1.5.

Theory of the Firm

Perfect Competition

Perfect competition describes a market structure whose assumptions are

extremely strong and highly unlikely to exist in most real-time and real-world
markets. The reality is that most markets are imperfectly competitive.
Nonetheless, there is some value in understanding how price, output and
equilibrium is established in both the short and the long run in a market that
holds true to the tough assumptions of a world of perfect competition.

Economists have become more interested in pure competition partly because of

the rapid growth of e-commerce as a means of buying and selling goods and
services. And also because of the popularity of auctions as a rationing device for
allocating scarce resources between competing ends.

Basic assumptions for pure competition to exist:

1. Many small firms, each of whom produces an insignificant percentage of
total market output and thus exercise no control over the ruling market
price.
2. No single firm can influence the market price, or market conditions. The
single firm is said to be a price taker, taking its price from the whole
industry. The single firm will not increase its price independently given
that it will not sell any goods at all. Neither will the rational producer lower
price below the market price given that it can sell all it produces at the
market price.
3. Many individual buyers, none of who has any control over the market
price
4. Perfect freedom of entry and exit from the industry. Firms face no sunk
costs - entry and exit from the market is feasible in the long run. This
assumption ensures all firms make normal profits in the long run.
5. Homogeneous products are produced that are perfect substitutes for each
other. This leads to each firms being price takers and facing a perfectly
elastic demand curve for their product.
6. Perfect knowledge consumers have readily available information about
prices and products from competing suppliers and can access this at zero
cost in other words, there are few transactions costs involved in
searching for the required information about prices.
7. No externalities arising from production and/or consumption, which lie
outside the market.
8. Given that producers and consumers have perfect knowledge, it is assumed
that they make rational decisions to maximize their self-interest -

1
 consumers look to maximize their utility, and producers look to maximize
their profits (produce where MC = MR).
9. Firms can only make normal profits in the long run, although they can make
abnormal (super-normal) profits in the short run.

Equilibrium under perfect competition

The firm as price taker

The single firm takes its price from the industry, and is, consequently, referred to
as a price taker. The industry is composed of all firms in the industry and the
market price is where market demand is equal to market supply. Each single firm
must charge this price and cannot diverge from it.

Questions
1: Explain why in a perfectly competitive market, the firm is a price taker. Why
cant the firm choose the price at which it sells its good?

2: Explain why a perfectly competitive firm would or would not advertise.

2
Perfect Competition and Profit Maximisation

The goal of a competitive firm is to maximize profit.

This means that the firm will want to produce the quantity that maximizes
the difference between total revenue and total cost.

3
 Profit maximization occurs at the quantity where marginal revenue equals
marginal cost.

Relationship between MR and MC

When MR > MC increase Q

When MR < MC decrease Q
When MR = MC Profit is maximized.

4
The firms decision regarding shut-down

A shutdown refers to a short-run decision not to produce anything during a

specific period of time because of current market conditions. Exit refers to a long-
run decision to leave the market.

The firm considers its sunk costs when deciding to exit, but ignores them when
deciding whether to shut down. Sunk costs are costs that have already been
committed and cannot be recovered.

The firm shuts down if the revenue it gets from producing is less than the
variable cost of production.
Shut down if TR < VC
Shut down if TR/Q < VC/Q
Shut down if P < AVC

The portion of the marginal-cost curve that lies above average variable cost is the
competitive firms short-run supply curve.

5
The firms decision regarding exit
In the long run, the firm exits if the revenue it would get from producing is less
than its total cost.
Exit if TR < TC
Exit if TR/Q < TC/Q
Exit if P < ATC

The competitive firms long-run supply curve is the portion of its marginal-cost
curve that lies above average total cost.

Summary

Short-Run Supply Curve

The portion of its marginal cost curve that lies above average variable cost

Long-Run Supply Curve

The marginal cost curve above the minimum point of its average total cost curve

6
Questions

3: Imagine that the restaurant industry is perfectly competitive. Joes Diner is

always packed in the evening but rarely has a customer at lunchtime. Why
doesnt Joes Diner close at lunchtime temporarily shut down?
- Not to lose market share
- Publicity benefits
- Gain revenue to cover the fixed costs (In this case, the price must be equal
to or higher than the average variable cost)

4: Tulip growing is a perfectly competitive industry, and all tulip growers have
the same cost curves. The market price of tulips is $25 (MR and AR) a bunch, and
each grower maximises profit by producing 2000 bunches a week. The average
total cost of producing tulips is $20 a bunch, and the average variable cost is $15
a bunch. Minimum average variable cost is $12 a bunch.
(a) What is the economic profit that each grower is making in the short run?
$5*2000= $10000
(b) What is the price at the growers shutdown point? <$12
(c) What is each growers profit at the shutdown point?

5: Cost figures for a hypothetical firm are given in the following table. Use them to
answer the questions below. The firm is selling in a perfectly competitive market.

Output FC ($) AFC VC ($) AVC TC ATC MC

1 50 50 30 30 80 80 -
2 50 25 50 25 100 50 20
3 50 50/3 80 80/3 130 43.3 30
4 50 50/4 120 50/4 170 42.5 40
5 50 10 170 10 220 44 50

(a) Fill in the blank columns

(b) What is the minimum price needed by the firm to break even?
(c) What is the shutdown price?
(d) At a price of $40, what output level would the firm produce? What would its
profits be?

6: Sarahs Salmon Farm produces 1000 fish a week. The marginal cost is $30 a
fish, average variable cost is $20 a fish, and the market price is $25 a fish. Is Sarah
maximising profit? Explain why or why not. If Sarah is not maximising profit, to
do so, will she increase or decrease the number of fish she produces in a week?
MR= $25, MC= $30 No profit maximizing
She should increase the number of fish produced to cover the fixed costs

7
7: Suppose the industry equilibrium price of residential housing construction is
$100 per square foot and the minimum average variable cost for a residential
construction contractor is $110 per square foot. What would you advise the
owner of this firm to do? Explain.
The first thing is to assess the
8: Myrtle Beach, South Carolina, is lined with virtually identical motels.
Summertime rates run about $100 a night. During the winter, one can find rooms
for as little as $20 a night. Assume the average fixed cost of a room per night
including insurance, taxes and depreciation is $50. The average guest-related cost
for a room each night, including maid service and linens, is $15. Would these
motels be better off renting rooms for $20 in the off-season or shutting down
until summer?

9: You are considering building a Rent Your Own Storage Center. You are trying
to decide whether to build 50 storage units at a total economic cost of $200000,
100 storage units at a total economic cost of $300000, or 200 storage units at a
total economic cost of $700000. If you wish to survive in the long run, which size
will you choose?

8
Profits and losses in perfect competition

9
Short-run equilibrium under perfect competition

Under perfect competition, firms can make super-normal profits or losses.

10
In the long run

However, in the long run firms are attracted into the industry if the incumbent
firms are making supernormal profits. This is because there are no barriers to
entry and because there is perfect knowledge. The effect of this entry into the
industry is to shift the industry supply curve to the right, which drives down
price until the point where all super-normal profits are exhausted. If firms are
making losses, they will leave the market as there are no exit barriers, and this
will shift the industry supply to the left, which raises price and enables those left
in the market to derive normal profits.

In the long run

The super-normal profit derived by the firm in the short run acts as an incentive
for new firms to enter the market, which increases industry supply and market
price falls for all firms until only normal profit is made.

11
Example of an increase in demand in the short run

12
 An increase in demand raises price and quantity in the short run.
Firms earn profits because price now exceeds average total cost.

13
Questions

10: What can you expect from an industry in perfect competition in the long run?
What will price be? What quantity will be produced? What will be the relation
between marginal cost, average cost and price?

11: Trout farming is a perfectly competitive industry, and all trout farms have the
same cost curves. The market price is $25 a fish. To maximise profit, each farm
produces 200 fish a week. Average total cost is $20 a fish, and average variable
cost is $15 a fish. Minimum average variable cost is $12 a fish.

(a) If the price falls to $20 a fish will trout farms continue to produce 200 fish a
week? Explain why or why not.
(b) If the price falls to $12 a fish, what will the trout farmer do?

12: 3M created Post-it Notes, also known as sticky notes. Soon many other firms
entered the sticky note market and started to produce sticky notes.

(a) What was the incentive for these firms to enter the sticky note market?

14
(b) As time goes by, do you expect more firms to enter this market? Explain why
or why not?
(c) Can you think of any reason why any of these firms might exit the sticky note
market?

13: When Rod Laver completed his first grand slam in tennis in 1962, all rackets
were made of wood. Today, tennis players use graphite rackets. As the demand
for wooden tennis rackets decreased permanently, how did the profits of the
firms producing wooden tennis rackets change? As some of these firms switched
to producing graphite rackets, how did their economic profits change?

14: Consider this statement: When marginal revenue equals marginal cost, total
cost equals total revenue, and the firm makes zero profit. Do you agree or
disagree? Explain.

15: The perfectly competitive firm will sell all the quantity of output consumers
will buy at the prevailing market price. Do you agree or disagree? Explain your
answer.

Efficient allocation of resources

Economists are concerned about the efficiency of markets, and ensuring that
resources are allocated efficiently.
Perfect competition is considered to be efficient because:
Supernormal profits are not made by any firm in perfect competition in the
long-run.
MC = price, so both parties, suppliers and customers, get exactly what they
want.
No wasteful advertising.
Firms are allocatively and productively efficient.
The major assumption behind this analysis and evaluation is that firms cannot
produce products cheaper if they were bigger. It assumes that there are no
economies of scale available in the market.

Allocative efficiency

Allocative efficiency occurs when the value consumers put on the good or
service equals the cost of producing the product or service. In other words,
when price = marginal cost.
15
We can see from Figure 1 below that when it is in long-run equilibrium, perfect
competition achieves allocative and productive efficiency as MC = MR = AC = AR.
This means that they are maximizing profits (MC = MR) but only making normal
profit (AC = AR).

Productive efficiency

Productive efficiency occurs when output is achieved at the minimum average

cost.

Figure 1: Long run equilibrium - perfect competition

So, perfect competition looks good, but is it always so? Problems with perfect
competition are:
There are no reasons to do anything better, or research new products.
As soon as you do, everybody else would step in and copy. Wait and let
somebody else do it.
Consumer has no choice. There is just one unbranded product on the
market.
Some economies of scale always exist.
Perfect competition is not competitive in the fullest sense of the word!
Barriers to entry will always exist. Even street traders will usually be
required to apply for and, usually, buy a trading license.

Look at economies of scale. Some are always likely to exist. Financial economies
apply - the better your reputation the cheaper the loans, bulk-buying economies
are there as well. Economies of scale are there, like gravity. It is up to the firm to
take advantage of them. Competition encourages their application and
exploitation.

16
Perfect competition may well operate efficiently, as far as economists are
concerned. The consumer, however, may get an ordinary product or service at a
high price. Is it worth it?

Evaluation
The benefits
It can be argued that perfect competition will yield the following benefits:
1. Because there is perfect knowledge, there is no information failure and
knowledge is shared evenly between all participants.
2. There are no barriers to entry, so existing firms cannot derive
any monopoly power.
3. Only normal profits made, so producers just cover their opportunity cost.
4. There is no need to spend money on advertising, because there is perfect
knowledge and firms can sell all they can produce. In addition, selling
unbranded goods makes it hard to construct an effective advertising
campaign.
5. There is maximum possible:
o Consumer surplus
o Economic welfare
6. There is maximum allocative and productive efficiency:
o Equilibrium will occur where P = MC, hence allocative efficiency.
o In the long run equilibrium will occur at output where MC = ATC,
which is productive efficiency.
7. There is also maximum choice for consumers.

17
How realistic is the model?

Very few markets or industries in the real world are perfectly competitive. For
example, how homogeneous is the output of real firms, given that even the
smallest of firms working in manufacturing or services try to differentiate their
product.

The assumption that producers and consumers act rationally is questioned

by behavioural economists, who have become increasingly influential over the
last decade. Numerous experiments have demonstrated that decision-making
often falls well short of what could be described as perfectly rational. Decision-
making can be biased and subject to rule of thumb guidance when consumers
and producers are faced with complex situations.

Although unrealistic, it is still a useful model in two respects. Firstly, many

primary and commodity markets, such as coffee and tea, exhibit many of the
characteristics of perfect competition, such as the number of individual
producers that exist, and their inability to influence market price. Secondly, for
other markets in manufacturing and services, the model is a useful yardstick by

18
which economists and regulators can evaluate levels of competition that exist in
real markets.

19