PERFECT COMPETITION
ECO 2023
Principles of Microeconomics
Dr. McCaleb
Perfect Competition
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TOPIC OUTLINE
I.
Perfectly Competitive Markets
II. The Short Run
III. The Long Run
IV. Incentive Effects of Profits and Losses
Perfect Competition
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Perfectly Competitive Markets
Perfect Competition
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PERFECTLY COMPETITIVE MARKETS
 Classification of Markets
Four types of market structure
• Perfect competition
• Monopoly
• Monopolistic competition
• Oligopoly
Perfect Competition
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PERFECTLY COMPETITIVE MARKETS
 Characteristics of Perfect Competition
Definition
A market in which there are many sellers, each selling an identical
product, with unrestricted or low-cost long-run entry and exit of
resources.
Key characteristics
• Many buyers and sellers
• Product homogeneity
• Unrestricted entry and exit
Perfect Competition
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PERFECTLY COMPETITIVE MARKETS
 Characteristics of Perfect Competition
Many buyers and sellers
No individual buyer or seller is large enough to affect the market
price.
Each seller can sell whatever quantity it wants at the market price,
but an increase or decrease in the quantity supplied by any one seller
has no effect on the market price.
Sellers in a perfectly competitive market are price takers, not price
makers.
Perfect Competition
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PERFECTLY COMPETITIVE MARKETS
 Characteristics of Perfect Competition
Product homogeneity
All sellers produce and sell identical products. Consumers view each
seller’s product as a perfect substitute for any other seller’s product.
Unrestricted entry and exit
In the long run, there are no barriers to the entry of new resources
into a perfectly competitive market where sellers are earning profits
and no limitations on the exit of resources from a perfectly
competitive market where sellers are incurring losses.
Perfect Competition
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PERFECTLY COMPETITIVE MARKETS
 Demand and Marginal Revenue
Demand
Market demand
The market demand curve is negatively-sloped. Market quantity
demanded is inversely related to market price.
Demand facing an individual seller
Consumers’ demand for the product of any individual seller is
perfectly elastic at the market price. The seller can sell as much or as
little as it wants without affecting the market price.
Perfect Competition
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PERFECTLY COMPETITIVE MARKETS
 Demand and Marginal Revenue
Marginal revenue equals price
When an additional unit is sold, the increase in total revenue equals
the price:
(TRQ)=MR=P
The seller’s marginal revenue curve is the same as the demand curve
facing the seller. The marginal revenue curve, like the demand curve,
is perfectly elastic.
Perfect Competition
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PERFECTLY COMPETITIVE MARKETS
Demand, Price, and Revenue
In part (a), market demand and
market supply determine the price
at which each seller can sell its
output.
Perfect Competition
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PERFECTLY COMPETITIVE MARKETS
Demand, Price, and Revenue
In part (b), the market price
determines the demand facing the
individual seller and its marginal
revenue.
Perfect Competition
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PERFECTLY COMPETITIVE MARKETS
Demand, Price, and Revenue
In part (c), if Dave sells 10 cans
of syrup a day, his total revenue is
$80 a day at point A.
Perfect Competition
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PERFECTLY COMPETITIVE MARKETS
Demand, Price, and Revenue
Dave’s total revenue curve is TR.
The table shows the calculations
of TR and MR.
Perfect Competition
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The Short Run
Perfect Competition
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THE SHORT RUN
 Seller’s Short-Run Equilibrium
What is the objective of a seller in the short run?
Maximize profits or, if profits are not possible, minimize losses.
A seller maximizes profits or minimizes losses by producing and
selling the quantity where marginal revenue equals marginal cost:
Profit maximizing QMR=MC
This is just a variation of the basic economic decision rule: choose
the amount of every activity where MB=MC. The seller’s marginal
revenue is equivalent to marginal benefit.
Perfect Competition
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THE SHORT RUN
Seller’s Short-Run Equilibrium Quantity
Marginal revenue is perfectly elastic at $8 per can.
Perfect Competition
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THE SHORT RUN
Seller’s Short-Run Equilibrium Quantity
Marginal cost decreases at low outputs but then increases.
Perfect Competition
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THE SHORT RUN
Seller’s Short-Run Equilibrium Quantity
Profit is maximized (or losses are minimized) when marginal revenue
equals marginal cost at 10 cans a day.
Perfect Competition
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THE SHORT RUN
Seller’s Short-Run Equilibrium Quantity
If output increases from 9 to 10 cans a day, marginal cost is $7, which is
less than the marginal revenue of $8 and profit increases.
Perfect Competition
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THE SHORT RUN
Seller’s Short-Run Equilibrium Quantity
If output increases from 10 to 11 cans a day, marginal cost is $9, which
exceeds the marginal revenue of $8 and profit decreases.
Perfect Competition
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THE SHORT RUN
 Seller’s Short-Run Equilibrium
Profits or losses?
Marginal revenue and marginal cost tell you the revenue and cost of
the incremental or marginal units of the good only. They do not tell
you the revenue and cost of all units sold.
MR=MC is consistent with either profits or losses. It only identifies
the quantity at which the profits are largest or the losses are smallest.
Perfect Competition
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THE SHORT RUN
 The Shutdown Decision
Why would a seller incurring losses continue to operate
in the short run?
A seller never operates if price is less than average variable cost
because those costs can be avoided by ceasing operations.
Fixed costs, however, are unavoidable. Even if the seller ceases to
operate, it still must pay the fixed costs.
Therefore, a seller continues to operate if price is at least as high as
average variable cost even If it doesn’t earn enough to pay its fixed
costs.
Perfect Competition
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THE SHORT RUN
 Short-Run Supply
Individual seller’s supply
The individual seller’s short-run supply curve shows what happens to
the profit-maximizing or loss-minimizing quantity when the price
increases or decreases.
If P>AVC, the marginal cost curve is the individual seller’s short-run
supply curve. At any P<AVC, the individual seller’s quantity
supplied is zero.
Thus, the segment of the marginal cost curve that lies above the
average variable cost curve is the individual seller’s supply curve.
Perfect Competition
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THE SHORT RUN
Deriving the Seller’s Shortrun Supply Curve
At any price less than $3, P<AVC
and the firm shuts down--Q=0. This
is the shutdown point.
At P=$3, MR also equals $3. The
short-run equilibrium quantity is 7
cans a day.
The combination of P=$3 and Q=7
is shown as point S on the seller’s
short-run supply curve in the lower
diagram.
Perfect Competition
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THE SHORT RUN
Deriving the Seller’s Shortrun Supply Curve
At P=$8, MR is also $8. The
marginal revenue curve is MR1. The
short-run equilibrium quantity is 10
cans a day.
The combination of P=$8 and
Q=10, shown by the black dot in the
lower diagram, is another point on
the seller’s short-run supply curve.
Perfect Competition
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THE SHORT RUN
Deriving the Seller’s Shortrun Supply Curve
At P=$12, MR is also $12, and the
marginal revenue curve is MR2. The
short-run equilibrium quantity is 11.
The combination of P=$12 and
Q=11, shown by the second black
dot in the lower diagram, is another
point on the seller’s short-run
supply curve.
Perfect Competition
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THE SHORT RUN
Deriving the Seller’s Shortrun Supply Curve
Connecting the dots, the blue curve
in the lower diagram is the seller’s
short-run supply curve.
At any P<$3, the seller shuts down
and the short-run equilibrium
quantity is 0.
At any P>$3, the short-run
equilibrium quantity is shown by a
point on the MC curve. The segment
of the MC curve that lies above
AVC is the seller’s short-run supply
curve.
Perfect Competition
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THE SHORT RUN
Deriving the Short-run Market Supply Curve
At the shutdown price of $3, each seller produces either 0 or 7 cans a day.
For example, with 10,000 identical sellers, market quantity supplied is
between 0 and 70,000.
Perfect Competition
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THE SHORT RUN
Deriving the Short-run Market Supply Curve
At a price of $8, each seller produces 10 cans a day. Market quantity
supplied is 100,000 cans a day.
Perfect Competition
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THE SHORT RUN
Deriving the Short-run Market Supply Curve
At a price of $12, each seller produces 11 cans a day. Market quantity
supplied is 110,000 cans a day.
Perfect Competition
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THE SHORT RUN
Deriving the Short-run Market Supply Curve
Market quantity supplied at each price is the sum of the quantities supplied
by the individual sellers at that price. The blue line is the market supply
curve. The market supply curve is perfectly elastic at the shutdown price.
Perfect Competition
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THE SHORT RUN
 Short-run Market Equilibrium
Do sellers in the short-run earn profits, break even, or
incur losses?
Price is revenue per unit of output. Average total cost is cost per unit
of output.
• If P>ATCSellers earn profits
• If P<ATCSellers incur losses
• If P=ATCSellers break even (zero economic profit or a normal
accounting profit)
Perfect Competition
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THE SHORT RUN
Short-run Market Equilibrium: Profit
If market demand is D1, the market equilibrium price is $8 per can, shown
in part (a) where market demand intersects market supply.
Perfect Competition
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THE SHORT RUN
Short-run Market Equilibrium: Profit
When market price is $8, Dave’s marginal revenue is also $8. His optimal
quantity is 10 cans a day, where marginal revenue equals marginal cost.
Perfect Competition
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THE SHORT RUN
Short-run Market Equilibrium: Profit
At the optimal quantity of 10, price ($8) exceeds average total cost
($5.10), so Dave makes an economic profit shown by the blue rectangle.
Perfect Competition
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THE SHORT RUN
Short-run Market Equilibrium: Loss
If market demand is D2, the market equilibrium price is $3 per can, shown
in part (a) where market demand intersects market supply.
Perfect Competition
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THE SHORT RUN
Short-run Market Equilibrium: Loss
When market price is $3, Dave’s marginal revenue is also $3. His optimal
quantity is 7 cans a day, where marginal revenue equals marginal cost.
Perfect Competition
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THE SHORT RUN
Short-run Market Equilibrium: Loss
At the optimal quantity of 7, price ($3) is less than average total cost
($5.14), so Dave incurs an economic loss shown by the red rectangle.
Perfect Competition
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THE LONG RUN
Short-run Market Equilibrium: Breakeven
In part (a), with market demand curve D3 and market supply curve S, the
price is $5 a can.
Perfect Competition
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THE LONG RUN
Short-run Market Equilibrium: Breakeven
When price is $5, Dave’s marginal revenue is also $5, so in part (b) he
produces 9 cans a day, where marginal cost equals marginal revenue.
Perfect Competition
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THE LONG RUN
Short-run Market Equilibrium: Breakeven
At the equilibrium quantity (9), price equals average total cost ($5). Dave
earns zero economic profit or a normal accounting profit.
Perfect Competition
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The Long Run
Perfect Competition
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THE LONG RUN
 Long-Run Equilibrium
Definition
In the long run, sellers choose whether to stay in a market or exit the
market and enter a new market. The long-run decision is market
entry or exit.
A market is in long-run equilibrium when there is no incentive for
new sellers to enter the market and no incentive for existing sellers to
exit the market--the market is neither expanding nor contracting.
Perfect Competition
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THE LONG RUN
 Long-Run Equilibrium
Long-run response to short-run economic profits
If short-run profits are positive,
• new sellers enter the market
• market supply increases
• equilibrium price decreases
• economic profits decrease until they are zero.
Perfect Competition
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THE LONG RUN
 Long-Run Equilibrium
Long-run response to short-run losses
If short-run profits are negative (losses),
• existing sellers exit the market
• market supply decreases
• equilibrium price increases
• economic losses decrease until they are zero.
Perfect Competition
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THE LONG RUN
 Long-Run Equilibrium
Sellers earn zero economic profit in long-run
equilibrium
Only if long-run profits are zero is there no incentive for new sellers
to enter the market and no incentive for existing sellers to exit the
market.
Therefore, a market is in long-run equilibrium only when there are
neither profits nor losses. In long-run equilibrium in a perfectly
competitive market, sellers break even and economic profits are zero.
Perfect Competition
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THE LONG RUN
 Long-Run Equilibrium
Why do sellers continue to operate in the long run if
they earn no profit?
In the long-run equilibrium, sellers in a competitive market earn zero
economic profit (neither a profit nor a loss). Zero economic profit is
the same as a positive but normal accounting profit.
Zero economic profit means sellers earn enough to cover total
opportunity cost, including a return on the owners’ and shareholders’
investment equal to what they could earn in any other business or
activity.
Perfect Competition
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THE LONG RUN
Changes in Equilibrium:
Increase in Demand
In the initial long-run equilibrium,
P=$5 and Q=90,000 cans a day.
Demand increases from D0 to
D1. P increases to $8. At $8,
P>ATC and sellers earn profits.
New sellers enter the market.
Supply increases from S0 to S1.
As supply increases, P decreases
back to $5, where economic profits
(or losses) are zero. Q increases
from 100,000 to 140,000.
Perfect Competition
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THE LONG RUN
Changes in Equilibrium:
Decrease in Demand
In the initial long-run equilibrium,
P=$5 and Q=90,000 cans a day.
Demand decreases from D0 to
D2. P decreases to $3 a can. At
$3, P<ATC and sellers incur losses.
Sellers exit the market, and supply
decreases from S0 to S2.
As supply decreases, P increases
back to $5, where economic profits
(or losses) are zero. Q decreases
from 100,000 to 40,000 cans a day.
Perfect Competition
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THE LONG RUN
 Changes in Equilibrium
Increase in cost
If cost increases, sellers incur short-run losses
• Existing sellers exit the market
• Market supply decreases
• Equilibrium price increases
• Economic losses decrease until they are zero.
Perfect Competition
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THE LONG RUN
 Changes in Equilibrium
Decrease in cost
If cost decreases, sellers earn short-run profits
• New sellers enter the market
• Market supply increases
• Equilibrium price decreases
• Economic profits decrease until they are zero.
Perfect Competition
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