C h a p t e r
11
PERFECT
COMPETITION
Outline
Sweet Competition
A. Maple syrup is produced by 12,000 farms in the United
States and Canada in a highly competitive market. We
study such a market in this chapter.
B. We explain the changes in price and output as the firms
in perfect competition respond to changes in demand and
technological change.
I.
Competition
A. Perfect competition exists when:
1. Many firms sell identical products to many buyers.
2. There are no restrictions to entry into the industry.
3. Established firms have no advantages over new ones.
4. Sellers and buyers are well informed about prices.
B. How Perfect Competition Arises
1. Perfect competition arises when firm’s minimum
efficient scale is small relative to market demand so
there is room for many firms in the industry.
2. And when each firm is perceived to produce a good or
service that has no unique characteristics, so
consumers don’t care which firm they buy from.
C. Price Takers
1. In perfect competition, each firm is a price taker.
2. No single firm can influence the price—it must “take”
the equilibrium market price.
3. Each firm’s output is a perfect substitute for the
output of the other firms, so the demand for each
firm’s output is perfectly elastic.
D. Economic Profit and Revenue
1. The goal of each firm is to maximize economic profit,
which equals total revenue minus total cost. Total
cost is the opportunity cost of production, which
includes normal profit.
2. A firm’s total revenue equals price, P, multiplied by
quantity sold, Q, or P  Q
3. A firm’s marginal revenue is the change in total revenue
that results from a one-unit increase in the quantity
sold. Because in perfect competition the price remains
the same as the quantity sold changes, marginal
revenue equals price.
4. Figure 11.1 (page 235) illustrates a firm’s revenue
concepts.
a) Figure 11.1a shows that market demand and supply
determine the price that the firm must take.
b) Figure 11.1b shows the demand curve for the firm’s
product, which is also its marginal revenue curve.
c) And Figure 11.1c shows the firm’s total revenue
curve.
II. The Firm’s Decisions in Perfect Competition
A. A perfectly competitive firm faces two constraints
1. A market constraint summarized by the market price and
the firm’s revenue curves,
2. And a technology constraint summarized by firm’s
product curves and cost curves (from Chapter 10).
3. The perfectly competitive firm makes two decisions in
the short run and two in the long run:
a) In the short run, each firm has a given plant and
the number of firms in the industry is fixed. A
firm’s short-run decisions are:
i) Whether to produce or to shut down.
ii) If the decision is to produce, what quantity to
produce.
b) In the long run, firms can enter or exit the
industry and change their plant size. A firm’s
long-run decisions are:
i) Whether to increase or decrease its plant size.
ii) Whether to stay in the industry or leave it.
B. Profit-Maximizing Output
1. A perfectly competitive firm chooses the output that
maximizes its economic profit. One way to find the
profit maximizing output is to use the total revenue
and total cost curves.
a) Figure 11.2 (page 237) shows the total revenue and
cost curves, as well as the profit for each level
of output for the sweater making firm.
b) At low and high outputs, the firm incurs an
economic loss—total cost exceeds total revenue.
2. At two output levels, total revenue equals total cost.
Such an output is called a break-even point. The
entrepreneur earns normal profit.
3. The output at which total revenues exceed total cost
by the largest amount is the profit-maximizing level
of output.
C. Marginal Analysis
1. The firm can use marginal analysis to determine the
profit-maximizing output.
2. Profit is maximized by producing the output at which
marginal revenue, MR, equals marginal cost, MC. That
is MR = MC.
3. Figure 11.3 (page 238) shows the level of output where
MR = MC for the sweater making firm. Because MR is
constant and MC increases as output increases.
a)
If MR > MC, economic profit increases if output
increases.
b) If MR < MC, economic profit decreases if output
increases.
c) If. MR = MC, economic profit decreases if output
changes in either direction, so economic profit is
maximized.
D. Profits and Losses in the Short Run
1. Maximum profit is not always a positive economic
profit. To determine whether a firm is earning an
economic profit or incurring an economic loss, we
compare the firm’s average total cost, ATC, at the
profit maximizing output with the market price.
2. Figure 11.4 (page 239) shows the three possible profit
outcomes.
a) If the price exceeds ATC, the firm earns a positive
economic profit.
b) If the price equals ATC, the firm earns zero
economic profit (normal profit).
c) If the price is less than ATC, the firm incurs an
economic loss—economic profit is negative.
E. The Firm’s Short-Run Supply Curve
1. A perfectly competitive firm’s short run supply curve
shows how the firm’s profit-maximizing output varies
as the market price varies, other things remaining the
same. Figure 11.5 (page 240) shows how to derive a
firm’s short-run supply curve.
2. Because the firm produces the output at which marginal
cost equals marginal revenue, and because marginal
revenue equals price, the firm’s supply curve is
linked to its marginal cost curve.
3. Temporary Plant Shutdown
a) If price is less than the minimum average variable
cost, the firm will shut down temporarily and incur
a loss equal to total fixed cost. This loss is the
largest that the firm must bear. If the firm were
to produce just 1 unit of output at price below
average variable cost, it would incur an additional
(and avoidable) loss.
b) The shutdown point is the output and price at which
the firm just covers its total variable cost. This
point is where average variable cost is at its
minimum. It is also the point at which the marginal
cost curve crosses the average variable cost curve.
At the shutdown point, the firm is indifferent
between producing and shutting down temporarily. It
incurs a loss equal to total fixed cost from either
action.
c) If the price exceeds minimum average variable cost,
the firm produces the quantity at which marginal
cost equals price. Price exceeds average variable
cost, and the firm covers all its variable cost and
at least part of its fixed cost.
4. The Short-Run Supply Curve
a) The firm’s short-run supply curve is the same as
its marginal cost curve at prices that equal or
exceed minimum average variable cost.
b) The firm’s quantity supplied is zero at prices
below minimum average variable cost. The supply
curve has a break at the price equal to minimum
average variable cost.
c) The firm will not produce quantities between zero
and the shutdown quantity.
F. Short-Run Industry Supply Curve
1. The short-run industry supply curve shows how the quantity
supplied by the industry at each price when the plant
size of each firm and the number of firms remain
constant.
2. Figure 11.6 (page 241) shows an industry supply curve.
a) The quantity supplied by the industry at any given
price is the sum of the quantities supplied by all
the firms in the industry at that price.
b) At a price equal to minimum average variable cost—
the shutdown price—the industry supply curve is
perfectly elastic because some firms will produce
the shutdown quantity and others will produces
zero.
III. Output, Price, and Profit in Perfect Competition
A. Short-run industry supply and industry demand determine
the market price and output.
B. Short-Run Equilibrium
1. Figure 11.7a (page 242) shows a short-run equilibrium
at the intersection of the demand and supply curves.
2. Figure 11.7b (page 242) shows how changes in demand
change the short-run equilibrium.
a) If demand increases, the demand curve shifts
rightward, the price rises, and firm’s increase
production along their supply curves.
b) If demand decreases, the demand curve shifts
leftward, the price falls, and firms decrease
production along their supply curves.
C. A Change in Demand
1. In short-run equilibrium, a firm may earn an economic
profit, earn normal profit, or incur an economic loss
and which of these states exists determines the
further decisions the firm makes in the long run. In
the long run, the firm may:
a) Enter or exit an industry
b) Change its plant size
D. Long-Run Adjustments
1. New firms enter an industry in which existing firms
earn an economic profit.
2. Firms exit an industry in which they incur an economic
loss.
3. Figure 11.8 (page 243) shows the effects of entry and
exit.
a) As new firms enter an industry, industry supply
increases. The industry supply curve shifts
rightward. The price falls, the quantity increases,
and the economic profit of each firm decreases.
b) As firms exit an industry, industry supply
decreases. The industry supply curve shifts
leftward. The price rises, the quantity decreases,
and the economic loss of each firm decreases.
4. Entry and exit stop when economic profit or economic
loss has been eliminated and the firms in the industry
earn normal profit.
E. Changes in Plant Size
1. Figure 11.9 (page 245) shows the effects of changes in
plant size.
2. Firms change their plant size whenever doing so is
profitable. If average total cost exceeds the minimum
long-run average cost, firms change their plant size
to lower costs and increase profits.
F. Long-Run Equilibrium
1. Long-run equilibrium occurs in a competitive industry
when:
a) Economic profit is zero, so firms neither enter nor
exit the industry.
b) Long-run average cost is at its minimum, so firms
don’t change their plant size.
III. Changing Tastes and Advancing Technology
A. A Permanent Change in Demand
1. Figure 11.10 (page 247) shows the effects of a
permanent decrease in demand on an industry and on a
firm in the industry.
a) A decrease in demand shifts the demand curve
leftward. The price falls and the quantity
decreases.
b) Starting from a position of long-run equilibrium,
the fall in price puts the price below each firm’s
minimum average total cost and firms incur an
economic loss.
c) Economic losses induce exit, which decreases shortrun supply and shifts the short-run industry supply
curve leftward.
d) As industry supply decreases, the price rises and
the market quantity continues to decrease.
e) With a rising price, each firm that remains in the
industry increases production in a movement along
the firm’s marginal cost curve (short-run supply
curve).
f) A new long-run equilibrium occurs when the price
has risen to equal minimum average total cost so
that firms do not incur economic losses, and firms
no longer leave the industry.
g) The main difference between the initial and new
long-run equilibrium is the number of firms in the
industry. In the new equilibrium, a smaller number
of firms produce the equilibrium quantity.
2. A permanent increase in demand has the opposite
effects to those just described and shown in Figure
11.9.
a) An increase in demand shifts the demand curve
rightward. The price rises and the quantity
increases.
b) Starting from a position of long-run equilibrium,
the rise in price puts the price above each firm’s
minimum average total cost and firms earn an
economic profit.
c) Economic profit induces entry, which increases
short-run supply and shifts the short-run industry
supply curve rightward.
d) As industry supply increases, the price falls and
the market quantity continues to increase.
e) With a falling price, each firm decreases
production in a movement along the firm’s marginal
cost curve (short-run supply curve).
f) A new long-run equilibrium occurs when the price
has fallen to equal minimum average total cost so
that firms do not earn economic profits, and firms
no longer enter the industry.
g) The main difference between the initial and new
long-run equilibrium is the number of firms in the
industry. In the new equilibrium, a larger number
of firms produce the equilibrium quantity.
B. External Economics and Diseconomies
The change in the long-run equilibrium price following a
permanent change in demand depends on external economies
and external diseconomies.
1. External economies are factors beyond the control of an
individual firm that lower the firm’s costs as the
industry output increases.
2. External diseconomies are factors beyond the control of a
firm that raise the firm’s costs as industry output
increases.
3. In the absence of external economies or external
diseconomies, a firm’s costs remain constant as
industry output changes.
4. Figure 11.11 (page 248) illustrates the three possible
cases and shows the long-run industry supply curve, which
shows how the quantity supplied by an industry varies
as the market price varies after all the possible
adjustments have been made, including changes in plant
size and the number of firms in the industry.
a) Figure 11.11a shows that in the absence of external
economies or external diseconomies, the price
remains constant when demand increases.
b) Figure 11.11b shows that when external diseconomies
are present, the price rises when demand increases.
c) Figure 11.11c shows that when external economies
are present, the price falls when demand increases.
C. Technological Change
New technologies are constantly discovered that lower
costs.
1. A new technology enables firms to producer at a lower
average cost and lower marginal cost—firms’ cost
curves shift downward.
2. Firms that adopt the new technology earn an economic
profit.
3. New-technology firms enter and old-technology firms
either exit or adopt the new technology.
4. Industry supply increases and the industry supply
curve shifts rightward. The price falls and the
quantity increases.
5. Eventually, a new long-run equilibrium emerges in
which all the firms use the new technology, the price
has fallen to the minimum average total cost, and each
firm earns normal profit.
6. The adjustment process as old-technology firms exit or
adopt the new technology and new-technology firms
enter can create great changes in local geographic
prosperity. Some regions experience economic decline
while others experience economic growth.
V. Competition and Efficiency
A. Efficient Use of Resources
1. Resources are used efficiently when no one can be made
better off without making someone else worse off.
2. This situation arises when marginal benefit equals
marginal cost.
B. Choices, Equilibrium, and Efficiency
1. We can describe an efficient use of resources in terms
of the choices of consumers and firms coordinated in
market equilibrium.
2. Choices
a) We derive a consumer’s demand curve by finding how
the best (most valued by the consumer) budget
allocation changes as the price of a good changes.
So consumers get the most value out of their
resources at all points along their demand curves,
which are also their marginal benefit curves.
b) Competitive firms produce the quantity that
maximizes profit. The supply curves are derived
from the profit maximizing quantities at each
price. So firms get the most value out of their
resources at all points along their supply curves,
which are also their marginal cost curves.
3. Equilibrium
a) In competitive equilibrium, the quantity demanded
equals the quantity supplied, so marginal benefit
equals marginal cost. All gains from trade have
been realized.
b) Gains from trade are the sum of consumer surplus
(the area under the demand curve but above the
price) plus producer surplus (the area under price
but above the supply curve).
4. Efficiency
a) Figure 11.12 (page 251) shows an efficient outcome
in a perfectly competitive industry.
b) Competitive equilibrium is efficient only if there
are no external benefits or costs.
i) External benefits are benefits that accrue to people
other than the buyer of a good.
ii) External costs are costs that are borne not by the
producer of a good or service but by someone
else.
C. Efficiency of Perfect Competition
Three main obstacles preventing society from achieving
efficiency in resource allocation are:
1. Monopoly, which restricts output below the competitive
level and raise the price (and economic profits) above
the competitive equilibrium level.
2. Public goods, where everyone benefits but no one would
willingly pay so that a competitive market would
produce a quantity below the efficient level.
3. External costs or benefits, where: i) external
benefits not valued by the market results in an
equilibrium output below the efficient level, or ii)
external costs not borne by the market results in an
equilibrium output above the efficient level.
ice that makes zero economic profit.