

35

41

48

56

$5

5

5

5

5

5

5

5

5

5

5

5

Total Total

Revenue Profit

$0

5

10

15

20

25



$10



10



8



5



1

2

30

35

40

45

50

55

4

5

5

4

2



1


24-23



• Profit-Maximizing Rate of Production

 The rate of production that maximizes total profits, or the difference between total revenues and total costs

 Also, the rate of production at which marginal revenue equals marginal cost


24-24

Figure 24-2

Profit Maximization, Panel (c)

Total

Output/

Sales/ Market Marginal Marginal day Price Cost Revenue

6

7

4

5

2

3

0

1

8

9

10

11

$5

5

5

5

5

5

5

5

5

5

5

5

$5

3

2

1

2

3

4

5

6

7

8

$5

5

5

5

5

5

5

5

5

5

5


24-25

Using Marginal Analysis to Determine the Profit-Maximizing Rate of Production

• Marginal Revenue

 The change in total revenues divided by the change in output

• Marginal Cost

 The change in total cost divided by the change in output


24-26

Using Marginal Analysis to

Determine the Profit-Maximizing

Rate of Production (cont'd)

• Profit maximization occurs at the rate of output at which marginal revenue equals marginal cost.


24-27

Short-Run Profits

• To find out what our competitive individual flash memory producer is making in terms of profits in the short run, we have to determine the excess of price above average total cost.


24-28

Short-Run Profits (cont'd)

• From Figure 24-2 previously, if we have production and sales of seven flash drives, TR = $35, TC = $30, and profit = $5.

• Now we take info from column 6 in panel (a) and add it to panel (c) to get

Figure 24-3.


24-29

Figure 24-3 Measuring Total Profits

• Profits are maximized where

MR = MC

• This occurs at Q = 7.5 units


24-30


• Graphical depiction of maximum profits

 The height of the rectangular box represents profits per unit.

 The length represents the amount of units produced.

 When we multiply these two quantities, we get total economic profits.


24-31

Figure 24-4

Minimization of Short-Run Losses

• Losses are minimized where

MR = MC

• This occurs at Q = 5.5 units


24-32


• Short-run average profits are determined by comparing ATC with

P = MR = AR at the profit-maximizing Q.

• In the short run, the perfectly competitive firm can make either economic profits or economic losses.


24-33

The Short-Run Shutdown Price

• What do you think?

 Would you continue to produce if you were incurring a loss?

 In the short run?

 In the long run?


24-34

The Short-Run

Shutdown Price (cont'd)

• As long as the loss from staying in business is less than the loss from shutting down, the firm will continue to produce.

• A firm goes out of business when the owners sell its assets; a firm temporarily shuts down when it stops producing, but is still in business.


24-35

The Short-Run


• As long as the price per unit sold exceeds the average variable cost per unit produced, the earnings of the firm’s owners will be higher if it continues to produce in the short run than if it shuts down.


24-36

The Short-Run


• Short-Run Break-Even Price

 The price at which a firm’s total revenues equal its total costs

 At the break-even price, the firm is just making a normal rate of return on its capital investment (it’s covering its explicit and implicit costs).

• Short-Run Shutdown Price





The price that just covers average variable costs

It occurs just below the intersection of the marginal cost curve and the average variable cost curve.


24-37

Figure 24-5 Short-Run Shutdown and Break-Even Prices


24-38

The Meaning of

Zero Economic Profits

• Question

 Why produce if you are not making a profit?

• Answer

 Distinguish between economic profits and accounting profits.

 Remember when economic profits are zero a firm can still have positive accounting profits.


24-39

The Supply Curve for a Perfectly

Competitive Industry

• Question

 What does the short-run supply curve for the individual firm look like?

• Answer

 The firm’s short-run supply curve is its marginal cost curve at and above the point of intersection with the average variable cost curve.


24-40

Figure 24-6 The Individual Firm’s

Short-Run Supply Curve

• Given the price, the quantity is determined where MC = MR

• Short-run supply = MC above minimum AVC


24-41


Competitive Industry (cont'd)

• The Industry Supply Curve

 The locus of points showing the minimum prices at which given quantities will be forthcoming

 Also called the market supply curve


24-42

Figure 24-7

Deriving the Industry Supply Curve


24-43


Competitive Industry (cont'd)

• Factors that influence the industry supply curve (determinants of supply)

 Firm’s productivity

 Factor costs

 Wages, prices of raw materials

 Taxes and subsidies

 Number of sellers


24-44

Price Determination Under

Perfect Competition

• Question

 How is the market, or “going,” price established in a competitive market?

• Answer

 This price is established by the interaction of all the suppliers (firms) and all the demanders.


24-45

Price Determination Under

Perfect Competition (cont'd)

• The competitive price is determined by the intersection of the market demand curve and the market supply curve.

 The market supply curve is equal to the horizontal summation of the supply curves of the individual firms.


24-46

Figure 24-8 Industry Demand and

Supply Curves and the Individual Firm

Demand Curve, Panel (a)

P e is the price the firm must take

P e and Q e determined by the interaction of the industry S and market D


24-47

Figure 24-8 Industry Demand and

Supply Curves and the Individual Firm

Demand Curve, Panel (b)

• Given P e

, firm produces q e where MC = MR

 If AC = AC

1

, break-even

• If AC = AC

2

, losses

• If AC = AC

3

, economic profit


24-48

The Long-Run Industry Situation:

Exit and Entry

• Profits and losses act as signals for resources to enter an industry or to leave an industry.


24-49


Exit and Entry (cont'd)

• Signals

 Compact ways of conveying to economic decision makers information needed to make decisions

 An effective signal not only conveys information but also provides the incentive to react appropriately.


24-50



• Exit and entry of firms

 Economic profits

 Signal resources to enter the market

 Economic losses

 Signal resources to exit the market


24-51



• Allocation of capital and market signals

 Price system allocates capital according to the relative expected rates of return on alternative investments.

 Investors and other suppliers of resources respond to market signals about their highest-valued opportunities.


24-52



• Tendency toward equilibrium (note that firms are adjusting all of the time)

 At break-even, resources will not enter or exit the market.

 In competitive long-run equilibrium, firms will make zero economic profits.


24-53



• Long-Run Industry Supply Curve

 A market supply curve showing the relationship between prices and quantities after firms have been allowed time to enter or exit from an industry, depending on whether there have been positive or negative economic profits


24-54



• Constant-Cost Industry

 An industry whose total output can be increased without an increase in long-run per-unit costs

 Its long-run supply curve is horizontal.


24-55

Figure 24-9 Constant-Cost,

Increasing-Cost, and Decreasing-Cost

Industries, Panel (a)


24-56



• Increasing-Cost Industry

 An industry in which an increase in industry output is accompanied by an increase in long-run per unit costs

 Its long-run industry supply curve slopes upward.


24-57



Industries, Panel (b)


24-58



• Decreasing-Cost Industry

 An industry in which an increase in industry output leads to a reduction in long-run per-unit costs

 Its long-run industry supply curve slopes downward.


24-59



Industries, Panel (c)


24-60

Example: Decreasing Costs and the

Market for Transistors

• Since the late 1960s, the annual production of transistors has expanded from 1 billion to

1 quintillion.

• At the same time, the cost per unit has dropped from about $1 to a miniscule fraction of a penny.

• Transistor production serves as a good illustration of a decreasing-cost industry.


24-61

Figure 24-10 World Transistor

Production and Prices Since 1968


24-62

Long-Run Equilibrium

• In the long run, the firm can change the scale of its plant, adjusting its plant size in such a way that it has no further incentive to change; it will do so until profits are maximized.

• In the long run, a competitive firm produces where price, marginal revenue, marginal cost, short-run minimum average cost, and long-run minimum average cost are equal.


24-63

Figure 24-11 Long-Run Firm

Competitive Equilibrium


24-64

Competitive Pricing:

Marginal Cost Pricing

• Marginal Cost Pricing

 A system of pricing in which the price charged is equal to the opportunity cost to society of producing one more unit of the good or service in question

 The opportunity cost is the marginal cost to society.


24-65

Competitive Pricing:

Marginal Cost Pricing (cont'd)

• Market Failure

 A situation in which an unrestrained market operation leads to either too few or too many resources going to a specific economic activity


24-66

Issues and Applications: The Big Rush to

Provide Digital Snaps in a Snap

• The photography industry brings in about

$85 billion in revenues each year.

• Since 2000, the majority of those revenues have been earned from the sale of digital cameras and related digital photography products and services.

• During the mid-2000s, a rapidly growing part of the digital photography business has been the market for digital photo printing services.


24-67

Issues and Applications: The Big Rush to

Provide Digital Snaps in a Snap (cont'd)

• The demand for digital photo printing services increased, and the market clearing price rose from

15 to about 19 cents.

• Numerous firms entered the industry causing market supply to increase and the market clearing price declined from 19 cents to about 12 cents.

• Hence, the long-run supply curve in this industry sloped downward, indicating that this is a decreasing-cost industry.


24-68

Figure 24-12 Short-Run and

Long-Run Adjustments in the Digital

Photo Printing Industry


24-69

Summary Discussion of Learning Objectives

• The characteristics of a perfectly competitive market structure

1.

Large number of buyers and sellers

2.

Homogeneous product

3.

Buyers and sellers have equal access to information

4.

No barriers to entry and exit


24-70

Summary Discussion of Learning Objectives (cont'd)

• How a perfectly competitive firm decides how much to produce

 Economic profits are maximized when marginal cost equals marginal revenue as long as the market price is not below the short-run shutdown price, where the marginal cost curve crosses the average variable cost curve.


24-71


• The short-run supply curve of a perfectly competitive firm

 The rising part of the marginal cost curve above minimum average variable cost

• The equilibrium price in a perfectly competitive market

 A price at which the total amount of output supplied by all firms is equal to the total amount of output demanded by all buyers


24-72


• Incentives to enter or exit a perfectly competitive industry

 Economic profits induce entry of new firms.

 Economic losses will induce firms to exit the industry.


24-73


• The long-run industry supply curve and constant-, increasing-, and decreasing-cost industries

 The relationship between price and quantity after firms have been able to enter or exit the industry

 Constant-cost industry

 Horizontal long-run supply curve

 Increasing-cost industry

 Upward-sloping long-run supply curve

 Decreasing-cost industry

 Downward-sloping long-run supply curve


24-74

End of

Chapter 24

Perfect

Competition

Chapter 24

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