Perfect Competition
14
CHAPTER 14
Perfect Competition
There’s no resting place for an enterprise
in a competitive economy.
— Alfred P. Sloan
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
Perfect Competition
14
Chapter Goals
• Discuss the six conditions for a perfectly competitive market
• Explain why producing an output at which marginal
cost equals price maximizes total profit for a perfect
competitor
• Demonstrate why the marginal cost curve is the supply
curve for a perfectly competitive firm
• Determine the output and profit of a perfect competitor
graphically and numerically
14-2
Perfect Competition
14
Chapter Goals
• Construct a market supply curve by adding together
individual firms’ marginal cost curves
• Explain why perfectly competitive firms make zero
economic profit in the long run
• Explain the adjustment process from short-run
equilibrium to long-run equilibrium
14-3
Perfect Competition
14
A Perfectly Competitive Market
• A perfectly competitive market is a market in which
economic forces operate unimpeded
• For a market to be perfectly competitive, six conditions
must be met:
1. Both buyers and sellers are price takers – a price
taker is a firm or individual who takes the price
determined by market supply and demand as given
2. The number of firms is large – any one firm’s output
compared to the market output is imperceptible and
what one firm does has no influence on other firms
14-4
Perfect Competition
14
A Perfectly Competitive Market
3. There are no barriers to entry – barriers to entry are
social, political, or economic impediments that prevent
firms from entering a market
4. Firms’ products are identical – this requirement means
that each firm’s output is indistinguishable from any
other firm’s output
5. There is complete information – all consumers know all
about the market such as prices, products, and
available technology
6. Selling firms are profit-maximizing entrepreneurial firms
– firms must seek maximum profit and only profit
14-5
Perfect Competition
14
The Definition of Supply and Perfect Competition
• These strong six conditions are seldom met
simultaneously, but are necessary for a perfectly
competitive market to exist
• Supply is a schedule of quantities of goods that will be
offered to the market at various prices
• When a firm operates in a perfectly competitive market,
its supply curve is its short-run marginal cost curve
above average variable cost
14-6
Perfect Competition
14
Demand Curves for the Firm and the Industry
Market demand is
downward sloping
Firm demand is perfectly
elastic (horizontal)
P
P
Market
Supply
P0
Firm
Demand
P = D = MR
P0
Market
Demand
Q
Q1
Q2
Q3
Q
14-7
Perfect Competition
14
Profit Maximizing Level of Output
• The goal of the firm is to maximize profits, the difference
between total revenue and total cost
• A firm maximizes profit when marginal revenue equals
marginal cost
• Marginal revenue (MR) is the change in total revenue
associated with a change in quantity
• Marginal cost (MC) is the change in total cost associated
with a change in quantity
14-8
Perfect Competition
14
Profit Maximizing Level of Output
• The profit-maximizing condition of a competitive firm is:
MR = MC
• For a competitive firm, MR = P
• A firm maximizes total profit, not profit per unit
If MR > MC,
• a firm can increase profit by increasing output
If MR < MC,
• a firm can increase profit by decreasing its output
14-9
Perfect Competition
14
Marginal Cost, Marginal Revenue, and Price Table
Price = MR ($)
Q
35
0
35
1
35
2
35
3
35
4
35
5
35
6
35
7
35
8
35
9
35
10
Marginal Cost ($)
28
20
16
14
12
17
The profit-maximizing condition
of a competitive firm is:
MC = MR = P
If MC < P,
increase production
Profit maximizing
quantity is where MC = P
22
30
40
If MC > P,
decrease production
54
14-10
Perfect Competition
14
Marginal Cost, Marginal Revenue, and Price Graph
Marginal
Cost
P
MC = P
$35
MC > P,
decrease output to
increase total profit
P = D = MR
MC < P,
increase output to
increase total profit
Q
MC = P at 8 units,
total profit is
maximized
14-11
Perfect Competition
14
The Marginal Cost Curve is the Supply Curve
Marginal
Cost
P
$61
=
Firm’s Supply
Curve
Because the marginal cost
curve tells us how much of
a good a firm will supply at
a given price, the
marginal cost curve is the
firm’s supply curve
$35
$19.50
6
8
10
Q
14-12
Perfect Competition
14
Profit Maximization using Total Revenue and Total Cost
• An alternative method to determine the profit-maximizing
level of output is to look at the total and total cost curves
• Total cost is the cumulative sum of the marginal
costs, plus the fixed costs
• Total profit is the difference between total
revenue and total cost curves
14-13
Perfect Competition
14
Total Revenue and Total Cost Table
Q
Total Revenue ($)
Total Cost ($)
Total Profit ($)
0
0
40
-40
1
35
68
-33
2
70
88
-18
3
105
104
1
4
140
118
22
5
175
130
45
6
210
147
63
7
245
169
76
8
280
199
81
9
315
239
76
10
350
293
57
Total profit is
maximized at 8
units of output
14-14
Perfect Competition
14
Total Revenue and Total Cost Table
Total Cost,
Total Revenue
TC
Max profit = $81
at 8 units of
output
TR
The total cost curve is
bowed upward at most
quantities reflecting
increasing marginal cost
$280
$175
$130
Losses
Losses
Profits
3
5
The total revenue curve
is a straight line
8
Q
Profits are maximized
when the vertical
distance between TR
and TC is greatest
14-15
Perfect Competition
14
Determining Profits Graphically: A Firm with Profit
P
Find output where
MC = MR, this is the
profit maximizing Q
MC
MC = MR
P
ATC
Profits
ATC
P = D = MR
AVC
ATC at Qprofit max
Qprofit max
Q
Find profit per unit
where the profit max Q
intersects ATC
Since P>ATC at the
profit maximizing quantity,
this firm is earning profits
14-16
Perfect Competition
14
Determining Profits Graphically:
A Firm with Zero Profit or Losses
P
Find output where
MC = MR, this is the
profit maximizing Q
MC
ATC
Find profit per unit
where the profit max Q
intersects ATC
Since P=ATC at the
profit maximizing quantity,
this firm is earning
zero profit or loss
MC = MR
AVC
P
=ATC
P = D = MR
ATC at Qprofit max
Qprofit max
Q
14-17
Perfect Competition
14
Determining Profits Graphically: A Firm with Losses
P
Find output where
MC = MR, this is the
profit maximizing Q
MC
ATC
ATC at Qprofit max
ATC
P
AVC
P = D = MR
Losses
MC = MR
Qprofit max
Q
Find profit per unit
where the profit max Q
intersects ATC
Since P<ATC at the
profit maximizing quantity,
this firm is earning losses
14-18
Perfect Competition
14
Determining Profits Graphically:
The Shutdown Decision
•
•
•
•
The shutdown point is the
point below which the firm
will be better off if it shuts
down than it will if it stays
in business
If P>min of AVC, then the
firm will still produce, but
earn a loss
If P<min of AVC, the firm
will shut down
If a firm shuts down, it still
has to pay its fixed costs
P
MC
ATC
AVC
PShut
P = D = MR
down
Qprofit max
Q
14-19
Perfect Competition
14
Short-Run Market Supply and Demand
• While the firm’s demand curve is perfectly elastic,
the industry’s demand curve is downward sloping
• The market (industry) supply curve is the horizontal
sum of all the firms’ marginal cost curves
• The market supply curve takes into account any
changes in input prices that might occur
14-20
Perfect Competition
14
Short-Run Market Supply and Demand Graph
P
P
Market
Firm
MC
Market
Supply
ATC
P
P
ATC
P = D = MR
Profits
Market
Demand
Q
Qprofit max
Q
14-21
Perfect Competition
14
Long-Run Competitive Equilibrium
• At long run equilibrium, economic profits are zero
• Profits create incentives for new firms to enter,
market supply will increase, and the price will fall
until zero profits are made
• The existence of losses will cause firms to leave the
industry, market supply will decrease, and the price
will increase until losses are zero
14-22
Perfect Competition
14
Long-Run Competitive Equilibrium
• Zero profit does not mean that the entrepreneur does
not get anything for his efforts
• Normal profit is the amount the owners would have
received in their next best alternative
• Economic profits are profits above normal profits
14-23
Perfect Competition
14
Long-Run Competitive Equilibrium Graph
P
At long-run equilibrium,
economic profits are zero
MC
LRATC
SRAT
C
P = D = MR
Q
14-24
Perfect Competition
14
Market Response to an Increase in Demand Graph
P
P
Market
Firm
MC
S0(SR)
P1
P0
S1(SR)
2
1
2
S(LR)
1
D1
1
2
Q0 Q1 Q2
D0
ATC
P1
P0
SR Profits
1
2
1
2
Q
Q0,2 Q1
Q
14-25
Perfect Competition
14
Long-Run Market Supply
• If the long-run industry supply curve is perfectly
elastic, the market is a constant-cost industry
• If the long-run industry supply curve is upward
sloping, the market is an increasing-cost industry
• If the long-run industry supply curve is downward
sloping, the market is a decreasing-cost industry
• In the short run, the price does more of the adjusting,
and in the long run, more of the adjustment is done
by quantity
14-26
Perfect Competition
14
Application: Kmart
• Although Kmart was making losses, Kmart decided
to keep 300 stores open because P>AVC
• After 2 years of losses, Kmart realized that the
decrease in demand was permanent
• They moved from the short run to the long run and
closed the stores because prices had fallen below
their long-run average costs
14-27
Perfect Competition
14
Chapter Summary
• The necessary conditions for perfect competition are:
1. Buyers and sellers are price takers
2. The number of firms is large
3. There are no barriers to entry
4. Firms’ products are identical
5. There is complete information
6. Sellers are profit-maximizing entrepreneurial firms
14-28
Perfect Competition
14
Chapter Summary
• Competitive firms maximize profit where MR = MC
• Profit is (P – ATC)(Q) at the profit-maximizing level of
output
• Perfectly competitive firms shut down if P < AVC
• The supply curve of a competitive firm is its MC curve
above minimum AVC
• The short-run market supply curve is the horizontal sum
of the MC curves above AVC for all the firms in the
market
14-29
Perfect Competition
14
Chapter Summary
• In the short run, competitive firms can make a profit or
loss. In the long run they make zero profits.
• If there are profits:
• Firms enter the industry
• Supply increases
• Price decreases, eliminating profit
• If there are losses:
• Firms leave the industry
• Supply decreases
• Price increases, eliminating losses
14-30
Perfect Competition
14
Chapter Summary
• The long-run industry supply curve is a schedule of
quantities supplied where firms are making zero profit
• Constant-cost industries have horizontal long-run supply
curves
• Increasing-cost industries have upward sloping long-run
supply curves
• Decreasing-cost industries have downward sloping
supply curves
• The slope of the long-run supply curve depends on what
happens to factor costs when output increases
14-31
Perfect Competition
14
Preview of Chapter 15:
Monopoly
• Summarize how and why the decisions facing a monopolist differ
from the collective decisions of competing firms
•
Explain why MR = MC maximizes total profit for a monopolist
• Determine a monopolist’s price, output, and profit graphically and
numerically
• Show graphically the welfare loss from monopoly
• Explain why a price-discriminating monopolist will earn more profit
than a normal monopolist
• Explain why there would be no monopoly without barriers to entry
• Discuss three normative arguments against monopoly
14-32