CH 24 - 1
CHAPTER 24
PERFECT COMPETITION
CHAPTER OVERVIEW
The main objective of this chapter is to present the model of
perfect competition. Its characteristics, why the perfectly
competitive firm faces a horizontal demand curve, and its
profit-maximizing rate of output are discussed. The firm's
break-even and shutdown points are analyzed.
An important
objective is the explanation of the economist's concept of zero
economic profits playing a role in determining equilibrium.
Another objective is to derive the firm's short-run supply
curve. Next competitive price determination is presented. Then
constant, increasing, and decreasing cost industries are defined
and related to the long run. The firm's long-run equilibrium
position is analyzed. Finally, there is a discussion of why the
perfectly competitive market structure is economically
efficient.
CHAPTER OBJECTIVES
After studying this chapter students should be able to
1.
Identify the characteristics of a perfectly
competitive market structure.
2.
Discuss the process by which a perfectly
competitive firm decides how much output to
produce.
3.
Understand how the short-run supply curve for a
perfectly competitive firm is determined.
4.
Explain how the equilibrium price is determined
in a perfectly competitive market.
5.
Describe what factors induce firms to enter or
exit a perfectly competitive industry.
6.
Distinguish among constant-, increasing-, and
decreasing-cost industries based on the shape of
the long-run industry supply.
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CHAPTER OUTLINE
I.
II.
CHARACTERISTICS OF A PERFECTLY COMPETITIVE MARKET
STRUCTURE: Perfect competition is a market structure in
which the decisions of buyers and sellers as individuals
have no effect on market price. Each firm is so small that
it cannot significantly affect the price of the product in
question and is a price taker.
A.
There must be a large number of buyers and sellers.
B.
The product sold by the firms in the industry must be
homogeneous.
C.
Any firm can enter or leave the industry without
serious impediments.
D.
Buyers and sellers have equal access to information.
DEMAND CURVE OF THE PERFECT COMPETITOR: Since the
perfectly competitive firm produces a homogeneous
commodity, the individual firm will lose all of its
business if it raises it price. The demand schedule for a
perfectly competitive firm is thus perfectly elastic at the
market supply and market demand determined price. The firm
is a price taker, i.e. it must take price as given because
the firm cannot influence market price.
III. HOW MUCH SHOULD THE PERFECT COMPETITOR PRODUCE?: The firm
has only one decision: how much should it produce?
IV.
A.
Total Revenues: Total revenue is the price per unit
times the total quantity sold. Market price and
average revenue are the same:
(AR) = TR / Q = (P x Q) / Q = P.
B.
Comparing Total Costs with Total Revenues: The firm
will maximize profits where the total revenue curve
exceeds the total cost, the sum of total fixed and
total variable costs, by the greatest amount.
USING MARGINAL ANALYSIS TO DETERMINE THE PROFIT MAXIMIZING
RATE OF PRODUCTION: The use of marginal analysis to
determine the profit-maximizing rate of production is
preferred to comparing total cost and revenue. The results
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are the same, but business decisions are really made on the
margin where marginal benefits and costs are compared.
A.
Marginal Revenue: The change in total revenues
resulting from a change in output (and sale) of one
unit of the product in question. It is computed as
the change in total revenue divided by the change in
output.
B.
When Are Profits Maximized?:
Profit maximization is
always at the rate of output at which marginal revenue
equals marginal cost.
V.
SHORT-RUN PROFITS: Total profits or losses can be computed
as TR-TC or as (P-ATC)XQ at the profit maximizing rate of
output.
VI.
THE SHORT-RUN SHUTDOWN PRICE: In the short-run the firm
will not shutdown as long as the loss from staying in
business is less than the loss from shutting down. The
firm must compare the cost of producing (while incurring
losses) with the cost of closing down. The cost of
continuing to produce in the short-run is given by the
total variable cost. Also, as long as price is greater
than average variable cost (AVC), the firm is better off
continuing to produce since it covers all variable costs
and some fixed costs.
A.
Calculating The Short-Run Break-Even Price: This is
the price at which a firm's total revenues equal it
total costs. At the break-even price, price equals
ATC. The firm is making a normal rate of return on
its capital investment, i.e., it is just covering its
explicit and implicit costs.
B.
Calculating the Short-Run Shutdown Price:
that just covers average variable costs.
The price
VII. THE MEANING OF ZERO ECONOMIC PROFITS: The average total
cost curve includes the full opportunity cost of capital.
Indeed, the average total cost curve includes the
opportunity cost of all factors of production used in the
production process. Economic profits are that part of
accounting profits over and above what are required to stay
in business in the long run. At the short-run break-even
price, economic profits are, by definition, zero.
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Accounting profits at that price are not, however, equal to
zero. They are positive.
A.
The Perfect Competitor's Short-Run Supply Curve:
The individual firm's supply curve is the portion of
its marginal cost curve above the average cost curve.
B.
The Short-Run Industry Supply Curve: The short-run
industry supply curve is the locus of points showing
the minimum prices at which given quantities will be
forthcoming, also called the market supply curve.
C.
Factors that Influence the Industry Supply Curve:
Anything that affects the marginal cost curves of the
firms will influence the industry supply curve. These
are factors that cause the variable costs of
production to change, such as changes in the
individual firm's productivity, or factor costs (wages
paid to labor, price of raw material, etc.). Because
these factors affect the position of the marginal cost
curve for the individual firm, they affect the
position of the industry supply curve. A change in any
of these non-price determinants of supply will shift
the market supply curve.
VIII.
COMPETITIVE PRICE DETERMINATION: The industry demand
curve is a representation of the demand curve for all
potential consumers. The short-run industry supply curve
is the horizontal summation of all the sections of the
marginal cost curves of the individual firms above their
respective minimum average variable cost points. The
intersection of the demand and supply curves determines the
equilibrium or market price. The individual firm demand
curve is set at the going market price.
IX.
THE LONG-RUN INDUSTRY SITUATION: EXIT AND ENTRY:
A.
Exit and Entry of Firms: If firms in an industry are
making economic profits, this will signal owners of
capital elsewhere in the economy that they should
enter this industry. If firms in an industry are
suffering economic losses, the losses signal resource
owners within the industry not to reinvest and if
possible to leave the industry. Profits direct
resources to their highest-valued use. In the long
run, capital and labor will flow to industries where
profitability is highest and will flow out of
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industries where profitability is lowest. In a
competitive long-run equilibrium situation firms will
be making zero economic profits.
B.
X.
1.
Constant-Cost Industries: Industries whose total
output can be increased without an increase in
long-run per-unit costs; an industry whose longrun supply curve is horizontal.
2.
Increasing-Cost Industries: Industries in which
an increase in output is accompanied by an increase in long-run per-unit costs, such that the
long-run industry supply curve slopes upward.
3.
Decreasing Cost Industries: Industries in which
an increase in output leads to a reduction in
long-run per-unit costs, such that the long-run
industry supply curve slopes downward.
LONG-RUN EQUILIBRIUM: Given a price of P and a marginal
cost curve MC, the firm produces output at which economic
profits must be zero in the long-run. The firm's short-run
average cost (SAC) is equal to P at that output which is
produced at minimum SAC. In addition, since the firm is in
long-run equilibrium, any economies of scale must be
exhausted so that it is on the minimum point of the longrun average cost curve. At that point price equals MR
equals MC equals average cost where both short-run and
long-run average costs are at a minimum.
A.
XI.
Long-Run Industry Supply Curves: Market supply curves
that show the relationship between price and
quantities after firms have been allowed the time to
enter into or exit from an industry, depending on
whether there have been positive or negative economic
profits.
Perfect Competition and Minimum Average Total Cost:
Perfect competition results in no "waste" in the
production system. Goods and services are produced
using the least costly combination of resources, i.e.
at minimum short- and long-run average total cost.
COMPETITIVE PRICING EQUALS MARGINAL COST PRICING: Competitive pricing is a system of pricing in which the price
charged for the last unit produced is equal to the opportunity cost to society of producing one more unit of the good
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or service in question as measured by marginal cost. The
competitive solution is economically efficient because it
is impossible to increase the output of any good without
lowering the value of the total output produced in the
economy. There are situations that arise where perfectly
competitive markets cannot efficiently allocate resources.
These situations are instances of market failure.
Externalities and public goods, parks and the military are
examples.
A.
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.
Examples are externalities and public goods.
SELECTED REFERENCES
Cootner, Paul H., ed., The Random Character of Stock Market
Price, Cambridge, MA: M.I.T., Press, 1964.
Knight, Frank H., Risk, Uncertainty, and Profit, New York:
Harper & Row, 1965.
Machlup, Fritz, Economics of Sellers' Competition, Baltimore:
John Hopkins Press, 1952.
Malkeil, Burton C., A Random Walk Down Wall Street, 4th edition,
New York: W.W. Norton and Company, 1985.
Miller, Roger L. and Roger E. Meiners, Intermediate
Microeconomics, New York: McGraw-Hill Book Company, 1986.
Robinson, E.A.G., Structure of Competitive Industry, Chicago:
University of Chicago Press, 1959.
Stigler, George J., "Perfect Competition, Historically
Contemplated," Journal of Political Economy, Vol. LXV, 1957, pp.
1-17.
Whitney, Simon N., Antitrust Policies, New York: The Twentieth
Century Fund, 1958, Chapter 13, Vol. 2.