Chapter 6 – Production
Behavior: Perfect Competition
This chapter examines perfect
competition as a market structure.
It also develops the profit maximizing
producer’s choice of output under
perfect competition, and the formation
of profits.
Finally, it examines how markets adjust
to firms making excess profits, or
suffering losses in perfect competition.
Perfect Competition:
Key Characteristics
There are a large number of producers
within a market for a certain good.
The goods within a market are
homogeneous – there exist no quality
differences, real or perceived, between
the same good made by different
producers.
Easy entry and exit (no barriers to
entry).
Market Demand and Supply
for Good in General
Consider, for example, eggs.
Market Demand – usual market
demand curve for eggs, discussed in
chapter 4.
Market Supply – usual market supply
curve for eggs, discussed in chapter 5.
Market forms an equilibrium price (P*)
and equilibrium quantity (Q*) of eggs.
Market Demand for the
Individual Producer’s Good
Homogeneous goods  individual
producer’s eggs are perfect
substitutes with other egg
producers’ eggs.
Therefore, the Demand for the
individual producer’s eggs is
described as a horizontal line at
the market equilibrium price P*.
Total Revenue
for the Individual Producer
Perfect Competition: firms are
price takers, they have no power
over setting or changing the price
of their product.
Total Revenue = (P*)(Q), where Q
is the amount they decide to
produce.
Total Cost
for the Individual Producer
Total Cost – the total expenditure the
firm spends due to its use of inputs
(materials, labor, capital) to produce a
certain amount of output.
-- Fixed Cost: the cost to the firm which
remains the same no matter how
much it produces (including zero).
-- Variable Cost: the cost to the firm
which varies based upon how much
it produces
Average and Marginal Cost
Average Cost (AC) – firm’s total
cost per unit of output.
AC = (Total Cost)/Q
Marginal Cost (MC) – the change
in total cost due to a change in
output.
MC = (Total Cost)/Q
An Example: King David’s
Production Function
Output (Lunches)
0
10
25
50
70
86
95
101
104
93
Labor Input (People)
0
1
2
3
4
5
6
7
8
9
Computing Total,
Average, and Marginal Cost
One needs information about fixed
cost, and cost per unit of labor.
For our numerical example,
suppose that:
-- Fixed Cost (materials, machine
and building rental) = $100.
-- Each Person Costs $30.
King David’s Total Cost
Labor Fixed Cost + Wage Cost = Total Cost
0
100
0
100
1
100
30
130
2
100
60
160
3
100
90
190
4
100
120
220
5
100
150
250
6
100
180
280
7
100
210
310
8
100
240
340
9
100
270
370
King David’s Average Cost
(AC) and Marginal Cost (MC)
Output (Q) Total Cost
0
100
10
130
25
160
50
190
70
220
86
250
95
280
101
310
104
340
93
370
AC
-13.0
6.4
3.8
3.1
2.9
2.9
3.1
3.3
4.0
MC
-3.0
2.0
1.2
1.5
1.9
3.3
5.0
10.0
--
Characteristics of Average
Cost and Marginal Cost Curves
Both are u-shaped,
When AC is decreasing,
MC < AC.
When AC is increasing,
MC > AC.
At the minimum point of the AC curve,
MC = AC.
Upward sloping part of MC depicts Law
of Diminishing Returns, “relevant
region” of production choice.
The Production Decision
and Producer Profits
To maximize profits, the individual
producer chooses to produce (Q0)
where P* = MC (marginal benefit of
producing the additional unit equals
the marginal cost of producing the
additional unit.
Profit = (Total Revenue) – (Total Cost),
Profit = (P*)(Q0) – (Total Cost),
Profit = (P*)(Q0) – (AC)(Q0).
Producer Choice and
Profits: King David’s
Suppose that the market price for
Marshall Street lunches (P*) equals
$10.00.
King David’s chooses output (Q0)
where P* = MC.
They compute Profits as
Profits = (P*)(Q0) – (AC)(Q0).
King David’s
Production (P* = 10.0)
Output (Q) Total Cost
0
100
10
130
25
160
50
190
70
220
86
250
96
280
102
310
104
340
95
370
AC
-13.0
6.4
3.8
3.1
2.9
2.9
3.1
3.3
4.0
MC
-3.0
2.0
1.2
1.5
1.9
3.3
5.0
10.0
--
King David’s Production
Choice and Profits
They choose an output level (Q0) where
P* = MC, which corresponds to 104
lunches.
Total Revenue = (10.00)(104) = 1040.
Total Cost = 340
[approximately (AC)(Q0), or (3.3)(104)].
Profit = 1040 - 340 = 700.
Economic Profit ()
Economic Profit () – Profits for a firm
where Total Costs include the
opportunity cost of the entrepreneur
taking his/her talents to another
industry.
Zero Economic Profit ( = 0) implies
just enough accounting profits to keep
the entrepreneur in the industry.
Positive Economic Profit ( > 0) implies
accounting profits in excess of the
“minimum requirement”.
A Graphical Description
Firms choose output (Q0) where P* = MC.
Total Revenue = Area of rectangle of width
Q0 and height P*.
Total Cost = Area of rectangle of width Q0
and height AC (based upon the choice of Q0).
Profit () = Difference in areas.
Profit () can be positive (wonderful), zero
(OK), or negative (firm considers closing).
Market Response
to Positive Profits
If firms in the industry are making
positive profits, invites other firms
to enter (no barriers to entry, or no
market power).
Increases market supply (shifts
market supply curve rightward),
decreases P*.
Changes the output choice (Q0)
and decreases the profits of the
individual firm.
Market Response
to Negative Profits
If firms in the industry are making
negative profits, some firms exit
the industry.
Decreases market supply (shifts
market supply curve leftward),
increases P*.
Changes the output choice (Q0)
and increases the profits of the
(surviving) individual firms.
Perfect Competition
in the Long-Run
Perfect Competition in the Long-Run:
Zero Economic Profits ( = 0)
Ultimate long-run position of markets
under perfect competition with the
“nice assumptions”.
No incentive for new firms to enter the
market.
No incentive for existing firms to exit
the market.
The Agility of Markets
Under Perfect Competition
The ability of firms to enter highly
favorable markets or exit highly
unfavorable markets creates
“market-resolving” changes in the
equilibrium price level.
As a result -- (1) firms don’t
maintain permanent advantages
and (2) unfavorable markets don’t
stay unfavorable for the survivors.