Chapter 8
Perfect Competition
© 2006 Thomson/South-Western
1
Terminology
An industry consists of all firms that supply
output to a particular market, interchangeable
with market
Many of the firm’s decisions depend on the
structure of the market in which it operates
Market structure describes the important
features of a market
2
Market Structure
 Number of suppliers
 Product’s degree of uniformity
Do firms in the market supply identical products or
are there differences across firms?
 Ease of entry into the market
Can new firms enter easily or are they blocked by
natural or artificial barriers?
 Forms of competition among firms
Do firms compete only through prices or are
advertising and product differences common as
well?
3
Perfectly Competitive Market Structure
Many buyers and sellers
Each buys and sells only a tiny fraction of the
total amount exchanged in the market
Standardized or homogeneous product
Buyers and sellers are fully informed about the
price and availability of all resources and
products
Firms and resources are freely mobile  over
time they can easily enter or leave the industry
4
Perfect Competition
Individual participants have no control over
the price
Price is determined by market supply and
demand  the perfectly competitive firm is a
price taker  it must “take” or accept, the
market price
Firm is free to produce whatever quantity
maximizes profit
5
Exhibit 1: Market Equilibrium and the
Firm’s Demand Curve in Perfect Competition
Market price of wheat of $5 per bushel is determined in the left panel by the intersection
of the market demand curve and the market supply curve. Once the market price is
established, farmer can sell all he or she wants at that market price  price taker
(b) Firm’s Demand
Price per bushel
S
$5
Price per bushel
(a) Market Equilibrium
d
$5
D
0
1,200,000
Bushels of
wheat per day
0
5
10
Bushels of
15 wheat per day
6
Total Revenue Minus Total Cost
The firm maximizes economic profit by finding
the rate of output at which total revenue
exceeds total cost by the greatest amount
Total revenue is simply output times the price
per unit
Exhibits 2 and 3 provide us with the needed
information
7
Exhibit 2: Short-Run Costs and Revenues
(1)
(2)
(3) = (1)  (2)
(4)
Bushels of Marginal
Wheat
Revenue
Total
Total
per day (Price)
Revenue
Cost
(q)
(p)
(TR = q  p) (TC)
0
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
-$5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
5
$0
5
10
15
20
25
30
35
40
45
50
55
60
65
70
75
80
$15.00
19.75
23.50
26.50
29.00
31.00
32.50
33.75
35.25
37.25
40.00
43.25
48.00
54.50
64.00
77.50
96.00
(5)
(6) = (4) + (1)
(7) = (3) - (4)

Marginal
Average
Economic
Cost
Total Cost
Profit or
MC=TC/  Q ATC = TC / q Loss = TR - TC
-$4.75
3.75
3.00
2.50
2.00
1.50
1.25
1.50
2.00
2.75
3.25
4.75
6.50
9.50
13.50
18.50
$19.75
11.75
8.83
7.25
6.20
5.42
4.82
4.41
4.14
4.00
3.93
4.00
4.19
4.57
5.17
6.00
-$15.00
-14.75
-13.50
-11.50
-9.00
-6.00
-2.50
1.25
4.75
7.75
10.00
11.75
12.00
10.50
6.00
-2.50
-16.00
8
Exhibit 3: Short-Run Profit Maximization
(a) Total Revenue Minus Total Cost
Total dollars
At output less than 7
bushels and greater
than 14 bushels, total
cost exceeds total
revenue  economic
loss measured by the
vertical distance
between the two
curves
Total revenue
exceeds total cost
between 7 and 14
bushels per day 
economic profit is
maximized at the rate
of 12 bushels of wheat
per day
Total revenue
(= $5 × q )
Total cost
$60
Maximum economic
profit = $12
48
15
0
5
7
10
12
15
Bushels of wheat
per day
9
Marginal Revenue Equals Marginal Cost
Marginal revenue, MR, is the change in total
revenue from selling another unit of output
Since the firm in perfect competition is a price
taker, marginal revenue from selling one more
unit is the market price  MR = P
Marginal cost is the change in total cost
resulting from producing another unit of
output
10
Exhibit 2: Short-Run Costs and Revenues
The firm will
increase quantity
supplied as long
as each additional
unit adds more to
total revenue that
to total cost – as
long as MR
exceeds MC
MR exceeds
MC for the first
12 bushels
Profit
maximizer will
limit output to 12
bushels per day
(1)
(2)
(3) = (1)  (2)
(4)
Bushels of Marginal
Wheat
Revenue
Total
Total
per day (Price)
Revenue
Cost
(q)
(p)
(TR = q  p) (TC)
0
1
2
3
4
5
6
7
8
9
10
11
-$5
5
5
5
5
5
5
5
5
5
5
$0
5
10
15
20
25
30
35
40
45
50
55
$15.00
19.75
23.50
26.50
29.00
31.00
32.50
33.75
35.25
37.25
40.00
43.25
12
5
60
48.00
13
14
15
16
5
5
5
5
65
70
75
80
54.50
64.00
77.50
96.00
(5)
(6) = (4) + (1)
Marginal
Average
Cost
Total Cost
MC=TC/ Q ATC = TC / q
-$4.75
3.75
3.00
2.50
2.00
1.50
1.25
1.50
2.00
2.75
3.25

(7) = (3) - (4)
Economic
Profit or
Loss = TR - TC
$19.75
11.75
8.83
7.25
6.20
5.42
4.82
4.41
4.14
4.00
3.93
-$15.00
-14.75
-13.50
-11.50
-9.00
-6.00
-2.50
1.25
4.75
7.75
10.00
11.75
4.75
4.00
12.00
6.50
9.50
13.50
18.50
4.19
4.57
5.17
6.00
10.50
6.00
-2.50
-16.00
11
Exhibit 3b: Short-Run Profit Maximization
(b) Marginal Cost Equals Marginal Revenue
Marginal cost
Dollars per unit
The MC curve intersects
the MR curve at point e,
where output is 12 bushels
per day
At rates of output less than
12 bushels, MR > MC – firm
can increase profit by
expanding output
At higher rates of output
MC > MR – firm can
increase profits by reducing
output
Profit appears in the blue
shaded rectangle and equals
the price of $5 minus the
average cost of $4, or $1 per
bushel
Average total cost
e
$5
d = Marginal revenue
= average revenue
Profit
4
a
0
5
10
12
15
Bushels of wheat
per day
12
Marginal Revenue Equals Marginal Cost
Golden rule of profit maximization:
Generally, a firm will expand output as long as
marginal revenue exceeds marginal cost and
will stop expanding output before marginal
cost exceeds marginal revenue
13
Economic Profit in the Short Run
Because the perfectly competitive firm can sell
any quantity for the same price per unit,
marginal revenue is also average revenue
Average revenue, AR, equals total revenue
divided by quantity  AR = TR / q
Regardless of the rate of output, the following
equality holds along the firm’s demand curve
Market price = marginal revenue = average
revenue
14
Minimizing Short-Run Losses
Sometimes the price that the firm is required to
“take” will be so low that no rate of output will
yield an economic profit
Faced with losses at all rates of output, the firm
has two options
It can continue to produce at a loss, or
Temporarily shut down
It cannot shut down in the short run because by
definition the short run is a period too short to allow
existing firms to leave or new firms to enter
15
Exhibit 4: Minimizing Losses
(1)
(2)
(3) = (1)  (2)
(4)
Bushels of Marginal
Wheat
Revenue
Total
Total
per day (Price)
Revenue
Cost
(q)
(p)
(TR = q  p) (TC)
0
1
2
3
4
5
6
7
8
9
-$3
3
3
3
3
3
3
3
3
10
11
12
13
14
15
16
3
3
3
3
3
3
3
(5)
(7)
Average
Marginal
Average
Variable
Cost
Total Cost
Cost
MC=TC/Q ATC = TC /q AVC = TVC / q
$0
3
6
9
12
15
18
21
24
27
$15.00
19.75
23.50
26.50
29.00
31.00
32.50
33.75
35.25
37.25
-$4.75
3.75
3.00
2.50
2.00
1.50
1.25
1.50
2.00
30
40.00
33
36
39
42
45
48
43.25
48.00
54.50
64.00
77.50
96.00
(6) = (4) + (1)

(8) = (3) - (4)
Economic
Profit or
Loss = TR - TC
$19.75
11.75
8.83
7.25
6.20
5.42
4.82
4.41
4.14
-$4.75
4.25
3.83
3.50
3.20
2.92
2.68
2.53
2.47
-$15.00
-16.75
-17.50
-17.50
-17.00
-16.00
-14.50
-12.75
-11.25
-10.25
2.75
4.00
2.50
-10.00
3.25
4.75
6.50
9.50
13.50
18.50
3.93
4.00
4.19
4.57
5.17
6.00
2.57
2.75
3.04
3.50
4.17
5.06
-10.25
-12.00
-15.50
-22.00
-32.50
-48.00
Marginal revenue exceeds marginal cost for the first 12 bushels of wheat. Because of the lower price, total
revenue is lower at all rates of output and economic profit has disappeared  column (8)
Column (8) indicates that the firm’s loss is minimized at $10 per day when 10 bushels are produced  the
net gain of $5 total cost. Exhibit 5 illustrates this same conclusion graphically
16
Exhibit 5: Minimizing Short-Run Losses
(a) Total Cost and Total Revenue
Total dollars
Total cost
Total revenue
(= $3 × q )
$40
30
Minimum economic
loss = $10
15
0
5
10
15
Bushels of wheat per day
b) Marginal Cost Equals Marginal Revenue
Dollars per bushel
In panel (a), Total revenue is
lower because of the lower price
Total revenue now lies below the
total cost curve at all output rates.
The vertical distance between the
two curves measures the loss at
each rate of output
The vertical distance is
minimized at an output rate of 10
bushels where the loss is $10 per
day
Same result in panel b
Firm will produce rather than
shut down if MR = MC at a rate of
output where price equals or
exceeds average variable cost
At point e, output is 10 bushels
per day and the price of $3 exceeds
the average variable cost of $2.50
 Total economic loss shown by
shaded area
Marginal cost
Average total cost
$4.00
3.00
2.50
0
Average variable cost
Loss
5
e
10
d = Marginal revenue
= average revenue
15
Bushels of wheat per day
17
Shutting Down in the Short Run
As long as the loss that results from producing
is less than the shutdown loss, the firm will
remain open for business in the short run
If the average variable cost of production exceeds
the price of all rates of output, the firm will shut
down
A re-examination of previous exhibit indicates
that if the price of wheat were to fall to $2 per
bushel, average variable cost exceeds $2 at all
rates of output
18
Shutting Down in the Short Run
Shutting down is not the same as going out of
business
In the short run, even a firm that shuts down
keeps its productive capacity intact  that
when demand increases enough, the firm will
resume operation
If market conditions look grim and are not
expected to increase, the firm may decide to
leave the market  a long run decision
19
Exhibit 6: Summary of Short-Run Output Decisions
Marginal cost
Break-even
point
Dollars per unit
At p1, the firm will
shut down rather than
operate because price
is below average
variable cost at all
output rates.
If the price is p3, the
firm will produce q3
to minimize its loss
while at p4, the firm
will produce q4 to
earn just a normal
profit: break-even
point
At p2, the firm is
indifferent: shutdown
point
If the price rises to
p5, the firm will earn a
short-run economic
profit by producing q5
5
p5
4
p4
3
p3
2
p2
p1
d
Average total cost 5
d
Average variable cost 4
d3
1
The short-run supply
curve is the upwardsloping portion of the
marginal cost curve
beginning at point 2.
Shutdown
point
0
q1
d2
d1
q2 q3 q4 q5
Quantity per period
20
Short-Run Firm Supply Curve
As long as the price covers average variable
cost, the firm will supply the quantity resulting
from the intersection of its upward-sloping
marginal cost curve and its marginal revenue,
or demand curve
Thus, that portion of the firm’s marginal cost
curve that intersects and rises above the lowest
point on its average variable cost curve
becomes the short-run firm supply curve
21
Exhibit 7: Aggregating Individual Supply to Form Market
Supply
Price per unit
(a) Firm A
(b) Firm B
SA
(d) Industry, or market, supply
(c) Firm C
SA+ SB+ SC = S
SC
SB
p'
p'
p'
p'
p
p
p
p
0
10
20
0
Quantity per period
10 20
Quantity per period
0
10 20
Quantity per period
0
30
60
Quantity per period
At a price below p, no output is supplied
At a price of p, each firm supplies 10 units: a market supply of 30 units
At a price of p', each firm supplies 20 units: a market supply of 60 units
The short-run industry supply curve is the horizontal sum of all firms’ short-run supply
curves: horizontal summation of the firm level marginal cost curves
22
Exhibit 8: Relationship Between Short-Run Profit
Maximization and Market Equilibrium
(b) Industry, or market
Price per unit
(a) Firm
MC = s
ATC
AVC
$5
4
Profit
d
ΣMC = S
$5
D
0
5
10 12
Bushels of wheat per day
0
1,200,000
Bushels of wheat per day
•If there are 100,000 identical wheat farmers, their individual supply curves are summed horizontally
to yield the market supply curve, panel b, where market price of $5 is determined.
•At this price, each farmer produces 12 bushels per day, as in panel a, for a total quantity supplied of
1,200,000 bushels per day
23
•Each farmer earns an economic profit of $12 per day as shown by the shaded rectangle.
Perfect Competition in Long Run
 Firms have time to enter and exit and to adjust their
scale of their operations: there is no distinction between
fixed and variable cost because all resources under the
firm’s control are variable
 Short-run economic profit will in the long run
encourage new firms to enter the market and may
prompt existing firms to expand the scale of their
operations: the industry supply curve shifts rightward
in the long run, driving down the price
 New firms will continue to enter a profitable industry
and existing firms will continue to increase in size as
long as economic profit is greater than zero
24
Exhibit 9: Long Run Equilibrium for the Firm and the
Industry
(a) Firm
(b) Industry, or market
S
ATC
LRAC
p
e
d
Price per unit
Dollars per unit
MC
p
D
0
q
Quantity per period
0
Q
Quantity per period
In the long run, market supply adjusts as firms enter or leave, or change their size. This process
continues until the market supply intersects the market demand at a price that equals the lowest point
on each firm’s long-run average cost curve, at point e with each firm producing q units. At point e,
25
marginal cost, short-run average total cost and long-run average cost are all equal.
Exhibit 10: Long-Run Adjustment to an Increase in Demand
(b) Industry, or Market
(a) Firm
S
S'
p'
d'
ATC
LRAC
Profit
p
d
Price per unit
Dollars per unit
MC
p'
b
a
c
p
S*
D'
D
0
q
q'
Quantity per period
0
Qa
Qb Qc
Quantity per period
Initial point of equilibrium is a in panel b: individual firm supplies q units and earns a normal profit
Suppose market demand increases from D to D': market price increases in short run to p'
Firms respond by expanding output along the short-run supply curve – quantity supplied increases
to q‘: economic profits attract new firms, market supply curve shifts to S' where it intersects D' at
point c: price returns to initial equilibrium level
Demand curve facing the individual firm shifts back down from d' to d
26
Exhibit 11: Long-Run Adjustment to a Decrease in Demand
(a) Firm
(b) Industry, or Market
S"
ATC
LRAC
e
p
d
Loss
p"
d"
Price per unit
Dollars per unit
MC
g
S
a
p
f
p"
S*
D
D"
0
q"
q
Quantity per period
0
Qg
Qf
Qa Quantity per period
Initial long-run equilibrium shown by point a in the market and e for the firm
Market demand declines from D to D” – market price falls to p” – demand curve facing each firm
drops to d” – firm responds by reducing its output to q” and market output falls to Qf: each firm faces
a loss
In the long run some firms go out of business: market supply will decrease from S to S" – price
increases back to p and the new market equilibrium is shown by point g. Market output has fallen to
27
Q and the remaining firms are just earning a normal profit as demand shifts back to d.
Long-Run Industry Supply Curve
Beginning at an initial long-run
equilibrium point, with demand shifting,
we found two more long-run equilibrium
points
Connecting these long-run equilibrium
points yields the long-run industry supply
curve, labeled S* in both of these exhibits
Shows the relationship between price and
quantity supplied once firms fully adjust
to any short-term economic profit or loss
resulting from a shift in demand
28
Constant-Cost Industry
 Firm’s long-run average cost curve does not shift as
industry output expands
 Resource prices and other production costs remain constant in
the long run as industry output increases or decreases
 Each firm’s per-unit production costs are independent
of the number of firms in the industry: the firm’s longrun average cost curve remains constant in the long
run as firms enter or leave the industry
 The industry uses such a small portion of the resources
available that increasing industry output does not bid up
resource prices
 The long-run supply curve for a constant-cost industry
is horizontal
29
Increasing-Cost Industry
Firms in some industries encounter higher
average costs as industry output expands
in the long run
Firms in these increasing-cost industries
find that expanding output bids up the
prices of some resources or otherwise
increases per-unit production costs: each
firm’s cost curves shift upward
30
Exhibit 12: An Increasing-Cost Industry
(a) Firm
(b) Industry, or Market
S
ATC
pa
a
da
Price per unit
Dollars per unit
MC
p
a
a
D
0
q
Quantity
per period
0
Qa
Quantity
per period
The initial position of equilibrium is shown at point a, where the initial market demand and supply
curves are D and S - the market price is pa and the market quantity Qa – the demand and marginal
revenue curve facing each firm is da – the firm produces q, average total cost is at a minimum: firm
31
earns no economic profit in this long-run equilibrium
Exhibit 12: An Increasing-Cost Industry
(a) Firm
(b) Industry, or Market
S
b
pb
db
ATC
pa
da
a
Price per unit
Dollars per unit
MC
pb
b
D'
p
a
a
D
0
q
0
qb
Quantity per period
Qa
QbQuantity per
period
Increase in market demand is shown by the shift from D to D‘, which intersects the short-run market
supply curve S at point b: short-run equilibrium price pb and market quantity Qb – each firm’s
demand curve shifts from da up to db – b in the left panel where the marginal cost curve intersects the
new demand curve – each firm produces qb: economic profit equal to qb times the difference between
32
the pb and the average total cost at that rate of output
Exhibit 12: An Increasing-Cost Industry
(a) Firm
(b) Industry, or Market
MC'
S
S'
pb
pc
b
ATC'
c
pa
db
ATC
dc
da
a
Price per unit
Dollars per unit
MC
pb
b
pc
c
D'
p
a
a
D
0
q
qb
Quantity
per period
0
Qa
Qb Qc
Quantity
per period
The existence of economic profit attracts new entrants but because this is an increasing-cost industry,
new entrants’ increased demand for resources drives up the costs of production and raises each firm’s
marginal and average cost curves. In the left panel, MC and ATC shift up to MC' and ATC'. The
entry of the new firms also shifts the short-run industry supply curve outward from S to S'  decline
33
in the market price from b to c.
Exhibit 12: An Increasing-Cost Industry
(a) Firm
(b) Industry, or Market
MC'
S
S'
pb
pc
b
ATC'
c
pa
db
ATC
dc
da
a
Price per unit
Dollars per unit
MC
pb
b
S*
pc
c
D'
p
a
a
D
0
q
qb
Quantity
per period
0
Qa
Qb Qc
Quantity
per period
A combination of a higher production cost and a lower price squeezes economic profit to zero: S'.
Market price does not fall back to initial equilibrium level because each firm’s ATC shifted up with the
expansion of industry output. New long-run market equilibrium occurs at point c, and when points a
34
and c are connected, we get the upward sloping long-run market supply curve shown as S*
Perfect Competition and Efficiency
There are two concepts of efficiency used
to judge market performance
Productive efficiency refers to producing
output at the least possible cost
Allocative efficiency refers to producing the
output that consumers value the most
Perfect competition guarantees both
allocative and productive efficiency in the
long run
35
Productive Efficiency: Making Stuff Right
Productive efficiency occurs when the firm
produces at the minimum point on its long-run
average-cost curve  the market price equals
the minimum average total cost
The entry and exit of firms and any adjustment
in the scale of each firm ensure that each firm
produces at the minimum point on its long-run
average cost curve
36
Allocative Efficiency: Making the Right Stuff
Occurs when firms produce the output that is
most valued by consumers
The demand curve reflects the marginal value
that consumers attach to each unit
 the
market price is the amount of money that people
are willing and able to pay for the final unit they
consume
In both the short run and the long run, the
equilibrium price in perfect competition equals
the marginal cost of supplying the last unit sold
37
Allocative Efficiency
 Marginal cost measures the opportunity cost of all
resources employed by the firm to produce the last
unit sold
 Supply and demand curves intersect at the
combination of price and quantity at which the
marginal value, benefit that consumers attach to
the final unit purchased, just equals the
opportunity cost of the resources employed to
produce that unit
 There is no way to reallocate resources to increase
the total utility consumers reap from production
38
What’s So Perfect About Perfect Competition?
Market exchange benefits both consumers and
producers
Recall that consumers garner a surplus from market
exchange because the maximum amount they would be
willing to pay for each unit of the good exceeds the
amount they in fact pay
39
Exhibit 13: Consumer Surplus and Producer Surplus
Consumer surplus is the
area below the demand
curve but above the market
clearing price of $10
Producers also derive a
net surplus from market
exchange because the
amount they receive for
their output exceeds the
minimum amount they
would require to supply the
amount
The short-run market
supply curve is the sum of
that portion of each firm’s
marginal cost curve at or
above the minimum point
on its average variable cost,
point m on the market
supply curve S
Dollars per unit
Consumer
surplus
S
e
$10
Producer
surplus
D
5
m
Quantity per period
0
100,000 120,000
200,000
40
If price increases from
$5 to $6, firms increase
quantity supplied until
marginal cost equals $6:
output increases from
100,000 to 120,000 and
total revenue increases
from $500,000 to $720,000.
In the short run,
producer surplus is total
revenue minus variable
cost of production.
Market clearing price is
$10
Productive and
allocative efficiency in the
short run occurs at point
e.
Dollars per unit
Exhibit 13: Consumer Surplus and Producer Surplus
Consumer
surplus
e
$10
6
5
0
S
Producer
surplus
D
m
100,000 120,000
200,000
Quantity
per period 41
Producer Surplus
Not the same as economic profit
Any price that exceeds average variable cost
will result in a short-run producer surplus,
even though that price could result in a shortrun economic loss
Ignores fixed cost, because fixed cost is
irrelevant to the firm’s short-run production
decision
42