Chapter 8
Perfect Competition
ECONOMICS: Principles and Applications, 4e
HALL & LIEBERMAN, © 2008 Thomson South-Western
Market structure
• The characteristics of a market that
influence how trading takes place
1. How many buyers and sellers?
2. Products: standardized or significantly
different?
3. Barriers to entry/exit ?
2
Market structure
• Types of markets
– Perfect competition
– Monopoly
– Monopolistic competition
– Oligopoly
3
Perfect Competition
• Many buyers and sellers
– no individual decision maker can
significantly affect the price of the
product
• Standardized product
– buyers do not perceive differences
between the products
• Sellers can easily enter/exit the market
– no significant barriers to discourage new
entrants
4
Is Perfect Competition Realistic?
• Many markets - while not strictly
perfectly competitive - come reasonably
close
• Perfect competition can approximate
conditions and yield accurate-enough
predictions in a wide variety of markets
5
The Competitive Firm’s Demand Curve
• Horizontal demand curve – perfectly
elastic - at the market price
• Output is standardized
• Price taker
– The price of its output is given
• Decision
– How much output to produce and sell
6
The Competitive Firm’s Demand Curve
• Figure 1 The Competitive Industry and Firm
1. The intersection of the market supply
and the market demand curve…
Price per
Ounce
Market
3. The typical firm can sell all it
wants at the market price…
Price per
Ounce
Firm
S
$400
$400
D
Ounces of Gold per Day
2. determines the
equilibrium market price
Demand
Curve Facing
the Firm
Ounces of Gold per Day
4. so it faces a horizontal
demand curve.
7
Cost and Revenue Data
• Marginal revenue
– Is the market price
• Marginal revenue curve
– The demand curve facing the firm
– A horizontal line at the market price
8
Profit Maximization
• Figure 2 Profit Maximization in Perfect Competition (a) TR-TC
Dollars
TR
$2,800
TC
Profit = TR-TC
Maximum Profit
per Day = $700
2,100
550
Slope = 400
1
2
3
4
5
6
7
8
9
10
Ounces of Gold per Day
9
Profit Maximization
• Figure 2 Profit Maximization in Perfect Competition (b) MR=MC
Dollars
Profit maximization
MR=MC
MC
$400
d = MR
1
2
3
4
5
6
7
8
9
10
Ounces of Gold per Day
10
Profit Maximization
•
•
•
•
Total Profit = TR – TC
MR>MC – increase output
Maximize profit: MR=MC
Measuring Total Profit
– Profit per unit = P – ATC
• If P > ATC – the firm earns profit
• If P < ATC – the firm suffers a loss
11
Measuring Profit or Loss
• Figure 3 Measuring Profit or Loss
a) Economic Profit
Total profit = profit per unit *Q
Dollars
ATC
Profit per unit=revenue per unit - cost per unit
Profit per Ounce ($100)
MC
d = MR
$400
300
MR=MC
Q=7
1
2
3
4
5
6
7
8
Ounces of
Gold per Day
12
Measuring Profit or Loss
• Figure 3 Measuring Profit or Loss
Dollars
b) Economic Loss
Total loss = loss per unit *Q
Loss per unit= cost per unit - revenue per unit
Loss per Ounce ($100)
MC
MR=MC
Q=5
ATC
$300
200
d = MR
1
2
3
4
5
6
7
8
Ounces of
Gold per Day
13
The Firm’s Short-Run Supply Curve
• The firm
– takes the market price as given
– decides how much output to produce at
that price
• Profit-maximizing output level: P=MC
– As price of output changes, firm will slide
along its MC curve in deciding how much
to produce
– Exception – If the firm is suffering a loss
large enough to justify shutting down
14
The Firm’s Short-Run Supply Curve
• Figure 4 Short-Run Supply Under Perfect Competition
(a)
(b)
Price per
Dollars
ATC
Bushel
MC
Curve
$3.50
d1=MR1
$3.50
2.50
2.00
d2=MR2
d3=MR3
2.50
2.00
d4=MR4
d5=MR5
1.00
0.50
1.00
0.50
AVC
1,000
4,000
7,000
2,000
5,000
Firm's Supply
Bushels
per Year
2,0004,000 7,000
5,000
Bushels
per Year
15
The Shutdown Price
• Price at which a firm is indifferent
between producing and shutting down
• If P>AVC – produce
• If P<AVC – shut down
• Firm’s supply curve
– Is its MC curve for all prices above AVC,
and a vertical line at zero units for all
prices below AVC.
16
Competitive Markets in the Short- Run
• Fixed number of firms in industry
• Market supply curve
– Quantity of output - all sellers in a market
will produce at different prices
– Add up the quantities of output supplied
by all firms in the market at each price
17
Competitive Markets in the Short- Run
• Figure 5 Deriving The Market Supply Curve
1. At each price . . .
3.The total supplied by all firms at different
prices is the market supply curve.
Market
Firm
Price per
Bushel
Firm's Supply Curve
Price per
Bushel
$3.50
$3.50
2.50
2.00
2.50
2.00
1.00
0.50
1.00
0.50
2,000 4,000
7,000 Bushels
per Year
5,000
2. the typical firm supplies the
profit-maximizing quantity.
Market Supply
Curve
400,000 700,000 Bushels
per Year
200,000 500,000
18
Short-Run Equilibrium
• Competitive firms can earn economic profit,
or suffer an economic loss
• The market
– sums buying and selling preferences of
individual consumers and producers, and
determines market price
• Each buyer and seller
– Takes market price as given
– Is able to buy or sell the desired quantity
19
Perfect Competition
• Figure 6 Perfect Competition
Individual
Demand
Curve
Quantity
Demanded at
Different Prices
Quantity
Supplied at
Different Prices
Added together
Market
Demand
Curve
Individual
Supply
Curve
Added together
Quantity Demanded
by All Consumers at
Different Prices
Quantity Supplied by
All Firms at Different
Prices
Market
Supply
Curve
Market Equilibrium
P
Quantity
Demanded by
Each Consumer
S
D
Q
Quantity Supplied
by Each Firm
20
Perfect Competition
• Figure 7 Short-Run Equilibrium in Perfect Competition
1. When the demand curve is D1 and
market equilibrium is here . . .
Price per
Bushel
Market
S
$3.50
2.00
D1
2. the typical firm operates here, earning
economic profit in the short run.
Firm
Dollars
MC ATC
d1
$3.50
Loss per Bushel
at p = $2
2.00
d2
Profit per Bushel
at p = $3.50
D2
400,000 700,000
3. If the demand curve shifts to
D2 and the market equilibrium
moves here . . .
Bushels
per Year
Bushels
per Year
4. the typical firm operates here and
suffers a short-run loss.
4,000
7,000
21
Competitive Markets in the Long Run
• New firms can enter the market
• Existing firms can exit the market
• Profit and loss in the long run
– Economic profit - outsiders enter the
market
– Economic losses - firms exit the market
22
From SR Profit to LR Equilibrium
– Economic profit attracts new entrants
– Market supply curve - shift rightward
– Market price - falls
– Demand curve facing each firm - shifts
downward
– Each firm - decrease output
• Positive economic profit - attracts new
entrants until economic profit = 0
23
Long-Run Equilibrium
• Figure 8 From Short-Run Profit to Long-Run Equilibrium
Market
S1
Price per
Bushel
A
$4.50
Firm
Dollars so each firm earns
an economic profit. MC
With initial supply
curve S1, market
A
price is $4.50…
$4.50
d
ATC 1
D
900,000
Bushels
per Year
9,000
Bushels
per Year
24
Long-Run Equilibrium
• Figure 8 From Short-Run Profit to Long-Run Equilibrium
Market
Firm
S1
Price per
Bushel
S2
Dollars
MC
A
$4.50
2.50
A
d
ATC 1
$4.50
E
E
2.50
d2
D
900,000 1,200,000 Bushels
5,000 9,000
per Year until market price falls to
Profit attracts entry, shifting
$2.50 and each firm earns
the supply curve rightward…
zero economic profit.
Bushels
per Year
25
From SR Loss to LR Equilibrium
– Economic losses - firms exit the market
– Market supply curve - shift leftward
– Market price - rises
– Demand curve facing each firm - shifts
upward
• Economic loses – firms exit until
economic loss = 0
• In the LR, firms earn “normal profit” zero economic profit
26
Perfect Competition and Plant Size
• In LR equilibrium, every firm will select
– Plant size
– Output level
• And
– Operate at minimum point of LRATC
curve
27
Perfect Competition and Plant Size
• Figure 9 Perfect Competition and Plant Size
3. As all firms increase plant size and
output, market price falls to its lowest
possible level . . .
Dollars
LRATC
LRATC
1. With its current plant and ATC curve
the firm earns zero economic profit.
Dollars
MC1
ATC1
d1 = MR1
MC2 ATC
P1
2
E
P*
q1
Output per
Period
2. The firm could earn positive profit
with a larger plant, producing here
d2 = MR2
Output per
Period
4. and all firms earn zero economic
profit and produce at minimum
28
LRATC.
q*
A Summary of the Competitive Firm in the LR
• In long-run equilibrium, the competitive
firm produces Q where:
•
• MC=minimum ATC=minimum LRATC=P
• Consumers are getting the best deal
they could possibly get
29