CHAPTER 14
Perfectly Competitive Markets:
Short-Run Analysis
Objective
• Analyze the firm’s output decision in a perfectly
competitive market in the short run (sr)
• Analyze the market effects of different policies
Properties of Perfectly Competitive
markets
• Large number of firms
• Large number of buyers
• Free entry and exit
• Homogenous product
• Perfect information
• This implies:
• No market power
• Firms take the market price as given
4
Competitive Markets in the SR
• Short run
• One input – fixed
• Number of firms – fixed
• The firm faces a horizontal demand or price line
• P=MR=AR
• Profit-maximizing quantity?
5
Cost and demand for a competitive firm
Price, Cost
MC
b
ATC
AVC
e
d
p1
p1=MR1=AR1
c
0
q’
q”
q3
Quantity
q’+1
In the short run, the optimal quantity equates the marginal cost to the given price,
provided that this price exceeds the average variable cost.
Shut down or stay in business
What should the firm do if the market price does not cover
its average cost? Shut down?
• Shut down if
Profit if in business <Profit if shut down
TR-VC-FC < 0-FC
TR<VC
The firm should shut down if the revenue is less than the variable
cost of production since fixed costs are sunk costs.
Simplify further and divide both sides by Q:
TR/Q < VC/Q
Therefore, the firm shuts down if
P < AVC
7
The Shut Down Price
Price, Cost
MC
b
p3
e
p1
ATC
Produce q3 at a profit
a
d
Produce q’’ at a loss
Shut down price
p0
p’0
0
AVC
produce nothing
q”
q3
The shut down price is at the min of the AVC curve
Quantity
8
Cost and demand for a competitive firm
Price, Cost
MC
b
p3
e
a
p2
d
p1
ATC
AVC
p3=MR3=AR3
p2=MR2=AR2
p1=MR1=AR1
p0=MR0=AR0
p0
p’0
c
0
q’ q’0 q0 q”
p’0=MR’0=AR’0
q3
Quantity
q’+1
In the short run, the optimal quantity equates the marginal cost to the given price,
provided that this price exceeds the average variable cost. Thus, at a price of p1,
the firm produces a quantity of q” but at a price of p’1 the firm produces nothing
9
A Competitive Firm’s Supply
• Supply function
• How much of a good
• One firm - willing to sell
• Given any market price
• Other factors constant
• Supply function
• Marginal cost curve
• Above - lowest point on AVC curve
10
A short-run supply curve for a competitive
firm Price, Cost
S
P0
Shut down price
0
q0
Quantity
At prices below p0, the firm produces nothing because these prices are less than
the average variable cost. At prices above p0, the supply curve is identical to the
marginal cost curve
11
Competitive Markets in the Short Run
• Market supply function (aggregate supply function)
• How much of a good
• All of firms supply
• Any given market price
• Horizontally add supply curves
• All of firms in the industry
• Aggregate short-run marginal cost
• Supply each unit
12
Market Supply
Price
Price
Price
FIRM 2
FIRM 1
Price
FIRM 3
MARKET SUPPLY
B
p4
p3
A
p’2
p2
p1
0 q11 q12’ q14
Quantity
0
q22’
Quantity
q24 0
q34
Quantity
0
q11
q12’ +q22’ q14+q24+q34
Quantity
The market supply curve is the horizontal sum of the marginal cost curves of all
of the firms in the industry
13
Competitive Markets in the Short Run
• Short-run equilibrium
• Price-quantity combination
• Prevail - perfectly competitive market
• Short run
• (1) Firms – no change (quantity supplied)
• (2) Consumers – no change (quantity demanded)
• (3) Aggregate supply = Aggregate demand
14
Equilibrium
Price
Market
Supply
p1
pe
p2
Market
Demand
0
q2s q1d
qe
q2d q1s
Quantity
The equilibrium price of pe and quantity of qe equate the aggregate supply and
aggregate demand in the market.
15
The SR equilibrium in competitive market
Price
Price
Price
FIRM 1
MC
FIRM 2
ATC
Price
FIRM 3
MC ATC
ATC
π2
π1
S
MC
pe
pe
D
0
q1e
Quantity
0
q2e
Quantity
0
q3e
Quantity
0
qe=q1e+q2e+q3e
Quantity
The short-run equilibrium for a competitive industry is consistent with positive
profits.
16
Policy Analysis in the Short Run
• Comparative static analysis
• Examine market equilibrium
• Before and after policy change
• Effect on market price and quantity
• Compare 2 static equilibria
17
The market for illegal drugs
Price
S2
S1
An increase in the
probability that a drug
dealer will be caught shifts
the supply curve to the
left, from S1 to S2, raises
the equilibrium price from
pa to pb, and lowers the
equilibrium quantity from qa
to qb.
b
pb
pa
a
D
0
qb qa
Quantity
18
The decision about whom to prosecute
Price
S2
A policy of prosecuting
illegal drug dealers
shifts the supply curve
from S1 to S2 and the
equilibrium from point a
to point c.
S1
c
pc
pa
pb
a
b
D2
0
qb qc qa
A policy of
prosecuting illegal drug
users shifts the demand
curve from D1 to D2 and
the equilibrium from
point a to point b.
D1
Quantity
19
The incidence of a tax and elasticity of
(a)
(b)
(c)
demand
Price
Price
Price
D
pa+α
S1
S2
S2
b
α
S2
S1
b
pb
S1
pa
pa
a
pa
d
a
c
D
D
0
qa Quantity 0
When demand is perfectly
inelastic, the incidence of
a tax of α per unit falls
entirely on the consumer
Quantity
When demand is
perfectly elastic, the
incidence of the tax falls
entirely on the producer
0
qb qa
Quantity
When elasticity is
intermediate between 0 and
-∞, the incidence of the tax
falls partly on the consumer
and partly on the producer
20
The labor market and the minimum wage
Price
S1
The establishment of a
minimum wage of wmin
raises the equilibrium wage
paid to employed workers
from wa to wmin and lowers
the number of employed
workers from qa to qmin .
wmin
a
wa
D1
0
qmin
qa
Quantity
21
Government-subsidized wages
Price
S1
A government subsidy of
the wages of teenage
workers shifts the demand
curve for labor from D1 to
D2, raises the equilibrium
wage from wa to wb, and
raises the number of
workers employed from qa
to qb.
wb
wa
D3
D2
D1
0
qa
qb
Quantity
22
Figure 14.11
Wage
• Subsidizing youth employment
S
wv
d
A subsidy leads to higher
wages and more young
employees
a
wmin
wa
c
b
e
D’
D
0
qmin
qa
Labor