Perfect Competition
Section 7
Objectives
• Explain the assumptions of perfect competition.
• Distinguish between the demand curve for the industry and for
the firm in perfect competition.
• Explain how the firm maximizes (short-run) profit in perfect
competition.
• Explain and illustrate short-run profit and loss situations in perfect
competition.
• Explain and illustrate long-run equilibrium in perfect competition.
• Explain and illustrate the movement from short run to long run in
perfect competition.
• Define and illustrate productive efficiency.
• Define and illustrate allocative efficiency.
• Explain and illustrate productive and allocative efficiency in the
short and long run in perfect competition.
Introduction
• As you know, economist build models.
• The models are build to simply explanations of
how things work and to allow us to visualize
possible outcomes of different economic
situations.
• Perfect competition is a model used as a
starting point to explain how firms operate.
• It is theoretical and based on some very
precise assumptions.
Assumptions of perfect competition
• Industry is composed of an extremely large number
of independent firms, each so small, relative to the
size of the industry, that it cannot alter its output
(supply) in order to influence price.
• Individual firms must sell at whatever price is set by
demand and supply in the industry as a whole; the
firm is a price-taker.
• Firms produce homogeneous (identical) products.
• It is not possible to distinguish between goods produced at
different firms.
• There are no brand names and no marketing to attempt to
make goods different from each other.
Assumptions continued…
• Firms are completely free to enter or exit the
industry, there are no barriers to entry or exit.
• Firms already in the industry do not have the ability to
stop new firms from entering the industry.
• There are no costs barriers and no legal barriers.
• They can exit freely as well.
• All producers and consumers have perfect
knowledge of the market.
• The producers are fully aware of market prices, costs
in the industry and workings of the market.
• The consumers are fully aware of prices in the market,
the quality of products and the availability of goods.
Perfect competition is theoretical
• The industry that is closest to perfect
competition is the agricultural industry.
• Textbook example- wheat market
• El Salvador Mango example
The demand curve for the industry and
the firm in Perfect Competition
Industry
P
($)
Firm
P
S
($)
D=MR=AR=P
D
Q
Q
• The firm is a price taker.
• Price is set by the interactions of supply and
demand within the industry
• The firm cannot affect price by changing its
output (it is so relatively small), therefore
attempting to charge a higher price would be
irrational as products are identical from firm to
firm (homogenous) and consumers will simply go
elsewhere (due to perfect information).
Profit Maximization
• Firms maximize profits when they produce at
the level of output where MC=MR.
• The firm takes the price “P” from the industry
and because demand is perfectly elastic,
P=D=AR=MR.
• Profit is maximized where MC=MR, at the level of
output Q1
• It is important to remember that although the
scale of the price indexes are the same for the
industry and firm, this is not true for output.
• The quantity produced is very small in relation to the
total industry output. (hence the small q)
Possible abnormal profits in the
short run in perfect competition
P
($)
The Industry
The Firm
S
MC
P
($)
AC
D=AR=MR
Abnormal profits
D
Q
Q
q
Q
Possible losses in the short run in
perfect competition
P
($)
The Industry
The Firm
S
MC
P
($)
Losses
AC
D=AR=MR
D
Q
Q
q
Q
Short run abnormal profits will not remain
for long in Perfect Competition
P
($)
The Industry
The Firm
S
S1
MC
P
($)
AC
P
Abnormal profits
D=AR=MR
P1
D
Q Q1
Quantity
q1 q
Quantity
Short run losses will not remain
for long in Perfect Competition
P
($)
The Industry
S1
The Firm
S
MC
P
($)
P1
Losses
P
AC
D=AR=MR
D
Q1
Q
Q
q q1
Q
Long Run Equilibrium
in Perfect Competition
P
($)
The Industry
The Firm
S
MC
AC
P
($)
P
D=AR=MR
PC
D
Q
Q
q1
Q
Equilibrium will persist until there is a change in either the industry demand curve or
the costs that the firm faces. If this happens the firm will either make short-run
abnormal profits or losses until the adjustments are made with firms entering or exiting
the market or until long-run equilibrium is restored.
Productive efficiency
• Productive efficiency- If a firm produces its
product at the lowest possible unit cost
(average total cost), it is said to be
productively efficient.
Costs
($)
Productive
efficiency
MC
AC
•At output q the firm is able to produce at the
most efficient level of output (the lowest
average total cost of production).
•MC=ATC [productively efficient level of output]
C
•Productive efficiency means the firm is
combining its resources as efficiently as possible
and resources are not being wasted by
inefficient use.
q
Q (output)
Allocative efficiency
• Allocative efficiency (the socially optimal level of output)
occurs where suppliers are producing the optimal mix of
goods and services required by consumers.
• Price reflects the value that consumers place on a good
and is shown on the demand curve (average revenue)
• Marginal cost reflects the cost to society of all the
resources used in producing an extra unit of a good,
including the normal profit required for a firm to stay in
business.
• Allocative efficiency occurs where marginal cost (the cost
of producing one more unit) is equal to average revenue
(the price received for a unit).
• MC=AR [allocatively efficient (socially optimal) level of
output]
Allocative efficiency
Imperfectly competitive firm
MC
Price ($)
Price ($)
Perfectly competitive firm
MC
D=AR=MR
D=AR
0
q
Output
0
Allocative efficient
level of output:
MC=AR
The cost to
producers
The value to
consumers
q
MR
Output
Allocative efficiency
• Allocative efficiency is important because
when a firm is producing at the allocatively
efficient level of output there is a situation of
“Pareto optimality”
– where it is impossible to make one person better
off without making someone else worse off
Productive and allocative efficiency in
the short run in perfect competition
• Abnormal profits in Perfect competition in the
short run means a lack of productive efficiency
P
($)
The
Industry
The Firm
S
MC
P
($)
AC
Abnormal profits
The firm always produces at
MR=MC (profit maximizing)
MC=AR (allocatively efficiency)
X MC=AC (productively efficiency)
D=AR=MR
D
Q
q
q2
Q
Productive and allocative efficiency in
the short run in perfect competition
• Losses in Perfect competition in the short run
also means a lack of productive efficiency
The firm always produces at
MR=MC (profit maximizing)
P
($)
The Industry
The Firm
S
P
($)
Losses
MC AC
D=AR=
MR
D
Q
q
q2
Q
MC=AR (allocatively efficiency)
X MC=AC (productively efficiency)
Productive and allocative efficiency in
the long run in perfect competition
P
($)
The Industry
The Firm
S
MC
AC
P
($)
Pc
P
D=AR=MR
D
Q
Q
q
Q
q (MR=MC)
q (MC=AC) productively efficient
q (MC=AR) allocatively efficient