The Model of Perfect
Competition
Microeconomics - Dr. D. Foster
Perfect Competition - An Ideal
Firms are primarily distinguished from each other by
the degree of competition they face:
Perfect
Competition
Monopolistic
Competition
Oligopoly
Profit maximization.
The Model of Perfect Competition.
Allocative and Productive efficiencies.
Long-run costs and adjustments
Monopoly
Profit Maximizing Rule
No matter what kind of firm we are
talking about, they will max. profit when:
Marginal Revenue = Marginal Cost
(MR)
(MC)
If MR > MC, you are foregoing profit.
If MR < MC, you are foregoing profit.
Perfect Competition
All goods are identical.
--One cannot be (usefully) distinguished from another.
Many buyers and sellers.
--No one can affect price through their actions.
There are no barriers to entry/exit.
--Firms cannot earn economic profit in the long run.
Buyers & sellers have perfect information.
--A single price will prevail in the market.
Perfect Competition
Market price = price to the firm = MR
(This is the “demand” for the firm’s output & is perfectly elastic.)
P
$
S
MC
Pe = MR = d
Pe
D
Qe
Q
The Market
q
q1 q* q2 A Firm
Perfect Competition
How can we tell if a firm
makes a profit?
Calculate:
Total Revenue = P•q*
& Total Cost = ATC •q*
$
MC
ATC
Pe
MR = d
Econ Profit = TR - TC
q
q*
A Firm
Scenario #1 - Positive Profit
The ATC must be less than the price,
so that calculated profit is positive.
$
What will
happen in this
industry in the
long run?
MC
ATC
Pe
MR = d
q
q*
A Firm
Scenario #2 - Zero Econ Profit
The ATC must be equal to the price, so
that calculated profit is zero.
$
MC
ATC
What will
happen in this
industry in the
long run?
Pe
MR = d
q
q*
A Firm
Scenario #3 - Negative Profit I
The ATC must be more than the price,
so that calculated profit is negative.
Will this firm stay
in business in the
short run?
It depends . . .
$
MC
Pe
What will
happen in this
industry in the
long run?
ATC
AVC
MR = d
q
q*
A Firm
Scenario #3 - Negative Profit II:
The Shutdown Point
The firm will shut down, right away, if the
Price (MR) is less than the AVC…
or, if the total loss > fixed costs
What will
happen in this
industry in the
long run?
Do worksheet
on perfect
competition.
$
ATC
AVC
MC
Fixed Costs
Pe
MR = d
q
q*
A Firm
Perfect Competition
& Efficiency
Allocative Efficiency (What to produce?)
occurs when Price = Marginal Cost
Why ?
Productive Efficiency (How to produce?)
occurs where output level is at the
minimum ATC
Why ?
Perfect Competition
& Efficiency
Perfectly competitive
firms always charge a
price = MC. Why?
$
MC
ATC
Pe
In the LR, perfectly
competitive firms produce
at min. ATC. Why?
MR = d
q*
q
Perfectly competitive firms are always Allocatively Efficient
In the LR, perfectly competitive firms are Productively Efficient
Perfect Competition in LR
We know that in SR, firms can earn a positive,
or negative, economic profit.
What happens in the long run?
P
P
S
If econ profits
are positive,
S*
S*
S
entry occurs
Pe
If econ profits
are negative,
exit occurs
D
Qe
The Market
Q
Pe
D
Qe
The Market
Q
Perfect Competition in LR
If a firm earns positive economic profit, in the
long run that will be dissipated as firms enter.
P
$
S
S*
MC
ATC
MR = d
MR* = d*
Pe
Pe*
Pe
D
Qe
The Market
Q
q
q*q*
A Firm
In the LR,
this firm
earns 0
econ profit.
Perfect Competition in LR
If a firm earns negative economic profit, in the
long run that will be eliminated as firms exit.
P
S*
$
S
MC
MR* = d*
Pe*
Pe
Pe
ATC
MR = d
D
Qe
The Market
Q
q
q q*
A Firm
In the LR,
this firm
earns 0
econ profit.
Perfect Competition in LR
If the market is in equilibrium . . . econ profits = 0.
If demand increases (e.g., incomes rise), what
happens in SR and LR in this market?
P
S
S1
Pe
P
S
S2
S3
LRS1
LRS2
Pe
D*
D
Qe
The Market
D
Q
Qe
The Market
D*
LRS3
Q
The Paradox of Taxing
Economic Profit
In the short run, there are no consequences!
P
$
S
MC
P*
ATC
MR* = d*
Pe
Pe = MR = d
D*
D
Q
Qe Q*
The Market
q
q q*
A Firm
The Paradox of Taxing
Economic Profit
In the short run, there are no consequences!
But, what about the long run?
Firms no longer earn an economic profit.
No firms will enter into this market.
The price will not fall; the output will not rise.
Long Run Costs
$
A Firm
ATC1 ATC
2
LRAC
q
q*
Economies
of scale
ATC3
Diseconomies
of scale
Long Run Costs
Special Case - The Flat Bottomed LRAC
A Firm
$
LRAC
q1
q2
Constant Returns
to scale
q
Firms of varying
size survive
together; q1 is
the “minimum
efficient scale.”
The Model of Perfect
Competition
Microeconomics - Dr. D. Foster