Chapter 9
Perfectly Competitive Markets
Introduction
We have been developing theoretical
foundations for studying markets
We now apply those tools to the study of
perfectly competitive markets
We will later analyze markets that are NOT
perfectly competitive
Perfect Competition:
Assumptions
Characteristics of Competitive Markets
Fragmented (many buyers and sellers)
Undifferentiated (homogeneous) products
Perfect information about prices and product
attributes
Free entry
Equal access to resources
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Perfect Competition:
Implications
Implications for perfectly competitive markets
Buyers and sellers are price takers
The law of one price prevails
Free entry (no impediments to entry; if an activity
is profitable, firms will enter the market)
Economic Profit and
Accounting Profit
Profit is total revenue less total cost.
For economists, the proper cost concept is always
opportunity cost.
This includes any returns that might have been earned in
the best alternative use of resources.
Suppose that I own and operate a burger restaurant.
My accountant tells me that I am earning profits.
But suppose that I could have made more profit with a
pizza restaurant than a burger restaurant.
Then the profits forgone in pizza become a cost of
operating the burger store.
This makes my economic profit negative.
Profit Maximization for a
Competitive Firm
Price is taken as given.
A firm must decide how much to produce.
The solution:
If it is worthwhile producing any positive amount,
the firm should produce up to the point where P =
MC (where MC is increasing).
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Short-run Shut-down?
Assume that all fixed costs are sunk
The restaurant will shut down (produce
positive output) so long as its total revenue
for the period is less than its total variable
costs of production:
TR < TVC
P < AVC
More on Shut-down
Your text gives considerable attention to the
case where fixed costs are not (all) sunk.
The firm will continue to operate if total revenue
exceeds the costs that it bears as a consequence of
remaining open.
This would include variable costs, but also non-sunk
fixed costs.
A firm will shut down if
TR < TVC + NSFC
P < ANSC
A Firm’s Short-run Supply
Curve
Assume that all fixed costs are sunk
The firm’s short-run supply curve is the MC curve
above AVC.
Suppose that some fixed costs are not sunk
The firm’s short-run supply curve is the MC curve
above ANSC.
3
Market Supply
In the short-run, the market supply curve is
the horizontal summation of all firm short-run
supply curves
In the short-run, the number of firms cannot
change
Horizontal summation: At each price, add
quantities supplied across all firms.
Price Determination
Demand and Supply Revisited
We have now derived a market demand curve by
adding up consumer demands and we have
derived a supply curve by adding up firm supply
curves.
Market price and quantity are determined by the
intersection of demand and supply curves.
Price is determined by demand and supply in the
market; at that price firms choose output such that
P = MC, for P above average non-sunk costs.
Diagrams!
I will illustrate firm profit maximization, supply,
and market equilibrium in a series of
diagrams.
I focus on the case where all fixed costs are sunk
(i.e., zero non-sunk fixed costs)
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The Firm in Short-run
Equilibrium
$/unit
MC
AC
AVC
Qi
Short-run Equilibrium
$/unit
MC
AC
AVC
P
Qi
Qi
Short-run Equilibrium
$/unit
MC
AC
AVC
P
Qi
Qi
5
Short-run Equilibrium
$/unit
MC
AC
AVC
P
Qi
Qi
Short-run Equilibrium
$/unit
MC
AC
AVC
P
Qi
Qi
Short-run Equilibrium
$/unit
MC
AC
AVC
P
Qi
Qi
6
Shut-Down?
$/unit
MC
AC
AVC
P
Qi
Qi
Shut-Down
$/unit
MC
AC
AVC
P < AVC
PQ < AVC x Q
TR < VC
AVC
P
Qi
Qi
The Firm in Equilibrium
$/unit
MC
AC
AVC
Supply
Qi
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Calculating Profit
$/unit
MC
AC
AVC
P
Qi
Qi
Total Revenue
$/unit
MC
AC
AVC
P
Qi
Qi
Total Cost
$/unit
MC
AC
AVC
P
AC
Qi
Qi
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Profit
$/unit
MC
AC
AVC
P
Profit (green area)
AC
Qi
Qi
Question
$/unit
MC
AC
AVC
P
The area shown is equal to:
A: Total Revenue
B: Total Cost
Qi
Qi
Question
$/unit
MC
AC
AVC
P
The area shown is equal to:
A: Total Revenue
Qi
Qi
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Question
$/unit
MC
AC
AVC
P
The gray area shown is
equal to:
A: Profit
B: Total Cost
Qi
Qi
Question
$/unit
MC
AC
AVC
P
The gray area shown is
equal to:
B: Total Cost
Qi
Qi
Question
$/unit
MC
AC
AVC
P
The gray area shown is
equal to:
A: Profit
B: Average Cost
Qi
Qi
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Question
$/unit
MC
AC
AVC
P
The gray area shown is
equal to:
A: Profit
Qi
Qi
Equilibrium
In the short-run, for equilibrium:
Each firm produces an output where price equals
marginal cost
The sum of those outputs is the quantity supplied
in the market
The quantity of output supplied in the market must
equal the quantity demanded
Equilibrium
Market
P
Firm
S
$/unit
MC
AC
P
D
Q
Q
Qi
Qi
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The Long Run
In the long-run, firms can vary all inputs; firms can
also enter or exit the market.
Equilibrium in the long run must satisfy all short-run
equilibrium requirements and one more: firms earn
zero economic profit.
Remember, costs include opportunity costs! Earning a
“normal” profit on invested capital is treated as a cost.
This condition implies that firms operate at the
minimum of their (long-run) average cost curve.
P = AC = MC
Short-run Equilibrium
Market
Firm
P
$/unit
S
MC
AC
P
D
Q
Qi
Q
Qi
Long-run Equilibrium
Market
Firm
$/unit
P
MC
S
AC
P
D
Q
Q
Qi
Qi
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Question
Which statement is true about a short-run
equilibrium in a competitive market?
A: Economic profit is equal to zero
B: Each firm produces a quantity such that P =
SMC.
C: Each firm produces at the minimum point on its
SAC curve.
D: All of the above.
Question
Which statement is true about a short-run
equilibrium in a competitive market?
B: Each firm produces a quantity such that P =
SMC.
Question
Which statement is true about a long-run
equilibrium in a competitive market?
A: Economic profit is equal to zero
B: Each firm produces a quantity such that P =
MC.
C: Each firm produces at the minimum point on its
AC curve.
D: All of the above.
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Question
Which statement is true about a long-run
equilibrium in a competitive market?
A: Economic profit is equal to zero
B: Each firm produces a quantity such that P =
MC.
C: Each firm produces at the minimum point on its
AC curve.
D: All of the above.
Question
Suppose that economic profits are positive in
a short-run equilibrium. Then as the market
goes from short-run to long-run equilibrium:
A: Entry occurs
B: Exit occurs
C: Neither entry nor exit occurs.
Question
Suppose that economic profits are positive in
a short-run equilibrium. Then as the market
goes from short-run to long-run equilibrium:
A: Entry occurs
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Comparative Statics
Illustrate comparative static analysis of
demand and supply shocks:
Show how equilibrium changes in the short- and
long-runs in the market for oranges if it is
discovered that orange juice is an effective cancer
preventative.
Show how equilibrium changes in the short- and
long-runs in the market for oranges if the price of
insecticides used in orange groves increases.
Long-run Market Supply
Long-run supply accounts for entry
Show three cases:
Constant-cost industry
Increasing-cost industry
Decreasing-cost industry
Producer Surplus
In the short-run, producer surplus is the difference
between total revenue and non-sunk fixed costs (if
all fixed costs are sunk, this is just variable cost)
This represents gains from trade for sellers.
It is also the area below the market price and above the
firm supply curve, out to the quantity produced.
This geometric interpretation also holds for the market
supply curve (adding horizontally over individual firm
supply curves)
The difference between profit and producer surplus is fixed
cost in the short-run
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Economic Rent
Consider the case of varying qualities of farm land.
Is it more profitable to enter into dairy farming in Wisconsin
or South Carolina?
In long-run equilibrium, the marginal entrant should expect
to earn zero profit in either location (so long as production
is occurring in both states).
Suppose that the long-run supply curve for milk is upward
sloping.
In the long-run, there are no fixed costs, so is the producer
surplus profit?
No, profits are zero in the long-run. The producer surplus is
rent paid to especially valuable dairy farming land.
Profit, Producer Surplus, Rent
SR
LR
Industry Profit
TR-TC
0
Industry Producer
Surplus
Area between
Supply and
Market Price
TR-TNSC
0
Industry Producer
Surplus
0 for Constant Cost
Industry
Rent for Increasing
Cost Industry.
The End
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