Perfect Competition

Slides by: John & Pamela Hall

ECONOMICS 3e / HALL & LIEBERMAN PERFECT COMPETITION 2005 South-Western/Thomson Learning

Perfect Competition
Sellers want to sell at the highest possible price
Buyers seek lowest possible price All trade is voluntary

When we observe buyers and sellers in action

See that different goods and services are sold in vastly different ways

When economists turn their attention to differences in trading they think immediately about market structure
Characteristics of a market that influence behavior of buyers and sellers when they come together to trade 2

Perfect Competition
To determine structure of any particular market, we begin by asking
How many buyers and sellers are there in the market? Is each seller offering a standardized product, more or less indistinguishable from that offered by other sellers
Or are there significant differences between the products of different firms?

Are there any barriers to entry or exit, or can outsiders easily enter and leave this market?

Answers to these questions help us to classify a market into one of four basic types
Perfect competition Monopoly Monopolistic Oligopoly

The Three Requirements of Perfect Competition

Large numbers of buyers and sellers, and
Each buys or sells only a tiny fraction of the total quantity in the market Sellers offer a standardized product Sellers can easily enter into or exit from market

A Large Number of Buyers and Sellers

In perfect competition, there must be many buyers and sellers
How many?
Number must be so large that no individual decision maker can significantly affect price of the product by changing quantity it buys or sells

A Standardized Product Offered by Sellers

Buyers do not perceive significant differences between products of one seller and another
For instance, buyers of wheat do not prefer one farmers wheat over another

Easy Entry into and Exit from the Market

Entry into a market is rarely freea new seller must always incur some costs to set up shop, begin production, and establish contacts with customers
But perfectly competitive market has no significant barriers to discourage new entrants
Any firm wishing to enter can do business on the same terms as firms that are already there

In many markets there are significant barriers to entry

Legal barriers Existing sellers have an important advantage that new entrants can not duplicate
Brand loyalty enjoyed by existing producers would require a new entrant to wrest customers away from existing firms

Significant economies of scale may give existing firms a cost advantage over new entrants

Easy Entry into and Exit from the Market

Perfect competition is also characterized by easy exit
A firm suffering a long-run loss must be able to sell off its plant and equipment and leave the industry for good, without obstacles

Significant barriers to entry and exit can completely change the environment in which trading takes place
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Is Perfect Competition Realistic?

Assumptions market must satisfy to be perfectly competitive are rather restrictive In vast majority of markets, one or more of assumptions of perfect competition will, in a strict sense, be violated
Yet when economists look at real-world markets, they use perfect competition more often than any other market structure

Why is this?
Model of perfect competition is powerful Many marketswhile not strictly perfectly competitivecome reasonably close

We can evenwith some cautionuse model to analyze markets that violate all three assumptions Perfect competition can approximate conditions and yield accurate-enough predictions in a wide variety of markets 9

The Perfectly Competitive Firm

When we examine a competitive market from a distance, we get one view of what is occurring
When we closely examine the individual competitive firm, we get an entirely different picture

In learning about competitive firm, must also discuss competitive market in which it operates
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Figure 1: The Competitive Industry and Firm

1. The intersection of the market supply and the market demand curve Price per Ounce Market S 3. The typical firm can sell all it wants at the market price Firm Price per Ounce

$400 D

$400

Demand Curve Facing the Firm

Ounces of Gold per Day 2. determine the equilibrium market price

Ounces of Gold per Day 4. so it faces a horizontal demand curve

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Goals and Constraints of the Competitive Firm

Perfectly competitive firm faces a cost constraint like any other firm Cost of producing any given level of output depends on
Firms production technology Prices it must pay for its inputs

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The Demand Curve Facing a Perfectly Competitive Firm

Panel (b) of Figure 1 shows demand curve facing Small Time Gold Mines
Notice special shape of this curve
Its horizontal, or infinitely price elastic

Why should this be?

In perfect competition output is standardized No matter how much a firm decides to produce, it cannot make a noticeable difference in market quantity supplied
So cannot affect market price 13

The Demand Curve Facing a Perfectly Competitive Firm

Means Small Time has no control over the price of its output
Simply accepts market price as given
In perfect competition, firm is a price taker
Treats the price of its output as given and beyond its control

Since a competitive firm takes the market price as given

Its only decision is how much output to produce and sell
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Cost and Revenue Data for a Competitive Firm

For a competitive firm, marginal revenue at each quantity is the same as the market price For this reason, marginal revenue curve and demand curve facing firm are the same
A horizontal line at the market price

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Figure 2a: Profit Maximization in Perfect Competition

Dollars $2,800 2,100 TR TC Maximum Profit per Day = $700

550

Slope = 400

8 9 10 Ounces of Gold per Day

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Figure 2b: Profit Maximization in Perfect Competition

Dollars

MC

$400

D = MR

8 9 10 Ounces of Gold per Day

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The Total Revenue and Total Cost Approach

Most direct way of viewing firms search for the profit-maximizing output level At each output level, subtract total cost from total revenue to get total profit at that output level
Total Profit = TR - TC

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The Marginal Revenue and Marginal Cost Approach

Firm should continue to increase output as long as marginal revenue > marginal cost Remember that profit-maximizing output is found where MC curve crosses MR curve from below Finding the profit-maximizing output level for a competitive firm requires no new concepts or techniques Sir slides ends here.
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Measuring Total Profit

Start with firms profit per unit
Revenue it gets on each unit minus cost per unit
Revenue per unit is the price (P) of the firms output, and cost per unit is our familiar ATC, so we can write
Profit per unit = P ATC

Firm earns a profit whenever P > ATC

Its total profit at the best output level equals area of a rectangle with height equal to distance between P and ATC, and width equal to level of output

A firm suffers a loss whenever P < ATC at the best level of output
Its total loss equals area of a rectangle
Height equals distance between P and ATC Width equals level of output

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Figure 3a: Measuring Profit or Loss

Economic Profit
Dollars ATC

Profit per Ounce ($100) $400 300

MC d = MR

Ounces of Gold per Day

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Figure 3b: Measuring Profit or Loss

Economic Loss
Dollars

MC
Loss per Ounce ($100) ATC $300 200 d = MR Ounces of Gold per Day

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The Firms Short-Run Supply Curve

A competitive firm is a price taker
Takes market price as given and then decides how much output it will produce at that price

Profit-maximizing output level is always found by traveling from the price, across to the firms MC curve, and then down to the horizontal axis, or
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
It will not produce along its MC curve It will produce zero units instead

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Figure 4: Short-Run Supply Under Perfect Competition

(a)
Dollars ATC $3.50 2.50 2.00 1.00 0.50 MC d1=MR1 d2=MR2 d3=MR3 d4=MR4 d5=MR5 Bushels 1,000 4,000 7,000 per Year 2,000 5,000

(b)
Price per
Bushel

Firm's Supply
Curve

$3.50 2.50 2.00 1.00 0.50 2,000 4,000 5,000

Bushels 7,000 per Year

AVC

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The Shutdown Price

Price at which a firm is indifferent between producing and shutting down Can summarize all of this information in a single curve firms supply curve
Tells us how much output the firm will produce at any price

Supply curve has two parts

For all prices above minimum point on its AVC curve, supply curve coincides with MC curve For all prices below minimum point on AVC curve, firm will shut down
So its supply curve is a vertical line segment at zero units of output

For all prices below $1the shutdown priceoutput is zero and the supply curve coincides with vertical axis 25

Competitive Markets in the ShortRun

Short-run is a time period too short for firm to vary all of its inputs
Quantity of at least one input remains fixed

Lets extend concept of short-run from firm to market as a whole Conclusion

In short-run, number of firms in industry is fixed

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The (Short-Run) Market Supply Curve

Once we know how to find supply curve of each individual firm in a market
Can easily determine the short-run market supply curve
Shows amount of output that all sellers in market will offer at each price
To obtain market supply curve sum quantities of output supplied by all firms in market at each price

As we move along this curve, we are assuming that two things are constant
Fixed inputs of each firm Number of firms in market

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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.

Firm
Price per Bushel $3.50 2.50 2.00 1.00 0.50 Firm's Supply Curve Price per Bushel $3.50 2.50 2.00 1.00 0.50

Market Market Supply Curve

2,000 4,000 7,000 Bushels per Year 5,000 2. the typical firm supplies the profit-maximizing quantity.

400,000 700,000 Bushels per Year 200,000 500,000

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Short-Run Equilibrium
How does a perfectly competitive market achieve equilibrium?
In perfect competition, market sums buying and selling preferences of individual consumers and producers, and determines market price
Each buyer and seller then takes market price as given
Each is able to buy or sell desired quantity

Competitive firms can earn an economic profit or suffer an economic loss

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Figure 6: Perfect Competition

Individual Demand Curve Quantity Demanded at Different Prices Quantity Supplied at Different Prices Individual Supply Curve

Added together Market Demand Curve Quantity Demanded by All Consumers at Different Prices

Added together Quantity Supplied by All Firms at Different Prices Market Supply Curve

Market Equilibrium
P S D Q

Quantity Demanded by Each Consumer

Quantity Supplied by Each Firm

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Figure 7: Short-Run Equilibrium in Perfect Competition

1. When the demand curve is D1 and market equilibrium is here . . . Price per Bushel $3.50 Market Dollars S

2. the typical firm operates here, earning economic profit in the short run.
Firm

MC ATC $3.50 Loss per Bushel at p = $2 2.00 d1

d2 Profit per Bushel at p = $3.50 4,000 7,000
Bushels per Year

2.00 D2

D1

400,000 700,000 per Year 3. If the demand curve shifts to D2 and the market equilibrium moves here . . .

Bushels

4. the typical firm operates here and suffers a short-run loss.

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Profit and Loss and the Long Run

In a competitive market, economic profit and loss are the forces driving long-run change
Expectation of continued economic profit (losses) causes outsiders (insiders) to enter (exit) the market

In real world entry and exit occur literally every day

In some cases, we see entry occur through formation of an entirely new firm Entry can also occur when an existing firm adds a new product to its line

Exit can occur in different ways

Firm may go out of business entirely, selling off its assets and freeing itself once and for all from all costs Firm switches out of a particular product line, even as it continues to produce other things

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From Short-Run Profit to Long-Run Equilibrium

As we enter long-run, much will change
Economic profit will attract new entrants
Increasing number of firms in market
As number of firms increases, market supply curve will shift rightward causing several things to happen Market price begins to fall As market price falls, demand curve facing each firm shifts downward Each firmstriving as always to maximize profitwill slide down its marginal cost curve, decreasing output

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From Short-Run Profit to Long-Run Equilibrium

This process of adjustmentin the market and the firmcontinues untilwell, until when?
When the reason for entrypositive profitno longer exits Requires market supply curve to shift rightward enough, and the price to fall enough
So that each existing firm is earning zero economic profit

In a competitive market, positive economic profit continues to attract new entrants until economic profit is reduced to zero
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Figure 8a/b: From Short-Run Profit To Long-Run Equilibrium

Market Price per Bushel A $4.50 S1 With initial supply curve S1, market price is $4.50 Dollars Firm So each firm earns an economic profit.

MC A d ATC 1

$4.50

900,000

Bushels per Year

9,000

Bushels per Year

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Figure 8c/d: From Short-Run Profit To Long-Run Equilibrium

Market Price per Bushel A $4.50 $4.50 S1 S2 Dollars MC A d ATC 1 E 2.50 D
Bushels 900,000 1,200,000

Firm

2.50

d1
Bushels per Year

per Year

5,000

9,000

Profit attracts entry, shifting the supply curve rightward

until market price falls to $2.50 and each firm earns zero economic profit.

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From Short-Run Loss to Long-Run Equilibrium

What if we begin from a position of loss?
Same type of adjustments will occur, only in the opposite direction

In a competitive market, economic losses continue to cause exit until losses are reduced to zero When there are no significant barriers to exit
Economic loss will eventually drive firms from the industry
Raising market price until typical firm breaks even again

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Distinguishing Short-Run from LongRun Outcomes

In short-run equilibrium, competitive firms can earn profits or suffer losses
In long-run equilibrium, after entry or exit has occurred, economic profit is always zero

When economists look at a market, they automatically think of short-run versus longrun
Choose the period more appropriate for question at hand
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The Notion of Zero Profit in Perfect Competition

We have not yet discussed plant size of competitive firm The same forcesentry and exitthat cause all firms to earn zero economic profit also ensure
In long-run equilibrium, every competitive firm will select its plant size and output level so that it operates at minimum point of its LRATC curve
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Perfect Competition and Plant Size

Figure 9(a) illustrates a firm in a perfectly competitive market
But panel (a) does not show a true long-run equilibrium How do we know this?
In long-run typical firm will want to expand Why?
Because by increasing its plant size, it could slide down its LRATC curve and produce more output at a lower cost per unit By expanding firm could potentially earn an economic profit

Same opportunity to earn positive economic profit will attract new entrants that will establish larger plants from the outset

Entry and expansion must continue in this market until the price falls to P*
Because only then will each firmdoing the best that it can do earn zero economic profit

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Figure 9: Perfect Competition and Plant Size

1. With its current plant and ATC curve, this firm earns zero economic profit.
Dollars MC1 LRATC ATC1 d1 = MR1 MC2 ATC E
2

3. As all firms increase plant size and output, market price falls to its lowest possible level . . .
Dollars LRATC

P1 P*

d2 = MR2 Output per Period

2. The firm could earn positive profit with a Output per 4. and all firms earn q1 larger plant, q* Period producing here. zero .economic profit and produce at minimum LRATC.

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A Summary of the Competitive Firm in the Long-Run

Can put it all together with a very simple statement
At each competitive firm in long-run equilibrium
P = MC = minimum ATC = minimum LRATC

In figure 9(b), this equality is satisfied when the typical firm produces at point E
Where its demand, marginal cost, ATC, and LRATC curves all intersect

In perfect competition, consumers are getting the best deal they could possibly get

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A Change in Demand
Short-run impact of an increase in demand is
Rise in market price Rise in market quantity Economic profits

What happens in long-run after demand curve shifts rightward?

Market equilibrium will move from point A to point C

Long-run supply curve

Curve indicating quantity of output that all sellers in a market will produce at different prices
After all long-run adjustments have taken place

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Figure 10a/b: An Increasing-Cost Industry

INITIAL EQUILIBRIUM
Price per Unit

Market
S1

Dollars

Firm
MC ATC1

P1

P1

d1 = MR1

D1 Q1 Output per Period q1 Output per Period

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Figure 10: An Increasing-Cost Industry

NEW EQUILIBRIUM
Price per Unit PSR P2 P1 A D2 D1 Q1 QSR Q2 Output per Period q1 q1 q1 Output per Period

Market
S1 B S2 SLR

Dollars PSR

Firm
B C MC ATC2 ATC1d = MR 2 2 d1 = MR1
dSR = MRSR

P2 P1

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Increasing, Decreasing, and Constant Cost Industries

Increase in demand for inputs causes price of those inputs to rise This type of industry (which is the most common) is called an increasing cost industry
Entry causes input prices to rise
Shifts up typical firms ATC curve
Raises market price at which firms earn zero economic profit As a result, long-run supply curve slopes upward

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Increasing, Decreasing, and Constant Cost Industries

Other possibilities
Industry might use such a small percentage of total inputs that even as new firms enterthere is no noticeable effect on input prices
Called a constant cost industry
Entry has no effect on input prices, so typical firms ATC curve stays put Market price at which firms earn zero economic profit does not change Long-run supply curve is horizontal

Decreasing cost industry, in which entry by new firms actually decreases input prices
Entry causes input prices to fall
Causes typical firms ATC curve to shift downward Lowers market price at which firms earn zero economic profit As a result, long-run supply curve slopes downward

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Market Signals and the Economy

In real world, demand curves for different goods and services are constantly shifting As demand increases or decreases in a market, prices change Economy is driven to produce whatever collection of goods consumers prefer In a market economy, price changes act as market signals, ensuring that pattern of production matches pattern of consumer demands
When demand increases, a rise in price signals firms to enter market, increasing industry output When demand decreases, a fall in price signals firms to exit market, decreasing industry output

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Market Signals and the Economy

Market signal
Price changes that cause firms to change their production to more closely match consumer demand

No single person or government agency directs this process

This is what Adam Smith meant when he suggested that individual decision makers act for the overall benefit of society
Even though, as individuals, they are merely trying to satisfy their own desires As if guided by an invisible hand

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Using the Theory: Changes in Technology

Competitive markets ensure that technological advances are turned into benefits for consumers One industry that has experienced especially rapid technological changes in the 1990s is farming Lets see what happens when new, higher-yield corn seeds are made available
Suppose first that only one farm uses the new technology

In long-run, economic profit at this farm will cause two things to happen
All other farms in market will have a powerful incentive to adopt new technologyto plant the new, genetically engineered seed themselves Outsiders will have an incentive to enter this industry with plants utilizing the new technology
Shifting market supply curve rightward and driving down the market price

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Using the Theory: Changes in Technology

Can draw two conclusions about technological change under perfect competition
All farms in the market must use the new technology Gainers are consumers of corn, since they benefit from the lower price

Impact of technological change

Under perfect competition, a technological advance leads to a rightward shift of market supply curve, decreasing market price
In short-run, early adopters may enjoy economic profit, but in long-run, all adopters will earn zero economic profit Firms that refuse to use the new technology will not survive

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Using the Theory: Changes in Technology

Technological advances in many competitive industries have spread quickly
Shifting market supply curves rapidly and steadily rightward over the past 100 years
While this has often been hard on individual competitive firms it has led to huge rewards for consumers

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Figure 11: Technological Change in Perfect Competition

Market
Price per Bushel S1 Dollars per Bushel ATC1 $3 B 2 D 2 d2= MR ATC2 d1 = MR1

Firm

S2

A
$3

Q1

Q2

Bushels per Day

1000

Bushels per Day

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