Chapter 9: Perfect Competition
•Thus far we have examined how the
consumer and firm attempt to optimize their
decisions
•The results of this optimization depend on
the set-up of the economy
•In this course we will examine the extreme
set-ups: Perfect Competition and Monopoly
1
Chapter 9: Perfect Competition
In this chapter we will cover:
9.1 Perfect Competition Characteristics
9.2 Economic and Accounting Profit
9.3 PC Profit Maximization
9.4 PC Short Run Supply and Equilibrium
9.5 PC Long Run Supply and Equilibrium
9.6 PC Costs
9.7 Economic Rent
9.8 Producer Surplus
2
1) Fragmented Industry
-Many buyers and sellers
-No one buyer or seller has an effect on the
industry
-Each firm and consumer is a price taker (uses
market price)
2) Homogeneous products
-All firms produce identical products
-No quality differences, no brand loyalty
3
3) Perfect Information
-Buyers and sellers have full information,
especially regarding prices
4) No barriers to entry or exit
-No input is restricted to potential customers
or firms
-Any firm or customer can enter or exit the
market in the long run
4
As a result, we have:
• Many buyers and sellers
• Buying and selling identical goods
At a given, set price.
Note: although we are examining a market for
outputs (goods and services), a similar analysis
can apply to the market for inputs
5
As seen before,
Accounting Costs = Explicit Costs
Economic Costs = Explicit Costs + Implicit Costs
Furthermore,
Accounting Profit = Revenue – Explicit Costs
Economic Profit = Revenue – Explicit Costs
- Implicit Costs
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Explicit Costs: Costs that involve an exchange of
money
-ie: Rent, Wages, Licence, Materials
Implicit Costs = Opportunity Costs: Costs that
don’t involve an exchange of money; Cost of
giving up the next best opportunity
-ie: Wage that could have been earned
working elsewhere; profitability of a goat if
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used mowing lawns instead of for meat
7.1.3 Economic and Accounting Costs
Economists are interested in studying how firms make
production & pricing decisions. They include all costs.
Economic Costs = Explicit + Implicit Costs
Accountants are responsible for keeping track of the
money that flows into and out of firms. They focus
on explicit costs.
Accounting Costs = Explicit Costs
Note: Different textbooks define costs differently. Refer to these
notes for our class’ definitions.
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Implicit Costs are the BEST ALTERNATIVE return
of ALL of an agent’s input (time, money, etc).
Alternately, an agent’s time could earn a wage
elsewhere.
(ie: Work at Simtech for $3000 a month)
An agent’s money both isn’t used currently and
can be used elsewhere.
(ie: Investing $5,000 @ 10% instead of using it
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to start a business gives an implicit cost of $500)
Profit: Economists vs Accountants
Revenue
Economist’s
View
Accountant’s
View
Economic
Profit
Accounting
Profit
Implicit
Costs
Explicit
Costs
Revenue
Economic
Costs
Explicit
Costs
10
Buck opens his own Bait shop in a store he owns,
which cost $5,000 per month to run, but he makes
$10,000 a month. Buck could have worked for Worms
R Us for $2,000 per month, or rented out the store for
$1,500 per month.
Explicit Costs = $5,000
Accounting Profit = Revenue – Explicit Costs
Accounting Profit = $10,000 - $5,000
Accounting Profit = $5,000
11
Buck opens his own Bait shop in a store he owns,
which cost $5,000 per month to run, but he makes
$10,000 a month. Buck could have worked for Worms
R Us for $2,000 per month, or rented out the store for
$1,500 per month.
Implicit Costs = $2,000 (labour) + $1,500 (capital)
Implicit Costs = $3,500
Econ Profit = Revenue – Explicit Costs – Implicit Costs
Econ Profit = $10,000 - $5,000 - $3,500
12
Econ Profit = $1,500
Sunk Costs are costs that must be incurred no
matter what the decision. These costs are not
considered when making a future decision.
The Talus Dome was built in
2011 for $600,000. That
cost is now SUNK, and
shouldn’t be considered in
any further analysis.
(ie: Keep cleaning it or get Picture Source: City of Edmonton
Webpage (www.edmonton.ca)
rid of it)
Price Source: Edmonton Journal13
While previously we studied cost minimizing, in
reality a firm is more concerned with maximizing
its profits.
Total Revenue: TR(Q)=PQ
Total Cost: TC(Q) as found in previous chapters
ie: TC(Q)=100+2Q
Profit =Total Revenue – Total Cost:
π(Q)=TR(Q)-TC(Q)
14
TC(Q) in general is derived as follows:
Originally:
Tangency Condition:
Production Function:
(2) + (3)
(2) + (4)
(1) + (4) + (5)
TC=wL+rK
(1)
L=f(K)
(2)
Q=f(L,K)
(3)
Q=f(L) and
L=f(Q)
(4)
K=f(Q)
(5)
TC=wf(Q)+rf(Q)
TC=f(Q)
15
For Example:
Originally:
Tangency Condition:
Production Function:
(2) + (3)
(2) + (4)
(1) + (4) + (5)
TC=wL+rK
(1)
L=K
(2)
Q=2(LK)1/2
(3)
Q=2L and
L=Q/2
(4)
K=Q/2
(5)
TC=wQ/2+rQ/2
TC=(w+r)Q/2
16
Definition: Marginal revenue is the change in revenue when
output changes
Marginal revenue is the slope of the total revenue curve.
Since the PC firm is a price taker, the additional revenue
gained from 1 additional output is equal to P.
TR(Q)
MR (Q) 
P
Q
17
As seen previously, marginal cost changes as production
increases.
If for the next unit, MR>MC, that unit should be produced,
as it yields profit.
If for the last unit, MC>MR, that unit should not have been
produced, as it decreases profit.
Therefore profit is maximized where
MC=MR=P
18
Total Cost, Total Revenue, Total Profit ($/yr)
Total revenue = pq
Total Cost
Example: Profit Maximization Condition
Total profit
15
q (units per year)
MC
P, MR
15
6
30
q (units per year)
19
The previous curves are expressed by:
TC(q) = 242q - .9q2 + (.05/3)q3
MC(q) = 242 - 1.8q + .05q2
P = 15
At profit maximizing point: 1) P = MC
But this occurs twice. At one point, profit is
maximized, at another minimized. Therefore, in
order to MAXIMIZE profit:
2) MC must be rising
20
In the paper industry, MC=20+2Q (which is always
rising), where Q=100 reams of paper. Find the costmaximizing quantity if P=30 or P=40
Solution:
P=MC
30=20+2Q
5=Q
P=MC
40=20+2Q
10=Q
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In the short run, the firm either produces or
temporarily shuts down, thus facing costs:
STC(Q)
= SFC + NSFC + TVC(q) when q > 0
= SFC
when q = 0
SFC: Sunk Fixed costs – unavoidable sunk costs
NSFC: Non-sunk Fixed costs – fixed costs that are
avoidable if the firm temporarily shuts down
TVC: Total Variable Costs; depends on output 22
Definition: The firm’s Short run supply curve
tells us how the profit maximizing output changes
as the market price changes.
3 Cases:
Case 1: all fixed costs are sunk
Case 2: all fixed costs are non-sunk
Case 3: some fixed costs are sunk
23
Case 1: all fixed costs are sunk
NSFC=0
STC=TVC(q) + SFC
If the firm chooses to produce a positive
output, P = SMC defines the short run
supply curve of the firm. But…
24
The firm will produce if:
(q) > (0)
Pq – TVC(q) – SFC > -SFC 
Pq – TVC(q) > 0 
P > AVC(q)
Definition: The price below which the firm
would opt to produce zero is called the shut
down price, Ps. In this case, Ps is the
minimum point on the AVC curve.
25
Therefore, the firm’s short run supply function is
defined by:
1. P=SMC, as long as P > Ps
2. 0 where P < Ps
This means that a perfectly competitive firm
may choose to operate in the short run even if
profit is negative.
26
$/yr
Example: Short Run Supply Curve of the Firm, NSFC = 0
SMC
SAC
AVC
Ps
27
Quantity (units/yr)
At prices below SAC but above AVC, profits
are negative if the firm produces…but the firm
loses less by producing than by shutting down
because of sunk costs.
Example:
STC(q) = 100 + 20q + q2
SFC
= 100 (nb: this is sunk)
TVC(q) = 20q + q2
AVC(q) = 20 + q
SMC(q) = 20 + 2q
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a. At the minimum level of the AVC,
AVC = SMC
20 + q = 20 + 2q
q=0
P = SMC = 20 + 2q
P = 20 + 2(0) = 20
b. If the firm produces, then:
P = SMC
P = 20+2q
qs = ½P - 10
29
P
P
10 if P  20
2
0
if P  20
q {
s
SMC
SAC
AVC
Ps = $20
Q
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Case 2: all fixed costs are non-sunk
SFC=0
STC=TVC(Q)+NSFC
If the firm chooses to produce a
positive output,
P = SMC defines the short run supply
curve of the firm. But…
31
The firm will produce if:
(q) > (0)
Pq – TVC(q) - NSFC > 0
P > AVC(q) + AFC(q)
P > SAC(q)
Now, the shut down price, Ps is the
minimum of the SAC curve
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$/yr
Example: Short Run Supply Curve of the Firm, All
Fixed Costs Non-Sunk
SMC
SAC
Ps
AVC
Quantity (units/yr)
33
Case 3: Short Run Supply Curve
(Some costs are sunk):
NSFC≠0, SFC ≠0
Average Nonsunk Cost = Average Variable Cost +
Average Nonsunk Fixed Cost
ANSC=AVC + NSFC/Q
34
The firm will choose to produce a positive
output only if:
(q) > (0)
Pq – TVC – SFC - NSFC > -SFC
Pq – TVC - NSFC > 0
P > AVC + NSFC/Q
P > ANSC (average non-sunk cost)
Definition: The price below which the firm
would opt to produce zero is called the shut
down price, Ps. In this case, Ps is the
minimum point on the ANSC curve,
35
BETWEEN AVC AND SAC.
$/yr
Example: Short Run Supply Curve of the Firm
SMC
SAC
ANSC
AVC
Ps
36
Quantity (units/yr)
If all fixed costs are sunk,
(AVC=ANSC)
Shut down if P<AVC (low)
If all fixed costs are nonsunk,
(ANSC=SAC)
Shut down if P<SAC (high)
If some fixed costs are sunk, some nonsunk,
Shut down if P<ANSC (middle)
37
A firm will produce
If
It can cover its Non-Sunk Costs
38
Thus far we have seen that the individual firm’s
short run supply curve comes from their marginal
cost curve.
Definition: The market supply at any price is the
sum of the quantities each firm supplies at that
price.
The short run market supply curve is the
HORIZONTAL sum of the individual firm supply
curves. (Just as market demand is the
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HORIZONTAL sum of individual demand curves)
Example: From Short Run Firm Supply Curve to Short Run Market Supply Curve
Typical firm:
Individual supply curves
per firm. 1000 firms of each
type
SMC3
SMC2
$/unit
$/unit
Market:
SMC1
Market supply
30
24
22
20
0
300 400 500
q (units/yr)
0
1.2
40
mill
Q (m units/yr)
Definition: A short run perfectly competitive
equilibrium occurs when the market quantity
demanded equals the market quantity supplied.
ni=1 qs(P) = Qd(P)
Qs(P)= Qd(P)
and qs(P) is determined by the firm's
individual profit maximization condition.
41
Example: Short Run Perfectly Competitive Equilibrium
Typical firm:
Market:
$/unit
$/unit
Supply
SMC
SAC
P*
AVC
Demand
Ps
q*
Units/yr
Q*
42
m. units/yr
300 identical firms
Qd(P) = 60 – P
STC(q) = 0.1 + 150q2
SMC(q) = 300q
NSFC = 0
AVC(q) = 150q
43
a. Short Run Equilibrium
Individual Firm:
P = SMC
P = 300q
qs= P/300
Industry:
Qs = 300(qs)
Qs = P (for industry)
44
a. Short Run Equilibrium
Market Price:
Qs(P) = Qd(P)
P = 60 – P
P*= 30
Quantities:
q* = P/300= 30/300
q* = 0.1
Q* = P
Q* = 30
45
b. Do firms make positive profits at the
market equilibrium?
SAC
SAC
SAC
SAC
=
=
=
=
STC/q
0.1/q + 150q
0.1/0.1 + 150(0.1)
16
Therefore, P* > SAC so profits are positive.
46
Comparative Statics in the
Short Run
•As seen in previous chapters, the entry or exit of
firms or consumers, among other things, can shift
the market demand and supply curves
•Shifts in the market demand and supply curves
will shift the equilibrium quantity as seen in
chapters 1 and 2
47
In the short run, capital is fixed and firms may
temporarily operate under an economic profit
or loss.
In the long run, capital can change and firms can
enter and leave the market, resulting in zero
economic profit.
Remember that in the long run, all costs are
nonsunk (they are all avoidable at zero output)
48
Just as in the short run the firm operated at:
P=SMC
In the long run the firm operates at
P=MC
SMC≠MC (in general) since costs are reduced in
the long run.
Only at LR profit maximization is SMC=MC
(because the short run is operating at the LR
49
optimal capital point: Point A next slide)
$/unit
P
In the long run, this firm has an incentive to change
plant size to level K1 from K0:
MC
SMC0 SAC0
A
AC
•
SAC1
SMC1
1.8
6
50
q (000 units/yr)
In the long run, a firms supply curve is
The firm’s LR MC curve above AC.
For if P>AC, Profits>0.
Since Profits = (PxQ)-(ACxQ)
As in the short run, market supply is the
horizontal sum of individual firm supply.
51
$/unit
Long Run Supply Curve:
MC
S
AC
P
SMC1
1.8
6
52
q (000 units/yr)
Long Run Perfectly Competitive Equilibrium
occurs when:
1) Each firm maximizes profit with regards to
output and capital (P=MC)
2) Each firm’s economic profit is zero (as firms
keep entering until the price is pushed down to
zero profits) (P=AC)
3) Market Demand=Market Supply
53
Long Run Perfectly Competitive Equilibrium
Typical Firm
$/unit
Market
$/unit
MC
SAC
Market demand
AC
P*
SMC
q*=50,000
q
Q*=10M.
54
Q
•to increase production, a firm must increase inputs
•Increasing MARKET output could change costs,
therefore changing equilibrium price
•A CONSTANT COST INDUSTRY is an industry
where changes in output do not affect the price of
inputs
•This determines the LR supply curve
55
-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2,
lowering price back to P1
$/unit
$/unit
S1
SMC
S2
SAC
P2
LS
P1
D2
D1
Typical Firm
q
Market
56
Q
•Industry-specific inputs are scarce inputs used
primarily by one industry
-ie:Plutonium is only used in the nuclear industry
•Changes in production will have an impact on
the market for industry-specific inputs
•An INCREASING COST INDUSTRY is an
industry where increases in output increase the
57
price of inputs
-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2,
increasing costs and lowering price to P3 (>P1)
$/unit
$/unit
SMC3
SMC1
SAC3
S1
S2
LS
P2
P3
P1
SAC1
D2
D1
Typical Firm
q
Market
58
Q
•Some industries require a small amount of an
expensive/rare input
-ie: Liquid Nitrogen computer cooling
•An increase in input demand may drive down
input prices by reducing input AC
•A DECREASING COST INDUSTRY is an
industry where increases in output decrease the
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price of inputs
-Demand increases to D2, Price rises to P2
-New firms enter, Supply increases to S2,
decreasing costs and lowering price to P3 (<P1)
$/unit
$/unit
S1
SMC1
SMC3
P2
SAC1
S2
SAC3
P1
LS
P3
D2
D1
Typical Firm
q
Market
60
Q
Although economic profit is possible in
the short run,
In the long run the entry of firms will
push economic profit to zero
This entry could increase, decrease,
or not change the equilibrium price.
61
• In general, we assume that all workers are
identical.
• In reality, some workers are masters; they are
more productive than their peers.
• The cost savings of a master worker is their
ECONOMIC RENT
62
Joe is an amazing worker that works in a button
factory. While most workers can only press
one or two buttons at a time, Joe can press a
dozen.
A normal worker produces buttons at an average
cost of 5 cents, but Joe can make buttons at
an average cost of 1 cent each. If Joe
produced buttons at a cost of 5 cents each,
he’d be hired to produce 900 a day.
63
Economic Rent = Cost Savings
ER = (0.05-0.01)900
ER = $36
The economic rent from a master worker (Joe) is
$36 a day.
64
• If a firm is able to employ a master worker at
a normal worker’s wage, that worker’s
economic rent becomes the firm’s economic
profit
• In a perfectly competitive industry, in all
likelihood a master worker will be stolen by
other firms at higher wages until his wage
matches his productivity
• Master workers therefore often provide no
65
profit in perfect competition
Definition: Producer Surplus is the area above
the supply curve and below the price. It is a
monetary measure of the benefit that producers
derive from producing a good at a particular price.
Note that the producer earns the price for
every unit sold, but only incurs the SMC for
each unit. This is why the difference
between the P and SMC curve measures the
total benefit derived from production.
66
$/yr
Producer Surplus, Individual Firm
SMC
ANSC
P
Producer
Surplus
67
Quantity (units/yr)
Further, since the market supply curve is simply
the sum of the individual supply curves…which
equal the marginal cost curves…the difference
between price and the market supply curve
measures the surplus of all producers in the
market.
Note that producer’s surplus does not deduct
fixed costs, so it does not equal profit!
68
Market Producer Surplus
P
Market Supply Curve
50
Producer Surplus = (1/2)BH
PS=(1/2)800(40)
PS=16,000
10
Q
800
69
Producer surplus is the difference between total
revenue and total nonsunk costs;
Producer Surplus=TR-NSFC-TVC
In the short run, if Producer
Surplus>SFC, economic profit is
possible.
70
In the long run, no costs are fixed,
Therefore Producer Surplus = Economic Profit
BUT
In the long run, Economic Profit=0
How?
71
An industry has an upward sloping supply if it
employs scarce resources (increasing cost
industry – master growers)
Producer Surplus is therefore the economic rent
captured by the master worker or owner of the
input
In the LR PC: Producer Surplus=Economic Rent
72
P
Long Run Producer Surplus =
Economic Rent
LS
50
Economic
Rent
D
10
Q
800
73
Chapter 9 Key Concepts
Perfect competition features:
Many buyers and sellers
Homogeneous products
Perfect Information
No Barriers to Entry
Perfect competition results in a single,
equilibrium price that no one consumer or
firm can influence
Economists include implicit costs in their
economic profits (Accountants do not)
74
Chapter 9 Key Concepts
Total cost (TC) depends on total output
(Q)
Marginal revenue is the change in total
revenue from one additional output (Q)
A firm will produce where MR=MC
MR=P in Perfect Competition
A firm’s supply curve is its MC curve
above its shut-down point
A firm will operate if it can cover its
variable costs
In the SR, this could cause a loss
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Chapter 9 Key Concepts
In the LR, costs can vary with the entry of
firms
This can affect equilibrium price
Skilled workers produce economic rent,
which is often captured by higher wages
Producer Surplus is the area between
price and the supply curve
This is before fixed costs
In the long run, Producer Surplus is
captured by skilled workers
Economics > Accounting
76