Market Structure and
Perfect Competitive Firm
Hall and Lieberman, 3rd edition,
Thomson South-Western, Chapter 8
Overview
What you will learn from this lecture
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Market structure
3 Requirements for perfect competition
Demand curve for a competitive firm
Supply curve for a competitive firm
How is the profit is maximized? At which
output level?
How is profit or loss is measured using graphs?
Short Run Equilibrium
Long Run Equilibrium
Perfect Competition and Plant Size in the long
run
What happens when things change?
2
Part I Market Structure
Sellers want to sell at the
highest possible price
– Buyers seek lowest possible price
– All trade is voluntary
– different goods and services are
sold in vastly different ways
Economists think about market
structure
– Characteristics of a market that
influence behavior of buyers and
sellers when they come together
to trade
3
Types of Market
For any particular market, we ask
– How many buyers and sellers are there in the
market?
– Is each seller offering a standardized product,
more or less indistinguishable from that
offered by other sellers?
– Are there any barriers to entry or exit, or can
outsiders easily enter and leave this market?
Four basic types of market
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Perfect competition
Monopoly
Monopolistic competition
Oligopoly
4
Part II. The Three Requirements of Perfect
Competition
Large numbers of buyers and sellers
– Each buys or sells only a tiny fraction of the
total quantity in the market
Sellers offer a standardized product
Sellers can easily enter into or exit
from market
– Significant barriers to entry and exit can
completely change the environment in
which trading takes place
Examples?
5
i. A Large Number of Buyers and Sellers
In perfect competition, there
must be many buyers and
sellers
– How many?
Number must be so large that
no individual decision maker can
significantly affect price of the
product by changing quantity it
buys or sells
6
ii. Selling Standardized Products
Buyers do not perceive
significant differences between
products of one seller and
another
– For instance, buyers of wheat do
not prefer one farmer’s wheat over
another
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iii. Easy Entry into and Exit from the Market
Easy Entry
– no significant barriers to discourage
new entrants
– any firm wishing to enter can do
business on the same terms as firms
that are already there
Easy exit
– A firm suffering a long-run loss must
be able to sell off its plant and
equipment and leave the industry for
good, without obstacles
8
iii. Easy Entry into and Exit from the Market
In many markets there are
significant barriers to entry
– Legal barriers
– Existing sellers have an important
advantage that new entrants can not
duplicate
Brand loyalty
– Cost advantage of existing firms from
significant economies of scale
9
Is Perfect Competition Realistic?
Assumptions are rather restrictive
In reality, one or more of assumptions will
be violated in vast majority of markets
– Yet economists use perfect competition
more often than any other market
structure
Why?
– Model of perfect competition is powerful
– Many markets come reasonably close to
be perfect competitive
Perfect competition can approximate
conditions and yield accurate-enough
predictions in a wide variety of markets
10
Even if conditions for perfectly competitive
markets are not satisfied…
Assumptions are close
enough for predictions of
– Firm entry or exit
– Price increase or decrease
– Increase or decrease in
industry quantity
– Increase or decrease in firm
quantity
11
Part III. The Perfectly Competitive Firm
What is occurring in a
competitive market is quite
different from the view we get
when looking at a perfect
competitive firm.
– entirely different picture
In learning about competitive
firm, must also discuss
competitive market in which it
operates
12
Figure 1: The Competitive Industry and Firm
1. The intersection of the market supply
and the market demand curve…
Price per
Ounce
Market
3. The typical firm can sell all it
wants at the market price…
Price per
Ounce
Firm
S
$400
$400
D
Ounces of Gold per Day
2. determine the equilibrium
market price
Demand
Curve Facing
the Firm
Ounces of Gold per Day
4. so it faces a horizontal
demand curve
13
Goals and Constraints
Perfectly competitive firm faces a
cost constraint when producing
any given level of output
– Firm’s production technology
– Prices it must pay for its inputs
Cost function for a perfectly
competitive firm is standard
14
The Demand Curve Facing a
Perfectly Competitive Firm
Demand curve is
price elastic
horizontal, or infinitely
Why?
– Output is standardized
– No matter how much a firm decides to
produce, it cannot make a noticeable
difference in market quantity supplied
So cannot affect market price
– Firm is a price taker
Treats the price of its output as given and
beyond its control
Its only decision is how much output to
produce and sell
15
Cost and Revenue
MR at each quantity is the
same as the market price
– MR = Price
– marginal revenue curve and
demand curve facing firm are
the same
– A horizontal line at the market
price
16
Profit Maximization: The Total Revenue
and Total Cost Approach
Firm’s profit per unit
– ( Revenue per unit ) – ( cost per unit )
profit per unit = P – ATC
Total Profit = TR – TC=Q(P-ATC)
TR and TC approach
– Pick out the output level where there
is biggest difference between TR and
TC
– Most direct way of viewing firm’s
search for the profit-maximizing
output level
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Figure 2a: Profit Maximization: find
greatest TR - TC
Dollars
TR
$2,800
TC
Maximum Profit
per Day = $700
2,100
550
Slope = 400
1
2
3
4
5
6
7
8
9
10
Ounces of Gold per Day
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Profit Maximization: The Marginal Revenue
and Marginal Cost Approach
Profit-maximizing output is
found where MC curve
crosses MR curve from
below
– Or where P =MC
Firm should continue to
increase output as long as
p=MR>MC
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Figure 2b: Profit Maximization
Find MR =MC from below
Dollars
MC
$400
D = MR
1
2
3
4
5
6
7
8
9
10
Ounces of Gold per Day
20
Measuring Total Profit Graphically
How to measure profit or loss?
1. Find the optimal output level Q*
from profit maximization
–
MR =MC or using TR & TC method
2. At Q* , find the ATC, unit cost for
producing that amount of outputs
3. Pointing out the difference
between P and ATC along the
vertical axis
4. The area (P-ATC) X Q* is
–
–
Profit if P>ATC
Loss if P<ATC
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Figure 3a: Measuring Profit if P > ATC
Economic Profit
Dollars
ATC
Profit per Ounce ($100)
MC
d = MR
$400
300
1
2
3
4
5
6
7
8
Ounces of
Gold per Day
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Figure 3b: Measuring Loss if P < ATC
Economic Loss
Dollars
MC
Loss per Ounce ($100)
ATC
$300
200
d = MR
1
2
3
4
5
6
7
8
Ounces of
Gold per Day
23
The Firm’s Short-Run Supply Curve
A competitive firm is a price taker
– Then decides how much output it will
produce at that price
– Whenever the market price is set at a
new level, the best output level will be
determined by firms, using the MR and
MC approach
– Exception
If the firm is suffering a loss large enough to
justify shutting down, it will not produce
along its MC curve
– Zero output produced instead
24
Figure 4: Short-Run Supply Under Perfect
Competition
(a)
(b)
Price per
Dollars
ATC
Bushel
MC
Curve
$3.50
d1=MR1
$3.50
2.50
2.00
d2=MR2
d3=MR3
2.50
2.00
d4=MR4
d5=MR5
1.00
0.50
1.00
0.50
AVC
Bushels
1,000
4,000
7,000 per Year
2,000
5,000
Firm's Supply
2,0004,000
5,000
Bushels
7,000 per Year
25
The Shutdown Price and Supply Curve
Shutdown price is the price at which a
firm is indifferent between producing
and shutting down
Supply curve has two parts
– Whenever P>AVC, supply curve coincides
with MC curve
– Whenever P<AVC, firm will shut down
A vertical line segment at zero units of output
Figure 4: For all prices below $1—the
shutdown price—output is zero and the
supply curve coincides with vertical axis
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The (Short-Run) Market Supply Curve
The shut run market supply curve is
obtained from the aggregation of
individual firm’s supply curve
– summing quantities of output supplied
by all firms in market at each price
As we move along the market supply
curve, we are assuming that two
things are constant
– Fixed inputs of each firm
– Number of firms in market
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Figure 5: Deriving The Market Supply Curve
3.The total supplied by all firms at different
prices is the market supply curve.
1. At each price . . .
Market
Firm
Price per
Bushel
Firm's Supply Curve
Price per
Bushel
$3.50
$3.50
2.50
2.00
2.50
2.00
1.00
0.50
1.00
0.50
2,000 4,000
7,000 Bushels
per Year
5,000
2. the typical firm supplies the
profit-maximizing quantity.
Market Supply
Curve
400,000 700,000 Bushels
per Year
200,000 500,000
28
Figure 6: Perfect Competition
Individual
Demand
Curve
Quantity
Demanded at
Different Prices
Quantity
Supplied at
Different Prices
Added together
Market
Demand
Curve
Individual
Supply
Curve
Added together
Quantity Demanded
by All Consumers at
Different Prices
Quantity Supplied by
All Firms at Different
Prices
Market
Supply
Curve
Market Equilibrium
P
Quantity
Demanded by
Each Consumer
S
D
Q
Quantity Supplied
by Each Firm
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Part IV. Short-Run Equilibrium
In perfect competition, market
sums buying and selling
preferences of individual
consumers and producers, and
determines market price
–Each buyer and seller then takes
market price as given
–Each is able to buy or sell
desired quantity
Competitive firms can earn an economic
profit or suffer an economic loss
– Example: Figure 2
30
Figure 7 Short-run Profit Maximization
10 firms each producing 100 units
Short-run equilibrium conditions met (K fixed)
Firm
Industry
P
S
P
MC
ATC
P0
P0
D
100
q
1000
Q
But firm is making positive economic profit :
Long Run equilibrium?
Incentive for entry or exit?
Firm
Industry
P
MC
P0
S
P
ATC
P0
Profit>0
D
100
q
1000
Q
Part V. Long-run equilibrium conditions
Short-run
Firm: Price = Marginal Cost: Firms
maximize profits
Industry: supply = demand
Long-run
Firm: Price = ATC: Zero economic
profit
No incentive to enter or exit
Profit and Loss in the Long Run
Economic profit and loss are the forces
driving long-run change
– Entry of outsiders if expecting continued
economic profit
– Exit of insiders if expecting losses
In real world entry and exit occur literally
every day
In some cases, we see entry occur
through formation of an entirely new firm
or occur when an existing firm adds a new
product to its line
Exit can occur in different ways
– Selling off its assets and freeing itself once and
for all from all costs
– Switches out of a particular product line, even
as it continues to produce other things
34
Figure 8 Positive Economic Profit Invites Entry in
the Long-run and Causes Industry Supply to Rise
Firm
Industry
P
S
P
MC
S’
ATC
P0
P1
P0
P1
D
90 100
q
1000 1080
Q
Long-run equilibrium
Number of firms rises to12 firms = 1080/90
P = ATC
Firm
Industry
P
S
P
MC
S’
ATC
P0
P1
P0
P1
D
90 100
q
1000 1080
Q
From Short-Run Profit to Long-Run Equilibrium
-- start with profit in the short run
Positive economic profit will attract
new entrants
Increasing number of firms in market
As number of firms increases, market
supply curve will shift rightward causing
several things to happen
1. Market price falls
2. Then demand curve facing each firm
shifts downward
3. Each then slide down its marginal
cost curve, decreasing output
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From Short-Run Profit to Long-Run Equilibrium
-- start with profit in the short run
This process of adjustment continues,
requiring market supply curve to
shift rightward enough, and the price
to fall enough
Until when the reason for entry—
positive profit—no longer exits
– So that each existing firm is
earning zero economic profit
In sum, in a competitive market,
positive economic profit continues to
attract new entrants until economic
profit is reduced to zero
38
Figure 9 : Short-run Profit Maximization
15 firms each producing 80 units
Short-run equilibrium conditions met (K fixed)
Firm
Industry
P
P
MC ATC
S
AVC
P0
P0
D
80
q
1200
Q
Short-run Profit Maximization
15 firms each producing 80 units
Short-run equilibrium conditions met (K fixed)
Firm
Industry
P
P
MC ATC
S
AVC
P0
LOSS
P0
D
80
q
1200
Q
Negative Economic Profit Induces
Exit in the Long-run, Industry Supply Falls
Number of firms falls to 12 firms =
1080/90
Firm
Industry
P
P
S’
MC ATC
S
AVC
P1
P0
P1
P0
D
80 90
q
1080 1200
Q
From Short-Run Profit to Long-Run Equilibrium
-- start with loss in the short run
In a competitive market,
economic losses continue to
cause exit until losses are
reduced to zero
–Raising market price until
typical firm breaks even again
42
Distinguishing Short-Run from Long-Run
Outcomes
In short-run equilibrium, competitive
firms can earn profits or suffer losses
In long-run equilibrium, after entry
or exit has occurred, economic profit
is always zero
When economists look at a market,
they choose the period more
appropriate for question at hand
43
Figure 10a/b: From Short-Run Profit To
Long-Run Equilibrium
Market
Firm
S1
Price per
Bushel
A
$4.50
Dollars
With initial supply
curve S1, market
price is $4.50…
$4.50
So each firm
earns an
economic profit.
MC
A
d
ATC 1
D
900,000
Bushels
per Year
9,000
Bushels
per Year
44
Figure 10c/d: From Short-Run Profit To
Long-Run Equilibrium
Market
Firm
S1
Price per
Bushel
S2
Dollars
MC
A
$4.50
A
d
ATC 1
$4.50
E
E
2.50
d1
2.50
D
900,000 1,200,000Bushels
per Year
Profit attracts entry, shifting
the supply curve rightward…
5,000
9,000
until market price falls to
$2.50 and each firm earns
zero economic profit.
Bushels
per Year
45
Part VI. The Notion of Zero Profit in
Perfect Competition
The same forces—entry and
exit—that cause all firms to earn
zero economic profit also ensure
– in long-run equilibrium, every
competitive firm will select its
plant size and output level so
that it operates at minimum
point of its LRATC curve
46
Perfect Competition and Plant Size
Figure 6 illustrates a firm in a perfectly
competitive market
– Left panel does not show a true long-run
equilibrium
In long-run typical firm will want to expand
by sliding down its LRATC curve and
produce more output at a lower cost per
unit
– potentially earn an economic profit
Same opportunity to earn positive
economic profit will attract new
entrants that will establish larger plants
from the outset
Entry and expansion must continue in this
market until the price falls to P* where each
firm earn zero economic profit
47
Figure 11: Perfect Competition and Plant Size
1. With its current plant and ATC
curve, this firm earns zero
economic profit.
Dollars
3. As all firms increase plant size and
output, market price falls to its lowest
possible level . . .
Dollars
MC1
LRATC
LRATC
ATC1
d1 = MR1
MC2 ATC
P1
2
E
P*
2. The firm could earn
positive profit with a
Output per 4. and all firms earn
q1 larger plant,
q*
Period
producing here.
zero .economic profit
and produce at
minimum LRATC.
d2 = MR2
Output per
Period
48
A Summary of the Competitive Firm in the Long-Run
At each competitive firm in long-run
equilibrium
P = MC = minimum ATC = minimum
LRATC
This equality is satisfied when the typical firm
produces at point E in figure 6
– Where its demand, marginal cost, ATC, and
LRATC curves all intersect
In perfect competition, consumers are getting
the best deal they could possibly get
49
Part IV. What Happens When Things Change?
-- 1. A Change in Demand
Short-run impact of an increase in demand is
– Rise in market price
– Rise in market quantity
– Economic profits
This will cause:
– More entrants and higher market supply
– Market equilibrium will move from point A to
point C
Long-run supply curve
– indicating quantity of output that all sellers in a
market will produce at different prices after all
long-run adjustments have taken place
50
Figure 12a/b: An Increasing-Cost Industry
INITIAL EQUILIBRIUM
Market
Price
per Unit
Firm
Dollars
MC
S1
ATC1
P1
P1
A
A
d1 = MR1
D1
Q1
Output per
Period
q1
Output per
Period
51
Figure 12c/d: An Increasing-Cost Industry
NEW EQUILIBRIUM
Price
per Unit
Market
S1
B
PSR
P1
B
S2
PSR
P2
C
P1
A
MC
dSR = MRSR
C
SLR
P2
Firm
Dollars
A
ATC2
ATC1d = MR
2
2
d1 = MR1
D2
D1
Q1 QSR Q2
Output per
Period
q1 q1 qSR Output per
Period
52
Increasing Cost Industry
This type of industry (which is the
most common) is called an increasing
cost industry
Entry  Increase in demand for inputs
price of those inputs increases
– Shifts up typical firm’s ATC curve
Raises market price at which firms earn
zero economic profit
As a result, long-run supply curve slopes
upward
53
Decreasing and Constant Cost Industries
A constant cost industry -- entry has no
effect on input prices
– Industry might use such a small percentage of
total inputs that there is no noticeable effect on
input prices
– Typical firm’s ATC curve stays put
Market price at which firms earn zero economic
profit does not change
Long-run supply curve is horizontal
Decreasing cost industry -- entry by
new firms actually decreases input
prices
– Causes typical firm’s ATC curve to shift downward
– Lowers market price at which firms earn zero
economic profit
– Long-run supply curve slopes downward
54
Small Summary
Increasing
Cost
Industry
Constant
Cost
Industry
Decreasin
g Cost
Industry
Up
No effect
Down
ATC curve
Shifts up
Stays
Shifts down
Zero profit
market
Price
Up
Not change
Down
Slope
upward
Horizontal
Slope
downward
Entry effect
on input
prices
Long-run
supply
curve
55
Part V. Using the Theory: Changes in Technology
Technological advance that results in increasing
returns to scale will
– Induce some firms to change technologies and
produce more
– lead to a rightward shift of market supply curve,
decreasing market price
– In short-run, early adopters may enjoy
economic profit
– in long-run, more will adopt, economic profit
falls to zero
– Firms that refuse to use the new technology
will not survive
– Some technologies are biased toward large
firms, others toward smaller firms. If
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technologies lower minimum efficient scale,
more firms will enter as industry price falls
Summary
– 3 Requirements for perfect competition
many sellers and buyers
standardized products
free entry and exit
– Demand curve for a competitive firm is perfect
elastic (horizontal line)
MR = P
– Supply curve for a competitive firm is discrete
is MC when P> AVC
is zero when P<AVC
– 2 approaches to maximize profit by choosing
output level
Maximized difference between TR and TC
MR = MC
– Profit can be measured using graphs
– Short run equilibrium: profits or loss
– Long run equilibrium: zero economic profits
P=marginal cost=minimum ATC=minimum LRATC
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